As more fully discussed in Note F to the consolidated financial statements, at December 31, 2007, $70.5 million, or 19% of shareholders’ equity, represented net assets of the Company’s insurance subsidiaries which, at that time, could not be transferred in the form of dividends, loans or advances to the parent company because of minimum statutory capital requirements. However, management believes that these restrictions pose no material liquidity concerns for the Company. The financial strength and stability of the subsidiaries permit ready access by the parent company to short-term and long-term sources of credit. The Company has no debt outstanding at December 31, 2007.
Direct premiums written for 2007 totaled $176.1 million, a decrease of $8.0 million (4%) from 2006. This decrease is primarily attributable to a decrease in the Company’s private passenger automobile business of $10.4 million (31%), a small fleet trucking program decrease of $8.3 million (32%) and a large trucking fleet decrease of $14.2 million (22%). These decreases were partially offset by increases in the Company’s independent contractor program of $23.9 million (42%). Decreases in direct premiums written volume were a result of ongoing rate competition and the resultant loss of business. The higher premium volume from the independent contractor program resulted from the addition of contractors by existing accounts and from modifications to the program whereby workers’ compensation coverages were offered to employees of the independent contractors.
After giving effect to changes in unearned premiums, net premiums earned increased 5% to $179.1 million for 2007 from $169.8 million for 2006. Net premiums earned from all trucking-related insurance products (large trucking fleet, independent contractor and small fleet trucking) program increased by $1.8 million (2%). Additionally, net premiums earned from non-affiliated reinsurance assumed increased by $13.4 million (102%). Net premiums earned from the Company’s private passenger automobile decreased by $6.8 million (19%).
The Fleet trucking loss ratio for 2007 was favorably impacted by an increase in savings on prior year losses and a continued low frequency of extremely severe accidents. Factors such as fluctuations in premium volume, the levels of self-insured retentions and the Company’s higher net retention under reinsurance treaties in recent years tend to allow for more volatility in losses. The increase in the private passenger automobile loss ratio is associated with product modifications as competitive market conditions are ongoing. The lower small fleet trucking loss ratio resulted from a decrease in the frequency and severity of current year accidents as the Company discontinued marketing its products in certain unfavorable geographic areas and insured groups. The loss ratio for reinsurance assumed increased as the result of the Company’s expansion of catastrophe coverages to the U.S. Midwest during 2007. An unusually large number of tornado and hail losses were incurred resulting in a loss ratio of 94.5% on this book of business. The reinsurance assumed loss ratio for the year was 33.0%, or slightly lower than 2006 on our other reinsurance assumed book of business.
The Company produced an overall savings on the handling of prior year claims during 2007 of $21.3 million. This net savings is included in the computation of loss ratios shown in the table insert, as is the $16.9 million savings produced during 2006 on prior year claims. Approximately $9.0 million of the $15.9 million savings from fleet trucking relates to favorable claim settlements in the Company’s independent contractor program. The remaining savings relates to the Company’s large fleet trucking business and is generally consistent with recent prior years before consideration of savings related to retrospectively-rated contracts. Because of the high limits provided by the Company to its large trucking fleet insureds, the length of time necessary to settle larger, more complex claims and the volatility of the trucking liability insurance business, the Company believes it is important to take a conservative posture in its reserving process. As claims are settled in years subsequent to their occurrence, the Company’s claim handling process has, historically, tended to produce savings from the reserves provided. Changes in both gross premium volumes and the Company’s reinsurance structure for its fleet trucking business can have a significant impact on future loss developments and, as a result, loss and loss expense ratios and prior year reserve development may not be consistent year to year.
Other operating expenses for 2007, before credits for allowances from reinsurers, increased $9.7 million (19.9%) to $58.4 million. This increase is due primarily to a $5.2 million increase in commission expense related to non-affiliated workers’ compensation business. Commission expense increased by an additional $2.9 million related to commissions on increased reinsurance assumed premium volume. Additionally, 2006 operating expenses were favorably impacted by a recovery of nearly $1 million previously written off related to bankrupt reinsurers. After consideration for these three items, expenses before ceding allowances increased $.6 million, or 1.2% from 2006. In general, only commissions to independent agents, premium taxes and other acquisition costs vary directly with premium volume. Much of the Company’s expense structure is fixed, that is, expenses do not vary directly with revenue, as revenue consists principally of net premiums earned by the insurance subsidiaries.
Reinsurance ceded credits were $.8 million (69%) higher in 2007, resulting from the Company retaining a lesser percentage of the gross premium for its own account under recent reinsurance treaties.
Substantially all fleet trucking business is produced by direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Instead, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. are included in operating expenses. In general, commissions paid by the insurance subsidiaries to the parent company exceed related acquisition costs incurred in the
Direct premiums written for 2006 totaled $184.1 million, a decrease of $25.4 million (12%) from 2005. This decrease is primarily attributable to a decrease in fleet trucking liability premiums of $38.8 million (37%) from 2005 levels. Direct premium writings from the Company’s private passenger automobile program also decreased by $4.5 million (12%). These decreases were partially offset by increases in the Company’s independent contractor and small fleet trucking programs of $7.8 million (15%) and $10.5 million (67%), respectively. Large trucking fleet volume decreased as the result of ongoing rate competition, which resulted in the loss of business and the writing of lower limits for renewed accounts. Increased competitive pressures were also responsible for the decline in premium volume from the private passenger automobile program. The higher premium volume from the independent contractor program resulted from the addition of contractors by existing accounts and the increase in premium volume from the small fleet trucking program was due to geographic expansion, increased marketing efforts and slightly improved competitive conditions.
Premiums assumed from other insurers and reinsurers totaled $12.9 million during 2006, an increase of $1.2 million (10%) from 2005, which included $2.0 million of reinstatement premiums related to the 2005 hurricanes. The increase disregarding reinstatement premiums was 33%, reflective of higher premium rates following the hurricane activity of 2004 and 2005. Premium volume from reinsurance assumed will fluctuate depending on the favorability of pricing for the coverages provided. Further, premium volume for this segment is limited by the Company’s self-imposed limitation to loss from a single catastrophic event.
After giving effect to changes in unearned premiums, net premiums earned decreased 9% to $169.8 million for 2006 from the record $186.2 million for 2005. Excluding inter-company reinsurance arrangements, net premiums earned from all trucking-related insurance products decreased by $9.6 million (7%). Net premiums earned from the Company’s private passenger automobile and discontinued small business workers’ compensation programs also decreased by $4.1 million (11%) and $2.7 million (99%), respectively. An increase in net premiums earned from non-affiliated reinsurance assumed of $1.2 million (10%) was offset by a $1.0 million (73%) decrease in premiums assumed from involuntary residual markets.
Net gains on investments totaled $17.1 million in 2006 compared to $23.0 million in 2005. These totals include gains from both direct securities trading and investments in limited partnerships. The decrease in gains in 2006 is attributable to lower direct investing activities and a $3.6 million decline in the earnings of limited partnership investments. The Company’s investments in limited partnership ventures, consists primarily of securities trading and small venture capital activities and,
The Company produced an overall savings on the handling of prior year claims during 2006 of $16.9 million. This net savings is included in the computation of loss ratios shown in the table insert. Approximately $7.2 million of this savings relates to retrospectively-rated contracts whereby return premiums were recorded concurrently with the loss savings. The majority of the remaining $9.7 million in savings relates to the Company’s large fleet trucking business, generally consistent with, but higher than, recent prior years. Because of the high limits provided by the Company to its large trucking fleet insureds, the length of time required to settle larger, more complex claims and the volatility of the trucking liability insurance business, the Company has long favored a conservative posture in its reserving process. As claims are settled in years subsequent to their occurrence, the Company’s claim handling process has, historically, tended to produce savings from the reserves provided. Changes in both gross premium volumes and the Company’s reinsurance structure for its large trucking fleets can have a significant impact on future loss developments and, as a result, loss and loss expense ratios and prior year reserve development may not be consistent year to year.
All marketable securities are included in the Company’s balance sheet at current fair market value.
In determining if and when a decline in market value below cost is other-than-temporary, we first make an objective analysis of each individual security where current market value is less than cost. For any security where the unrealized loss exceeds 20% of original or adjusted cost, and where that decline has existed for a period of at least six months, the decline is treated as an other-than-temporary impairment, without any subjective evaluation as to possible future recovery. For individual issues where the decline in value is less than 20% but the amount of the decline is considered significant, we will also evaluate the market conditions, trends of earnings, price multiples and other key measures for the securities to determine if it appears that the decline is other-than-temporary. In those instances, the Company also considers its intent and ability to hold investments until recovery or maturity. For any decline which is considered to be other-than-temporary, we recognize
an impairment loss in the current period earnings as an investment loss. Declines which are considered to be temporary are recorded as a reduction in shareholders’ equity, net of related federal income tax credits.
For the three years in the period ended December 31, 2007, reinsurance ceded transactions were as follows:
It should be noted, however, that a change in the estimate of amounts due from reinsurers on unpaid claims will not, in itself, result in charges or credits to losses incurred. This is because any change in estimated recovery follows the estimate of the underlying loss. Thus, it is the computation of the underlying loss that is critical.
The Company’s loss and loss expense reserves for each significant segment are shown in the following table for direct and assumed and on a net of reinsurance basis at December 31, 2007 and 2006. Those lines of business individually comprising less than three percent of the Company’s total reserves are shown in the aggregate as “All other”.
The reserving process requires management to continuously monitor and evaluate the life cycle of claims based on the class of business and the nature of claims. Our claims range from the very routine private passenger automobile “fender bender” to the highly complex and costly third party bodily injury claim involving large tractor-trailer rigs. Reserving for each class of claims requires a set of assumptions based upon historical experience, knowledge of current industry trends and seasoned judgment. The high limits provided in the Company’s trucking liability policies provide for greater volatility in the reserving process for more serious claims. Court rulings, legislative actions and trends in jury awards also play a significant role in the estimation process of larger claims. The Company continuously reviews and evaluates loss developments subsequent to each measurement date and adjusts its reserve estimation assumptions, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time. Changes to previously established reserve amounts are charged or credited to losses and loss expenses incurred in the accounting periods in which they are determined. Note C to the consolidated financial statements includes additional information relating to loss and loss adjustment expense reserve development.
Management is aware of the potential for variation from the reserves established at any particular point in time. Redundancies or deficiencies could develop in future valuations of the currently established loss and loss expense reserve estimates under a variety of reasonably possible scenarios. The Company’s reserve selections are developed to be a “best estimate” of unpaid loss at a point in time and, due to the unique nature of our exposures, particularly in the large fleet trucking excess product where insured’s policies of insurance combine large self-insured retentions with high policy limits, ranges of reserve estimates are not established during the reserving process. However, basic assumptions that could potentially impact future volatility of our valuations of current loss and loss expense reserve estimates include, but are not limited to, the following:
retentions, policy limits and reinsurance structure may vary widely period to period
To the extent possible, the Company attempts to recover the costs of inflation by increasing the premiums it charges. Within the fleet trucking business, a majority of the Company’s premiums are charged as a percentage of an insured’s gross revenue or payroll. As these charging bases increase with inflation, premium revenues are immediately increased. The remaining premium rates charged are adjustable only at periodic intervals and often require state regulatory approval. Such periodic increases in premium rates may lag far behind cost increases.
The most significant of the three identified market risks relates to prices in the equities market. Though not the largest category of the Company’s invested assets, equity securities have a high potential for short-term price fluctuation. The market value of the Company’s equity positions at December 31, 2007 was $99.7 million or approximately 15% of invested assets. This market valuation includes $54.5 million of appreciation over the cost basis of the equity security investments. Funds invested in the equities market are not considered to be assets necessary for the Company to conduct its daily operations and, therefore, can be committed for extended periods of time. The long-term nature of the Company’s equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuations, is the primary focus.
The Company’s fixed maturity portfolio totaled $338.0 million at December 31, 2007. Approximately 91% of this portfolio is made up of U.S. Government and government agency obligations and state and municipal debt securities; 87% of the portfolio matures within 5 years; and the average life of the Company’s fixed maturity investments is approximately 3.7 years. Although the Company is exposed to interest rate risk on its fixed maturity investments, given the anticipated duration of the Company’s liabilities (principally insurance loss and loss expense reserves) relative to investment maturities, even a 100 to 200 basis point increase in interest rates would not have even a moderate impact on the Company’s ability to conduct daily operations or to meet its obligations.
There is an inverse relationship between interest rate fluctuations and the fair value of the Company’s fixed maturity investments. Additionally, the fair value of interest rate sensitive instruments may be affected by the financial strength of the issuer, prepayment options, relative values of alternative investments, liquidity of the investment and other general market conditions. The Company monitors its sensitivity to interest rate risk by measuring the change in fair value of its fixed maturity investments relative to hypothetical changes in interest rates. As previously indicated, several other factors can impact the fair values of fixed maturity investments and, therefore, significant variations in market interest rates could produce quite different results from the hypothetical estimates presented in the next paragraph.
market and short-term investments, bonds maturing within twelve months and expected positive cash flow from operations for 2007 is equal to more than 100% of net loss and loss expense reserves at December 31, 2007.
The investment commitments in the above table relate to maximum unfunded capital obligations for limited partnership investments and other investments at December 31, 2007 and were funded through the disposal of equity securities during the fourth quarter of 2007, the proceeds of which are included in cash equivalent investments at year end.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc. and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, changes in equity other than capital, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Baldwin & Lyons, Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
In the ordinary course of business, the Company’s federal income tax returns are audited by the Internal Revenue Service. Deferred income tax assets and liabilities are recognized for temporary differences between the financial statement and tax return bases of assets and liabilities based on enacted tax rates and laws. The deferred tax benefits of the deferred tax assets are recognized to the extent realization of such benefits is more likely than not. Deferred income tax expense or benefit generally represents the net change in deferred income tax assets and liabilities during the year. Current income tax expense represents the tax consequences of revenues and expenses currently taxable or deductible on various income tax returns for the year reported.
The Company’s fixed maturity investment portfolio is sensitive to interest rate fluctuations, which impact the fair value of individual securities. Accordingly, unrealized losses on fixed maturity securities reported above were generally caused by the effect of a rising interest rate environment on certain securities with stated interest rates currently below market rates. The Company has the ability and intent to hold these fixed maturity securities until their full cost can be recovered. Therefore, the Company does not believe the unrealized losses represent an other-than-temporary impairment as of December 31, 2007.
The fair value and the cost or amortized cost of fixed maturity investments, at December 31, 2007, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers have, in some cases, the right to call or prepay obligations with or without call or prepayment penalties.
The 2007 net gains from limited partnerships, as shown in the above table, include approximately $15,300 of unrealized gains as reported in the net income of the various partnerships. Shareholders’ equity includes approximately $30,500 million, net of deferred federal income taxes, of earnings yet undistributed by limited partnerships as of December 31, 2007.
There is no primary or secondary market for the Company’s investments in limited partnerships and, in most cases, the Company is prohibited from disposing of its limited partnership interests for some period of time and must seek approval from the general partner for any such disposal. Distributions of earnings from these partnerships are largely at the sole discretion of the general partners and distributions are generally not received by the Company for many years after the earnings have been reported. The Company has commitments to contribute an additional $1,600 to various limited partnerships as of December 31, 2007.
respectively. During 2007, 2006 and 2005, the Company has recorded management fees of $765, $604 and $481, respectively, and performance-based fees of $4,902, $1,587 and $1,687, respectively, to these organizations for management of these limited partnerships. The Company has been informed that the fee rates applied to its investments in these limited partnerships are the same as, or lower than, the fee rates charged to unaffiliated customers for similar investments.
The fair value of regulatory deposits with various insurance departments in the United States and Canada totaled $23,432 at December 31, 2007.
The Company’s limited partnerships include one significant investment accounted for using the equity method, which exceeds 10% of earnings. This limited partnership investment’s value as of December 31, 2007 and 2006 was $44,716 and $27,492, respectively. At December 31, 2007, the Company’s ownership interest in this limited partnership investment was less than 4%.
Favorable loss development is influenced by the Company’s long-standing policy of reserving for losses realistically and a willingness to settle claims based upon a seasoned evaluation of its exposures. Reserve savings developed related to retrospectively-rated accident and health business resulted in the concurrent recording of return premiums of approximately $662, $4,738 and $4,484 for the years ended December 31, 2007, 2006 and 2005, respectively. As more fully discussed in Note D, the Company has generally increased its per occurrence retention of risk related to trucking liability business over the past several years. The increased net retention per occurrence is reflected in the increasingly favorable developments on other direct business during 2007, 2006 and 2005. These trends were considered in the establishment of the Company’s reserves at December 31, 2007 and 2006.
The Company has not changed its original estimate for the loss sustained as a result of the terrorist attacks of September 11, 2001. Therefore, there is no impact on the loss developments shown in the above table except for payments against the original established reserves. The Company has paid $11,100 to date and carries a remaining reserve of $8,900 at December 31, 2007.
The insurance subsidiaries cede portions of their gross premiums written to certain other insurers under excess and quota share treaties and by facultative placements. Risks are reinsured with other companies to permit the recovery of a portion of related direct losses. Management determines the amount of net exposure it is willing to accept generally on a product line basis. Certain treaties covering large fleet trucking include annual deductibles which must be exceeded before the Company can recover under the terms of the treaty. In these cases, the Company retains a higher percentage of the direct premium in consideration of the deductible provisions. The Company remains liable to the extent the reinsuring companies are unable to meet their obligations under reinsurance contracts.
Net losses and loss expenses incurred for 2007, 2006 and 2005 have been reduced by ceded reinsurance recoveries of approximately $4,981, $14,026 and $39,389, respectively. Ceded reinsurance premiums and loss recoveries for catastrophe reinsurance contracts were not material.
Net losses and loss expenses incurred for 2007, 2006 and 2005 include approximately $14,638, $2,623 and $20,152 relating to reinsurance assumed from non-affiliated insurance or reinsurance companies, including involuntary residual market pools. The assumed reinsurance losses in 2006 and 2005 included $1,457 and $17,595 respectively, related to hurricanes Katrina and Wilma, before reinstatement premium.
Cash flows related to federal income taxes paid, net of refunds received, for 2007, 2006 and 2005 were $14,502, $16,097, and $12,147, respectively.
The Company recognizes accrued interest and penalties, if any, related to unrecognized tax benefits in income tax expense and changes in such accruals would impact the Company’s effective tax rate. Amounts accrued for the payment of interest at December 31, 2007 and December 31, 2006 were not material.
Net income of the insurance subsidiaries, as determined in accordance with statutory accounting practices, was $35,605, $26,632, and $18,221 for 2007, 2006 and 2005, respectively. Consolidated statutory surplus for these subsidiaries was $360,965 and $343,974 at December 31, 2007 and 2006, respectively.
Minimum statutory surplus necessary for the insurance subsidiaries to satisfy statutory risk based capital requirements was $70,489 at December 31, 2007.
Under the Director Option Plan (the Director Plan), which is shareholder approved, the Company has reserved 300,000 shares of Class B common stock for the granting of discounted and market value options to non-employee directors. Approximately 167,000 shares of Class B common stock are available for future grants. No options were granted to directors during 2007 and 2006. Additionally, no discounted options were outstanding at December 31, 2007 and 2006. Prior to May, 2005, discounted options were granted to non-employee directors in lieu of cash directors’ fees. In addition, during 2005 non-employee directors were each granted 1,500 options at market value on the date of grant as part of their regular annual directors’ fees. During 2006, all market value options were terminated, without compensation to the directors, and all subsequent directors’ fees have been paid in cash. It is not anticipated that any additional grants will be made to directors under this plan as part of their regular directors’ compensation.
Under the Employee Option Plan (the Employee Plan), which is shareholder approved, the Company has reserved 1,125,000 shares of Class B common stock for the granting of discounted and market value options to employees. Approximately 259,000 shares of Class B common stock are available for future grants. No options were granted to employees during the three year period ended December 31, 2007. Discounted options granted to employees in the past were exercisable immediately. Market value options granted to employees in the past vested over three years. All options expired ten years from the date of grant. No options remain outstanding at December 31, 2007. During 2007 all options were exercised at $20.60 per share.
A summary of option activity under the Employee Plan as of December 31, 2007, and changes during the year then ended is presented below:
The Company’s policy is to issue new shares to satisfy share option exercises.
The above amounts for voluntary reinsurance assumed include certain intersegment reinsurance agreements. Intersegment premiums earned during 2007, 2006 and 2005 were $2,314, $2,283 and $1,570, respectively. Intersegment losses and loss expenses incurred during 2007, 2006 and 2005 were $2,994, $3,005 and $1,595, respectively. Reinsurance assumed premium written for 2007 is shown net of $4,800 representing the cost of a retrocession limiting the Company’s probable maximum loss on its assumed book of business.
The Company writes policies of excess insurance attaching above a self-insured retention (“SIR”) and also writes policies that contain large, per-claim deductibles. Those losses and claims that fall within the SIR or deductible are obligations of the insured. The Company also writes surety bonds in favor of various regulatory agencies guaranteeing the insured’s payment of claims within the SIR. Losses and claims under a large deductible policy are payable by the Company with reimbursement due the Company from the insured. The Company requires collateral from its insureds to serve as a source of reimbursement if the Company is obligated to pay claims within the SIR by reason of an insured’s default or if the insured fails to reimburse the Company for deductible amounts paid by the Company.
Acceptable collateral may be provided in the form of letters of credit on Company approved banks, Company approved marketable securities or cash. At December 31, 2007, the Company held collateral in the aggregate amount of $230,464.
Investments in limited partnerships include an aggregate of $58,380 invested in three related partnerships, New Vernon India Fund, New Vernon Global Opportunity Fund and New Vernon North American Opportunity Fund.
In December 2007, Financial Accounting Standards Board issued Statement No. 141 (revised 2007), “Business Combinations” (“SFAS No. 141(R)”). SFAS No. 141(R) changes the requirements for an acquirer’s recognition and measurement of the assets acquired and the liabilities assumed in a business combination. SFAS No. 141(R) is effective for annual periods beginning after December 15, 2008 and should be applied prospectively for all business combinations entered into after the date of adoption. SFAS 141(R) is not expected to have a significant impact on the Company’s consolidated financial condition or results of operations.