The current facilities are expected to be adequate for the Company's operations for the foreseeable future.
The primary sources of the Company's liquidity are (1) funds generated from insurance premiums, (2) net investment income and (3) maturing investments. The Company generally experiences positive cash flow resulting from the fact that premiums are collected on insurance policies in advance of the disbursement of funds in payment of claims. Operating costs of the insurance subsidiaries, other than loss and loss expense payments and commissions paid to the parent company, generally average between 25% and 35% of premiums earned on a consolidated basis and the remaining amount is available for investment for varying periods of time depending on the type of insurance coverage provided. During extended periods of declining premium volume, however, operating cash flows may turn negative as loss settlements exceed net premium revenue and receipts of investment income.
For several years, the Company's investment philosophy has emphasized the purchase of short-term instruments with maximum quality and liquidity. As interest rates have remained relatively low and yield curves have been essentially flat in recent years, the Company has not committed funds to longer term fixed maturity investments. The average life of the Company's bond and short-term investment portfolio was 3.6 years compared to 3.1 years for 1996. The Company also remains an active participant in the equity securities market. Investments made by the Company's domestic insurance subsidiaries are regulated by guidelines promulgated by the National Association of Insurance Commissioners which are designed to provide protection for both policyholders and shareholders.
The Company's assets at December 31, 1997 included $24.9 million in short-term investments which are readily convertible to cash without market penalty and an additional $76.5 million of fixed maturity investments maturing in less than one year. The Company believes that these liquid investments, plus the expected cash flow from current operations, are more than sufficient to provide for projected claim payments and operating cost demands. In addition, the Company's reinsurance program is structured to avoid serious cash drains that might accompany catastrophic losses. In the event competitive conditions continue to produce inadequate rates and the Company chooses to further reduce volume, the Company believes that the liquidity of its investment portfolio would permit it to continue to pay claims as settlements are reached without requiring the disposal of investments at a loss, regardless of interest rates in effect at the time.
As more fully discussed in Note G to the consolidated financial statements, at December 31, 1997, $64.8 million, or 22.0% 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 due to statutory restrictions on the allowable transfers. 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 parent company had cash and marketable investments of approximately $40.1 million at December 31, 1997.
1997 COMPARED TO 1996 Direct premiums written for 1997 totaled $66.0 million, an increase of $2.6 million (4.2%) from 1996. This increase is primarily attributable to an increase in nonstandard private passenger automobile business of $9.9 million (72.2%) from 1996 offset by decreases in the majority of the Company's trucking- related products although "work accident" program premiums increased $1.7 million (13.2%) from 1996. Premium writings from small trucking fleet risks also increased by $.4 million while the new small business workers' compensation program generated $.4 million in new premium. Large and medium fleet trucking premium writings declined $6.4 million (26.6%) and $.9 million (30.5%), respectively, reflecting the continued intense competition in these markets. In addition, premiums for large deductible workers' compensation policies decreased $2.4 million.
Premium writings ceded to reinsurers decreased $3.6 million (30.8%) during 1997 to $8.2 million. The percentage of premiums ceded to direct premiums written decreased to 12.4% for 1997 from 18.6% for 1996 due primarily to the decline in trucking-related premiums which carry larger reinsurance rates than the Company's other products and the increased use of lower cost facultative placements. In addition, ceded premium declined due to the termination of the quota share treaty on the Company's "work accident" program in April, 1996. Ceding rates on the Company's primary treaties for 1997 were consistent with the prior year.
Realized net capital gains were $17.3 million in 1997 compared to $6.9 million for 1996. The current year net gain consisted of gains on equity securities and fixed maturities of $18.2 million and $.1 million, respectively, and losses on other investments of $1.0 million.
Losses and loss expenses incurred during 1997 increased $6.1 million (18.1%) to $39.9 million. The 1997 consolidated loss and loss expense ratio was 64.6% compared to 57.5% for 1996. Losses and loss expenses incurred for 1996 included adverse development on environmental liability claims of $2.4 million relating to policies written in the 1970's. Adjusted for the development on environmental liability claims, the consolidated loss and loss expense ratio for 1996 was 53.4%. The increase in the loss and loss expense ratio is principally attributable to a decline in the savings realized on the closing of prior year claims during 1997 as compared to 1996. These savings related predominantly to the Company's trucking and trucking-related business. Because of the high limits provided by the Company to its insureds, the length of time required to settle larger, more complex claims and the volatility of the trucking liability insurance business, the Company believes it is important to have a high degree of comfort 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. The Company believes that the favorable loss development may be attributable, at least in part, to changes in trucking safety in general resulting from the implementation of the national commercial driver license, mandatory drug testing and an increased awareness by trucking companies of the cost of unsafe operations. It is further believed that the Company's selection techniques, minimum safety standards and claims handling have also contributed to the current favorable loss experience. The Company has established provisions for incurred but not reported environmental losses at December 31, 1997 which are believed to be sufficient to cover all anticipated exposure.
Premium writings from reinsurance assumed decreased by $2.3 million (19.2%) to $9.9 million during 1996. This decrease relates principally to a $2.1 million reduction in premiums assumed from voluntary property catastrophe retrocession pools, to $9.2 million, during 1996. The lower catastrophe assumed premium is attributable to withdrawal from certain markets by the ceding reinsurers as the result of declining premium rates.
Premium writings ceded to reinsurers decreased $4.7 million (28.7%) during 1996 to $11.8 million. The percentage of premiums ceded to direct premiums written decreased to 18.6% for 1996 from 24.5% for 1995 due primarily to the termination of the quota share treaty on the Company's "work accident" program in April, 1996. Ceding rates on the Company's primary treaties for 1996 were consistent with the prior year.
Losses and loss expenses during 1996 decreased $5.0 million (12.9%) to $33.8 million. The 1996 consolidated loss and loss expense ratio was 57.5% compared to 65.9% for 1995. Losses and loss expenses incurred for 1996 and 1995 included adverse development on environmental
liability claims of $2.4 million and $7.6 million, respectively, relating to policies written in the 1970's. Adjusted for the development on environmental liability claims, the consolidated loss and loss expense ratios for 1996 and 1995 were 53.4% and 53.0%, respectively. The consolidated savings on all prior year losses was $12.2 million for 1996 compared to $5.5 million for 1995. Adjusted for the development on environmental liability claims, savings on prior accident year losses were $14.6 million and $13.1 million during 1996 and 1995, respectively. See comments in the foregoing discussion of operations for 1997 compared to 1996 regarding the development of prior year reserves.
The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have time-sensitive features may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in normal business activities. The insurance industry is especially aware of the Year 2000 concern given that the majority of its products and services are time and date sensitive (e.g., policy effective periods and loss occurrence dates).
The Company has been in the process of developing software for its new and rapidly expanding products since 1995. All internally developed new product software is Year 2000 compliant, with minor exceptions, and currently handles approximately 90% of the Company's processed transactions. The Company is also engaged in an ongoing analysis of its remaining systems to determine the nature and extent of existing deficiencies and the appropriate corrective solutions. The Company believes that with modifications to existing software and conversions to new software, the Year 2000 Issue will not pose significant operational problems for its computer systems. However, if such modifications and conversions are not made, or are not completed on a timely basis, the Year 2000 Issue could have a significant impact on the operations of the Company.
The costs of the project and the date on which the Company believes it will complete its Year 2000 effort are based on management's best estimates, which were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties.
EARNINGS PER SHARE During 1997, the Company adopted Financial Accounting Standards Board Statement No. 128, EARNINGS PER SHARE. Statement No. 128 requires companies to present per share data on both basic (without the dilutive effect of stock equivalents) and diluted bases. The Company has restated all per share data for prior years in conformity with Statement No. 128, with minimal effect on previously reported amounts.
SEGMENTS In June, 1997, the Financial Accounting Standards Board issued Statement No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. The Company will report segment information in accordance with Statement No. 131 in its 1998 annual report. At this time, the Company has not completed its analysis of Statement No. 131, but anticipates changes from its current disclosure.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Baldwin & Lyons, Inc. and subsidiaries at December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with 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.
DISCONTINUED OPERATIONS: The Company sold its interests in Hoosier Insurance Company (Hoosier) and Amli Realty, Inc. (Amli) in 1995 and 1996, respectively. Related income and expense amounts for the prior years and the gain recognized on the sale of Hoosier are reported as discontinued operations. No gain or loss was realized on the Amli sale which was treated as a non-monetary, tax-free exchange. The consolidated statements of cash flows for 1996 and 1995 include changes in certain assets and liabilities which are presented without the effects of the sales of Amli in 1996 and Hoosier in 1995.
EARNINGS PER SHARE: Diluted earnings per share of common stock are based on the average number of shares of Class A and Class B common stock outstanding during the year, adjusted for the effect, if any, of options outstanding. Basic earnings per share are presented exclusive of the effect of options outstanding. See note M.
NOTE B - INVESTMENTS (CONTINUED) At December 31, 1997, the Company had investments in common stock and bonds of UICI, a publicly traded insurance and holding company with current market capitalization of approximately $1.3 billion. The market value of the Company's investments in UICI was $40,077 with a cost basis of $11,886 at December 31, 1997.
The Company has holdings in money-market accounts which were managed by or purchased through companies affiliated with certain directors of the Company. Other investments includes $2,161 and $2,237 at December 31, 1997 and 1996, respectively, representing limited partnership interests in ventures in which Amli serves as general partner. A director of the Company is also a director and officer of Amli.
Loss reserves on certain permanent total disability workers' compensation reserves have been discounted to present value at pre-tax rates not exceeding 3.5%. At December 31, 1997 and 1996, loss reserves have been reduced by approximately $5,431 and $4,694, respectively. Discounting is applied to these claims since the amount of periodic payments to be made during the lifetime of claimants is fixed and determinable.
Loss reserves have been reduced by estimated salvage and subrogation recoverable of approximately $1,725 at both December 31, 1997 and 1996.
Net premiums earned for 1997, 1996 and 1995 have been reduced by reinsurance ceded premiums of approximately $8,091, $11,698 and $16,340, respectively. Net losses and loss expenses incurred for 1997, 1996 and 1995 have been reduced by reinsurance recoveries of approximately $11,155, $991 and $26,554, respectively. Ceded reinsurance premiums and loss recoveries for catastrophe reinsurance contracts were not material. The Company remains liable to the extent the reinsuring companies are unable to meet their obligations under reinsurance contracts. Net premiums earned for 1997, 1996 and 1995 include approximately $10,609, $10,220 and $12,322, respectively, relating to the assumption of reinsurance from other companies and from reinsurance pools.
During 1997, 1996 and 1995, purchases of treasury stock included 96,214, 49,000 and 41,198 shares, respectively, from officers and directors for $1,850, $821 and $644, respectively, at prices based upon the midpoint between the bid and ask prices on the date of purchase.
Shareholders' equity at December 31, 1997 includes $273,094 representing GAAP shareholder's equity of insurance subsidiaries, of which $38,437 may be transferred by dividend or loan to the parent company without approval by, or notification to, regulatory authorities. An additional $169,879 of shareholder's equity of such insurance subsidiaries may be advanced or loaned to the Company with prior notification to regulatory authorities.
Note H - Employee Benefit Plans The Company maintains a defined contribution 401(k) Employee Savings and Profit Sharing Plan ("the Plan") which covers all employees who have completed one year of service. The Company's contributions to the Plan for 1997, 1996 and 1995 were $585, $499 and $465, respectively.
NOTE I - COMPREHENSIVE INCOME In June 1997, the Financial Accounting Standards Board issued Statement No. 130, REPORTING COMPREHENSIVE INCOME. Statement No. 130 requires companies to report, as an addition to net income, certain unrealized potential income or loss items that, previously, were included only as separate components of shareholders' equity until realized. Statement No. 130 requires disclosure of other comprehensive income items related to unrealized gains and losses on securities, foreign currency items and minimum pension liability adjustments. The Company has elected to adopt the provisions of Statement No. 130 as of December 31, 1997.
During 1985, in accordance with the terms of the 1984 Stock Option and Stock Appreciation Plan (1984 Plan, amended during 1991), the Company granted options to purchase 30,000 shares (Class A) and 120,000 shares (Class B) of common stock at the then book value of $3.22 per share. These options were exercised during 1995 and no further shares are available for issuance. The exercise of these options is included in the following option table.
The fair value of the market value options granted during 1997 was determined using a Black Scholes option pricing model with the following assumptions: risk- free interest rate of 5.8%; dividend yield of 1.8%; volatility factor of the expected market price of the Company's common stock of .21; and an expected life of the option of 10 years. If the Company had followed Financial Acounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, the effect on net income and earnings per share related to the issuance of market value options during 1997 would not be material.
Exercise prices for options outstanding as of December 31, 1997 were $.33, $1.00 or $25.75. The weighted-average remaining contractual life of options exercisable at either $.33 or $1.00 is 4.6 years with a weighted-average exercise price of $.577. The remaining contractual life of options exercisable at $25.75 is 10 years. The compensation cost that has been charged against income for all stock-based compensation plans was $.1 million, $.5 million and $.5 million for 1997, 1996 and 1995, respectively.
NOTE K - INDUSTRY SEGMENTS (CONTINUED) One customer of the insurance underwriting segment and the insurance brokerage/agency segment accounted for 29% and 42% of premiums written and intersegment commission income, respectively, in 1997. This same customer accounted for 30% and 38% of premiums written and intersegment commission income, respectively, in 1996 and 42% and 47%, respectively, in 1995.
Identifiable assets of the insurance underwriting segment and the insurance brokerage/agency segment give effect to allocations of property and equipment used by both segments. Capital expenditures and depreciation expense are not material.
NOTE L - DISCONTINUED OPERATIONS On November 9, 1996, Amli closed an agreement with UICI, a publicly traded financial services and insurance company, which resulted in UICI acquiring 100% of Amli's outstanding stock. The Company received 617,278 shares of UICI common stock in a non-monetary, tax-free exchange for its 38% stake in Amli. The Company accounted for its minority investment in Amli by the equity method. The book value of the Company's investment in Amli at the date of the exchange was $7.5 million.
On October 2, 1995, the Company sold its subsidiary, Hoosier, for $36.5 million. Included in the Company's insurance underwriting segment, Hoosier marketed general lines of insurance to individuals and small commercial customers in the state of Indiana.
NOTE M - EARNINGS PER SHARE In February, 1997, the Financial Accounting Standards Board issued Statement No. 128, Earnings Per Share. Statement No. 128 redefined the computation of earnings per share and requires companies to report per share earnings on both basic (without dilution) and diluted bases. The effect of restatement of earnings per share for the years 1996 and 1995, resulting from the adoption of Statement No. 128, was not material.
The following is a reconciliation of the denominators used in the calculations of basic and diluted earnings per share for the years ended December 31:
No effect on net income was considered to result from the presumed exercise of the options used in calculating diluted earnings per share. Options to purchase 497,000 shares of common stock at $25.75 per share were issued in December, 1997 and were outstanding at December 31, 1997. These options were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the Company's stock.