The Company’s assets at December 31, 2014 included $62.3 million in short-term and cash equivalent investments which are readily convertible to cash without market penalty and an additional $129.6 million of fixed maturity investments (at par) 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 the event competitive conditions produce inadequate premium rates and the Company chooses to further restrict volume, the liquidity of its investment portfolio would permit management 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. In addition, the Company’s reinsurance program is structured to avoid significant cash outlays that accompany large losses.
Net premiums written by the Company’s Insurance Subsidiaries for 2014 equaled approximately 66% of the combined statutory surplus of these subsidiaries, a level consistent with the past several years. Premium writings of 100% to 200% of surplus are generally considered acceptable by regulatory authorities. Further, the statutory capital of each of the Insurance Subsidiaries substantially exceeds minimum risk based capital requirements set by the National Association of Insurance Commissioners. Accordingly, the Company has the ability to significantly increase its business without seeking additional capital to meet regulatory guidelines.
At December 31, 2014, $94.9 million, or 24% 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 maintains a $40 million unsecured line of credit with $20 million of unused capacity at December 31, 2014.
Premiums written by the Reinsurance segment totaled $39.2 million during 2014, a decrease of $15.5 million (28%) from 2013. Premiums generated by property reinsurance products decreased $13.0 million (45%), reflective of management’s decision to reduce exposures to property catastrophe losses. Further contributing to the Reinsurance segment decrease was a decrease in the Company’s book of professional liability reinsurance assumed.
The lower loss ratio for Fleet Transportation was the result of more favorable frequency and severity experience during the year as well as prior year reserve savings. The increase in the Private Passenger Automobile loss ratio is reflective of adverse weather conditions early in the year and increases in frequency throughout the year. Unfavorable loss development on a single MGA produced program in Primary Professional Liability resulted in the increase in loss ratios reported in 2014. This program was terminated late in 2013 with inforce policies running off during 2014. The property reinsurance loss ratio for 2014 was impacted by a small number of catastrophic losses aggregating over $11 million.
Other operating expenses for 2014, before credits for ceding allowances from reinsurers, increased $5.7 million (5%) to $111.8 million, generally in line with increases in premium written. This increase is due primarily to an increase in salary and salary related expenses, reflective of the Company’s growing workforce in response to the continued expansion of the Company’s products and services, and from higher expenses related to technological advances within the Company, both in the area of telematics and information technology. Reinsurance ceded credits were 14% higher in 2014, resulting from favorable changes to the terms of certain reinsurance treaties as well as increased business ceded to other companies under quota share reinsurance treaties which provide commissions to the Insurance Subsidiaries. After consideration of these expense offsets, operating expenses increased $2.7 million, or 3% from the prior year.
A portion of the Company’s fleet transportation business is produced by the direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Rather, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. is included in operating expenses. In general, commissions paid by the Insurance Subsidiaries to the parent company exceed related acquisition costs incurred in the production of the property and casualty insurance business. The ratio of net operating expenses of the Insurance Subsidiaries to net premiums earned was 32.0% in 2014 and 32.4% in 2013. Including the agency operations and corporate expenses, and after elimination of inter-company commissions, the ratio of operating expenses to operating revenue (defined as total revenue less gains or losses on investments) was 31.8% for 2014 compared with 31.9% for 2013.
Net income for 2014 of $29.7 million compares to net income of $36.6 million during 2013. Diluted earnings per share of $1.98 were recorded in 2014 compared to per share income of $2.45 in 2013.
The ratio of net operating expenses of the Insurance Subsidiaries to net premiums earned was 32.4% in 2013 and 30.8% in 2012. Including the agency operations and corporate expenses, and after elimination of inter-company commissions, the ratio of operating expenses to operating revenue (defined as total revenue less gains (losses) on investments) was 31.9% for 2013 compared with 30.6% for 2012 with the current year increase being largely attributable to higher salary expense as noted above.
The effective federal tax rate on the consolidated pre-tax income for 2013 was 33.4%. The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.
For those loss adjustment expenses not specific to individual claims (general claims handling expenses referred to as unallocated loss adjustment expenses) the Company uses standard industry loss adjustment expenses paid to losses paid (net of reinsurance) ratio analysis to establish the necessary reserves. The selected factors are applied to 100% of IBNR reserves and to case reserves with consideration given for that portion of loss adjustment expense already paid at the reserve measurement date. Such factors are monitored and revised, as necessary, on a quarterly basis.
To the extent possible, the Company attempts to recover the impact of inflation to loss costs and operating expenses by increasing the premiums it charges. Within the fleet transportation business, a majority of the Company’s accounts are charged as a percentage of an insured’s gross revenue, mileage 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.
Based on the structure of the Company’s investment portfolio, the most potentially significant of the three identified market risks relates to prices in the equity security 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, 2014 was $162.1 million or approximately 21% of invested assets. This market valuation includes $83.3 million of appreciation over the adjusted 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 $451.8 million at December 31, 2014. Approximately 49% of this portfolio is made up of U.S. Government and government agency obligations and state and municipal debt securities; 75% of the portfolio matures within 5 years; and the average contractual maturity of the Company's fixed maturity investments is approximately 4.8 years with an average modified duration of approximately 2.0 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 and would, in fact, result in significantly higher investment income in a relatively short period of time as short term investments and maturing bonds could be reinvested in the higher yielding securities very quickly.
The table below sets forth the amounts of the Company's contractual obligations at December 31, 2014.
Borrowings made under a line of credit can be called by the bank, under certain circumstances, with short notice. The line of credit has a current expiration of September 23, 2018; however, it is expected that this line of credit will be renewed for a multiple year period prior to maturity.
The unrealized net gains or losses (net of applicable tax effect) related to equity securities are reflected directly in shareholders’ equity, unless a decline in value is determined to be other-than-temporary, in which case the loss is charged to income. In determining if and when a decline in market value below cost is other-than-temporary, an objective analysis is made of each individual security where current market value is less than cost. For any equity 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. Additionally, the Company takes into account any known subjective information in evaluating for impairment, without consideration to the Company’s quantitative criteria defined above, as well as the Company’s intent and ability to retain the equity security for a period of time sufficient to allow for such recovery in fair value.
Recognition of Revenue and Costs: Premiums are earned over the period for which insurance protection is provided. A reserve for unearned premiums, computed by the daily pro-rata method, is established to reflect amounts applicable to subsequent accounting periods. Commissions to unaffiliated companies and premium taxes applicable to unearned premiums are deferred and expensed as the related premiums are earned. The Company does not defer acquisition costs which are not directly variable with the production of premium. If it is determined that expected losses and deferred expenses will likely exceed the related unearned premiums, the asset representing deferred policy acquisition costs is reduced and an expense is charged against current operations to reflect any such premium deficiency. In the event that the expected premium deficiency exceeds deferred policy acquisition costs, an additional liability would be recorded with a corresponding expense to current operations for the amount of the excess premium deficiency. Anticipated investment income is considered in determining recoverability of deferred acquisition costs.
The Company accounts for foreign and domestic reinsurance using the periodic method. Under the periodic method, premiums are recognized as revenue ratably over the contract term, and claims, including an estimate of claims incurred but not reported, are recognized as they occur.
Restricted Stock: Restricted shares vest ratably over the vesting period from the date of grant and are accelerated for retirement eligible recipients in accordance with the non-substantive post-grant date vesting clause of Accounting Standard Codification (“ASC”) 715, Compensation-Retirement Benefits. Restricted stock is valued based on the closing price of the stock on the day the award is granted. Non-vested restricted shares will be forfeited should an executive’s employment terminate for any reason other than death, disability, or retirement as defined by the Compensation Committee.
Fair Value Measurements: The Company provides disclosures related to recurring and non-recurring fair value measurements with separate disclosures for the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements, along with an explanation for the transfers. Additionally, separate disclosures are provided for purchases, sales, issuances and settlements on a gross basis for Level 3 fair value measurements as well as additional clarification for both the level of disaggregation reported for each class of assets or liabilities and disclosures of inputs and valuation techniques used to measure fair value for both recurring and non-recurring fair value measurements for assets and liabilities categorized as Level 2 or Level 3.
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 generally 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 $2,868 to various limited partnerships as of December 31, 2014.
The Company’s limited partnerships include one significant investment which invests in public and private equity markets in India. This limited partnership investment’s value as of December 31, 2014 and 2013 was $29,868 and $22,692, respectively. At December 31, 2014, the Company’s estimated ownership interest in this limited partnership investment was approximately 5%. The Company's share of earnings (losses) from this limited partnership investment was $7,176, ($3,176) and $2,404 in 2014, 2013 and 2012, respectively. The summarized financial information of the significant limited partnership investment as of and for the years ended December 31 is as follows:
Short-term investments at December 31, 2014 include $2,966 in time certificates of deposit issued by a Bermuda bank.
The Company’s fixed maturities are over 85% invested in investment grade fixed maturity investments. The Company has a total of $15,430, representing five different investments, of fixed maturity investments which were originally issued with guarantees by two different third party insurance companies, with the largest exposure to a single investment being $5,150. The average S&P credit rating of such investments, with consideration of the guarantee, is AA. The average S&P underlying credit rating of such investments, without consideration of the guarantee, would remain AA. The Company does not have any direct exposure to any guarantor.
The table above shows that a savings of $10,354 was developed during 2014 in the settlement of claims occurring on or before December 31, 2013 with comparative developments for the two previous calendar years. The net savings for each year are composed of individual claim savings and deficiencies which, in the aggregate have resulted from the settlement of claims at amounts lower than previously reserved and from changes in estimates of losses incurred but not reported as part of the normal reserving process.
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, 2014 and 2013, loss reserves have been reduced by approximately $3,129 and $5,885, 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 $7,158 and $8,115 at December 31, 2014 and 2013, respectively.
The Company also serves as an assuming reinsurer on treaties with direct writing insurance companies and, prior to January 1, 2014, under retrocessions from other reinsurers for catastrophic property coverages. Accordingly, the occurrence of catastrophic events can have a significant impact on the Company's operations. The Company also assumes reinsurance from direct writing insurance companies for casualty insurance coverages. In addition, the insurance subsidiaries participate in certain mandatory residual market pools which require insurance companies to provide coverages on assigned risks. The assigned risk pools allocate participation to all insurers based upon each insurer’s portion of premium writings on a state or national level. Historically, the operation of these assigned risk pools have resulted in net losses allocated to the Company although such losses have not been material in relation to the Company’s operations.
Net losses and loss expenses incurred for 2014, 2013 and 2012 include approximately $23,163, $20,014 and $16,486, respectively, net of retrocessional recoveries of $20,000 during 2012, relating to reinsurance assumed from non-affiliated insurance or reinsurance companies.
The Company has no uncertain tax positions as of December 31, 2014 or 2013. 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, 2014, 2013 and 2012 were not material.
The Company maintains a defined contribution 401(k) Employee Savings and Profit Sharing Plan (the “Plan”) which covers nearly all employees who have completed one year of service. The Company's contributions to the Plan for 2014, 2013 and 2012 were $1,798, $1,798 and $1,539, respectively.
Each year, beginning in 2009, the Company has issued shares of class B restricted stock to the Company’s outside directors. The shares serve as the annual retainer compensation for the outside directors for the periods shown below. The shares are distributed on the vesting date and have a total value of $440 for each of the annual periods. The table below provides detail of the stock issuances for 2014, 2013 and 2012:
Compensation expense related to the above stock grant is recognized over the period in which the directors render the services.
The Company evaluates performance and allocates resources based on past or expected results from insurance underwriting operations before income taxes. Underwriting gain or loss does not include net investment income or gains or losses on the Company's investment portfolio. All investment-related revenues are managed at the corporate level. Underwriting gain or loss for the property and casualty insurance segment includes revenue and expense from the Company's agency operations since the agency operations serve as a primary direct marketing facility for this segment. Management does not identify or allocate assets to reportable segments when evaluating segment performance and depreciation expense is not material for any of the reportable segments. The accounting policies of each reportable segment are the same as those described in the summary of significant accounting policies.
The following table reconciles reportable segment profits to the Company’s consolidated income before federal income taxes:
An additional $208,580, $177,389 and $146,447 for 2014, 2013 and 2012, respectively, is placed with the Company by a non-affiliated broker on behalf of independent contractors of this same customer but is not dependent upon the direct business with this customer.
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, 2014, the Company held collateral in the aggregate amount of $234,312.
The amount of collateral required of an insured is determined by the financial condition of the insured, the type of obligations guaranteed by the Company, estimated reserves for incurred losses within the SIR or deductible that have been reported to the insured or the Company, estimated incurred but not reported losses, and estimates for losses that are expected to occur, within the SIR or deductible, prior to the next collateral adjustment date. In general, the Company attempts to hold collateral equal to 100% of the ultimate losses that would be paid by or due the Company in the event of an insured’s default. Periodic audits are conducted by the Company to evaluate its exposure and the collateral required. If a deficiency in collateral is noted as the result of an audit, additional collateral is requested
Transfers between levels, if any, are recorded as of the beginning of the reporting period. The U.S. government obligations were transferred to Level 2 during 2014 based on market data as well as other factors including region, price type and provider on each asset. There were no significant transfers of assets between Level 1 and Level 2 during 2013 and 2012.
The following methods, assumptions and inputs were used to estimate the fair value of each class of financial instrument:
A summary of the carrying value and fair value by level of financial instruments not recorded at fair value on the Company’s consolidated balance sheet at December 31, 2014 and 2013 is as follows:
State regulatory authorities prescribe calculations of the minimum amount of statutory capital and surplus necessary for each insurance company to remain authorized. These computations are referred to as Risk Based Capital (“RBC”) requirements and are based on a number of complex factors taking into consideration the quality and nature of assets, the historical adequacy of recorded liabilities and the specific nature of business conducted. At December 31, 2014 the minimum statutory capital and surplus requirements of the insurance subsidiaries was $94,892. Actual consolidated statutory capital and surplus at December 31, 2014 exceeded this requirement by $303,870, which equals to 320% of minimum RBC.
Other comprehensive income reclassification adjustments for the years ended December 31 are as follows: