Baldwin & Lyons, California leases approximately 2,700 square feet of office space in a suburb of Los Angeles, California. The lease expires in August, 1997 with a three year renewal option which the company intends to exercise. All west coast operations are conducted from these facilities.
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 30% 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 3.1 years compared to 2.9 years for 1995. 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.
1996 COMPARED TO 1995 Direct premiums written for 1996 totaled $63.4 million, a decrease of $4.0 million (6.0%) from 1995. This decrease is primarily attributable to decreases in the majority of the Company's trucking-related products. Large fleet and medium fleet trucking premium writings decreased $9.9 million (29.1%) and $.8 million (20.7%), respectively, reflecting the continued intense competition in these markets which resulted in the non-renewal of several accounts and rate reductions on those accounts renewed. Premium writings for Protective's "work accident" program also decreased by $2.1 million (13.8%) from 1995, reflecting rate reductions on renewed accounts. Decreases in premium writings were also derived from Sagamore's program for small trucking fleet risks and surety premiums related to large fleet risks of $.7 million each. The above decreases were partially offset by an increase in Sagamore's non-standard private passenger automobile business of $8.8 million (181.6%) from 1995. In addition, premiums for retrospectively rated workers' compensation policies increased $1.3 million reflecting loss development on prior year policies.
The effective federal tax rate for consolidated operations for 1996 was 31.6%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.
The Company's net income for 1996 totaled $21.7 million compared to a record $29.4 million reported during 1995, which included a $7.6 million gain on the sale of Hoosier Insurance Company. Earnings per share decreased to $1.51 in 1996 from a record $1.97 in 1995.
1995 COMPARED TO 1994 Direct premiums written for 1995 totaled $67.4 million, an increase of $1.2 million (1.8%) from 1994. This increase is attributable to a myriad of changes in the Company's product categories. Increases in premium writings were derived from Sagamore's new product lines for non-standard private passenger automobile and small trucking fleet risks of $4.9 million and $3.4 million, respectively. In addition, Protective's "work accident" program produced higher premium volume for the sixth straight year since this product was introduced, increasing $.9 million, or 6.4%, during 1995. The Company also recorded net additional premiums for retrospectively rated workers' compensation policies of $.4 million compared to net returns of $1.2 million during 1994. The above increases were partially offset by decreases in large fleet and medium fleet trucking premium writings of $7.1 million (17.2%) and $2.4 million (39.4%) reflecting the continued intense competition in these markets which resulted in the non-renewal of several accounts and rate reductions on those accounts renewed.
Premium writings from reinsurance assumed decreased by $.9 million (6.5%) to $12.2 million during 1995. This decrease relates principally to changes in reinsurance assumed from mandatory state pools and underwriting associations. Voluntary reinsurance assumed from property catastrophe retrocession pools was $11.3 million during 1995, level with 1994. This program has become a significant source of revenue for the Company and it is expected that these retrocession assumptions will continue as long as market conditions are favorable.
Premium writings ceded to reinsurers decreased $1.7 million (9.4%) during 1995 to $16.5 million. The percentage of premiums ceded to direct premiums written was 24.5% for 1995, unchanged from 1994. Ceding rates on the Company's primary treaties for 1995 were consistent with the prior year.
Consolidated realized net capital gains were $6.2 million in 1995 compared to $.5 million for 1994. The current year net gain consisted of gains on equity securities and fixed maturities of $6.7 million and $.3 million, respectively, and losses of $.8 million on short-term and other investments.
Losses and loss expenses during 1995 increased $5.8 million (17.8%) to $38.8 million. The 1995 consolidated loss and loss expense ratio was 65.9% compared to 53.8% for 1994. The loss and loss expense ratio on current year trucking and trucking-related accidents actually decreased from 97.8% for 1994 to 76.5% for 1995 as the unusually high frequency and severity experienced during 1994 was not repeated during the current year. In addition, the loss ratio on reinsurance assumed under catastrophe retrocessions decreased from 69.9% in 1994 to 42.3% in 1995. However, offsetting these more favorable factors was a significant decrease in the savings realized on the development of prior year losses during 1995. The results from 1994 included an unusually high savings on prior year losses of $22.9 million. During 1995, the Company experienced adverse development totaling $7.6 million relating to environmental liability claims for policies written in the 1970's. However, consolidated savings on all prior year losses was $5.5 million, including the development on environmental liability claims. Adjusted for the development on environmental liability claims, savings on prior accident year losses were $13.1 million during 1995. See comments in the foregoing discussion of operations for 1996 compared to 1995 regarding the development of prior year reserves.
The effective federal tax rate for consolidated operations for 1995 was 31.4%. This rate is lower than the statutory rate primarily because of a $.2 million reduction in current federal taxes payable related to the "fresh start" provisions of the 1986 Tax Reform Act and because of tax-exempt investment income. The effective federal tax rate was 32.2% without the effect of the "fresh start" credits.
As a result of the factors mentioned above, income from consolidated continuing operations for 1995 was $20.6 million and remained essentially level with that of 1994. The Company recognized a gain on the sale of Hoosier Insurance Company of $7.6 million, net of federal income tax, and recorded $.7 million in income for its share of Hoosier's operations prior to the sale.
The Company's net income for 1995 totaled a record $29.4 million compared to $20.8 million reported during 1994. Earnings per share increased to a record $1.97 in 1995 from $1.37 in 1994.
Any forward-looking statements in this report, including without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties including without limitation the following:
The liability method is used in accounting for federal income taxes. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The provision for deferred federal income tax was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. Net deferred tax liabilities of $10.7 million and $.5 million were recorded at December 31, 1996 and 1995, respectively. The net deferred tax liability at December 31, 1996 included $7.0 million in special tax deposits covered under Section 847 of the Internal Revenue Code, as explained in the following paragraph, which compares to $7.3 million in special tax deposits at December 31, 1995. Adjusted for the special deposits, a net deferred tax liability of $17.7 million was recorded at December 31, 1996 compared to a net deferred tax liability of $7.8 million at December 31, 1995. The increase in deferred federal taxes payable is attributable to changes in unrealized capital gains in the investment portfolio.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc., and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income and retained earnings and cash flows for each of the three years in the period ended December 31, 1996. Our audits also include the financial statement schedules listed in the index at item 14(a)(1) and (2). 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.
DISCONTINUED OPERATIONS: The consolidated statements of income for 1995 and 1994 have been restated to reflect the sales of Amli Realty, Inc. (Amli) in 1996 and Hoosier Insurance Company (Hoosier) in 1995. Related income and expense amounts for the current and 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. The consolidated balance sheet at December 31, 1995 and the consolidated statements of cash flows for 1995 and 1994 have not been restated.
CASH AND CASH EQUIVALENTS: Carrying amounts for these instruments approximate their fair values. Checks outstanding are classified with accounts payable and other liabilities.
INVESTMENTS: Carrying amounts for fixed maturity securities (bonds, notes and redeemable preferred stocks) represent fair value and are based on quoted market prices, where available, or broker/dealer quotes for specific securities where quoted market prices are not available. Equity securities (nonredeemable preferred stocks and common stocks) and other investments are carried at quoted market prices (fair value). All fixed maturity and equity securities are considered to be available for sale; the related unrealized net gains or losses (net of applicable tax effect) are reflected directly in shareholders' equity. Although the Company has classified fixed maturity investments as available for sale, it has the ability to hold its fixed maturity investments to maturity. Short-term investments are carried at cost which approximates their fair values. Realized gains and losses on disposals of investments are determined by specific identification of cost of investments sold and are included in income.
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) RECOGNITION OF REVENUE AND COSTS (CONTINUED): subsequent accounting periods. Commissions to unaffiliated companies and other acquisition costs applicable to unearned premiums are deferred and expensed as the related premiums are earned. Anticipated investment income is considered in determining recoverability of deferred acquisition costs.
The carrying amounts and fair values of fixed maturity investments at December 31, 1996, 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. Maturities for mortgage-backed securities are determined on a specific identification basis.
NOTE B - INVESTMENTS (CONTINUED) Approximately 38% of purchases and 58% of sales of investments during the three years ended December 31, 1996 were made through securities broker-dealers in which certain directors of the Company were officers, directors or owners. Fees paid to affiliated investment advisors were $932, $965 and $627 in 1996, 1995 and 1994, respectively.
Note D - Loss and Loss Expense Reserves Activity in the reserves for losses and loss expenses is summarized as follows. All amounts are shown net of reinsurance recoverable.
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, 1996 and 1995, loss reserves have been reduced by approximately $4,694 and $8,096, 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, 1996 and 1995.
During 1996 and 1995, purchases of Class B treasury stock included 49,000 and 41,198 shares, respectively, from officers and directors for $821 and $644, respectively, at prices based upon the midpoint between the bid and ask prices on the date of purchase.
Net premium earned by the insurance underwriting segment is produced in all states. The following products accounted for more than 10% of net premium earned by this segment for the years ended December 31, as follows:
One customer of the insurance underwriting segment and the insurance brokerage/agency segment accounted for 30% and 38% of premiums written and intersegment commission income, respectively, in 1996. This same customer accounted for 42% and 47% of premiums written and intersegment commission income, respectively, in 1995 and 36% and 38%, respectively, in 1994.
NOTE L - INDUSTRY SEGMENTS (CONTINUED) 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.