2 Inclues extra dividends of $1.25, $.65, and $1.70 for 2010, 2007, and 2006, respectively.
3 Inclues money market instruments classified with cash in the Consolidated Balance Sheets.
For several years, the Company’s investment philosophy has emphasized the purchase of short-term bonds with maximum quality and liquidity. As flat yield curves have not provided a strong incentive to lengthen maturities in recent years, the Company has continued to maintain its fixed maturity portfolio at short-term levels. The average contractual life of the Company’s bond and short-term investment portfolio increased from 3.8 to 4.5 years during 2010. The average duration of the Company’s fixed maturity portfolio is shorter than the contractual maturity average and much shorter than the duration of the Company’s liabilities. The Company also remains an active participant in the equity securities market using capital which is in excess of amounts considered necessary to fund current operations. The long-term horizon for the Company’s equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuation, is the primary focus. 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.
Net premiums written by the Company’s insurance subsidiaries for 2010 equaled approximately 46% of the combined statutory surplus of these subsidiaries. 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, 2010, $74.8 million, or 20% 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 $20 million unsecured line of credit and has $15.0 million of drawings outstanding on this line at December 31, 2010, the proceeds of which were used principally for treasury stock repurchases and extra dividend payments.
After giving effect to changes in unearned premiums, net premiums earned totaled $214.7 million for 2010 compared to $181.3 million for 2009. These changes are in line with expectations and result from product expansion and continuing marketing efforts in the Property and Casualty Insurance segment and from program changes, effective January 1, 2010, in the Reinsurance segment including the introduction of professional liability reinsurance.
Losses and loss expenses incurred during 2010 increased $46.6 million (47%) to $146.0 million with the majority of the increase attributable to increases in catastrophe losses, including major earthquakes and windstorms, of $25.2 million with the remainder attributable to increased premium volume. The 2010 consolidated loss and loss expense ratio was 68.0% compared to 54.8% for 2009. The Company's loss and loss expense ratios for major product lines are summarized in the following table.
The fleet transportation loss ratio was impacted by 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 allow for more volatility in losses. The increase in the private passenger automobile loss ratio is due primarily to higher current year losses. The Reinsurance loss ratio was higher in 2010 as the result of increases in catastrophe losses, including major earthquakes and windstorms.
The Company produced an overall savings on the handling of prior year claims during 2010 of $8.8 million. This net savings is included in the computation of loss ratios shown in the previous table, as is the $9.6 million savings produced during 2009 on prior year claims. The $6.6 million net savings attributable to direct business was distributed among all of the Company’s products, with the majority attributable to the Company's fleet transportation businesses, and is generally consistent with recent prior years. Because of the high limits provided by the Company to its fleet transportation insureds, the length of time necessary to settle larger, more complex claims and the volatility of the fleet transportation 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 transportation 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.
Reinsurance ceded credits were $4.7 million (88%) higher in 2010, resulting from the Company ceding a higher percentage of the gross premium to other companies under reinsurance treaties, principally for workers’ compensation coverages. After consideration of these expense offsets, operating expenses remained flat decreasing $.3 million, or less than 1% from the prior year.
As a result of the factors mentioned above, and primarily the increase in catastrophic losses and a decline in realized investment gains, the Company experienced net income for 2010 of $25.0 million compared to net income of $44.8 million for 2009. Diluted earnings per share income of $1.69 were recorded in 2010 compared to $3.04 in 2009.
After giving effect to changes in unearned premiums, net premiums earned remained relatively flat at $181.3 million for 2009 compared to $182.3 million for 2008. Increases in net premiums earned were recorded on the Company’s reinsurance
business ($5.1 million or 14.4%) and private passenger automobile business ($1.8 million or 8.2%). The new commercial property and business owners’ liability business generated $2.8 million in net premium earned. These increases were offset by a $10.7 million (8.6%) decrease in net premium earned on fleet transportation products as higher reinsurance ceded reduced level gross premium writings within the fleet transportation products, as noted above.
The Company produced an overall savings on the handling of prior year claims during 2009 of $9.6 million. This net savings is included in the computation of loss ratios shown in the previous table, as is the $17.1 million savings produced during 2008 on prior year claims. This net savings included a $4.6 million deficiency attributable to reinsurance, principally resulting from increases to Hurricane Ike losses not reported to the Company until 2009. The $14.2 million net savings attributable to direct business was distributed among all of the Company’s products, with the majority attributable to the Company's independent contractor and large fleet transportation businesses, and is generally consistent with recent prior years. Because of the high limits provided by the Company to its fleet transportation insureds, the length of time necessary to settle larger, more complex claims and the volatility of the fleet transportation 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 transportation 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 2009, before credits for allowances from reinsurers, increased $12.7 million (21%) to $74.4 million. This increase is due primarily to a $5.3 million increase in commission expense and a $4.3 million increase in salary and salary-related expenses. The higher commissions reflect expansion of the Company’s distribution channels to
It is important to note that all investments included in the Company’s financial statements are valued at current fair market values. The evaluation process for determination of other-than-temporary decline in value of investments does not change these valuations but, rather, determines when a decline in value will be recognized in the income statement (other-than-temporary decline) as opposed to a charge to shareholders’ equity (temporary decline). Subsequent recoveries in value of investments which have incurred other-than-temporary impairment adjustments are accounted for as unrealized gains until the security is actually disposed of or sold. At December 31, 2010, unrealized gains include $9.5 million of appreciation on investments previously adjusted for other-than-temporary impairment, compared to $7.6 million of impairment write-downs at that date. This evaluation process is subject to risks and uncertainties since it is not always clear what has caused a decline in value of an individual security or since some declines may be associated with general market conditions or economic factors which relate to an industry, in general, but not necessarily to an individual issue. The Company has attempted to minimize many of these uncertainties by adopting a largely objective evaluation process as described above. However, to the extent that certain declines in value are reported as unrealized at December 31, 2010, it is possible that future earnings charges will result should the declines in value increase or persist or should the security actually be disposed of while market values are less than cost. At December 31, 2010, the total gross unrealized loss included in the Company’s investment portfolio was approximately $2.1 million. No individual issue constituted a material amount of this total. Had this entire amount been considered other-than-temporary at December 31, 2010, there would have been no impact on total shareholders’ equity or book value since the decline in value of these securities was already recognized as a reduction to shareholders’ equity at December 31, 2010.
For the Company’s fleet transportation risks, which are covered by annually-changing reinsurance agreements and which contain wide-ranging self-insured retentions (“SIR”) as low as $25,000 per loss occurrence and as high as several million dollars per occurrence, traditional actuarial methods are supplemented by other methods in consideration of the Company’s exposures to loss. In situations where the Company’s reinsurance structure, the insured’s SIR selections, policy volume, and other factors are changing, current accident period loss exposures may not be homogenous with historical loss data to allow for reliable projection of future developed losses. Therefore, the Company supplements the above-described actuarial methods with loss ratio reserving techniques developed from our databases to arrive at the reserve for losses incurred but not reported for the calendar/accident period under review. Management relies on its extensive historical pricing and loss history databases to produce reserve factors unique to this specialty business. As losses for a given calendar/accident period develop with the passage of time, management evaluates such development on a quarterly basis and adjusts reserve factors, as necessary, to reflect current judgment with regard to the anticipated ultimate incurred losses. This process continues until all losses are settled for each period subject to this method.
For those loss adjustment expenses not specific to individual claims (general claims handling expenses referred to as unallocated LAE) 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.
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. As previously noted, our claims range widely in scope and complexity. 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 fleet transportation 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 estimations, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time.
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 transportation 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:
Under reasonably possible scenarios, it is conceivable that the Company’s selected loss reserve estimates could be 10%, or more, redundant or deficient. The majority of the Company’s reserves for losses and loss expenses, on either a gross or a net of reinsurance basis, relates to the fleet transportation product. Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company’s fleet transportation products for policies subject to certain recent major reinsurance treaties (approximately $80.7 million, or approximately 28% of carried direct reserves for directly produced property and casualty business).
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 reported at December 31, 2010 and 2009 consisted of (dollars in thousands):
To the extent possible, the Company attempts to recover the costs of inflation by increasing the premiums it charges. Within the fleet transportation 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.
To the extent inflation influences yields on investments, the Company is also affected. The Company’s short-term and fixed investment portfolios are structured in direct response to available interest rates over the yield curve. As available market interest rates fluctuate in response to the presence or absence of inflation, the yields on the Company’s investments are
The Company's fixed maturity portfolio totaled $415.6 million at December 31, 2010. Approximately 62% of this portfolio is made up of U.S. Government and government agency obligations and state and municipal debt securities; 83% of the portfolio matures within 5 years; and the average life of the Company's fixed maturity investments is approximately 4.5 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.
The following tables present the estimated effects on the fair value of financial instruments at December 31 due to an instantaneous change in yield rates of varying magnitudes on a static balance sheet to determine the effect such a change in rates would have on current fair value. The analysis presents the sensitivity of the fair value of the Company’s financial instruments to selected changes in market rates and prices. The range of change chosen reflects the Company’s view of changes that the Company believes are reasonably possible over a one-year period. The Company’s selection of the range of values chosen to represent changes in interest rates should not be construed as the Company’s prediction of future market
events, but rather an illustration of the impact of such events. The equity portfolio was compared to the S&P 500 index due to its correlation with the vast majority of the Company’s current equity portfolio. The limited partnership portfolio was compared to the S&P 500 and Indian BSE 500 indices due to their significant correlation with the vast majority of our limited partnership portfolio. 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 below.
The table below sets forth the amounts of the Company's contractual obligations at December 31, 2010.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Baldwin & Lyons, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2011 expressed an unqualified opinion thereon.
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, subject to an evaluation as to possible future recovery, and the
Restricted Stock: Restricted shares vest ratably over the vesting period from the date of grant and are accelerated for retirement eligible recipients due to the non-substantive post-grant date vesting clause per 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.
The fair value and the cost or amortized cost of fixed maturity investments, at December 31, 2010, 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. Pre-refunded municipal bonds are classified based on their pre-refunded call dates.
Gains and losses on investments, including equity method earnings from limited partnerships, for the years ended December 31 are summarized below:
Shareholders' equity includes approximately $30,000, net of deferred federal income taxes, of earnings yet undistributed by limited partnerships as of December 31, 2010.
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 $1,200 to various limited partnerships as of December 31, 2010.
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, 2010 and 2009 was $33,197 and $29,676, respectively. At December 31, 2010, the Company’s estimated ownership interest in this limited partnership investment was less than 4%. The Company's share of earnings from this limited partnership investment was $3,521, $10,915 and ($25,955) in 2010, 2009 and 2008, respectively.
Short-term investments at December 31, 2010 include $4,021 in foreign time certificates of deposit.
The Company’s fixed maturities are over 91% invested in investment grade fixed maturity investments. The Company has a total of $24,300 (par value), representing 11 different investments, of fixed maturity investments which were originally issued with guarantees by three different third party insurance companies, with the largest exposure to a single investment being $4,000. 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, is AA. The Company does not have any direct exposure to any guarantor.
Approximately $36,200 of fixed maturity investments (5.7% of total invested assets) consists of bonds rated as less than investment grade at year end. These investments include a diversified portfolio of over 40 investments including catastrophe bonds and have a $784 net unrealized gain position at December 31, 2010.
The table above shows that a savings of $8,823 was developed during 2010 in the settlement of claims occurring on or before December 31, 2009 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, 2010 and 2009, loss reserves have been reduced by approximately $6,463 and $6,656, 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 $6,370 and $5,724 at December 31, 2010 and 2009, respectively.
The Company also serves as an assuming reinsurer on treaties with direct writing insurance companies for catastrophic property coverages as well as under retrocessions from other reinsurers. The retrocessions are comprised primarily of catastrophe treaties. Accordingly, the occurrence of catastrophic events can have a significant impact on the Company's operations. 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.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities as of December 31 are as follows:
Cash flows related to federal income taxes paid, net of refunds received, for 2010, 2009 and 2008 were $9,000, $6,037 and $11,186, respectively.
The Company is required to establish a valuation allowance for any portion of the gross deferred tax asset that management believes will not be realized. Management has determined that no such valuation allowance is necessary at December 31, 2010 or 2009. As of December 31, 2010, the Internal Revenue Service had completed examinations and settled all audits through the Company’s 2004 tax year.
The Company follows the FASB guidance on accounting for uncertainty in income taxes for recognizing and measuring uncertain tax positions. The Company’s tax positions are uncertain only as to the timing of deductibility and therefore, if recognized would have no impact on the Company’s effective tax rate. 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, 2010, 2009 and 2008 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 2010, 2009 and 2008 were $1,497, $1,292 and $1,183, respectively.
The Company maintains two stock option plans and one restricted stock unit plan which are described below.
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 146,000 shares of Class B common stock are available for future grants. No options were granted to directors during the three year period ended December 31, 2010. Additionally, no discounted options were outstanding or
Effective June 11, 2009, the Company issued 20,900 shares of class B restricted stock to the Company’s outside directors. The restricted shares became fully vested on May 5, 2010 and were distributed to directors on that date. The shares represent the annual retainer compensation for outside directors for the period July 1, 2009 through June 30, 2010. Each share was valued at $21.05 per share representing a total value of $440. Compensation expense related to the above stock grant was recognized over the period in which the directors rendered the services.
The Company has two reportable business segments in its operations: property and casualty insurance and reinsurance. The property and casualty insurance segment provides multiple line insurance coverage primarily to fleet transportation companies and to independent contractors who contract with fleet transportation companies. In addition, the Company offers individual personal automobile coverage, business owners’ policies and commercial property business. The reinsurance segment accepts cessions from other insurance companies as well as retrocessions from selected reinsurance companies, principally reinsuring against catastrophes.
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 limits are obligations of the insured; however, the Company writes surety bonds in favor of various regulatory agencies guaranteeing the insureds’ payment of claims within the SIR. Further, losses and claims under large deductible policies are payable by the Company with reimbursement due the Company from the insureds. 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, 2010, the Company held collateral in the aggregate amount of $210,637.
In addition, the Company's balance sheet includes paid and estimated unpaid amounts recoverable from reinsurers under various agreements totaling $127,228 at December 31, 2010, as more fully discussed in Note D - Reinsurance. These recoverables are largely uncollateralized. The three largest estimated amounts due from individual reinsurers were $24,789, $18,894, and $13,839 at December 31, 2010.
The Company has $15,000 and $10,000 outstanding as of December 31, 2010 and December 31, 2009, respectively under the Company’s revolving line of credit which expires on June 23, 2011. Borrowing under the line carry variable interest rates which ranged from .76% to .80%, and averaged .79%, at December 31, 2010. The Company has $5,000 remaining unused under the revolving line of credit. The current outstanding borrowings were used principally for treasury stock repurchases and extra dividend payments.
The Level 3 assets consist of an investment portfolio of insurance-linked securities. The insurance-linked securities are valued using the average of estimated market quotes from multiple insurance-linked securities brokers. The broker quotes include Level 3 inputs which are significant to the valuation of the insurance-linked securities. A reconciliation of the beginning and ending balances of assets measured at fair value on a recurring basis using Level 3 inputs is as follows for the years ended December 31:
Quoted market prices are obtained for these disclosures whenever possible. Where quoted market prices are not available, fair values are estimated using present value or other valuation techniques. These techniques are significantly affected by our assumptions, including discount rates and estimates of future cash flows. Potential taxes and other transaction costs have not been considered in estimating fair values.
The carrying amounts reported in the consolidated balance sheets for cash, accounts receivables, reinsurance recoverable, notes receivable, accounts payable and accrued expenses, income taxes payable, short term borrowings and unearned income approximate fair value because of the short term nature of these items.
There were no significant transfers of assets between level 1 and level 2 during 2010 and 2009.