The Company leases office space at 1099 North Meridian Street, Indianapolis, Indiana. This building is located approximately one mile from downtown Indianapolis. The lease covers approximately 72,000 square feet and expires in August, 2008, with an option to renew for an additional five years. The Company's entire operations, with the exception of Baldwin & Lyons, California, are conducted from these leased facilities.
The Company owns a building and the adjacent real estate approximately two miles from its main office. This building contains approximately 3,300 square feet of usable space, and is used primarily as a contingent back up and disaster recovery site for computer operations.
The Company's assets at December 31, 2004 included $97.2 million in short-term and cash equivalent investments which are readily convertible to cash without market penalty and an additional $144.9 million of fixed income 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 restrict volume, 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. In addition, the Company's reinsurance program is structured to avoid serious cash drains that might accompany catastrophic losses.
Net premiums written by the Company's U.S. insurance subsidiaries for 2004 equaled approximately 41% of the combined statutory surplus of these subsidiaries. Premium writings of 200% to 300% 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.
As more fully discussed in Note F to the consolidated financial statements, at December 31, 2004, $79.2 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 has no long-term debt outstanding at December 31, 2004. Short-term borrowing totaled $6.0 million at December 31, 2004.
Direct premiums written for 2004 totaled $237.1 million, an increase of $21.5 million (10%) from 2003. This increase is primarily attributable to an increase in fleet trucking liability premiums of $16.7 million (15%) from 2003 levels. Direct premium writings from the Company's independent contractor program also increased by $7.2 million (18%). These increases were partially offset by decreases in the Company's private passenger automobile, small business workers' compensation and small fleet trucking programs of $1.4 million (3%), $.6 million (6%) and $.4 million (3%), respectively. Large trucking fleet volume increased primarily from the addition of new accounts during 2004, increased revenues from renewal accounts and, to a lesser degree, premium rate increases. The higher premium volume from the independent contractor program resulted from the addition of contractors by existing accounts. Increased competitive pressures are responsible for the decline in premium volume from the Sagamore personal automobile and small fleet trucking programs. The decline in small business workers' compensation premium resulted from management's decision to discontinue marketing this business during the fourth quarter of 2004.
Premiums assumed from other insurers and reinsurers totaled $8.7 million during 2004, a decrease of $2.4 million (21%) from 2003 reflecting the discontinuance of a single large program for which renewal pricing was not considered to be favorable. Premium volume from reinsurance assumed will fluctuate depending on the favorability of pricing for the coverages provided. Further, premium volume for this segment is limited by the Company's self-imposed limitation to loss from a single catastrophic event.
increasingly short-term level during the past several years as long-term interest rates were not considered to be sufficient to commit funds for extended periods. Increases in short-term rates during 2004 did not have a dramatic impact on longer-term rates, providing no incentive to lengthen maturities. Consequently, the average yield on maturing bonds exceeded the reinvestment rate during 2004 as shorter-term instruments were utilized in anticipation of more dramatic increases in long-term rates in 2005 and beyond.
Losses and loss expenses incurred during 2004 increased $30.6 million (32%) to $126.3 million. The increase in losses incurred is reflective of the 18% increase in net premiums earned, and primarily the 24% increase in premiums from trucking-related products, as previously discussed, and from $5.0 million of losses attributable to the Florida hurricanes during September, 2004. The 2004 consolidated loss and loss expense ratio was 73.4% compared to 65.5% for 2003. The Company's loss and loss expense ratios for individual product lines are summarized in the following table.
The Company produced an overall savings on the handling of prior year claims during 2004 of $15.0 million. This net savings is included in the computation of loss ratios shown in the table insert. Because of the high limits provided by the Company to its large trucking fleet insureds, the length of time required to settle larger, more complex claims and the volatility of the trucking liability insurance business, the Company believes it is important to have a high degree of conservatism 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 favorable loss developments are attributable to the Company's long-standing policy of reserving for losses realistically and a willingness to settle claims based upon a seasoned evaluation of its exposures. Changes in both gross premium volumes and the Company's
Other operating expenses for 2004, before credits for allowances from reinsurers, increased $.9 million (2%) to $51.5 million. Gross expenses increased at a lower rate than the increase in premium volume because much of the Company's expense structure is fixed and does not vary directly with volume. In general, only commissions to independent agents, premium taxes and other acquisition costs vary directly with premium volume. Direct commission expense increased $.8 million (7%) due to growth in business produced by outside agents. Resulting primarily from the increase in premium earned, taxes other than federal income and salary-related taxes increased $.7 million (12%) from 2003. Most other expense categories were level or down from the prior year as the investment in automation during the past several years has allowed for the handling of higher premium volume without the addition of employees.
Substantially all fleet trucking business is produced by direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Instead, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. are included in operating expenses. In general, commissions paid by the insurance subsidiaries to the parent company exceed related acquisition costs incurred in the production of fleet trucking business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 24.0% during 2004 compared to 26.5% for 2003. Including the agency operations, and after elimination of inter-company commissions, the ratio of other operating expenses to operating revenue (defined as total revenue less realized gains on investments) was 16.2% for 2004 compared with 18.4% for 2003, and reflects the fixed nature of certain of the Company's expenses, as discussed above.
Premiums ceded to reinsurers increased $9.7 million (15%) during 2003 to $73.5 million. The consolidated percentage of premiums ceded to direct premiums written decreased to 34% for 2003 from 39% for 2002. This decrease is reflective of the Company's increased exposure under reinsurance treaties effective in 2002 and 2003 covering large fleet trucking risks. The Company's maximum retained loss under these treaties has increased over the last two years and, as a result, a lower percentage of the direct premiums are ceded to reinsurers.
After giving effect to changes in unearned premiums, net premiums earned increased 40% to $146.2 million for 2003 from $104.4 million for 2002. Excluding inter-company reinsurance arrangements, net premiums earned from all trucking-related insurance products increased by $29.3 million (48%). Net premiums earned from the Company's private passenger automobile, non-affiliated reinsurance assumed and small business workers' compensation programs also increased $6.4 million (20%), $3.0 million (39%) and $2.6 million (76%), respectively.
Including the deficiency noted above for the small business workers' compensation product, the Company produced an overall savings on the handling of prior year claims during 2003 of $13.6 million. See comments regarding prior year reserve savings in the comparison of 2004 to 2003.
The Company's significant accounting policies are discussed in Note A to the consolidated financial statements. The following discussion is provided to highlight areas of the Company's accounting policies which are both material and subject to significant degrees of estimation.
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 the 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 an other than temporary impairment adjustment are accounted for as unrealized gains until the security is actually disposed of or sold. At December 31, 2004, unrealized gains include $4.2 million of appreciation on investments previously adjusted for "other than temporary" impairment, compared to a $4.5 million impairment allowance at that date. See Note B to the consolidated financial statements for additional detail with respect to this process. 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 which results in automatic income statement recognition of any investment which, over a six month period, is unable to recover from a 20% decline in value from our cost basis. However, to the extent that certain declines in value are reported as unrealized at December 31, 2004, 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, 2004, the total gross unrealized loss included in the Company's investment portfolio was less than $1.8 million. No individual issue constituted a material amount of this total. Had this entire amount been considered other than temporary at December 31, 2004, realized capital gains would have decreased by $.08 per share for the year. There would, however, have been no impact on total shareholders equity or book value per share since the decline in value of these securities was already recognized as a reduction to shareholders equity at December 31, 2004.
often require state regulatory approval. Such periodic increases in premium rates may lag far behind cost increases.
The Company operates solely within the property and casualty insurance industry and, accordingly, has significant invested assets which are exposed to various market risks. These market risks relate to interest rate fluctuations, equities market prices and, to a far lesser extent, foreign currency rate fluctuations. All of the Company's invested assets are classified as available for sale and are listed as such in Note B to the consolidated financial statements.
The Company's loss and loss expense reserves do not have contractual maturity dates and the exact timing of the payment of claims cannot be predicted with certainty. However, based upon historical payment patterns, we have included an estimate of when we might expect our direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid in the preceding table. Timing of the collection of the related reinsurance recoverable, estimated to be $233.0 million at December 31, 2004, would approximate that of the above projected direct reserve payout.
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Baldwin & Lyons, Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Baldwin & Lyons, Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
In our opinion, management's assessment that Baldwin & Lyons, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Baldwin & Lyons, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
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 (non-redeemable preferred stocks and common stocks) are carried at quoted market prices (fair value). Other investments are carried at either market value, cost or cost adjusted for operations of limited partnerships, depending on the nature of the investment. Put options used as a fair value hedge for a specific portion of the Company's equity security portfolio are included with other investments at market value. All fixed maturity, equity and derivative 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 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 security where the unrealized loss exceeds 20% of original or adjusted cost, and where that decline has existed for a period of at least six months, the decline is treated as an other than temporary impairment, without any subjective evaluation as to possible future recovery. Although the Company has classified fixed maturity investments as available for sale, it has the ability to, and generally does, 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.
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 and are not refundable in the event of policy cancellation. If it is determined that expected losses and deferred expenses will 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. If the expected premium deficiency exceeds deferred policy acquisition costs, an additional liability is 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.
REINSURANCE: Reinsurance premiums, commissions, expense reimbursements and reserves related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded to other insurers have been reported as a reduction of premium earned. Amounts applicable to reinsurance ceded for unearned premium and claim loss reserves have been reported as reinsurance recoverable assets. Certain reinsurance contracts provide for additional or return premiums and commissions based upon profits or losses to the reinsurer over prescribed periods. Estimates of additional or return premiums and commissions are adjusted quarterly to recognize actual loss experience to date as well as projected loss experience applicable to the various contract periods. Reinstatement premiums on reinsurance assumed contracts covering catastrophic events are recorded concurrently with the related loss.
STOCK-BASED COMPENSATION: The Company uses the "fair value method" to account for options granted to employees and non-employee directors in accordance with Statement of Financial Accounting Standards No. 123, STOCK-BASED COMPENSATION, as amended by Statement of Financial Accounting Standards No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION - TRANSITION AND DISCLOSURE.
The enclosed STATEMENT OF CHANGES IN EQUITY OTHER THAN CAPITAL refers to comprehensive income as TOTAL REALIZED AND UNREALIZED INCOME. Items of other comprehensive income included in this statement are referred to as CHANGE IN UNREALIZED GAINS (LOSSES) ON INVESTMENTS and FOREIGN EXCHANGE ADJUSTMENT. A reclassification adjustment to other comprehensive income is made for GAINS REALIZED DURING PERIOD INCLUDED IN NET INCOME.
The Company has not changed its original estimate for the loss sustained as a result of the terrorist attacks of September 11, 2001. Therefore, there is no impact on the loss developments shown in the above table except
for payments against the original established reserves. The Company has paid $10.9 million to date and carries a remaining reserve of $9.1 million at December 31, 2004.
Loss reserves have been reduced by estimated salvage and subrogation recoverable of approximately $3,462 and $3,490 at December 31, 2004 and 2003, respectively.
reinsurance companies. 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.
The Company's Class A and Class B common stock has a stated value of approximately $.04 per share.
Shareholders' equity at December 31, 2004 includes $322,999 representing GAAP shareholder's equity of insurance subsidiaries, of which $47,837 may be transferred by dividend or loan to the parent company with proper notification to, but without approval from, regulatory authorities. An additional $196,018 of shareholder's equity of such insurance subsidiaries may be advanced or loaned to the parent company with prior notification to and approval from regulatory authorities.
The Company maintains stock option plans and has reserved an aggregate of 1,312,500 shares of Class B common stock for the granting of stock options to employees and directors. No options were granted to employees during the three year period ended December 31, 2004. All employee options outstanding at December 31, 2004 are exercisable. Options granted to directors are generally not exercisable for one year from the date of grant. All discounted options expire ten years after the date of grant. Market value options granted to directors as part of their regular annual directors' fees expire seven years after the date of grant. All of the Company's option plans have received shareholder approval. Approximately 303,000 of such options are available for future grants.
The fair value of the market value options granted during 2004 was determined using a Black-Scholes-Merton option pricing model with the following assumptions: risk-free interest rate of 1.0%; dividend yield of 1.6%; volatility factor of the expected market price of the Company's common stock of .30; and an expected life of the option of 7 years. During 2004, the Company recorded expense, net of federal income tax, of $53 for these market value options using the straight-line method based upon a one-year vesting period.
Company's investment portfolio. All investment-related revenues are managed at the corporate level. Underwriting gain or loss for the fleet trucking segment includes revenue and expense from the Company's agency operations since the agency operations serve as an exclusive direct marketing facility for this segment. Underwriting gain or loss also includes fee income generated by each segment in the course of its underwriting operations. 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. Based upon these performance criteria, the Company placed the small business workers' compensation segment in runoff status effective during the fourth quarter of 2004.
NOTE L - REPORTABLE SEGMENTS (CONTINUED) The following table provides certain profit and loss information for each reportable segment for the years ended December 31:
For 2004 and 2003, the above amounts for voluntary reinsurance assumed include certain intersegment reinsurance agreements. Intersegment premiums earned during 2004 and 2003 were $1,609 and $1,239, respectively. Intersegment losses and loss expenses incurred during 2004 and 2003 were $1,270 and $1,357, respectively.
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, 2004, the Company held collateral in the aggregate amount of $216,317. 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 the 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 immediately. Because collateral amounts contain numerous estimates of the Company's exposure, are adjusted only periodically and are sometimes adjusted based on the financial condition of the insured, the amount of collateral held by the Company at a given point in time may not be sufficient to fully reimburse the Company for all of its guarantees or amounts due in the event of an insured's default. Further, the Company is not fully collateralized for the guarantees made for, or the deductible amounts that may be due from, the Company's largest customer, and in the event of that customer's default, such default may have a material adverse impact on the Company. The Company estimates its uncollateralized exposure related to this Fortune 500 company to be as much as 30% of shareholders' equity at December 31, 2004.
In addition, the Company has recorded paid and unpaid amounts recoverable from reinsurers under various agreements totaling $236,288 at December 31, 2004, as more fully discussed in Note E - Reinsurance. With minor exception, these recoverables are uncollateralized. Estimated amounts recoverable from four reinsurers in the group, each exceeding 10% of the total amount recoverable from all reinsurers, totaled $113,544 at December 31, 2004.
The company adopted the fair-value-based method of accounting for share-based payments effective with grants of market value options to non-employee directors during 2004 using the "modified prospective method" described in SFAS No. 148, ACCOUNTING FOR STOCK-BASED COMPENSATION--TRANSITION AND DISCLOSURE. Currently, the company uses a Black-Scholes-Merton model to estimate the value of stock options granted to non-employee directors and expects to continue to use this acceptable option valuation model upon the required adoption of SFAS No. 123R on July 1, 2005. The company does not anticipate that adoption of SFAS No. 123R will have a material impact on its results of operations or its financial position. However, SFAS No. 123R also requires that the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after the effective date. While the company cannot estimate what those amounts will be in the future (because they depend on, among other things, when option exercises occur), the amount of operating cash flows recognized in prior periods for such excess tax deductions were $226, $147, and $26 in 2004, 2003 and 2002, respectively.