Baldwin & Lyons, California leases approximately 2,700 square feet of office space in a suburb of Los Angeles, California. The lease expires in August, 2001 with a three-year renewal option. All West Coast operations are conducted from these facilities.
For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds 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 4.3 years and 4.6 years for 1999 and 1998, respectively. 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.
Net premiums written by the Company's U.S. insurance subsidiaries for 1999 were approximately 22% 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 statutory guidelines.
As more fully discussed in Note H to the consolidated financial statements, at December 31, 1999, $56.4 million, or 19.8% of shareholders' equity, represented net assets of the Company's insurance subsidiaries
which, at that time, could not be transferred in the form of dividends, loans or advances to the parent company due to statutory restrictions on the allowable transfers. However, management believes that these restrictions pose no material liquidity concerns for the Company. The financial strength and stability of the subsidiaries permit ready access by the parent company to short-term and long-term sources of credit. The parent company had cash and marketable investments of approximately $11.0 million at December 31, 1999.
Premiums ceded to reinsurers increased $5.7 million (44.9%) during 1999 to $18.3 million. The percentage of premiums ceded to direct premiums written increased to 21.3% for 1999 from 16.3% for 1998, as the Company's new reinsurance agreements for its fleet trucking products, effective June 1, 1998, were inforce for the full year. The new treaties provide for the Company to cede larger portions of its premium as well as the underlying risk.
After giving effect to changes in unearned premiums, net premiums earned increased .4% to $69.1 million for 1999 from $68.9 million for 1998. Net premiums earned from all trucking-related insurance products increased by $2.5 million (8.5%), including $2.2 million (59.7%) for small fleet trucking. Premiums earned from private passenger autobobile increased by $1.0 million. The above increases were offset by a $3.7 million decrease (43.8%) in voluntary reinsurance assumed premium during 1999.
Net investment income decreased by $.2 million (.9%) during 1999 due to lower average invested assets while overall pre-tax yields remained relatively unchanged from 1998. The average pre-tax yield on invested assets was 5.0% for both 1999 and 1998 and after-tax yields also remained unchanged at 3.6%. Investment expenses, which are netted directly against income, were relatively unchanged in 1999 and were 5.8% of gross investment income for both 1999 and 1998.
The effective federal tax rate for consolidated operations for 1999 was 29.8%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.
1998 COMPARED TO 1997 Direct premiums written for 1998 totaled $77.9 million, an increase of $11.9 million (17.9%) from 1997. This increase is primarily attributable to an increase in nonstandard private passenger automobile business of $10.3 million (43.6%) from 1997. Direct premium writings from small trucking fleet risks and fleet trucking's independent contractor program also increased by $2.2 million and $2.0 million, respectively. The new small business workers' compensation program also generated $.5 million in new premium during 1998. These increases were partially offset by decreases in the remainder of the Company's trucking- related products. Market conditions for the Company's large and medium fleet trucking products continued to be competitive
during 1998, resulting in further downward pressure on pricing. In addition, favorable claims development from expired retrospectively rated workers' compensation policies reduced direct premium by $1.0 million in 1998.
Premium writings ceded to reinsurers increased $4.5 million (55.1%) during 1998 to $12.7 million. The percentage of premiums ceded to direct premiums written increased to 16.3% for 1998 from 12.4% for 1997, as the Company entered into new reinsurance agreements for its fleet trucking products, effective June 1, 1998, whereby it ceded more premiums and retained less risk. Reinsurance retentions were also decreased for the Company's small fleet trucking products with no material impact on premium ceded.
After giving effect to changes in unearned premiums, net premiums earned increased 11.7% to $68.9 million for 1998 from $61.7 for 1997. Net premiums earned from all trucking-related insurance products, including small fleet trucking, decreased by $3.9 million (11.5%). Premiums earned from voluntary reinsurance assumed decreased by $1.6 million. The above decreases were offset by a $12.9 million increase (74.9%) in private passenger automobile premium during 1998.
Realized net capital gains were $2.8 million in 1998 compared to $17.3 million for 1997. The current year net gain consisted of gains on equity securities and fixed maturities of $2.9 million and $.2 million, respectively, and losses on other investments of $.3 million. The lower realized net capital gains during 1998 reflect the realization of losses on several under-performing issues which were sold during the year.
Losses and loss expenses incurred during 1998 increased $2.7 million (6.7%) to $42.5 million. The 1998 consolidated loss and loss expense ratio was 61.8% compared to 64.6% for 1997. Losses and loss expenses incurred for 1998 included adverse development on environmental liability claims of $1.1 million relating to policies written in the 1970's. The Company has established provisions for incurred but not reported environmental losses at December 31, 1998 which are believed to be sufficient to cover all anticipated exposure. Adjusted for the development on environmental liability claims, the consolidated loss and loss expense ratio for 1998 was 60.2%. The decrease in the loss and loss expense ratio is principally attributable to an increase in the savings realized on the closing of prior year claims during 1998 as compared to 1997. These savings related predominantly to the Company's trucking and trucking-related business. See comments in the discussion of operations for 1999 compared to 1998 regarding the development of prior year loss reserves.
Other operating expenses for 1998, before credits for allowances from reinsurers, increased $5.1 million (21.0%) to $29.5 million. Personnel related expenses, including amounts allocated to loss expenses and investment income, were essentially unchanged from 1997 levels despite a net 26% increase in the number of employees during the year, attributable to the expansion of the Company's new products. Salary expense for 1998 was reduced as the result of lower accruals for equity appreciation rights which represent a broad-based employee incentive program which is tied to changes in the Company's book value. Direct commission
expense increased $1.9 million (32.2%) as the result of increases in premiums from Sagamore's personal automobile, small fleet and small business workers' compensation products. These increases were partially offset by the decrease in voluntary reinsurance assumed from catastrophe pools. Allowances from reinsurers increased $2.4 million (325.3%) resulting from new reinsurance agreements entered into in 1998 which provide ceding commissions to Protective on its fleet trucking business. Previous reinsurance treaties covering Protective's fleet trucking business carried no ceding commission. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 32.0% during 1998 compared to 33.3% for 1997. Including the agency operations, which absorbed a portion of the development costs for the Company's new products, the ratio of other operating expenses to total revenue, adjusted to remove net realized gains, was 29.4% for 1998 compared with 28.9% for 1997. Expenses for 1998 and 1997 include expenditures for Year 2000 (Y2K) compliance, as discussed more thoroughly elsewhere in this discussion. While it is not possible to precisely isolate Y2K expenditures from those for ongoing development of current product lines, management believes that amounts spent during 1998 for Y2K related issues were higher than expenditures during 1997.
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 $7.7 million and $10.2 million were recorded at December 31, 1999 and 1998, respectively. The net deferred tax liability at December 31, 1999 included $5.0 million in special tax deposits covered under Section 847 of the Internal Revenue Code, as explained in the following paragraph, which compares to $5.9 million in special tax deposits at December 31, 1998. Adjusted for the special deposits, a net deferred tax liability of $12.7 million was recorded at December 31, 1999 compared to a net deferred tax liability of $16.1 million at December 31, 1998. The decrease in deferred federal taxes payable is primarily attributable to changes in unrealized capital gains in the investment portfolio.
The Company's fixed maturity portfolio totaled $250.4 million at December 31, 1999 and is heavily weighted toward U. S. government and government agency obligations and state and municipal debt securities. Over 79% of this portfolio matures within 5 years and the average life of the Company's fixed maturity investments is approximately 4.3 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 maturities, even a 100 to 200 basis point increase in interest rates would not have a significant impact on the Company's ability to conduct daily operations or to meet its obligations.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Baldwin & Lyons, Inc. and subsidiaries at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
COMPREHENSIVE INCOME: The Company records accumulated other comprehensive income from unrealized gains and losses on available-for-sale securities as a separate component of shareholders' equity. Foreign exchange adjustments are immaterial and the Company has no pension plan.
NOTE B - INVESTMENTS (CONTINUED) Gross realized gains and losses on investments for the years ended December 31 are summarized below:
Approximately 27% of purchases and 44% of sales of investments during the three years ended December 31, 1999 were made through securities broker-dealers in which certain directors of the Company were officers, directors or owners. Fees earned by affiliated investment advisors were $614, $590 and $604 in 1999, 1998 and 1997, respectively.
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, 1999 and 1998, loss reserves have been reduced by approximately $5,553 and $5,272, 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 $2,363 and $1,700 at December 31, 1999 and 1998, respectively.
NOTE D - EMPLOYEE BENEFIT PLANS The Company maintains a defined contribution 401(k) Employee Savings and Profit Sharing Plan ("the Plan") which covers all employees who have completed one year of service. The Company's contributions to the Plan for 1999, 1998 and 1997 were $620, $615 and $585, respectively.
NOTE E - INCOME TAXES (CONTINUED) The components of the provision for deferred federal income taxes are as follows:
Cash flows related to federal income taxes paid, net of refunds received, for 1999, 1998 and 1997 were $7,367, $6,533 and $7,800, respectively, including Section 847 special tax deposits. Future tax benefits on approximately $5,049 of deferred tax assets at December 31, 1999 arising from loss reserve discounting is assured based on Section 847 of the Internal Revenue Code.
Net premiums earned for 1999, 1998 and 1997 have been reduced by reinsurance ceded premiums of approximately $19,037, $12,337 and $8,091, respectively. Net losses and loss expenses incurred for 1999 have been increased by net savings on reinsured claims of $655. Net losses and loss expenses incurred for 1998 and 1997 have been reduced by reinsurance recoveries of approximately $10,255 and $11,155, respectively. Ceded reinsurance premiums and loss recoveries for catastrophe reinsurance contracts were not material. The Company remains liable to the extent the reinsuring companies are unable to meet their obligations under reinsurance contracts. Net premiums earned for 1999, 1998 and 1997 include approximately $4,981, $8,338 and $10,609, respectively, relating to the assumption of reinsurance from other companies and from reinsurance pools.
The Company's Class A and Class B common stock has a stated value of approximately $.05. During 1997, purchases of treasury stock included 96,214 shares from officers and directors for $1,850 at prices based upon the midpoint between the bid and ask prices on the date of purchase.
NOTE I - EARNINGS PER SHARE The following is a reconciliation of the denominators used in the calculations of basic and diluted earnings per share for the years ended December 31:
No effect on net income was considered to result from the presumed exercise of the options used in calculating diluted earnings per share. The market value options, discussed in Note K, were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the Company's stock.
NOTE J - REPORTABLE SEGMENTS The Company and its consolidated subsidiaries market and underwrite casualty insurance in three major speciality areas (reportable segments): (1) fleet trucking, (2) non-standard private passenger automobile and (3) the assumption of reinsurance. The fleet trucking segment provides multiple line insurance coverage to large trucking fleets which generally retain substantial amounts of self-insurance and to medium-sized trucking fleets on a first dollar or small deductible basis. The non-standard private passenger automobile segment provides motor vehicle liability and physical damage coverage to individuals. The reinsurance assumed segment accepts retrocessions from selected reinsurance companies, principally reinsuring against catastrophes.
NOTE J - REPORTABLE SEGMENTS (CONTINUED) The following tables are reconciliations of reportable segment revenues and profits to the Company's consolidated revenue and income from operations before federal income taxes, respectively.
One customer of the fleet trucking segment represents approximately $22,301, $18,436 and $19,278 of the Company's consolidated revenue in 1999, 1998 and 1997, respectively.
The fair value of the market value options granted during 1997 was determined using a Black Scholes option pricing model with the following assumptions: risk- free interest rate of 5.8%; dividend yield of 1.8%; volatility factor of the expected market price of the Company's common stock of .21; and an expected life of the option of 10 years. If the Company had followed Financial Acounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, 1999 and 1998 net income and earnings per share would each have been reduced by $975 and $.07, respectively, related to the issuance of 1997 market value options. The effect on 1997 earnings resulting from the issuance of these options would not have been material.