The Company also owns a building and the adjacent real estate approximately eleven miles from its main office (nine miles from the new office headquarters in Carmel, Indiana). The building contains approximately 15,000 square feet of usable space, and is used primarily for off-site data storage and as a contingent back up and disaster recovery site.
The Company's entire operations are conducted from these facilities. The current and new facilities are expected to be adequate for the Company's operations for the foreseeable future.
The primary sources of the Company’s liquidity are (1) funds generated from insurance operations including net investment income, (2) proceeds from the sale of investments and (3) proceeds from maturing investments. The Company generally experiences positive cash flow from operations 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, generally average less than 30% of net 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. Because losses are often settled in periods subsequent to when they are incurred, operating cash flows may, at times, become negative as loss settlements on claim reserves established in prior years exceed current revenues. During 2012, cash flow from operations totaled $55.8 million which is consistent with the $54.3 million total for 2011.
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 incentive to lengthen maturities in recent years, the Company has continued to maintain its fixed maturity portfolio at short-term levels. While the average contractual life of the Company’s bond and short-term investment portfolio increased from 3.1 to 3.6 years during 2012, the average duration of the Company’s fixed maturity portfolio remains much shorter than the contractual maturity average and significantly 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 2012 equaled approximately 55% 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.
Net gains on investments, before taxes, totaled $9.0 million in 2012 compared to net losses on investments of $17.8 million during 2011. Both years’ results were heavily influenced by limited partnership results with gains of $7.0 million in 2012 and losses of $21.9 million in 2011. Limited partnership ventures utilized by the Company are primarily engaged in the trading of public and private securities, including foreign securities and, to a lesser extent, small venture capital activities and real estate development. The aggregate of the Company’s share of gains in these entities represented a 13% appreciation in value for 2012 compared to a decline in value of 29% for 2011. To the extent that accounting rules require the limited partnerships to include realized and unrealized gains or losses in their net income, the Company’s proportionate share of net income will include the results as reported to the Company by the various general partners. During 2012, the $7.0 million net gain was composed of $8.6 million attributable to an increase in unrealized gains and $1.6 million attributable to realized losses. Recoveries of $1.3 million on previously impaired available-for-sale securities that were sold in 2012 are included in the net gains stated above.
Other operating expenses for 2012, before credits for ceding allowances from reinsurers, increased $7.8 million (9%) to $92.6 million. This increase is due primarily to a $5.3 million increase in salary related expenses, reflective of the Company’s growing workforce in response to the continued expansion of the Company’s products and services and the fact that incentive bonuses were eliminated in 2011 in light of the significant operating loss sustained that year. In addition, expenses attributable to continual upgrade to the Company’s automation systems and taxes based on income increased during 2012.
The effective federal tax rate on the consolidated pre-tax loss for 2012 was 31.5%. The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.
Direct premiums written for 2011 totaled $274.1 million, an increase of $24.4 million (10%) from 2010. The increase is primarily attributable to $23.7 million (13%) in premiums generated by fleet transportation products and $9.5 million in premiums generated by the professional liability business launched in 2010. Premiums ceded to reinsurers on direct business increased $8.2 million (11%) during 2011 to $84.1 million, as the consolidated percentage of premiums ceded to direct premiums written remained relatively level at 30.7% for 2011 compared to 30.4 % for 2010.
After giving effect to changes in unearned premiums, net premiums earned totaled $244.6 million for 2011 compared to $214.7 million for 2010, an increase of 13.9%. 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 the continued growth of professional liability reinsurance within the Reinsurance segment.
The fleet transportation loss ratio was impacted by factors such as fluctuations in premium volume, the levels of self-insured retentions and the high policy limits which allow for more volatility in losses. The property reinsurance loss ratio was higher in 2011 as the result of a historically unprecedented number of significant world-wide catastrophe losses. Losses from large catastrophic events during 2011 totaled $66.6 million compared to $25.2 million during 2010, itself a historically severe year for international catastrophic events.
The Company produced an overall savings on the handling of prior year claims during 2011 of $9.7 million. This net savings is included in the computation of loss ratios shown in the previous table, as is the $8.8 million savings produced during 2010 on prior year claims. The $7.4 million net savings attributable to the property and casualty insurance business was distributed among all of the Company’s products, with the majority attributable to the Company's fleet transportation and personal automobile businesses, and is generally consistent with recent prior years. See additional comments related to prior year loss developments included in the comparison of 2012 to 2011, above.
Other operating expenses for 2011, before credits for allowances from reinsurers, increased $6.0 million (8%) to $84.8 million. This increase is due primarily to a $6.2 million increase in commission expense partially offset by decreases in salary related expenses and taxes, licenses and fees. The higher commissions reflect expansion of the Company’s distribution channels to additional non-affiliated agents.
Reinsurance ceded credits were $1.4 million (14%) higher in 2011, resulting from increased gross premiums written on business ceded to other companies under quota share reinsurance treaties which provide commissions to the Insurance Subsidiaries. After consideration of these expense offsets, operating expenses increased $4.6 million, or 7% from the prior year, well below the increase in net premiums earned, as noted above.
A portion of the Company’s fleet transportation business is produced by the direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Rather, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. is included in operating expenses. In general, commissions paid by the insurance subsidiaries to the parent company exceed related acquisition costs incurred in the production of the property and casualty insurance business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 30.2% in 2011 and 31.0% in 2010. Including the agency operations and corporate expenses, and after elimination of inter-company commissions, the ratio of operating expenses to operating revenue (defined as total revenue less gains (losses) on investments) was 28.1% for 2011 compared with 29.5% for 2010 with the decreases in both cases attributable to the fact that expenses grew at a slower pace than premium volume.
Approximately 69% of the Company’s assets are composed of investments at December 31, 2012. Approximately 91% of these investments are publicly-traded, owned directly and have readily-ascertainable market values. The remaining 9% of investments are composed primarily of minority interests in several limited partnerships. These
Amounts recoverable under the terms of reinsurance contracts comprise approximately 18% of total Company assets as of December 31, 2012. In order to be able to provide the high limits required by the Company’s insureds, we share a significant amount of the insurance risk of the underlying contracts with various insurance entities through the use of reinsurance contracts. Some reinsurance contracts provide that a loss be shared among the Company and its reinsurers on a predetermined pro-rata basis (“quota-share”) while other contracts provide that the Company keep a fixed amount of the loss, similar to a deductible, with reinsurers taking all losses above this fixed amount (“excess of loss”). Some risks are covered by a combination of quota-share and excess of loss contracts. The computation of amounts due from reinsurers is based upon the terms of the various contracts and follows the underlying estimation process for loss and loss expense reserves, as described below. Accordingly, the uncertainties inherent in the loss and loss expense reserving process also affect the amounts recorded as recoverable from reinsurers. Estimation uncertainties are greatest for claims which have occurred but which have not yet been reported to the Company. Further, the high limits provided by the Company’s insurance policies for fleet transportation liability, workers’ compensation and professional liability risks provide more variability in the estimation process than lines of business with lower coverage limits.
The Company’s reserves for losses and loss expenses (“reserves”) are determined based on complex estimation processes using historical experience, current economic information and, when necessary, available industry statistics. Reserves are evaluated in three basic categories (1) “case basis”, (2) “incurred but not reported” and (3) “loss adjustment expense” reserves. Case basis reserves are established for specific known loss occurrences at amounts dependent upon various criteria such as type of coverage, severity and the underlying policy limits, as examples. Case basis reserves are generally estimated by experienced claims adjusters using established Company guidelines and are subject to review by claims management. Incurred but not reported reserves, which are established for those losses which have occurred, but have not yet been reported to the Company, are not linked to specific claims but are computed on a “bulk” basis. Common actuarial methods are employed in the establishment of incurred but not reported loss reserves using company historical loss data, consideration of changes in the Company’s business and study of current economic trends affecting ultimate claims costs. Loss adjustment expense reserves, or reserves for the costs associated with the investigation and settlement of a claim, are also bulk reserves representing the Company’s estimate of the costs associated with the claims handling process. Loss adjustment expense reserves include amounts ultimately allocable to individual claims as well as amounts required for the general overhead of the claims handling operation that are not specifically allocable to individual claims. Historical analyses of the ratio of loss adjusting expenses to losses paid on prior closed claims and review of current economic trends affecting loss settlement costs are used to estimate the loss adjustment reserve needs related to the established loss reserves. Each of these reserve categories contain elements of uncertainty which assure variability when compared to the ultimate costs to settle the underlying claims for which the reserves are established. 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. The Company’s claims range from the very routine private passenger automobile “fender bender” to the highly complex and costly third party bodily injury claim involving large tractor-trailer rigs. 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 many of the Company’s 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 estimation assumptions, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time. Changes to previously established reserve amounts are charged or credited to losses and loss expenses incurred in the accounting periods in which they are determined. Note C to the consolidated financial statements includes additional information relating to loss and loss adjustment expense reserve development.
To the extent possible, the Company attempts to recover the impact of inflation to loss costs and operating expenses by increasing the premiums it charges. Within the fleet transportation business, a majority of the Company’s 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.
Reference is made to the discussion of limited partnership investments in Critical Accounting Policies presented on page 28 of this report. All of the market risks, attendant to equity securities, apply to the underlying assets in these partnerships, and to a greater degree because of the generally more aggressive investment philosophies utilized by the partnerships. In addition, these investments are illiquid. There is no primary or secondary market on which these limited partnerships trade and, in most cases, the Company is prohibited from disposing of its limited partnership interests for some period of time and 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. Finally, through the application of the equity method of accounting, the Company’s share of net income reported by the limited partnerships may include significant amounts of unrealized appreciation on the underlying investments. As such, the likelihood that reported income from limited partnership investments will be ultimately returned to the Company in the form of cash is markedly lower than the Company’s other investments, where appreciation is reported only when a security is actually sold.
The following tables present the estimated effects on the fair value of financial instruments at December 31 which would result from 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, should they occur. 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, 2012.
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, the above table presents an estimate of when we might expect our direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid. Timing of the collection of the related reinsurance recoverable, estimated to be $175.2 million at December 31, 2012, or 42% of the amounts presented in the above table, would approximate that of the above projected direct reserve payout.
The investment commitments in the above table relate to maximum unfunded capital obligations for limited partnership investments at December 31, 2012. The actual call dates for such funding could vary from that presented.
Basis of Presentation: The consolidated financial statements include the accounts of Baldwin & Lyons, Inc. and its wholly owned subsidiaries (the “Company"). All significant inter-company transactions and accounts have been eliminated in consolidation.
Other investments, if any, are carried at either market value or cost, depending on the nature of the investment. Short-term investments are carried at cost, which approximates their fair values.
The unrealized net gains or losses (net of applicable tax effect) related to equity securities are reflected directly in shareholders’ equity, unless a decline in value is determined to be other-than-temporary, in which case the loss is charged to income. In determining if and when a decline in market value below cost is other-than-temporary, an objective analysis is made of each individual security where current market value is less than cost. For any equity security where the unrealized loss exceeds 20% of original or adjusted cost, and where that decline has existed for a
period of at least six months, the decline is treated as an other-than-temporary impairment. Additionally, the Company takes into account any known subjective information in evaluating for impairment without consideration to the Company’s quantitative criteria defined above, and the Company’s intent and ability to retain the equity security for a period of time sufficient to allow for such recovery in fair value.
Goodwill and Other Intangible Assets: Goodwill is not amortized. It is instead tested for impairment in accordance with FASB guidance, at the reporting-unit level. Goodwill is tested annually (during the fourth quarter) or more often if events or circumstances, such as adverse changes in the business climate, indicate there may be impairment. Intangible assets determined to have finite lives, such as customer relationships and employment agreements, are amortized over their estimated useful lives in a manner that best reflects the economic benefits of the intangible asset. In addition, impairment testing is performed on these amortizing intangible assets if impairment indicators are noted.
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 $7,846 to various limited partnerships as of December 31, 2012.
Approximately $42,600 of fixed maturity investments (6.3% 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 $408 net unrealized gain position at December 31, 2012.
The table above shows that a savings of $9,875 was developed during 2012 in the settlement of claims occurring on or before December 31, 2011 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.
Net losses and loss expenses incurred for 2012, 2011 and 2010 include approximately $16,486, $88,934, and $38,318, respectively, net of retrocessional recoveries of $20,000 during 2012, relating to reinsurance assumed from non-affiliated insurance or reinsurance companies.
The table below reconciles the amount of unrecognized federal income taxes as of December 31, 2012 and 2011. The amount has no impact on the Company’s effective tax rate and excludes interest, which is treated as income tax expense per the Company’s accounting policy. During 2012, the Company decided it was no longer necessary to carry this amount as it was determined that the tax years to which uncertain tax positions related are now closed.
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 2012, 2011 and 2010 were $1,539, $1,452 and $1,497, respectively.
Effective February 9, 2011, the Company issued 14,473 shares of class B restricted stock to certain of the Company’s executives. The restricted shares will be paid solely in the Company’s class B stock. The restricted shares represent compensation to certain executives under the Company’s 2010 Executive Incentive Bonus Plan. The restricted shares vest ratably over a three year 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 was valued based on the closing price of the stock on the day the award was granted. Each share was valued at $23.39 per share representing a total value of $339. 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.
Effective February 4, 2013, the Company issued 52,389 shares of class B restricted stock to certain of the Company’s executives. The restricted shares will be paid solely in the Company’s class B stock. The restricted shares represent compensation to certain executives under the Company’s 2012 Executive Incentive Bonus Plan. The restricted shares will vest ratably over a three year 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 was valued based on the closing price of the stock on the day the award was granted. Each share was valued at $23.69 per share representing a total value of $1,241. 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.
Through 2002, the Company provided loans to certain employees for the sole purpose of purchasing the Company’s Class B common stock in the open market. The underlying securities served as collateral for these loans. All employee loans had been paid in full as of March 31, 2012. No additional loans will be made under this program.
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, 2012, the Company held collateral in the aggregate amount of $197,978.
In addition, the Company's balance sheet includes paid and estimated unpaid amounts recoverable from reinsurers under various agreements totaling $175,191 at December 31, 2012, as more fully discussed in Note D - Reinsurance. These recoverables are largely uncollateralized. The largest estimated amount due from an individual reinsurer was $51,493, for which the Company holds approximately $43,600 in collateral. The second largest estimated amount due was $21,753 at December 31, 2012.
On October 31, 2008, the Company purchased Transportation Specialty Insurance Agency, Inc., (“TIA”) of Toledo, Ohio for a cash purchase price of $3,500. TIA is a commercial lines specialty insurance agency primarily focusing on the needs of the transportation industry including trucking independent contractors as well as fleet trucking companies. TIA is part of the Company’s property and casualty insurance segment. As part of the purchase, the Company recorded goodwill of $3,152 and intangible assets related to customer relationships and employment agreements of $179 which are included in Other Assets in the consolidated balance sheets and has recorded amortization of intangible assets of $28, $35 and $41 during 2012, 2011 and 2010, respectively. Accumulated amortization on intangible assets was $158 and $130 as of December 31, 2012 and 2011, respectively.
The Company maintains a revolving line of credit with a $30,000 limit, with an expiration date of September 23, 2014. Interest on this line of credit is referenced to LIBOR and can be fixed for periods of up to one year at the Company’s option. Outstanding drawings on this line of credit were $10,000 as of December 31, 2012 and 2011. At December 31, 2012, the effective interest rate was 1.11%. The Company has $20,000 remaining unused under the line of credit at December 31, 2012. The current outstanding borrowings were used principally for general corporate purchases.
The Level 3 assets consist of a 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. There were no Level 3 sales, no transfers into Level 3 and no transfers out of Level 3 during 2012 or 2011. 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:
Minimum statutory surplus necessary for the insurance subsidiaries to satisfy statutory risk based capital requirements was $86,060 at December 31, 2012.
The Company leases office space and certain computer and related equipment using noncancelable operating leases. Lease expense for 2012, 2011 and 2010 was $1,506 $1,483 and $1,386, respectively. At December 31, 2012, future lease payments for operating leases with initial or remaining noncancelable terms of one year or more consisted of the following: