Net premiums written by the Company's U.S. insurance subsidiaries for 1998 were approximately 23% 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.
Due primarily to a $15.3 million decline in unrealized net gains on investments, shareholders' equity decreased to $288.6 million at December 31, 1998, from $294.0 million at December 31, 1997. The change in shareholders' equity also included $1.3 million in treasury share purchases and $5.5 million of dividends to shareholders. Book value per common share outstanding decreased 2% to $20.91 at December 31, 1998 from $21.23 per share at December 31, 1997.
As more fully discussed in Note H to the consolidated financial statements, at December 31, 1998, $67.6 million, or 23.4% 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 $19.2 million at December 31, 1998.
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 "work accident" 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.
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 nonstandard 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 that 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 that 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. Because of the high limits provided by the Company to its 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 comfort 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 the favorable loss development may be attributable, at least in part, to changes in trucking safety in general resulting from the implementation of the national commercial driver license, mandatory drug testing and an increased awareness by trucking companies of the cost of unsafe operations. It is further believed that the Company's selection techniques, minimum safety standards and claims handling have also contributed to the current favorable loss experience.
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.
Losses and loss expenses incurred during 1997 increased $6.1 million (18.1%) to $39.9 million. The 1997 consolidated loss and loss expense ratio was 64.6% compared to 57.5% for 1996. Losses and loss expenses incurred for 1996 included adverse development on environmental liability claims of $2.4 million relating to policies written in the 1970's. Adjusted for the development on environmental liability claims, the consolidated loss and loss expense ratio for 1996 was 53.4%. The increase in the loss and loss expense ratio is principally attributable to a decline in the savings realized on the closing of prior year claims during 1997 as compared to 1996. These savings related predominantly to the Company's trucking and trucking-related business. See comments in the foregoing discussion of operations for 1998 compared to 1997 regarding the development of prior year reserves.
The liability method is used in accounting for federal income taxes. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The provision for deferred federal income tax was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. Net deferred tax liabilities of $10.2 million and $16.2 million were recorded at December 31, 1998 and 1997, respectively. The net deferred tax liability at December 31, 1998 included $5.9 million in special tax deposits covered under Section 847 of the Internal Revenue Code, as explained in the following paragraph, which compares to $6.2 million in special tax deposits at December 31, 1997. Adjusted for the special deposits, a net deferred tax liability of $16.1 million was recorded at December 31, 1998 compared to a net deferred tax liability of $22.4 million at December 31, 1997. The decrease in deferred federal taxes payable is primarily attributable to changes in unrealized capital gains in the investment portfolio.
A provision in the Technical and Miscellaneous Revenue Act of 1988 created a mechanism which would allow for a recognizable deferred tax asset specifically for property and casualty loss reserves discounted for tax purposes. Adopted as Section 847 of the Internal Revenue Code, this provision allows an insurer to take a special tax deduction equal to the discount on post 1986 accident year loss and loss expense reserves while making "special estimated tax payments" equal to the amount of the tax benefit derived from the special deduction. The "special estimated tax payments" can be carried forward for fifteen years to offset taxes arising from decreases in the special deduction and can be treated as regular estimated payments or refunded at the end of the carryforward period. Based upon the concerns regarding the recognition of deferred tax assets, the Company adopted the provisions of Section 847 for all tax years 1987 and subsequent and has taken deductions
for the entire amount of discount on post-1986 loss reserves. As mentioned above, special Section 847 estimated tax deposits totaling $5.9 million have been paid in connection with this election.
The Company has communicated with its significant suppliers and large customers to determine the extent to which the Company's interface systems are vulnerable to third party failures to remediate Year 2000 system deficiencies. Currently, there is no known third party Year 2000 deficiency believed to pose a serious threat to the Company's ability to conduct business. It is believed that the Company's total Year 2000 project costs will not be significantly impacted by third party Year 2000 Issues based on presently available information. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be converted on a timely basis and would not have an adverse effect on the Company's systems. The Company has determined it has no significant exposure to contingencies related to the Year 2000 Issue for the products it has sold.
materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties.
The most significant of the three identified market risks relates to prices in the equities market. Though not the largest category of the Company's invested assets, equity securities have the greatest potential for short-term price fluctuation. The market value of the Company's equity positions at December 31, 1998 was $148.1 million or approximately 32% of invested assets, including money market instruments classified as cash. Funds invested in the equities market are not considered to be assets necessary for the Company to conduct its daily operations and, therefore, can be committed for extended periods of time. The long-term nature of the Company's equity investments allows it to invest in positions where ultimate value, and not short-term market fluctuations, are the most important feature.
The Company's fixed maturity portfolio totaled $268.3 million at December 31, 1998 and is heavily weighted toward U. S. government and government agency obligations and state and municipal debt securities. Over 74% of this portfolio matures within 5 years and the average life of the Company's fixed maturity investments is approximately 4.6 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.
SEGMENTS During 1998, the Company adopted Financial Accounting Standards Board Statement No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. Statement No. 131 requires companies to use a
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, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. 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.
NOTE A - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) 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 income. 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.
The fair values and the cost or amortized cost of fixed maturity investments at December 31, 1998, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because borrowers have, in some cases, the right to call or prepay obligations with or without call or prepayment penalties. Maturities for mortgage-backed securities are determined on a specific identification basis.
Cash flows related to federal income taxes paid, net of refunds received, for 1998, 1997 and 1996 were $6,533, $7,800 and $11,805, respectively, including Section 847 special tax deposits. Future tax benefits on approximately $5,875 of deferred tax assets at December 31, 1998 arising from loss reserve discounting is assured based on Section 847 of the Internal Revenue Code.
NOTE F - REINSURANCE The insurance subsidiaries cede portions of their gross premiums written to certain other insurers under excess and quota share treaties and by facultative placements. Risks are reinsured with other companies to permit the recovery of a portion of related direct losses. Protective also serves as an assuming reinsurer under retrocessions from certain other reinsurers. These retrocessions include individual risks as well as catastrophe pools. Accordingly, the occurrence of a major catastrophic event could have a significant impact on the Company's financial statements. In addition, the insurance subsidiaries participate in certain involuntary reinsurance 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.
NOTE G - OTHER OPERATING EXPENSES Details of other operating expenses are as follows:
NOTE H - SHAREHOLDERS' EQUITY Changes in common stock outstanding and additional paid-in capital are as follows:
The Company's Class A and Class B common stock has a stated value of approximately $.05. During 1997 and 1996, purchases of treasury stock included 96,214 and 49,000 shares, respectively, from officers and directors for $1,850 and $821, respectively, at prices based upon the midpoint between the bid and ask prices on the date of purchase.
NOTE K - STOCK PURCHASE AND OPTION PLANS In accordance with the terms of the 1981 Stock Purchase Plan (1981 Plan), the Company is obligated to repurchase shares issued under the 1981 Plan, at a price equal to 90% of the book value of the shares at the end of the quarter immediately preceding the date of repurchase. No shares were repurchased during 1998, 1997 or 1996. At December 31, 1998 there were 136,229 shares (Class A) and 375,766 shares (Class B) outstanding which are eligible for repurchase by the Company.
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 Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, 1998 net income and earnings per share would have been reduced by $964 and $.07, respectively, related to the issuance of 1997 market value options. The affect on 1997 earnings resulting from the issuance of these options would not have been material.
Exercise prices for options outstanding as of December 31, 1998 were $.33, $1.00 or $25.75. The weighted-average remaining contractual life of options exercisable at either $.33 or $1.00 is 4.4 years with a weighted-average exercise price of $.59. The remaining contractual life of options exercisable at $25.75 is 9 years. The compensation cost that has been charged against income for all stock-based compensation plans was $.1 million, $.1 million and $.5 million for 1998, 1997 and 1996, respectively.