Baldwin & Lyons, California leases approximately 1,900 square feet of office space in a suburb of Los Angeles, California. All West Coast operations are conducted from these facilities.
(3) Includes money market instruments classified with cash in the Consolidated Balance Sheets.
For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds with maximum quality and liquidity. As interest rates have declined and yield curves have not provided a strong incentive to lengthen maturities in recent years, the Company has maintained its short-term position with respect to the vast majority of its fixed maturity investments. The average life of the Company's bond and short-term investment portfolio was 3.8 years and 4.0 years for 2001 and 2000, 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.
The Company's assets at December 31, 2001 included $51.5 million in short-term investments which are readily convertible to cash without market penalty and an additional $47.5 million of fixed maturity investments 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 addition, the Company's reinsurance program is structured to avoid serious cash drains that might accompany catastrophic losses. In the event competitive conditions produce inadequate rates and the Company chooses to restrict volume, the Company believes that 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.
As more fully discussed in Note G to the consolidated financial statements, at December 31, 2001, $47.6 million, or 16.5% 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 $17.4 million at December 31, 2001.
Premiums ceded to reinsurers increased $13.5 million (56%) during 2001 to $37.7 million. The percentage of premiums ceded to direct premiums written increased to 33% for 2001 from 25% for 2000 consistent with the increase in direct premiums written for the more heavily reinsured large trucking fleet program discussed above.
Net investment income decreased $1.4 million (7.5%) during 2001 reflecting lower overall pre-tax yields on slightly higher average invested assets. The average pre-tax yield on invested assets was 5.0% and 5.5% for 2001 and 2000, respectively. After-tax yields were 3.6% and 3.9% for 2001 and 2000, respectively.
Losses and loss expenses incurred during 2001 increased $24.4 million (42%) to $81.9 million, including a $20 million loss related to the events of September 11, 2001. The 2001 consolidated loss and loss expense ratio was 98.5% compared to 74.2% for 2000. Adjusted for the September 11, 2001 loss, the consolidated loss and loss expense ratio was 74.4%. While the adjusted consolidated loss ratio remained virtually unchanged, individual product lines varied from year-to-year as less favorable loss development in the Company's large fleet trucking product was offset by significant improvement in the Company's private passenger automobile division. The loss and loss expense ratio for private passenger automobile dropped from 94.5% during 2000 to 69.5% during 2001. As previously discussed, improved underwriting selection and rate increases are directly responsible for the improved private passenger automobile results. 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. However, due to the aforementioned changes in the Company's reinsurance structure for its large trucking fleets, whereby a smaller portion of the risk is retained, the impact of future loss developments on the loss and loss expense ratios may not be consistent with prior years.
As a result of the factors mentioned above, net income from consolidated operations for 2001 was $5.4 million compared to $19.8 million for 2000. Diluted earnings per share decreased to $.44 in 2001 from $1.57 in 2000 due primarily to the losses related to the events of September 11, 2001. Diluted earnings per share from operations before realized gains on investments was $.17 in 2001 compared to $.93 in 2000.
trucking fleet volume increases resulted primarily from the addition of new accounts. Increases in independent contractor premiums resulted from the addition of new accounts and volume increases on existing accounts, while increases in private passenger automobile, small fleet and small workers' compensation were due primarily to geographic expansion.
Premiums assumed from other reinsurers of $4.2 million during 2000 were relatively unchanged from 1999 although 2000's premium included $1.7 million of reinstatement premium attributable to losses occurring in late 1999. Without this premium, reinsurance assumed volume would have decreased 37% from the prior year. Pricing in this market began to firm up toward the end of 2000.
After giving effect to changes in unearned premiums, net premiums earned increased 12% to $77.4 million for 2000 from $69.1 million for 1999. Premiums earned from private passenger automobile increased by $6.6 million. Net premiums earned from all trucking-related insurance products increased by $1.7 million (5%), including $1.9 million (32%) for small fleet trucking. Net investment income increased by $.2 million (1%) during 2000 reflecting higher overall pre-tax yields on slightly lower average invested assets. The average pre-tax yield on invested assets was 5.5% and 5.0% for 2000 and 1999, respectively. After-tax yields were 3.9% and 3.6% for 2000 and 1999, respectively.
Losses and loss expenses incurred during 2000 increased $12.6 million (28%) to $57.5 million. The 2000 consolidated loss and loss expense ratio was 74.2% compared to 65.0% for 1999. The increase in the loss and loss expense ratio is primarily attributable to adverse loss development and an increased frequency and severity of claims in the Company's personal automobile division. Changes in the Company's remaining products were generally favorable.
Other operating expenses for 2000, before credits for allowances from reinsurers, increased $2.9 million (9%) to $34.7 million. Personnel related expenses, including amounts allocated to loss expenses and investment income, increased 7% and accounted for approximately 40% of the total operating expense increase, reflecting the fully-employed labor market from which the Company draws. Direct commission expense increased $.9 million (13%) as the result of higher direct premiums from all of the Company's products. Ceding commission allowances from reinsurers increased $1.9 million (28%), resulting from increased premium volume covered under the reinsurance agreements covering Protective's fleet trucking business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 28.1% during 2000 compared to 29.6% for 1999. Including the agency operations, the ratio of other operating expenses to total revenue, adjusted to remove net realized gains, was 26.0% for 2000 compared with 27.5% for 1999. Expenses for 1999 included expenditures in preparation for Year 2000 (Y2K) compliance that were not present in the year 2000.
The effective federal tax rate for consolidated operations for 2000 was 31.8%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.
due primarily to the increase in realized gains on investments. Diluted earnings per share from operations before realized gains on investments was $.93 in 2000 compared to $1.11 in 1999.
Amounts recoverable under the terms of reinsurance contracts comprise almost 19% of total Company assets as of December 31, 2001. In order to be able to provide the high limits required by the Company's trucking company 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 losses 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 trucking liability and workers' compensation, provide more variability in the estimation process than lines of business with lower coverage limits.
As with any receivable, credit risk exists in the recoverability of reinsurance. This is even more pronounced than in normal receivable situations since recoverable amounts will not be due until the loss is settled which, in some cases, may be many years after the contract was written. If a reinsurer is unable, in the future, to meet the reinsurer's financial commitments under the terms of the contracts, the Company would be responsible for its portion of the loss. The financial strength of each of the Company's reinsurers is reviewed on a continual basis and, should impairment in the ability of a reinsurer be determined to exist, current year operations would be charged in amounts sufficient to provide for the Company's additional liability.
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. Our 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 used 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 study 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 that guaranty variability when compared to the ultimate costs to settle the underlying claims for which the reserves are established.
The reserving process requires us to continuously monitor and evaluate the life cycle of claims based on the class of business and the nature of claims. Our claims range from the very routine private passenger automobile "fender bender" to the highly complex and costly third party bodily injury claim. Reserving for each class of claims requires a set of assumptions based upon historical experience, knowledge of current industry trends and seasoned judgment. The high limits provided in the Company's trucking liability policies provide for greater variation in the reserving process for more serious claims. Court rulings, tort reform (or lack thereof) 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.
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, 2001 was $136.4 million or approximately 31% 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.
securities, 86% of the portfolio matures within 5 years and the average life of the Company's fixed maturity investments is approximately 3.8 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.
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 $9.9 million and $12.5 million were recorded at December 31, 2001 and 2000, respectively. The net deferred tax liability at December 31, 2001 included $4.3 million in special tax deposits covered under Section 847 of the Internal Revenue Code, as explained in the following paragraph, which compares to $4.2 million in special tax deposits at December 31, 2000. Adjusted for the special deposits, a net deferred tax liability of $14.2 million was recorded at December 31, 2001 compared to a net deferred tax liability of $16.7 million at December 31, 2000. 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 $4.3 million have been paid in connection with this election.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc. and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of income, changes in equity other than capital, and cash flows for each of the three years in the period ended December 31, 2001. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
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 defined benefit pension plan.
Gross realized losses in the above table included other than temporary write- downs of $2,081 and $5,000 in 2001 and 2000, respectively.
The fair value and the cost or amortized cost of fixed maturity investments at December 31, 2001, 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.
Approximately 31% of purchases and 52% of sales of investments during the three years ended December 31, 2001 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 $1,110, $1,499 and $614 in 2001, 2000 and 1999, 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 2001, 2000 and 1999 were $736, $657 and $620, respectively.
NOTE E - INCOME TAXES (CONTINUED) Cash flows related to federal income taxes paid, net of refunds received, for 2001, 2000 and 1999 were $5,200, $8,807 and $7,367, respectively, including Section 847 special tax deposits. Future tax benefits on approximately $4,298 of deferred tax assets at December 31, 2001 arising from loss reserve discounting are assured based on Section 847 of the Internal Revenue Code.
Net premiums earned for 2001, 2000 and 1999 include approximately $5,931, $4,678 and $4,981, respectively, relating to the assumption of reinsurance from other companies and from reinsurance pools. Losses and loss expenses incurred for 2001 included an estimated $20,000 for the Company's exposure from reinsurance assumed treaties related to the events of September 11, 2001.
NOTE G - SHAREHOLDERS' EQUITY Changes in common stock outstanding and additional paid-in capital are as follows:
Shareholders' equity at December 31, 2001 includes $278,249 representing GAAP shareholder's equity of insurance subsidiaries, of which $40,815 may be transferred by dividend or loan to the parent company without approval by, or notification to, regulatory authorities. An additional $189,859 of shareholder's equity of such insurance subsidiaries may be advanced or loaned to the Company with prior notification to and approval from regulatory authorities.
Net income of the insurance subsidiaries, as determined in accordance with statutory accounting practices, was $5,660, $24,309 and $18,212 for 2001, 2000 and 1999, respectively. Consolidated statutory shareholder's equity for these subsidiaries was $273,072 and $291,371 at December 31, 2001 and 2000, respectively.
The Company and its consolidated subsidiaries market and underwrite casualty insurance in three major specialty 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.
The Company's reportable segments are business units that operate in the property/casualty insurance industry and each offers products to different classes of customers. The reportable segments are managed separately due to the differences in underwriting criteria used to market products to each class of customer and the methods of distribution of the products each reportable segment provides. Segment information shown in the table below as "all other" includes products marketed and underwritten by the Company in other specialty areas and the runoff of discontinued product lines.
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 2001, 2000 or 1999. At December 31, 2001 there were 136,179 shares (Class A) and 375,766 shares (Class B) outstanding which are eligible for repurchase by the Company.
Exercise prices for options outstanding as of December 31, 2001 were $.33, $1.00 or $25.75. The weighted-average remaining contractual life of options exercisable at either $.33 or $1.00 is 4.9 years with a weighted-average exercise price of $.83. The remaining contractual life of options exercisable at $25.75 is 6 years. The compensation cost that has been charged against income for all stock-based compensation plans, consisting of directors' fees only, was $130, $136 and $139 for 2001, 2000 and 1999, respectively.