Shareholders' equity decreased to $284.6 million at December 31, 2002, from $288.4 million at December 31, 2001, including $9.0 million in treasury share purchases, $4.6 million of cash dividends to shareholders, and a $2.7 million decrease in unrealized net gains on investments. Book value per common share outstanding increased 2.4% to $19.43 at December 31, 2002 from $18.98 per share at December 31, 2001.
In connection with the treasury stock purchases mentioned above, the Company established short-term borrowing facilities with two banks during 2002 in the total amount of $17 million. Drawings under these facilities totaled $10 million in 2002 with repayments of $2.5 million, leaving $7.5 million outstanding at December 31, 2002. These borrowing facilities expire in 2003 but are expected to be renewed.
Premiums assumed from other reinsurers totaled $8.1 million during 2002, an increase of $2.5 million (43%) from 2001. Premiums assumed for 2001 included $1.0 million of reinstatement premiums attributable to losses reported that year. Without these reinstatement premiums, reinsurance assumed volume would have increased 74% from the prior year. Improved pricing in this market allowed the Company to increase its participation via several new treaties since the 2001 period. Premium volume for this division is limited by the Company's intention to expose itself to a maximum loss of $10 million from a single catastrophic event. Further, the Company's participation in reinsurance assumed in the future will be restricted should pricing become less favorable.
After giving effect to changes in unearned premiums, net premiums earned increased 26% to $104.4 million for 2002 from $83.1 million for 2001. Net premiums earned from all trucking-related insurance products increased
by $18.6 million (44%). Net premiums earned from the Company's voluntary reinsurance assumed and small workers' compensation programs increased $2.1 million (37%) and $.7 million (26%), respectively. These increases were partially offset by a $.3 million (1%) decrease in premiums earned from private passenger automobile.
Net investment income decreased $2.7 million (15.1%) during 2002 reflecting lower overall pre-tax yields while average invested assets increased 5%. The average pre-tax yield on invested assets dropped to 4.1% this year from 5.0% during 2001. The largest decline in yields came from short-term investments which averaged 1.4% during 2002 compared to 3.7% last year. Average bond yields also declined from 6.0% in 2001 to 5.1% in 2002. The short-term nature of the Company's bond portfolio results in a rapid recognition of changes in interest rates, either positive or negative. The steady decline in interest rates over the past few years continues to impact the average yield of the bond portfolio, as noted above. After-tax yields were 2.9% and 3.6% for 2002 and 2001, respectively, in line with pre-tax yield changes.
The improved loss and loss expense ratios for the Company's private passenger automobile, small fleet trucking and small business workers' compensation programs are due primarily to improved underwriting selection and rate increases. 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 reinsurance structure for its large trucking fleets can have a significant impact on future loss developments and, as a result, loss and loss expense ratios may not be consistent year to year.
Realized net capital gains were $5.1 million in 2001 compared to $12.5 million for 2000. The current year's net gain consisted of gains on equity securities of $7.3 million and losses on fixed maturities and other investments of $2.2 million. The decrease in realized gains during 2001 was generally reflective of the substantially less robust stock market during 2001 for reasons described in the comparison of 2002 to 2001. Gains from equity trading during 2000, of $16.0 million, were unusually high as the result of more favorable market conditions. Realized net gains for 2001 and 2000 included other than temporary write downs totaling $2.1 million and $5.0 million, respectively. The largest single losses realized on investments actually sold during 2001 were $1.0 million on PICO Holdings, Inc. and $.4 million on Capital Transamerican Corp.
common stocks. The largest single losses reported as realized on investments still owned were $.6 million on Loral Space and Communication and $.5 million on Great Lakes Chemical Company common stocks.
The effective federal tax rate for consolidated operations for 2001 was 16.3%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.
Approximately 70% of the Company's assets are composed of investments at December 31, 2002. Less than .5% of these investments, consisting of limited partnership investments in real estate and venture capital assets, do not have readily determinable market values. For these investments, we estimate fair value by reference to the underlying assets of the limited partnerships. In addition, approximately $8.1 million of marketable bonds owned at December 31, 2002 (1.8% of invested assets), are rated below investment grade. All marketable securities are included in the Company's balance sheet at current fair market value.
In determining if and when a decline in market value below cost is other than temporary, we first make an objective analysis 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. The only exception exists where substantial recovery to
cost has actually occurred prior to the issuance of the financial statements. For individual issues where the decline in value is less than 20% but the amount of the decline is considered significant, a similar objective evaluation is conducted but, in these cases, we will also evaluate the market conditions, trends of earnings, price multiples and other key measures for the securities to determine if it appears that the decline is other than temporary. For any decline which is considered to be other than temporary, we recognize an impairment loss in the current period operating results as an addition to realized capital losses. Declines which are considered to be temporary are recorded as a reduction in shareholders' equity, net of related federal income tax credits.
Amounts recoverable under the terms of reinsurance contracts comprise almost 21% of total Company assets as of December 31, 2002. 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 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 trucking liability and workers' compensation, provide more variability in the estimation process than lines of business with lower coverage limits.
that such forward-looking statements involve risks and uncertainties including without limitation the following: (i) the Company's plans, strategies, objectives, expectations and intentions are subject to change at any time at the discretion of the Company; (ii) the Company's business is highly competitive and the entrance of new competitors into or the expansion of the operations by existing competitors in the Company's markets and other changes in the market for insurance products could adversely affect the Company's plans and results of operations; and (iii) other risks and uncertainties indicated from time to time in the Company's filings with the Securities and Exchange Commission.
A provision in the Technical and Miscellaneous Revenue Act of 1988 created a mechanism which allows 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 $4.6 million have been paid in connection with this election.
anticipated effect of inflation is implicitly considered when estimating liabilities for losses and loss adjustment expenses.
There is an inverse relationship between interest rate fluctuations and the fair value of the Company's fixed maturity investments. Additionally, the fair value of interest rate sensitive instruments may be affected by the financial strength of the issuer, prepayment options, relative values of alternative investments, liquidity of the investment and other general market conditions. The Company monitors its sensitivity to interest rate risk by measuring the change in fair value of its fixed maturity investments relative to hypothetical changes in interest rates. 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 in the following summary.
We estimate that a 100 basis point increase in market interest rates would have resulted in a pre-tax loss in the fair value of fixed maturity investments of approximately $5.6 million at December 31, 2002. Similarly, a 100 basis point decrease in market interest rates would have resulted in an estimated pre-tax gain in the fair value of these instruments of approximately $6.0 million at December 31, 2002. Note, however, that the hypothetical loss mentioned above would only be realized if the Company was obligated, or elected, to sell bonds prior to maturity, which is extremely unlikely. The aggregate value of money market and short-term investments, bonds maturing within twelve months and expected positive cash flow from operations for 2003 is equal to more than 100% of net loss and loss expense reserves at December 31, 2002.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc. and subsidiaries as of December 31, 2002 and 2001, 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, 2002. Our audits also included the financial statement schedules listed in the Index at Item 15(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.
BASIS OF PRESENTATION: The consolidated financial statements include the accounts of Baldwin & Lyons, Inc. and its wholly owned subsidiaries (the Company). All significant intercompany transactions and accounts have been eliminated in consolidation.
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. Reinstatement premiums on reinsurance assumed contracts covering catastrophic events are recorded concurrently with the related loss.
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 recorded other than temporary writedowns of $7,726, $2,081 and $5,000 in 2002, 2001 and 2000, respectively.
The Company has holdings in money-market accounts which were managed by or purchased through companies affiliated with certain directors of the Company.
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, 2002 and 2001, loss reserves have been reduced by approximately $6,396 and $4,724, 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 $2,810 and $2,717 at December 31, 2002 and 2001, respectively.
Cash flows related to federal income taxes paid, net of refunds received, for 2002, 2001 and 2000 were $7,250, $5,200 and $8,807, respectively, including Section 847 special tax deposits. Future tax benefits on approximately $4,554 of deferred tax assets at December 31, 2002 arising from loss reserve discounting are assured based on Section 847 of the Internal Revenue Code.
Shareholders' equity at December 31, 2002 includes $277,583 representing GAAP shareholder's equity of insurance subsidiaries, of which $40,347 may be transferred by dividend or loan to the parent company without approval by, or notification to, regulatory authorities. An additional $181,544 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.
NOTE J - REPORTABLE SEGMENTS The Company and its consolidated subsidiaries market and underwrite casualty insurance in five major speciality areas (reportable segments): (1) fleet trucking, (2) non-standard private passenger automobile, (3) small fleet trucking, (4) the assumption of reinsurance and (5) small business workers' compensation. 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 coverages to individuals. The small fleet trucking segment provides commercial automobile coverages to small trucking fleets and owner/operators. The reinsurance assumed segment accepts retrocessions from selected reinsurance companies, principally reinsuring against catastrophes. The small business workers' compensation segment provides workers' compensation coverages to small businesses and other entities.
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 2002, 2001 or 2000. At December 31, 2002 there were 170,224 shares (Class A) and 469,708 shares (Class B) outstanding which are eligible for repurchase by the Company.
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. Discounted options granted to employees are generally exercisable immediately while discounted options granted to directors are generally not exercisable for one year from the date of grant. All options expire ten years after the date of grant. All of the Company's option plans have received shareholder approval. Approximately 333,000 of such options are available for future grants.
The fair value of 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, 2000 net income and earnings per share would have been reduced by $918 and $.06, respectively, related to the issuance of 1997 market value options. There would have been no impact on net income or earnings per share related to these options for the years 2002 or 2001.
Exercise prices for options outstanding as of December 31, 2002 were $.80 or $20.60. The weighted-average remaining contractual life of options exercisable at $.80 is 4.5 years. The remaining contractual life of options exercisable at $20.60 is 5 years. The compensation cost that has been charged against income for all stock-based compensation plans, consisting of directors' fees only, was $134, $130 and $136 for 2002, 2001 and 2000, respectively.
NOTE K - STOCK PURCHASE AND OPTION PLANS (CONTINUED) During 2002, 2001 and 2000, the Company offered loans to certain key employees for the sole purpose of purchasing the Company's Class B common stock in the open market. $7,494 and $2,257 of such full-recourse loans were issued and outstanding at December 31, 2002 and 2001, respectively, and carry interest rates ranging from 4.75% to 6%, payable annually on the loan anniversary date. The underlying securities serve as collateral for these loans, which must be repaid no later than 10 years from the date of issue.
NOTE N - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Quarterly results of operations are as follows: