ITEM 1. BUSINESS - -----------------
Baldwin & Lyons, Inc. was incorporated under the laws of the State of Indiana in 1930. Through its divisions and subsidiaries, Baldwin & Lyons, Inc. (referred to herein as "B & L") specializes in marketing and underwriting property and casualty insurance. B & L's subsidiaries are: Protective Insurance Company (referred to herein as "Protective"), with licenses in all 50 states, the District of Columbia and all Canadian provinces; Sagamore Insurance Company (referred to herein as "Sagamore"), which is currently licensed in 47 states; and B & L Insurance, Ltd. (referred to herein as "BLI"), which is domiciled and licensed in Bermuda. These subsidiaries are collectively referred to herein as the "Insurance Subsidiaries." The "Company", as used herein, refers to Baldwin & Lyons, Inc. and all its subsidiaries unless the context indicates otherwise.
Approximately 62% of the gross direct premiums written and assumed by the Insurance Subsidiaries during 2006 was attributable to business produced directly by B & L. Approximately 7% of gross premium is assumed from several non-affiliated insurance and reinsurance companies through retrocessions. The remaining 31% consists primarily of business written by Sagamore which was originated through an extensive network of independent agents.
The Insurance Subsidiaries cede portions of their gross premiums written to several non-affiliated reinsurers under excess of loss and quota-share treaties and by facultative (individual policy-by-policy) placements. Reinsurance is ceded to spread the risk of loss among several reinsurers. In addition to the assumption of non-affiliated reinsurance, described below, the Insurance Subsidiaries participate in numerous mandatory government-operated reinsurance pools which require insurance companies to provide coverages on assigned risks. These assigned risk pools allocate participation to all insurers based upon each insurer's portion of premium writings on a state or national level. Assigned risk premium typically comprises less than 1% of gross direct premium written and assumed.
The Insurance Subsidiaries serve various specialty markets as follows:
FLEET TRUCKING INSURANCE - ------------------------
Protective provides coverage for larger companies in the motor carrier industry which retain substantial amounts of self-insurance, independent contractors utilized by large trucking companies as well as for medium-sized trucking companies on a first dollar or small deductible basis. Large fleet trucking products are marketed exclusively by the B&L agency organization directly to trucking clients although broker or agent intermediaries are used on a limited basis for certain smaller accounts. The principal types of insurance marketed by Protective are:
- - Casualty insurance including motor vehicle liability, physical damage and other liability insurance. - - Workers' compensation insurance. - - Specialized accident (medical and indemnity) insurance for independent contractors. - - Fidelity and surety bonds. - - Inland Marine consisting principally of cargo insurance. - - "Captive" insurance company products, which are provided through BLI in Bermuda.
B&L also performs a variety of additional services, primarily for Protective's insureds, including risk surveys and analyses, government compliance assistance, loss control and cost studies and research, development, and consultation in connection with new insurance programs including development of computerized systems to assist in monitoring accident data. Extensive claims handling services are also provided, primarily to clients with self-insurance programs.
NON-AFFILIATED ASSUMPTION REINSURANCE - -------------------------------------
Protective accepts cessions and retrocessions from selected insurance and reinsurance companies, principally reinsuring against catastrophes. Exposures under these retrocessions are generally in high upper layers, are spread among several geographic regions and are limited so that only a major catastrophic event or series of major events would have a material impact on the Company's operations or financial position.
PRIVATE PASSENGER AUTOMOBILE INSURANCE - --------------------------------------
Sagamore markets nonstandard private passenger automobile liability and physical damage coverages to individuals through a network of independent agents in thirty states.
SMALL FLEET TRUCKING INSURANCE - ------------------------------
Sagamore provides commercial automobile liability, physical damage and cargo insurance to truck owner-operators with six or fewer power units. These products are marketed through independent agents in thirty-one states.
The most significant expense category for the Company's insurance subsidiaries is losses and loss adjustment expenses incurred. A discussion of this expense category follows.
PROPERTY/CASUALTY LOSSES AND LOSS ADJUSTMENT EXPENSES - -----------------------------------------------------
The consolidated financial statements include the estimated liability for unpaid losses and loss adjustment expenses ("LAE") of the Insurance Subsidiaries. The liabilities for losses and LAE are determined using case basis evaluations and statistical projections and represent estimates of the Company's ultimate net exposure for all unpaid losses and LAE incurred through December 31 of each year. These estimates are subject to the effects of trends in claim severity and frequency and are continually reviewed and, as experience develops and new information becomes known, the liability is adjusted as necessary. Such adjustments, either positive or negative, are reflected in current operations.
The Company's reserves for losses and loss expenses ("reserves") are determined based on evaluations of individual reported claims and by 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, which comprise approximately 59% of total net reserves at December 31, 2006, are established for specific known loss occurrences at amounts dependent upon criteria such as type of coverage, severity of injury or property damage and the underlying policy limits, as examples. Case basis reserves are 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 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 which 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 which assure variability when compared to the ultimate costs to settle the underlying claims for which the reserves are established. For a more detailed discussion of the three categories of reserves, see "LOSS AND LOSS EXPENSE RESERVES" under the caption, "Critical Accounting Policies" beginning on page 32 in MANAGEMENT'S DISCUSSION AND ANALYSIS.
The reserving process requires management to continuously monitor and evaluate the life cycle of claims. Our claims range from the very routine private passenger automobile "fender bender" to the highly complex and costly claims 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 the Company's trucking liability policies provide for greater volatility in the reserving process for more serious claims. Court rulings, legislative actions, geographic location of the claim under consideration 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.
Loss reserves related to certain permanent total disability (PTD) workers' compensation claims have been discounted to present value using tables provided by the National Council on Compensation Insurance which are based upon a pretax interest rate of 3.5% and adjusted for losses retained by the insured. The loss and LAE reserves at December 31, 2006 have been reduced by approximately $4.9 million as a result of such discounting. Had the Company not discounted loss and LAE reserves, pretax income would have been approximately $.4 million lower for the year ended December 31, 2006.
For policies inforce at December 31, 2006, the maximum amount for which Protective insures a trucking risk is $10 million, less applicable self-insured retentions, although for the majority of policies written, the maximum limits provided by Protective are $5 million. Any limits above $10 million required by customers are either placed directly by Baldwin & Lyons, Inc. with excess carriers or are written by Protective but 100% reinsured. Certain coverages, such as workers' compensation, provide essentially unlimited exposure, although the Company protects itself to the extent believed prudent through the purchase of excess reinsurance for these coverages. After giving effect to current treaty reinsurance arrangements Protective's maximum exposure to loss from a single occurrence is approximately $2.4 million for the vast majority of risks insured although, for certain losses, Protective's maximum exposure could be as high as $3.7 million for a single occurrence. Reinsurance agreements effective since June 3, 2004 include provisions for aggregate deductibles that must be exceeded before the Company can recover under the terms of the treaties. The Company retains a higher percentage of the direct premium (and, therefore, cedes less premium to reinsurers) in consideration of these deductible provisions. Net premiums earned and losses incurred by the Company for 2006, 2005 and 2004 each include $23,366, $15,878 and $2,278, respectively, related to such deductible provisions. Protective has revised its treaty arrangements several times in prior years in response to changing market conditions. The current treaty arrangements are effective until June 3, 2007 and cover the entire policy period for all business written through that date. Treaty renewals are expected to occur annually in the foreseeable future. During the past ten years, Protective's maximum exposure to a single occurrence has ranged from less than $100,000 to current levels, as discussed above. Because Protective has, in the past, written multiple year policies and because losses from trucking business take years to develop, losses reported in the current year may be covered by a number of older reinsurance treaties with higher or lower loss retentions by Protective than those provided by current treaty provisions.
With respect to Sagamore's private passenger automobile and small fleet trucking business, the Company's maximum net exposure for a single occurrence has never exceeded $250,000.
The following table on page 5 sets forth a reconciliation of beginning and ending loss and LAE liability balances, for 2006, 2005 and 2004. That table is presented net of reinsurance recoverable to correspond with income statement presentation. However, a reconciliation of these net reserves to those gross of reinsurance recoverable, as presented in the balance sheet, is also shown. The table on page 12 shows the development of the estimated liability, net of reinsurance recoverable, for the ten years prior to 2006. The table on page 13 is a summary of the reestimated liability, before consideration of reinsurance, for the ten years prior to 2006 as well as the related reestimated reinsurance recoverable for the same periods.
The reconciliation above shows that a savings of $16.9 million was developed in the liability for losses and LAE recorded at December 31, 2005, with similar savings developed during the two prior calendar years. The following table is a summary of the above $16.9 million reserve savings by accident year.
The savings recorded for these loss years was derived from varied sources, as follows.
These developments, presented separately by line of business, were as follows.
The fleet trucking developments include developed redundancies from retrospectively-rated direct business, as shown in the following table. The "All other" category includes loss activity from involuntary residual markets, assigned risks and run-off of the Company's discontinued products, other than small business workers' compensation.
In order to better understand the dynamics of the loss developments shown above, the following table separates developments into unique components, which are discussed below.
A major component of the reserve savings in each of the years 2006, 2005 and 2004 is attributable to retrospectively-rated policies which are included in Fleet Trucking business. The majority of savings on these policies is returned to policyholders in the form of a retrospective premium adjustment which is recorded concurrently with the recognition of the reserve development. Accordingly, premium written and earned during 2006, 2005 and 2004 was reduced by approximately $5.4 million, $4.8 million and $2.2 million, respectively, associated with prior year loss reserve development on these policies and pre-tax income was increased by approximately $1.8 million (3.3%), $3.2 million (6.3%) and $3.2 million (7.3%), respectively.
The other direct business amounts include the non-retrospectively rated polices for Fleet Trucking, non-standard private passenger automobile, small fleet and small business workers' compensation lines, as well as runoff of discontinued products which constitute part of the "all other" line of business shown in the previous table. As shown, the savings from this category, which comprises all of the Company's directly produced, non-retrospectively rated business, ranged from $4.5 million in 2005 to $8.0 million in 2006. This fluctuation reflects the Company's continuing process of incorporating more recent loss development data into its loss reserving formulae, but also reflects the variability associated with the larger claims covered by the Company, particularly in more recent periods when the Company's net retentions have increased. As discussed elsewhere, the Company has experienced savings in its loss developments for several years owing to, among other things, its long-standing policy of reserving for losses realistically and a willingness to settle claims based upon a seasoned evaluation of its exposures. While the Company's basic assumptions have remained consistent, we continue to update loss data to reflect changing trends which can be expected to result in fluctuations in loss developments over time. Our goal is to produce an overall estimate of reserves which is sufficient and as close to expected ultimate losses as possible. The $8.0 million savings developed during 2006 represents approximately 15.3% of pre-tax net income for 2006 but only approximately 5% of December 31, 2005 net loss and LAE reserves on the related business.
The developments for reinsurance assumed and involuntary residual markets, which netted to $1.8 million of savings during 2006, are heavily dependent on the establishment of case basis and IBNR reserves by other insurance and reinsurance companies and by managers of state run residual market pools. While the Company evaluates the sufficiency of such reserving, considering the number of different entities involved and the fact that the Company must rely on external sources of information, the savings or deficiency developed from these products will likely fluctuate from year to year. We have found this to be particularly true during years when large catastrophic events occur near year end.
Factors affecting the development of environmental claims are more fully discussed in the following paragraphs. The savings recognized in 2005 and 2004 represent both case basis and IBNR reserve reductions resulting from favorable outcomes related to large environmental claims.
The Company has maintained a consistent, conservative posture in its reserving process and has not significantly altered its assumptions used in the reserving process since the mid-1980's; this process has proven to be fully adequate with no overall deficiencies developed since 1985. There were no significant changes in trends related to the numbers of claims incurred (other than correlative variances with premium volume), average settlement amounts, numbers of claims outstanding at period ends or the averages per claim outstanding during the year ended December 31, 2006 for most lines of business. However, the average settlement amounts of severe trucking claims have tended to increase significantly in recent years.
In the first table on page 6, the amounts identified as "Net (savings) deficiency on losses from directly-produced business" consist of development on cases known at December 31, 2005, losses reported which were previously unknown at December 31, 2005 (incurred but not reported), unallocated loss expense paid related to accident years 2005 and prior and changes in the reserves for incurred but not reported losses and loss expenses. Bulk loss reserves are established to provide for potential future adverse development on cases known to the Company and for cases unknown at the reserve date. Changes in the reserves for incurred but not reported losses and loss expenses occur based upon information received on known and newly reported cases during the current year and the effect of that development on the application of standard actuarial methods used by the Company.
Also shown in the above table are amounts representing the "(savings) deficiency reported under voluntary reinsurance assumption agreements and residual markets". These amounts relate primarily to the Company's voluntary participation in property catastrophe treaties. The Company records its share of losses from these treaties based on reports from the retrocessionaires and has no control over the establishment of case reserves related to this segment of the Company's business. The Company does, however, establish additional reserves for reinsurance assumed losses to supplement case reserves reported by the ceding companies, when considered necessary.
As described on page 4, changes have occurred in the Company's net per accident exposure under reinsurance agreements in place during the periods presented in the above table. It is much more difficult to reserve for losses where policy limits are as high as $10 million per accident as opposed to those losses in the lower layers. There are fewer policy limit losses in the Company's historical loss database on which to project future loss developments and the larger the loss, the greater the likelihood that the courts will become involved in the settlement process. As such, the level of uncertainty in the reserving process is much greater when dealing with larger losses and will often result in fluctuations among accident year developments.
The differences between the liability for losses and LAE reported in the accompanying 2006 consolidated financial statements in accordance with generally accepted accounting principles ("GAAP") and that reported in the annual statements filed with state and provincial insurance departments in the United States and Canada in accordance with statutory accounting practices ("SAP") are as follows:
The table on page 12 presents the development of GAAP balance sheet liabilities for each year-end 1996 through 2006, net of all reinsurance credits. The top line of the table shows the estimated liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and LAE for claims arising in all prior years that were unpaid at the respective balance sheet date, including losses that had been incurred, but not yet reported, to the Company.
The upper portion of the table shows the reestimated amount of the previously recorded liability based on additional information available to the Company as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of individual claims and as claims are settled and paid.
The "cumulative redundancy" represents the aggregate change in the estimates of each calendar year end reserve through December 31, 2006. For example, the 1996 liability has developed a $37.1 million redundancy over ten years. That amount has been reflected in income over those ten years, as shown on the table. The effect on income of changes in estimates of the liability for losses and LAE during each of the past three years is shown in the table on page 5.
Historically, the Company's loss developments have been favorable. Reserve developments for all years ended in the period 1986 through 2005 have produced redundancies as of December 31, 2006. In addition to improvements in reserving methods, loss reserve developments since 1985 have been favorably affected by several other factors. Perhaps the most significant single factor has been the improvement in safety programs by the trucking industry in general and by the Company's insureds specifically. Statistics produced by the American Trucking Association show that driver quality has improved markedly in the past decade resulting in fewer fatalities and serious accidents. The Company's experience also shows that improved safety and hiring programs have a dramatic impact on the frequency and severity of trucking accidents. Higher self-insured retentions also played a part in reduced insurance losses during portions of this period. Higher retentions not only raise the excess insurance entry point but also encourage trucking company management to focus even more intensely on safety programs. To a small degree, reserve savings have been achieved by the use of structured settlements on certain workers' compensation and liability claims of a long-term liability nature.
The establishment of bulk reserves requires the use of historical data where available and generally a minimum of ten years of such data is required to provide statistically valid samples. As previously mentioned, numerous factors must be considered in reviewing historical data including inflation, legislative actions, new coverages provided and trends noted in the current book of business which are different from those present in the historical data. Clearly, the Company's book of business in 2006 is different from that which generated much of the ten-year historical loss data used to establish reserves in recent years. Management has noted trends toward significantly higher settlements and jury awards associated with the more serious trucking liability claims. The inflationary factors affecting these claims appear to be more subjective in nature and not in line with compensatory equity. In addition to the factors mentioned above, savings realized in recent years upon the
closing of claims, as reflected in the tables on pages 5 and 12, 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 the underlying exposures. The Company will continue to review the trends noted and, should it appear that such trends are permanent and projectable, they will be reflected in future reserving method refinements.
The lower section of the table on page 12 shows the cumulative amount paid with respect to the previously recorded calendar year end liability as of the end of each succeeding year. For example, as of December 31, 2006, the Company had paid $87.5 million of losses and LAE that had been incurred, but not paid, as of December 31, 1996; thus an estimated $29.4 million in losses incurred through 1996 remain unpaid as of the current financial statement date ($116.9 million incurred less $87.5 million paid).
In evaluating this information, it is important to note that the method of presentation causes some development experience to be duplicated. For example, the amount of any redundancy or deficiency related to losses settled in 1999, but incurred in 1996, will be included in the cumulative development amount for each of the years-end 1996, 1997, and 1998. As such, this table does not present accident or policy year development data which readers may be more accustomed to analyzing. Rather, this table is intended to present an evaluation of the Company's ability to establish its liability for losses and loss expenses at a given balance sheet date. It is important to note that conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
The table presented on page 13 presents loss development data on a gross (before consideration of reinsurance) basis for each of the ten years December 31, 1996 through December 31, 2005 as of December 31, 2006 with a reconciliation of the data to the net amounts shown in the table on page 12. Readers are reminded that the gross data presented on page 13 requires significantly more subjectivity in the estimation of incurred but not reported and loss expense reserves because of the high limits provided by Protective to its trucking customers, much of which has been covered by reinsurance. This is particularly true of excess of loss treaties where Protective retains risk in only the lower, more predictable, layers of coverage. Accordingly, one would generally expect more variability in development on a gross basis than on a net basis.
ENVIRONMENTAL MATTERS: The Company's reserves for unpaid losses and loss expenses at December 31, 2006 included amounts for liability related to environmental damage claims. Given the Company's principal business is insuring trucking companies, it does on occasion receive claims involving a trucking accident which has resulted in the spill of a pollutant. Certain of the Company's policies may cover these situations on the basis that they were caused by an accident that resulted in the immediate spill of a pollutant. These claims are typically reported and resolved within a short period of time.
However, the Company has also received a few environmental claims that did not result from a "sudden and accidental" event. Most of these claims fall under policies issued in the 1970's primarily to one account which was involved in the business of hauling and disposing of hazardous waste. Although the Company had pollution exclusions in its policies during that period, the courts have ignored such exclusions in many environmental cases. Beginning with the year 1994 and through the year ended December 31, 2006, the Company has recorded a total of $6.6 million in losses incurred with respect to environmental claims including $39 during 2006. Incurred losses to date include a reserve for incurred but not reported environmental losses of $1.5 million at December 31, 2006.
Establishing reserves for environmental claims is subject to uncertainties that are greater than those represented by other types of claims. Factors contributing to those uncertainties include a lack of historical data, long reporting delays, uncertainty as to the number and identity of insureds with potential exposure, unresolved legal issues regarding policy coverage, and the extent and timing of any such contractual liability. Courts have reached different and sometimes inconsistent conclusions as to when the loss occurred and what policies provide coverage, what claims are covered, whether there is an insured obligation to defend, how policy limits are determined, how policy exclusions are applied and interpreted, and whether cleanup costs represent insured property damage. Management believes that those issues are not likely to be resolved in the near future.
However, to date, very few environmental claims have been reported to the Company. In addition, a review of the businesses of our past and current insureds indicates that exposure to further claims of an environmental nature is limited because most of the Company's accounts are not currently, and have not in the past been, involved in the hauling of hazardous substances. Also, the revision of the pollution exclusion in the Company's policies since 1986 is expected to further limit exposure to claims from that point forward.
The Company has never been presented with an environmental claim relating to asbestos and, based on the types of business the Company has insured over the years, it is not expected that the Company will have any significant asbestos exposure.
Accordingly, management believes that the Company's exposure to environmental losses beyond those already provided for in the financial statements is not material.
MARKETING - ---------
The Company's primary marketing areas are outlined on pages 2 and 3.
Since the mid-1980's, Protective has focused its marketing efforts on large and medium trucking fleets. Protective has its largest market share in the larger trucking fleets (over 150 power units). These fleets self-insure a portion of their risk and such self-insurance plans are a specialty of the Company. The indemnity contract provided to self-insured customers is designed to cover all aspects of trucking liability, including third party liability, property damage, physical damage, cargo and workers' compensation, arising from vehicular accident or other casualty loss. The self-insured program is supplemented with large deductible workers' compensation policies in states that do not allow for self-insurance. Protective also offers work-related accident insurance, on a group basis, to independent contractors under contract to a fleet sponsor. Throughout the 1990's, the market for Protective's products grew increasingly competitive. Competitive pressures eased significantly in the period 2001 through 2003, as competitors experienced unfavorable operating results but competition has once again begun to increase during 2004 through 2006 (see comments under "Competition" following). In 2006, fleet trucking products generated approximately 62% of direct premium written and assumed for the Company.
Since 1992, Protective has accepted reinsurance cessions and retrocessions, principally for catastrophe exposures, from selected reinsurers on an opportunistic basis. Protective is committed to participation in this market provided pricing remains conducive to profitable results. In determining the volume of catastrophe reinsurance assumed that it will accept, the Company first determines the exposure that it is willing to accept from a single "maximum foreseeable loss" (MFL) and a "probable maximum loss" (PML) within a given geographic area. As retrocessions are offered to the Company, computer models of geographic exposure are evaluated against these maximums and programs are only considered if they do not cause aggregate exposure to exceed the predetermined limits. Currently, the Company's estimate of its exposure to a MFL or a PML is approximately 8% and 5% of consolidated surplus, respectively. However, this amount is before state and federal tax credits and reinstatement premiums which would significantly reduce the impact of a MFL or a PML on the Company's surplus.
Since 1995, Sagamore has sold private passenger automobile insurance to nonstandard risks. This program is currently being marketed in thirty mid-western and southern states through independent agents. Sagamore utilizes state-of-the-art technology extensively in marketing its nonstandard automobile product in order to provide superior service to its agents and insureds.
Sagamore also offers a program of coverages for "small fleet" trucking concerns (owner-operators generally with one to six power units). This program is currently being marketed in thirty-one states through independent agents. Small Fleet Trucking shares much of the technology utilized by the non-standard automobile division in marketing its products.
INVESTMENTS - -----------
The Company's investment portfolio consists of (1) funds which are considered necessary to support insurance underwriting activities and (2) excess capital funds. In general, funds invested in fixed maturity and short-term instruments are intended to cover underwriting operations while equity securities and limited partnerships are utilized to invest excess capital funds. The following discussion will concentrate on the different investment strategies for these two major categories.
At December 31, 2006 the financial statement value of the Company's investment portfolio was approximately $628 million, including $42 million of money market instruments classified as cash equivalents. The adjusted cost of this portfolio was $512 million. A comparison of the allocation of assets within the Company's investment portfolio, using adjusted cost as a basis, is as follows:
FIXED MATURITY AND SHORT-TERM INVESTMENTS - -----------------------------------------
Fixed maturity and short-term securities comprised 71.1% of the market value of the Company's total invested assets at December 31, 2006. With the exception of U.S. Government obligations, the fixed maturity portfolio is widely diversified with no concentrations in any single industry or municipality. The largest amount invested in any single issuer was $7.9 million (1.4% of total invested assets) although most individual investments, other than municipal bonds, are less than $500,000. The Company does not actively trade fixed maturity securities but typically holds, and has the intent and ability to hold, such investments until maturity. Exceptions exist in the rare instances where the underlying credit for a specific issue is deemed to be diminished. In such cases, the security will be considered for disposal prior to maturity. In addition, fixed maturity securities may be sold when realignment of the portfolio is considered beneficial (i.e. moving from taxable to non-taxable issues) or when valuations are considered excessive compared to alternative investments.
The Investment Committee has determined that the Company's insurance subsidiaries will, at all times, hold high grade fixed maturity securities and short-term investments with a market value equal to at least 100% of reserves for losses and loss expenses, net of applicable reinsurance credits. At December 31, 2006, investment grade bonds and short-term instruments held by insurance subsidiaries equaled 154% of net loss and loss adjustment expense reserves, thus providing a substantial margin.
The Company's concentration of fixed maturity funds in relatively short-term investments provides it with a level of liquidity which is more than adequate to provide for its anticipated cash flow needs. The structure of the investment portfolio also provides the Company with the ability to restrict premium writings during periods of intense competition, which typically result in inadequate premium rates, and allows the Company to respond to new opportunities in the marketplace as they arise. During the past several years, short-term yields have approximated those available for five and ten year obligations and, accordingly, the Company had concentrated the investment of new and maturing funds into high quality obligations with maturities of less than one year, which are classified above as short-term. During 2006, it was determined that after-tax investment yields could be enhanced by moving substantial portions of the short-term portfolio into high grade municipal bonds with short to moderate maturities. As a result, the total of investments classified with cash decreased from $131 million to $42 million and investments in municipal bonds were increased from $115 million to $213 million.
The following comparison of the Company's bond and short-term investment portfolios, using par value as a basis, indicates the changes in contractual maturities in the portfolio during 2006. Note the duration of the portfolio is less than the average life shown below because the Company has, in some cases, the right to put obligations and borrowers have, in some cases, the right to call or prepay obligations with or without call or prepayment penalties.
Approximately $15.9 million of fixed maturity investments (2.5% of total invested assets) consists of bonds rated as less than investment grade at year end. These investments are composed of shares in two widely diversified high yield bond funds where exposure to default by any single issuer is extremely limited. Both of these funds carry a Morningstar rating of five stars. We have included the investments in these funds in the total of non-investment grade bonds since, under the investment guidelines of the funds, the average bond quality rating could fall below BBB. The market value of these bond funds exceeded cost by 7% at December 31, 2006.
The market value of the consolidated fixed maturity portfolio was $.3 million less than cost at December 31, 2006, before income taxes, which compares to a $1.4 million unrealized loss at December 31, 2005. All declines were determined to result from interest rate increases and not from credit quality. As has been the Company's consistent policy, other-than-temporary impairment is recorded for any individual issue which has sustained a decline in current market value of at least 20% below original or adjusted cost, and the decline is ongoing for more than 6 months, regardless of the evaluation of the creditworthiness of the issuer or the specific issue. No fixed maturity investments met these criteria at December 31, 2006 or 2005. Gross unrealized losses on fixed maturity securities were $1.6 million in total at December 31, 2006, an average of .8% of amortized cost, with no individual issue having more than a 10% decline.
EQUITY SECURITIES - -----------------
Because of the large amount of high quality fixed maturity investments owned, relative to the Company's loss and loss expense reserves and other liabilities, amounts invested in equity securities are not needed to fund current operations and, accordingly, can be committed for long periods of time. Equity securities comprise 20.7% of the market value of the consolidated investment portfolio at December 31, 2006, though only 10.3% of related cost basis, as long-term holdings have appreciated significantly. The Company's equity securities portfolio consists of over 110 separate issues with diversification from large to small capitalization issuers and among several industries. The largest single equity issue owned has a market value of $5.1 million at December 31, 2006 (.9% of total investments).
In general, the Company maintains a buy-and-hold philosophy with respect to equity securities. Many current holdings have been continuously owned for more than ten years, accounting for the large unrealized gain at the current year end. An individual equity security will be disposed of when it is determined by investment managers or the Investment Committee that there is little potential for future appreciation and all equity securities are considered to be available for sale. Securities are not sold to meet any quarterly or annual earnings quotas but, rather, are disposed of only when market conditions are deemed to dictate, regardless of the impact, positively or negatively, on current period earnings.
During 2006, the Company disposed of numerous equity securities which were considered to have less than average near term potential for improvement. These sales generated both gains and losses but netted to a realized gain of $6.4 million. The net effect of other-than-temporary impairment adjustments included in the investment gains from equity securities was $1.4 million, or six cents per share, for the year. The reclassification of other-than-temporary unrealized losses to realized occurred on each individual issue where
the current market value was at least 20% below original or adjusted cost, and the decline was ongoing for more than 6 months at December 31, 2006, regardless of the evaluation of the issuer or the potential for recovery. Net unrealized gains on the equity security portfolio increased to $73.0 million at December 31, 2006 from $67.6 million last year end. The current net unrealized gain consists of $73.4 million of gross unrealized gains and $.4 million of gross unrealized losses with the average loss on issues where market was less than adjusted cost being 5.3%.
LIMITED PARTNERSHIPS - --------------------
For several years, the Company has invested in various limited partnerships engaged in securities trading activities, real estate development and small venture capital funding, as an alternative to direct equity investments. The funds used for these investments are part of the excess capital category mentioned above. At December 31, 2006, the aggregate cost basis of these investments was $33.5 million and the aggregate market value was $57.3 million.
As a group, these investments experienced very favorable earnings during 2006, with the aggregate of the Company's share of such earnings totaling approximately $11.2 million producing a 25% pre-tax yield. The current year limited partnership value increase is composed of estimated realized income of $5.0 million and estimated unrealized income of $6.2 million, as reported to the Company by the various general partners.
The Company follows the equity method of accounting for these investments and records the total change in value as a component of net gains or losses on investments. However, readers are cautioned that, to the extent that reported increases in equity value are unrealized, they can be reduced or eliminated quickly by volatile market conditions. At December 31, 2006, the total estimated unrealized gain included in the valuation of the Company's limited partnership portfolio was $23.8 million. In addition, a significant minority of the investments included in the limited partnerships do not have readily ascertainable fair market values and, accordingly, values assigned by the general partners may not be realizable upon the sale or disposal of the related assets, which may not occur for several years.
INVESTMENT YIELDS - -----------------
The interest rate environment was relatively stable, moving up slightly during 2006 after dramatic increases during the previous eighteen months. With few exceptions, the yield curve remains flat with yields on 30 day securities essentially equal to those on five and ten year obligations of similar quality considerations. As previously noted, a substantial portion of the Company's short-term investments were redeployed to short to medium term municipal bonds during 2006 to produce higher after tax yields. Overall, pre-tax net investment income increased $4.7 million (32%) during 2006 and after tax income increased $4.0 million, or 36%. A comparison of consolidated investment yields, before consideration of investment expenses, is as follows:
Readers are also directed to Note B to the consolidated financial statements and to the RESULTS OF OPERATIONS on pages 25 and 26 of this document for additional details of investment operations.
EMPLOYEES - ---------
As of December 31, 2006, the Company had 279 employees, representing an increase of 1 employee from December 31, 2005.
COMPETITION - -----------
The insurance brokerage and agency business is highly competitive. B & L competes with a large number of insurance brokerage and agency firms and individual brokers and agents throughout the country, many of which are considerably larger than B & L. B & L also competes with insurance companies which write insurance directly with their customers.
Insurance underwriting is also highly competitive. The Insurance Subsidiaries compete with other stock and mutual companies and inter-insurance exchanges (reciprocals). There are numerous insurance companies offering the lines of insurance which are currently written or may in the future be written by the Insurance Subsidiaries. Many of these companies have been in business for longer periods of time, have significantly larger volumes of business, offer more diversified lines of insurance coverage and have greater financial resources than the Company. In many cases, competitors are willing to provide coverage for rates lower than those charged by the Insurance Subsidiaries. Many potential clients self-insure workers' compensation and other risks for which the Company offers coverage, and some concerns have organized "captive" insurance companies as subsidiaries through which they insure their own operations. Some states have workers' compensation funds that preclude private companies from writing this business in those states. Federal law also authorizes the creation of "Risk Retention Groups" which may write insurance coverages similar to those offered by the Company.
The Company believes it has a competitive advantage in its major lines of business as the result of the extensive experience of its long-tenured management and staff, its superior service and products, its willingness to custom build insurance programs for its large trucking customers and the extensive use of technology with respect to its insureds and independent agent force. However, the Company is not "top-line" oriented and will readily sacrifice premium volume during periods of unrealistic rate competition. Accordingly, should competitors determine to "buy" market share with unprofitable rates, the Company's Insurance Subsidiaries will generally experience a decline in business until pricing returns to profitable levels.
AVAILABILITY OF DOCUMENTS - -------------------------
This Form 10-K and the Company's Code of Conduct will be sent to shareholders without charge upon written request to the Company's Investor Contact at the corporate address. These documents, along with all other filings with the Securities and Exchange Commission are available for review, download or printing from the Company's web site at WWW.BALDWINANDLYONS.COM.
ITEM 101(B), (C)(1)(I) AND (VII), AND (D) OF REGULATION S-K: - ------------------------------------------------------------
Reference is made to Note K to the consolidated financial statements which provides information concerning industry segments and is filed herewith under Item 8, Financial Statements and Supplementary Data.
ITEM 1A.
ITEM 1A. RISK FACTORS ------------
o THE COMPANY OPERATES IN THE INSURANCE INDUSTRY WHERE MANY OF ITS COMPETITORS ARE LARGER WITH FAR GREATER RESOURCES. Please see the caption "Competition" on this page above for a complete discussion of this risk factor.
o THE COMPANY, THROUGH ITS INSURANCE SUBSIDIARIES, REQUIRES COLLATERAL FROM ITS INSUREDS COVERING THE INSUREDS' OBLIGATIONS FOR SELF-INSURED RETENTIONS OR DEDUCTIBLES RELATED TO POLICIES OF INSURANCE PROVIDED. SHOULD THE COMPANY, AS SURETY, BECOME RESPONSIBLE FOR SUCH INSURED OBLIGATIONS, THE COLLATERAL HELD MAY PROVE TO BE INSUFFICIENT. For further discussion regarding this risk factor, see Note L to the consolidated financial statements beginning on page 59 of this Form 10-K.
o THE COMPANY LIMITS ITS RISK OF LOSS FROM POLICIES OF INSURANCE ISSUED BY ITS INSURANCE SUBSIDIARIES THROUGH THE PURCHASE OF REINSURANCE COVERAGE FROM OTHER INSURANCE COMPANIES. SUCH REINSURANCE DOES NOT RELIEVE THE COMPANY FROM ITS RESPONSIBILITY TO POLICYHOLDERS SHOULD THE REINSURERS BE UNABLE TO MEET THEIR OBLIGATIONS TO THE COMPANY UNDER THE TERMS OF THE UNDERLYING REINSURANCE AGREEMENTS. For further discussion regarding this risk factor, see the caption Reinsurance Recoverable and Notes D and L to the consolidated financial statements on pages 31, 51 and 59, respectively, of this Form 10-K.
o OPERATING IN THE INSURANCE INDUSTRY, THE COMPANY IS EXPOSED TO LOSS FROM POLICIES OF INSURANCE ISSUED TO ITS POLICYHOLDERS. A LARGE PORTION OF LOSSES RECORDED BY THE COMPANY ARE ESTIMATES OF FUTURE LOSS PAYMENTS TO BE MADE. SUCH ESTIMATES OF FUTURE LOSS PAYMENTS MAY PROVE TO BE INADEQUATE. For further discussion of this risk factor, see the caption Property/Casualty Losses and Loss Adjustment Expenses beginning on page 3, the caption Loss and Loss Expense Reserves beginning on page 32 and Note C to the consolidated financial statements beginning on page 50, respectively, of this Form 10-K.
o THE COMPANY DERIVES A SIGNIFICANT PERCENTAGE OF ITS DIRECT PREMIUM VOLUME FROM A SINGLE MAJOR CUSTOMER AND ITS INDEPENDENT CONTRACTORS. LOSS OF THIS MAJOR CUSTOMER WOULD SEVERELY REDUCE THE COMPANY'S REVENUE AND EARNINGS POTENTIAL. For further discussion regarding this risk factor, see Notes J and L to the consolidated financial statements beginning on pages 57 and 59, respectively, of this Form 10-K.
o GIVEN THE COMPANY'S SIGNIFICANT INTEREST-BEARING INVESTMENT PORTFOLIO, A DROP IN INTEREST RATES COULD HAVE A MATERIAL ADVERSE IMPACT ON THE COMPANY'S EARNINGS. CONVERSELY, AN INCREASE IN INTEREST RATES COULD HAVE A SIGNIFICANT TEMPORARY IMPACT ON THE MARKET VALUE OF THE COMPANY'S FIXED MATURITY INVESTMENT PORTFOLIO. For further discussion regarding this risk factor, see the caption Market Risk beginning on page 36 of this Form 10-K.
o THE COMPANY OPERATES IN A REGULATED INDUSTRY. Changes in laws and regulations governing the insurance industry could have a significant impact on the Company's ability to generate income from its insurance company operations.
ITEM 2.
ITEM 2. PROPERTIES ----------
The Company leases office space at 1099 North Meridian Street, Indianapolis, Indiana. This building is located approximately one mile from downtown Indianapolis. The lease covers approximately 72,000 square feet and expires in August, 2008, with an option to renew for an additional five years. The Company's entire operations, with the exception of Baldwin & Lyons, California, are conducted from these leased facilities.
The Company owns a building and the adjacent real estate approximately two miles from its main office. This building contains approximately 3,300 square feet of usable space, and is used primarily as a contingent back up and disaster recovery site for computer operations.
The Company's California domiciled agency subsidiary 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. The lease expires in May, 2007.
The current facilities are expected to be adequate for the Company's operations for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS -----------------
In the ordinary, regular and routine course of their business, the Company and its Insurance Subsidiaries are frequently involved in various matters of litigation relating principally to claims for insurance coverage provided. No currently pending matter is deemed by management to be material to the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Nothing to report.
PART II -------
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY ------------------------------------- AND RELATED STOCKHOLDER MATTERS -------------------------------
The Company's Class A and Class B common stocks are traded on The NASDAQ Stock Market(R) under the symbols BWINA and BWINB, respectively. The Class A and Class B common shares have identical rights and privileges except that Class B shares have no voting rights other than on matters for which Indiana law requires class voting. As of December 31, 2006, there were approximately 400 record holders of Class A Common Stock and approximately 1,000 record holders of Class B Common Stock.
The table below sets forth the range of high and low sale prices for the Class A and Class B Common Stock for 2006 and 2005, as reported by the National Association of Security Dealers, Inc. and published in the financial press. The quotations reflect interdealer prices without retail markup, markdown or commission and do not necessarily represent actual transactions.
The Company has paid quarterly cash dividends continuously since 1974. The current regular quarterly dividend rate is $.25 per share. The Company expects to continue its policy of paying regular cash dividends although there is no assurance as to future dividends because they are dependent on future earnings, capital requirements and financial conditions and are subject to regulatory restrictions as described in Note F to the consolidated financial statements.
Since the fourth quarter of 2003, the Company has paid an extra cash dividend in all but two quarters in recognition of the Company's more than adequate capitalization, the favorable income tax rates available to individuals on dividends and excellent earnings over the past three years. Total extra dividends paid in 2006 and 2005 were $1.70 and $.55 per share, respectively. The Board intends to address the subject of dividends at each of its future meetings considering the Company's earnings, returns on investments and its capital needs; however, shareholders should not expect extra dividends, if any, in the future to follow any predetermined pattern.
CORPORATE PERFORMANCE
The following graph shows a five year comparison of cumulative total return for the Corporation's Class B common shares, the NASDAQ Insurance Stock Index and the Russell 2000 Index. The basis of comparison is a $100 investment at December 31, 2001, in each of (i) Baldwin & Lyons, Inc., (ii) Nasdaq Insurance Stocks, and (iii) the Russell 2000 Index. All dividends are assumed to be reinvested.
[GRAPHIC OMITTED][GRAPHIC OMITTED]
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA -----------------------
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF --------------------------------------- FINANCIAL CONDITION AND RESULTS OF OPERATIONS ---------------------------------------------
LIQUIDITY AND CAPITAL RESOURCES - -------------------------------
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 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, turn negative as loss settlements on claim reserves established in prior years exceed net premium revenue and receipts of investment income. During 2006, positive cash flow from operations totaled $17.2 million compared to $48.9 million in 2005. Approximately $11 million of this decrease in operating cash flow resulted from non-recurring refunds of premium related to retrospectively rated policies with the remainder due largely to the decline in premium volume during 2006.
For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds with maximum quality and liquidity. As interest rates and yield curves have not provided a strong incentive to lengthen maturities in recent years, the Company has continued to maintain its fixed maturity portfolio at very conservative levels. The average contractual life of the Company's bond and short-term investment portfolio increased from 2.2 to 3.0 years during 2006 as it was determined that after-tax investment yields could be enhanced by moving portions of the short-term portfolio into high grade municipal bonds with short to moderate maturities. The average duration of the Company's fixed maturity portfolio is shorter than the contractual maturity average and much 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.
The Company's assets at December 31, 2006 included $101.8 million in short-term and cash equivalent investments which are readily convertible to cash without market penalty and an additional $171.5 million of fixed maturity investments (at par) 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 the event competitive conditions continue to produce inadequate premium rates and the Company chooses to further restrict volume, the liquidity of its investment portfolio would permit management 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. In addition, the Company's reinsurance program is structured to avoid serious cash drains that might accompany catastrophic losses.
Net premiums written by the Company's U.S. insurance subsidiaries for 2006 equaled approximately 38% 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 regulatory guidelines.
As more fully discussed in Note F to the consolidated financial statements, at December 31, 2006, $70.0 million, or 21% 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 because of minimum statutory capital requirements. 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 Company has no debt outstanding at December 31, 2006.
RESULTS OF OPERATIONS - ---------------------
2006 COMPARED TO 2005
Direct premiums written for 2006 totaled $184.1 million, a decrease of $25.4 million (12%) from 2005. This decrease is primarily attributable to a decrease in fleet trucking liability premiums of $38.8 million (37%) from 2005 levels. Direct premium writings from the Company's private passenger automobile program also decreased by $4.5 million (12%). These decreases were partially offset by increases in the Company's independent contractor and small fleet trucking programs of $7.8 million (15%) and $10.5 million (67%), respectively. Large trucking fleet volume decreased as the result of ongoing rate competition, which resulted in the loss of business and the writing of lower limits for renewed accounts. Increased competitive pressures were also responsible for the decline in premium volume from the private passenger automobile program. The higher premium volume from the independent contractor program resulted from the addition of contractors by existing accounts and the increase in premium volume from the small fleet trucking program was due to geographic expansion, increased marketing efforts and slightly improved competitive conditions.
Premiums assumed from other insurers and reinsurers totaled $12.9 million during 2006, an increase of $1.2 million (10%) from 2005, which included $2.0 million of reinstatement premiums related to the 2005 hurricanes. The increase disregarding reinstatement premiums was 33%, reflective of higher premium rates following the hurricane activity of 2004 and 2005. Premium volume from reinsurance assumed will fluctuate depending on the favorability of pricing for the coverages provided. Further, premium volume for this segment is limited by the Company's self-imposed limitation to loss from a single catastrophic event.
Premiums ceded to reinsurers decreased $14.8 million (37%) during 2006 to $24.8 million as the consolidated percentage of premiums ceded to direct premiums written decreased to 14% for 2006 from 19% for 2005. This decrease is reflective of the Company's increased retention under reinsurance treaties effective in 2004 through 2006 covering large fleet trucking risks. The Company's maximum retained loss under these treaties has increased over the last two years and, as a result, a lower percentage of the direct premiums are ceded to reinsurers. There were no other significant changes to reinsurance treaties during 2006.
After giving effect to changes in unearned premiums, net premiums earned decreased 9% to $169.8 million for 2006 from the record $186.2 million for 2005. Excluding inter-company reinsurance arrangements, net premiums earned from all trucking-related insurance products decreased by $9.6 million (7%). Net premiums earned from the Company's private passenger automobile and discontinued small business workers' compensation programs also decreased by $4.1 million (11%) and $2.7 million (99%), respectively. An increase in net premiums earned from non-affiliated reinsurance assumed of $1.2 million (10%) was offset by a $1.0 million (73%) decrease in premiums assumed from involuntary residual markets.
Pre-tax investment income increased 32% during 2006 to $19.5 million as yields were up 24% on average and invested assets increased by 5% despite lower cash flow from operations and the payment of over $38 million in cash dividends to shareholders during the year. This improvement followed similar increases in 2005. Short-term pre-tax rates increased most dramatically during 2006, averaging 55% higher than 2005. The after-tax investment income yield increased by 36% from 2005 as the movement of substantial portions of short-term
funds into short and moderate term municipal bonds enhanced after-tax yields by 29% compared to the prior year.
Net gains on investments totaled $17.1 million in 2006 compared to $23.0 million last year. These totals include gains from both direct securities trading and investments in limited partnerships. The decrease in gains in 2006 is attributable to lower direct investing activities and a $3.6 million decline in the earnings of limited partnership investments. The Company's investments in limited partnership ventures, consists primarily of securities trading and small venture capital activities and, to a lesser extent, real estate development. The estimated market value of these investments was $44.7 million at December 31, 2005 and the aggregate of the Company's share of earnings in these entities totaled approximately $11.2 million during 2006. While this lagged the $14.8 million of appreciation reported during 2005, it represented a return of over 25% for the year. The Company follows the equity method of accounting for its investments in limited partnerships. To the extent that the limited partnerships include realized and unrealized gains or losses in their net income, the Company's proportionate share of net income will include unrealized as well as realized gains or losses. The current year limited partnership total is composed of estimated realized income of $5.0 million and estimated unrealized income of $6.2 million, as reported to the Company by the general partners. Inception to date unrealized gains included in the December 31, 2006 asset valuation total $23.8 million. The final component of investment gains, consisting of adjustments attributable to "other-than-temporary impairment," was not significant during 2006 or 2005 and is more fully explained in Note B.
Losses and loss expenses incurred during 2006 decreased $28.0 million (20%) to $112.6 million. The decrease in losses incurred is due primarily to the lack of hurricane losses in 2006 and lower premium volume during 2006. 2006 loss and loss expenses included $1.5 million in hurricane losses, resulting from late reporting by ceding reinsurers of Hurricane Rita and Wilma losses, compared to $17.6 million during 2005. The 2006 consolidated loss and loss expense ratio was 66.3% compared to 75.5% for 2005. The Company's loss and loss expense ratios for individual product lines are summarized in the following table.
The Fleet trucking loss ratio for 2006 was favorably impacted by an increase in savings on prior year loss developments and a lack of extremely severe accidents. The number of severe fleet trucking losses during 2005 was also below recent historical averages. Factors such as fluctuations in premium volume, the levels of self-insured retentions and the Company's higher net retention under reinsurance treaties in recent years tend to allow for more volatility in losses. The increase in the private passenger automobile loss ratio is associated with product modifications in response to competitive conditions and the higher small fleet trucking loss ratio resulted largely from geographic expansion with higher loss ratios during the first half of the year and more favorable results in the second half.
The Company produced an overall savings on the handling of prior year claims during 2006 of $16.9 million. This net savings is included in the computation of loss ratios shown in the table insert. Approximately $7.2 million of this savings relates to retrospectively-rated contracts whereby return premiums were recorded concurrently with the loss savings. The majority of the remaining $9.7 million in savings relates to the Company's large fleet trucking business, generally consistent with, but higher than, recent prior years. 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 has long favored a conservative posture 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. 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 and prior year reserve development may not be consistent year to year.
Other operating expenses for 2006, before credits for allowances from reinsurers, increased $1.2 million (2.6%) to $48.7 million. This increase is due primarily to a $1.4 million increase in commission expense related to reinsurance assumed. A large portion of commission on reinsurance assumed is dependent on experience. During 2005, hurricane losses resulted in significant reductions to contingent commissions on this business. The favorable experience during 2006 returned commissions to normal levels in relation to premium volume. Offsetting much of the reinsurance assumed commission change was the recovery during 2006 of nearly $1 million previously written off related to bankrupt reinsurers. After consideration for these two items, expenses before ceding allowances increased $.7 million, or 1.7% from 2005. Because much of the Company's expense structure is fixed, expenses do not vary directly with revenue, which consists principally of net premiums earned from the insurance subsidiaries. In general, only commissions to independent agents, premium taxes and other acquisition costs vary directly with premium volume.
Reinsurance ceded credits were $6.6 million (85%) lower in 2006, resulting from the Company retaining a greater percentage of the gross premium for its own account under recent reinsurance treaties. This loss of ceding commission was the primary cause for the $7.8 million increase in net operating expenses for the year.
Substantially all fleet trucking business is produced by direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Instead, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. are 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 fleet trucking business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 26.6% during 2006 compared to 22.0% for 2005. Including the agency operations, and after elimination of inter-company commissions, the ratio of other operating expenses to operating revenue (defined as total revenue less gains on investments) was 24.2% for 2006 compared with 19.0% for 2005, reflective of the loss of nearly 85% of ceding commissions from reinsurers, as discussed above.
The effective federal tax rate for consolidated operations for 2006 was 28.0%. This rate is lower than the statutory rate primarily because of tax-exempt investment income and the reversal of accruals related to tax uncertainties rendered no longer necessary by the conclusion of IRS audits during 2006.
As a result of the factors mentioned above, net income for 2006 was $38.2 million compared to $34.2 million for 2005. Diluted earnings per share increased to $2.54 in 2006 from $2.30 in 2005. Earnings per share from operations, before gains on investments, was $1.80 in 2006 compared to $1.30, including hurricane losses that reduced operating income by $.68 per share in 2005.
2005 COMPARED TO 2004
Direct premiums written for 2005 totaled $209.5 million, a decrease of $27.6 million (12%) from 2004. This decrease is primarily attributable to a decrease in fleet trucking liability premiums of $21.2 million (17%) from 2004 levels. Direct premium writings from the Company's private passenger automobile program also decreased by $2.5 million (6%). Discontinued in 2004, direct premium writings from the Company's small business workers' compensation program decreased by $8.9 million (98%). These decreases were partially offset by increases in the Company's independent contractor and small fleet trucking programs of $4.0 million (9%) and $.9 million (6%), respectively. Large trucking fleet volume decreased as the result of increased rate competition, principally in the layers of coverage above $5 million per occurrence, which resulted in the loss of business and the writing of lower limits for renewed accounts. Increased competitive pressures were also responsible for the decline in premium volume from the private passenger automobile program. The higher premium volume from the independent contractor program resulted from the addition of contractors by existing accounts and the increase in premium volume from the small fleet trucking program was due to geographic expansion.
Premiums assumed from other insurers and reinsurers totaled $11.5 million during 2005, an increase of $2.8 million (32%) from 2004, including $2.0 million of reinstatement premiums related to the 2005 hurricanes. Premium volume from reinsurance assumed will fluctuate depending on the favorability of pricing for the coverages provided. Further, premium volume for this segment is limited by the Company's self-imposed limitation to loss from a single catastrophic event.
Premiums ceded to reinsurers decreased $38.9 million (50%) during 2005 to $39.7 million as the consolidated percentage of premiums ceded to direct premiums written decreased to 19% for 2005 from 33% for 2004. This decrease is reflective of the Company's increased retention under reinsurance treaties effective in 2004 and 2005 covering large fleet trucking risks. The Company's maximum retained loss under these treaties has increased over the last two years and, as a result, a lower percentage of the direct premiums are ceded to reinsurers. There were no other significant changes to reinsurance treaties during 2005.
After giving effect to changes in unearned premiums, net premiums earned increased 8% to $186.2 million for 2005 from $172.1 million for 2004. Excluding inter-company reinsurance arrangements, net premiums earned from all trucking-related insurance products increased by $18.8 million (17%). Net premiums earned from non-affiliated reinsurance assumed also increased by $2.1 million (22%). These increases were partially offset by decreases in net premiums earned from the Company's small business workers' compensation and private passenger automobile programs of $5.3 million (66%) and $1.9 million (5%), respectively.
The Company has maintained its portfolio of fixed maturity securities at an increasingly short-term level during the past several years as long-term interest rates were not considered to be sufficiently attractive to commit funds for extended periods. Since most of the Company's investments fell into the short end of the range, the increase in rates was instantly accretive, with pre-tax net investment income increasing $2.6 million (21%) during 2005. The impact on the fourth quarter was even more pronounced, with a 35% increase in pre-tax investment income compared to 2004. The average pre-tax yield on invested assets increased to 3.3% from 2.9% during 2004 (13%) and the after-tax yield of 2.4% compares to 2.2% in 2004. In addition to higher yields, average invested assets increased over 5% during the year.
Net gains on investments totaled $23.0 million in 2005 compared to only $9.8 million in 2004. The increase is attributable to equity in the earnings of limited partnership investments which have increased in significance during 2005. For several years, the Company had invested in various limited partnership ventures, consisting of real estate development, small venture capital and securities trading activities, with a cost basis of $7.8 million as of October 31, 2004. Between November 1, 2004 and December 31, 2005, the cost basis of limited partnership investments increased to $30.9 million, net of distributions received, with the majority of the increase allocated to securities trading activities, including $15 million committed to trading in the India stock market. Each of these new investments experienced very favorable earnings during 2005, with the aggregate of the Company's share of such earnings totaling approximately $14.8 million, compared to only $.6 million during 2004. The current year limited partnership total is composed of estimated realized income of $5.1 million and estimated unrealized income of $9.7 million, as reported to the Company by the general partners. The other component of this total, gains from direct trading of securities, was $8.2 million in 2005 compared to $9.2 million in 2004, including adjustments attributable to "other-than-temporary impairment", as more fully explained in Note B.
Losses and loss expenses incurred during 2005 increased $14.3 million (11%) to $140.6 million. The increase in losses incurred is due primarily to losses from hurricanes (Katrina, Rita, and Wilma) during 2005 of $17.6 million compared to $5.0 million of losses attributable to the Florida hurricanes during September, 2004. The 2005 consolidated loss and loss expense ratio was 75.5% compared to 73.4% for 2004. The Company's loss and loss expense ratios for individual product lines are summarized in the following table.
The loss and loss expense ratio for fleet trucking products for 2005 reflects a decrease in severity of accidents, particularly in the large fleet excess product. While overall frequency in the trucking lines has not changed significantly, the frequency of severe losses was lower in 2005. The Company's higher retention under recent reinsurance treaty renewals allows for more net volatility in this line of business.
The Company produced an overall savings on the handling of prior year claims during 2005 of $13.7 million. This net savings is included in the computation of loss ratios shown in the table insert. Approximately $8.0 million of this savings relates to retrospectively-rated contracts whereby return premiums were recorded concurrently with the loss savings. The majority of the remaining $5.7 million in savings relates to the Company's large fleet trucking business, generally consistent with, but less than, recent prior years. 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 and prior year reserve development may not be consistent year to year.
Other operating expenses for 2005, before credits for allowances from reinsurers, decreased $4.1 million (8%) to $47.4 million. Gross expenses decreased at a lower rate than the increase in premium volume because much of the Company's expense structure is fixed and does not vary directly with volume. In general, only commissions to independent agents, premium taxes and other acquisition costs vary directly with premium volume. Direct commission expense decreased $2.3 million (18%) due to a decline in business produced by outside agents, predominantly from the discontinued small business workers' compensation product. Resulting primarily from the decrease in direct premium writings, taxes other than federal income and salary-related taxes decreased $1.3 million (18%) from 2004, Most other expense categories were level or down from the prior year as the investment in automation during the past several years has allowed for the handling of higher premium volume without the addition of employees.
Reinsurance ceded credits were $12.7 million (62%) lower in 2005, resulting from the Company retaining a greater percentage of the gross premium for its own account under recent reinsurance treaties. The loss of ceding commission resulted in an $8.5 million increase in net operating expenses for the year.
The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 22.0% during 2005 compared to 24.0% for 2004. Including the agency operations, and after elimination of inter-company commissions, the ratio of other operating expenses to operating revenue (defined as total revenue less gains on investments) was 19.0% for 2005 compared with 16.2% for 2004, reflective of the loss of more than 60% of ceding commissions from reinsurers, as discussed above.
The effective federal tax rate for consolidated operations for 2005 was 32.5%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.
As a result of the factors mentioned above, net income for 2005 was $34.2 million compared to $30.3 million for 2004. Diluted earnings per share increased to $2.30 in 2005 from $2.05 in 2004. Earnings per share from operations, before gains on investments, was $1.30 in 2005 compared to $1.62 in 2004 with the hurricane losses reducing operating income by $.68 per share in 2005 versus only $.22 in the prior year.
CRITICAL ACCOUNTING POLICIES - ----------------------------
The Company's significant accounting policies are discussed in Note A to the consolidated financial statements. The following discussion is provided to highlight areas of the Company's accounting policies which are material and/or subject to significant degrees of judgment.
INVESTMENT VALUATION
All marketable securities are included in the Company's balance sheet at current fair market value.
Approximately 73% of the Company's assets are composed of investments at December 31, 2006. Approximately 91% of these investments are publicly-traded, owned directly and have readily-ascertainable market values. The remaining 9% of investments are composed of minority interests in several limited partnerships. These limited partnerships are engaged in the trading of public and non-public equity securities and debt, hedging transactions, real estate development and venture capital investment. These partnerships, themselves, do not have readily-determinable market values. Rather, the fair values recorded are those provided to the Company by the respective partnerships based on the underlying assets of the partnerships. While the majority of the underlying assets at December 31, 2006 are publicly-traded securities, some have been valued by the respective partnerships using their experience and judgment. In addition, approximately $15.9 million of fixed maturity investments (2.5% of total invested assets) consists of bonds rated as less than investment grade at year end. These investments are composed of shares in two diversified high yield bond funds where exposure to default by any single issuer is limited. Both of these funds carry a Morningstar rating of five stars. We have included the investments in these funds in the total of non-investment grade bonds since, under the investment guidelines of the funds, the average bond quality rating could fall below BBB. The market value of these bond funds exceeded cost by 7% at December 31, 2006.
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. For individual issues where the decline in value is less than 20% but the amount of the decline is considered significant, 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. In those instances, the Company also considers its intent and ability to hold investments until recovery or maturity. For any decline which is considered to be other-than-temporary, we recognize an impairment loss in the current period earnings as an investment loss. Declines which are considered to be temporary are recorded as a reduction in shareholders' equity, net of related federal income tax credits.
It is important to note that all investments included in the Company's financial statements are valued at current fair market values. The evaluation process for determination of other-than-temporary decline in value of investments does not change these valuations but, rather, determines when the decline in value will be recognized in the income statement (other-than-temporary decline) as opposed to a charge to shareholders' equity (temporary decline). Subsequent recoveries in value of investments which have incurred other-than-temporary impairment adjustments are accounted for as unrealized gains until the security is actually disposed of or sold. At December 31, 2006, unrealized gains include $6.4 million of appreciation on investments previously adjusted for other-than-temporary impairment, compared to $3.7 million of impairment write-downs at that date. See Note B to the consolidated financial statements for additional detail with respect to this process. This evaluation process is subject to risks and uncertainties since it is not always clear what has caused a decline in value of an individual security or since some declines may be associated with general market conditions or economic factors which relate to an industry, in general, but not necessarily to an individual issue. The Company has attempted to minimize many of these uncertainties by adopting a largely objective evaluation process which results in income statement recognition of any investment which, over a six month period, is unable to recover from a 20% decline in value from our cost basis. However, to the extent that certain declines in value are reported as unrealized at December 31, 2006, it is possible that future earnings charges will result should the declines in value increase or persist or should the security actually be disposed of while market values are less than cost. At December 31, 2006, the total gross unrealized loss included in the Company's investment portfolio was less than $2.1 million. No individual issue constituted a material amount of this total. Had this entire amount been considered other-than-temporary at December 31, 2006, investment gains would have decreased by $.09 per share for the year, after tax. There would, however, have been no impact on total shareholders equity or book value per share since the decline in value of these securities was already recognized as a reduction to shareholders equity at December 31, 2006.
REINSURANCE RECOVERABLE
For the three years ended December 31, 2006, reinsurance ceded transactions were as follows:
A discussion of the Company's reinsurance strategies is presented in Item 1, Business, on page 2.
Amounts recoverable under the terms of reinsurance contracts comprise approximately 19% of total Company assets as of December 31, 2006. 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.
It should be noted, however, that a change in the estimate of amounts due from reinsurers on unpaid claims will not, in itself, result in charges or credits to losses incurred. This is because any change in estimated recovery follows the estimate of the underlying loss. Thus, it is the computation of the underlying loss that is critical.
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 are not generally 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 its financial commitments under the terms of the contracts, the Company would be responsible for the reinsurer's portion of the loss. The financial condition of each of the Company's reinsurers is initially determined upon the execution of a given treaty and only reinsurers with the highest credit ratings available are utilized. However, as noted above, reinsurers are often not called upon to satisfy their obligations for several years and changes in credit worthiness can occur in the interim period. Reviews of the current financial strength of each reinsurer are made continually 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. Such charges are included in other operating expenses, rather than losses and loss expenses incurred, since the inability of the Company to collect from reinsurers is a credit risk rather than a deficiency associated with the loss reserving process. See Notes D and L to the consolidated financial statements, on pages 51 and 59, for further discussion of reinsurance and concentrations of credit risk with respect to reinsurance recoverable.
LOSS AND LOSS EXPENSE RESERVES
The Company's loss and loss expense reserves for each significant segment are shown in the following table for direct and assumed and on a net of reinsurance basis at December 31, 2006 and 2005. Those lines of business individually comprising less than three percent of the Company's total reserves are shown in the aggregate as "All other".
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 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 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. Our 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 the Company's trucking liability 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.
The Company's methods for determining loss and loss expense reserves are essentially identical for interim and annual reporting.
A detailed analysis and discussion for each of the above basic reserve categories follows.
RESERVES FOR KNOWN LOSSES (CASE RESERVES) - -----------------------------------------
The Company's reserves for known claims are determined on an individual case basis and can range from the routine private passenger "fender bender" valued at a few hundred dollars to the very complex long-haul trucking claim involving multiple vehicles, severe injuries and extensive property damage costing several millions of dollars to settle. Each known claim, regardless of complexity, is handled by a claims adjuster experienced with claims of this nature and a "case" reserve, appropriate for the individual loss occurrence, will be established. For very routine "short-tail" claims such as private passenger physical damage, the Company initially records an average reserve that is based upon historical loss settlements adjusted for current trends. As information regarding the loss occurrence is gathered in the claim handling process, the reserve is adjusted to reflect the anticipated ultimate cost to settle the claim. For more complex claims which can tend toward being "long-tail" in nature, an experienced claims adjuster will review the facts and circumstances surrounding the loss occurrence to make a determination of the reserve to be established. Many of the more complex claims involve litigation and necessitate an evaluation of potential jury awards in addition to the factual information to determine the value of each claim. Each claim is continually monitored and the recorded reserve is increased or decreased relative to information gathered during the settlement life cycle.
RESERVES FOR INCURRED BUT NOT REPORTED LOSSES - ---------------------------------------------
The Company uses both standard actuarial techniques common to most insurance companies as well as techniques developed by the Company in consideration of its specialty business products. For its short-tail lines of business, the Company uses predominantly the incurred or paid loss development factor methods. The Company has found that the use of accident quarter loss development triangles, rather than those based upon accident year, are most responsive to claim settlement trends and fluctuations in premium exposures for its short-tail lines. A minimum of 12 running accident quarters is used to project the reserve necessary for incurred but not reported losses for its short-tail lines.
The Company also uses the loss development factor approach for its long-tail lines of business. A minimum of 15 accident years is included in the loss development triangles used to calculate link ratios and the selected loss development factors used to determine the reserves for incurred but not reported losses. A minimum of 20 accident years is used for long-tail workers' compensation reserve projections. More emphasis is placed on the use of tail factors for the Company's long-tail lines of business.
For the Company's large fleet trucking risks, which are covered by annually-changing reinsurance agreements and which contain wide-ranging self-insured retentions ("SIR") as low as $25,000 per loss occurrence and as high as several million dollars per occurrence, traditional actuarial methods are supplemented by other methods in consideration of the Company's exposures to loss. In situations where the Company's reinsurance structure, the insured's SIR selections, policy volume, and other factors are changing, current accident period loss exposures may not be homogenous with historical loss data to allow for reliable projection of future developed losses. Therefore, the Company supplements the above-described actuarial methods with loss ratio reserving techniques developed from our databases to arrive at the reserve for losses incurred but not reported for the calendar/accident period under review. Management relies on its extensive historical pricing and loss history databases to produce reserve factors unique to this specialty business. As losses for a given calendar/accident period develop with the passage of time, management evaluates such development on a quarterly basis and will adjust reserve factors, as necessary, to reflect current judgment with regard to the anticipated ultimate incurred losses. This process continues until all losses are settled for each period subject to this method.
RESERVES FOR LOSS ADJUSTMENT EXPENSES - -------------------------------------
The Company uses historical analysis of the ratios of allocated loss adjustment expenses paid to losses paid on closed claims to arrive at the expected ultimate incurred loss adjustment expense factors for each of its major products. Once developed, the factors are applied to the expected ultimate incurred losses, including IBNR, on all open claims. The resulting ultimate incurred allocated loss adjustment expense is then reduced by amounts paid to date on all open claims to arrive at the reserve for allocated loss adjustment expenses to be incurred in the future for the handling of specific claims.
For those loss adjustment expenses not specific to individual claims (general claims handling expenses referred to as unallocated LAE) the Company uses standard industry loss adjustment expenses paid to losses paid (net of reinsurance) ratio analysis to establish the necessary reserves. The selected factors are applied to 100% of IBNR reserves and to case reserves with consideration given for that portion of loss adjustment expense already paid at the reserve measurement date. Such factors are monitored and revised, as necessary, on a quarterly basis.
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. Our 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 the Company's trucking liability 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.
The Company's methods for determining loss and loss expense reserves are essentially identical for interim and annual reporting.
SENSITIVITY ANALYSIS - POTENTIAL IMPACT ON RESERVE VOLATILITY FROM CHANGES IN - ----------------------------------------------------------------------------- KEY ASSUMPTIONS - ---------------
Management is aware of the potential for variation from the reserves established at any particular point in time. Redundancies or deficiencies could develop in future valuations of the currently established loss and loss expense reserve estimates under a variety of reasonably possible scenarios. The Company's reserve selections are developed to be a "best estimate" of unpaid loss at a point in time and, due to the unique nature of our exposures, particularly in the large fleet trucking excess product where insured's policies of insurance combine large self-insured retentions with high policy limits, ranges of reserve estimates are not established during the
reserving process. However, basic assumptions that could potentially impact future volatility of our valuations of current loss and loss expense reserve estimates include, but are not limited to, the following:
o Consistency in the individual case reserving processes
o The selection of loss development factors in the establishment of bulk reserves for incurred but reported losses and loss expenses
o Projected future loss trend
o Expected loss ratios for the current book of business, particularly the Company's large fleet excess product, where the number of accounts insured, selected self-insured retentions, policy limits and reinsurance structure may vary widely period to period
Under reasonably possible scenarios, it is conceivable that the Company's selected loss reserve estimates could be 10%, or more, redundant or deficient. As shown in the table on page 32, the majority of the Company's reserves for losses and loss expenses, on either a gross or a net of reinsurance basis, relates to the Fleet trucking product. Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company's large fleet excess product for policies subject to certain recent major reinsurance treaties (approximately $58.2 million, or approximately 18% of, carried reserves for Fleet trucking). A 10 percentage point increase or decrease in the loss factors actually utilized in the Company's reserve determination at December 31, 2006 would increase or decrease gross and net loss reserves by approximately $5.8 million and $2.6 million, respectively. Similarly, a 20 percentage point increase or decrease would increase or decrease gross and net loss reserves by $11.6 million and $5.3 million, respectively. The Company has initiated a study to provide a more comprehensive sensitivity analysis in its future Form 10K filings.
FORWARD-LOOKING INFORMATION - ---------------------------
Any forward-looking statements in this report including, without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned 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.
FEDERAL INCOME TAX CONSIDERATIONS - ---------------------------------
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 reported at December 31, 2006 and 2005 consisted of:
Deferred tax assets at December 31, 2006, include approximately $12,256 related to policy liability discounts required by the Internal Revenue Code which are perpetual in nature and, in the absence of the termination of business, will not reverse to a material degree in the foreseeable future. An additional $1,301 relates to impairment adjustments made to investments, as required by accounting regulations. The sizable unrealized gains in the Company's investment portfolios would allow for the recovery of this deferred tax at any time. The balance of deferred tax assets, approximately $1,248, consists of various normal operating expense accruals and is not considered to be material. As a result of its analysis, management does not consider any of these assets to be impaired at December 31, 2006.
IMPACT OF INFLATION - -------------------
To the extent possible, the Company attempts to recover the costs of inflation by increasing the premiums it charges. Within the fleet trucking 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.
To the extent inflation influences yields on investments, the Company is also affected. The Company's short-term and fixed investment portfolios are structured in direct response to available interest rates over the yield curve. As available market interest rates fluctuate in response to the presence or absence of inflation, the yields on the Company's investments are impacted. Further, as inflation affects current market rates of return, previously committed investments might increase or decline in value depending on the type and maturity of investment. (See comments under Market Risk, following.)
Inflation must also be considered by the Company in the creation and review of loss and loss adjustment expense reserves since portions of these reserves are expected to be paid over extended periods of time. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and loss adjustment expenses.
MARKET RISK - -----------
The Company operates solely within the property and casualty insurance industry and, accordingly, has significant invested assets which are exposed to various market risks. These market risks relate to interest rate fluctuations, equities market prices and, to a far lesser extent, foreign currency rate fluctuations. All of the Company's invested assets, with the exception of investments in limited partnerships, are classified as available for sale and are listed as such in Note B to the consolidated financial statements.
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 a high potential for short-term price fluctuation. The market value of the Company's equity positions at December 31, 2006 was $129.8 million or approximately 21% of invested assets. This market valuation includes $73.0 million of appreciation over the cost basis of the equity security investments. 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, is the primary focus.
Reference is made to the discussion of limited partnership investments in the Critical Accounting Policies portion 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 income is reported only when a security is actually sold.
The Company's fixed maturity portfolio totaled $338.5 million at December 31, 2006. Approximately 89% of this portfolio is made up of U. S. Government and government agency obligations and state and municipal debt securities; 84% of the portfolio matures within 5 years; and the average life of the Company's fixed maturity investments is approximately 3.0 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 investment maturities, even a 100 to 200 basis point increase in interest rates would not have even a moderate impact on the Company's ability to conduct daily operations or to meet its obligations.
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 next paragraph.
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 $5.0 million at December 31, 2006. 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 $5.4 million at December 31, 2006. Note, however, that the hypothetical loss mentioned above would only be realized if the Company was obligated 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 2007 is equal to more than 100% of net loss and loss expense reserves at December 31, 2006.
The Company's exposure to foreign currency risk is not material.
CONTRACTUAL OBLIGATIONS - -----------------------
The table below sets forth the amounts of the Company's contractual obligations at December 31, 2006.
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, we have included an estimate of when we might expect our direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid in the preceding table. Timing of the collection of the related reinsurance recoverable, estimated to be $157.4 million at December 31, 2006, 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 the Company owned at December 31, 2006.
ANNUAL REPORT ON FORM 10-K
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ITEM 8
ITEM 8 - -FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
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YEAR ENDED DECEMBER 31, 2006
BALDWIN & LYONS, INC.
INDIANAPOLIS, INDIANA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Baldwin & Lyons, Inc.
We have audited the accompanying consolidated balance sheets of Baldwin & Lyons, Inc. and subsidiaries as of December 31, 2006 and 2005, 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, 2006. 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.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Baldwin & Lyons, Inc. and subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Baldwin & Lyons, Inc.'s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2007 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Indianapolis, Indiana March 9, 2007
See notes to consolidated financial statements.
See notes to consolidated financial statements.
See notes to consolidated financial statements.
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Baldwin & Lyons, Inc. and Subsidiaries (DOLLARS IN THOUSANDS)
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
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.
USE OF ESTIMATES: Preparation of the consolidated financial statements requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS: The Company considers investments in money market funds to be cash equivalents. Carrying amounts for these instruments approximate their fair values.
INVESTMENTS: Carrying amounts for fixed maturity securities (bonds and notes) represent fair value and are based on quoted market prices, where available, or broker/dealer quotes for specific securities where quoted market prices are not available. Equity securities (common stocks) are carried at quoted market prices (fair value). Limited partnerships are accounted for using the equity method with the corresponding change in value recorded as a component of net gains or losses on investments. Other investments are carried at either market value or cost, depending on the nature of the investment. All fixed maturity and equity securities are considered to be available for sale; the related unrealized net gains or losses (net of applicable tax effect) 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 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 subjective evaluation as to possible future recovery. Although the Company has classified fixed maturity investments as available for sale, it has the ability to, and generally does, hold its fixed maturity investments to maturity. Short-term investments are carried at cost which approximates their fair values. Realized gains and losses on disposals of investments are determined by specific identification of cost of investments sold and are included in income.
PROPERTY AND EQUIPMENT: Property and equipment is carried at cost. Depreciation is computed principally by the straight-line method.
RESERVES FOR LOSSES AND LOSS EXPENSES: The reserves for losses and loss expenses, minor portions of which are discounted, are determined using case basis evaluations and statistical analyses and represent estimates of the ultimate cost of all reported and unreported losses which are unpaid at year end. These reserves include estimates of future trends in claim severity and frequency and other factors which could vary as the losses are ultimately settled. Although it is not possible to measure the degree of variability inherent in such estimates, management believes that the reserves for losses and loss expenses are adequate. The estimates are continually reviewed and as adjustments to these reserves become necessary, such adjustments are reflected in current operations.
RECOGNITION OF REVENUE AND COSTS: Premiums are earned over the period for which insurance protection is provided. A reserve for unearned premiums, computed by the daily pro-rata method, is established to reflect amounts applicable to subsequent accounting periods. Commissions to unaffiliated companies and premium taxes applicable to unearned premiums are deferred and expensed as the related premiums are earned. The Company does not defer acquisition costs which are not directly variable with the production of premium and are not refundable in the event of policy cancellation. If it is determined that expected losses and deferred expenses will exceed the related unearned premiums, the asset representing deferred policy acquisition costs is reduced and an expense is charged against current operations to reflect any such premium deficiency. In the event that the expected premium deficiency exceeds deferred policy acquisition costs, an additional liability would be recorded with a corresponding expense to current operations for the amount of the excess premium deficiency. Anticipated investment income is considered in determining recoverability of deferred acquisition costs.
NOTE A - SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REINSURANCE: 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 earned. 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. Estimates of reinstatement premiums on reinsurance assumed contracts covering catastrophic events are recorded concurrently with the related loss.
Should impairment in the ability of a reinsurer to satisfy its obligations to the Company be determined to exist, current year operations would be charged in amounts sufficient to provide for the Company's additional liability. Such charges, when incurred, are included in other operating expenses, rather than losses and loss expenses incurred, since the inability of the Company to collect from reinsurers is a credit risk rather than a deficiency associated with the loss reserving process.
The Company accounts for foreign reinsurance assumed using the periodic method. Under the periodic method, premiums from foreign reinsurance assumed are recognized as revenue over the contract term, and claims, including an estimate of claims incurred but not reported, are recognized as they occur.
FEDERAL INCOME TAXES: A consolidated federal income tax return is filed by the Company and includes all wholly owned subsidiaries.
In the ordinary course of business, our federal income tax returns are audited by the Internal Revenue Service. We establish additional tax liabilities when, despite our belief that our tax positions are fully supportable, it is probable that the taxes ultimately payable will exceed the amounts reflected in our filed tax returns. Changes in the estimate of these matters will impact the provision for income taxes in the period in which such determination is made.
SHARE-BASED PAYMENTS: The Company uses a "Black-Scholes-Merton" option pricing model to value options granted to employees and non-employee directors in accordance with Statement of Financial Accounting Standards No. 123R, SHARE-BASED PAYMENT, adopted January 1, 2006 with no material effect. Compensation costs for all share-based awards to employees and non-employee directors are measured based on the grant date fair value of the award and are recognized over the period(s) during which the employee or non-employee director is required to perform service in exchange for the award (the vesting period).
EARNINGS PER SHARE: Diluted earnings per share of common stock are based on the average number of shares of Class A and Class B common stock outstanding during the year, adjusted for the dilutive effect, if any, of options outstanding. Basic earnings per share are presented exclusive of the effect of options outstanding. See NOTE K - EARNINGS PER SHARE.
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 not material and the Company has no defined benefit pension plan.
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 DURING PERIOD INCLUDED IN NET INCOME.
RECLASSIFICATION: Certain prior year balances have been reclassified to conform to the current year presentation.
NOTE B - INVESTMENTS The following is a summary of investments at December 31:
NOTE B - INVESTMENTS (CONTINUED) The following table summarizes, for fixed maturity and equity security investments in an unrealized loss position at December 31, the aggregate fair value and gross unrealized loss categorized by the duration those securities have been continuously in an unrealized loss position.
The fair value and the cost or amortized cost of fixed maturity investments, at December 31, 2006, 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. The Company's fixed maturity investment portfolio is sensitive to interest rate fluctuations, which impact the fair value of individual securities. Accordingly, unrealized losses on fixed maturity securities reported above were generally caused by the effect of a rising interest rate environment on certain securities with stated interest rates currently below market rates. The Company has the ability and intent to hold these fixed maturity securities until their full cost can be recovered. Therefore, the Company does not believe the unrealized losses represent an other-than-temporary impairment as of December 31, 2006.
Major categories of investment income for the years ended December 31 are summarized as follows:
NOTE B - INVESTMENTS (CONTINUED) Gains and losses on investments, including equity method earnings from limited partnerships, for the years ended December 31 are summarized below:
The 2006 net gains from limited partnerships, as shown in the above table, include approximately $6.2 million of unrealized gains as reported in the net income of the various partnerships. Shareholders' equity includes approximately $15.5 million, net of deferred federal income taxes, of earnings yet undistributed by limited partnerships as of December 31, 2006.
Gain and loss activity for fixed maturity and equity security investments, as shown in the previous table, include adjustments for other-than-temporary impairment for the years ended December 31 and is summarized as follows:
Note: Recovery in market value of an investment which has previously been adjusted for other-than-temporary impairment is treated as an unrealized gain until the investment is disposed of.
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 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 $7.9 million to various limited partnerships as of December 31, 2006.
The Company has invested a total of $24,000 in three limited partnerships, with an aggregate market value of $39,203, that are managed by organizations in which two directors of the Company are executive officers, directors and owners. The Company's ownership interest in these limited partnerships ranges from 13% to 31%. These limited partnerships added $7,942 and $7,145, respectively, to investment gains in 2006 and 2005. During 2006 and 2005, the Company has recorded management fees of $604 and $481, respectively, and
NOTE B - INVESTMENTS (CONTINUED)
performance-based fees of $1,587 and $1,687, respectively, to these organizations for management of these limited partnerships. Fees paid in 2004 for management of a single limited partnership were $21. The Company has been informed that the fee rates applied to its investments in these limited partnerships are the same as, or lower than, the fee rates charged to unaffiliated customers for similar investments.
The Company utilized the services of a broker-dealer firm of which a director of the Company is an executive officer and owner. This broker-dealer serves as agent for purchases and sales of securities and manages an equity securities portfolio and fixed maturity portfolio with market values of approximately $3,854 and $16,052, respectively, at December 31, 2006. The Company has been informed that commission and management rates charged by this broker-dealer to the Company are commensurate with rates charged to non-affiliated customers for similar investments. Total commissions and fees earned by the broker-dealer and affiliates on these transactions and for advice and consulting were approximately $148, $279 and $151 during 2006, 2005 and 2004, respectively. The Company had previously entered into an agreement with an associate of this broker-dealer for management of a portion of its equity securities portfolio. That agreement was terminated during 2005. That associate earned performance-based compensation and management services fees and expense reimbursements totaling approximately $90 and $307 during 2005 and 2004, respectively. The Company has been informed that the broker-dealer retained none of this compensation for its own account.
The fair value of regulatory deposits with various insurance departments in the United States and Canada totaled $22,359 at December 31, 2006.
Short-term investments at December 31, 2006 include $7.3 million in foreign time certificates of deposit.
NOTE C - LOSS AND LOSS EXPENSE RESERVES Activity in the reserves for losses and loss expenses is summarized as follows. All amounts are shown net of reinsurance recoverable.
The reserves for losses and loss expenses, net of related reinsurance recoverables, at December 31, 2005, 2004 and 2003 were decreased by $16,947, $13,692 and $14,956, respectively, for claims that had occurred on or prior to those dates. These decreases are the result of the settlement of claims at amounts lower than previously reserved and changes in estimates of losses incurred but not reported as part of the normal reserving process.
NOTE C - LOSS AND LOSS EXPENSE RESERVES (CONTINUED)
The major components of the developments shown above are as follows:
Favorable loss development is influenced by 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. Reserve savings developed related to retrospectively-rated accident and health business resulted in the concurrent recording of return premiums of approximately $4,738, $4,484 and $2,700 for the years ended December 31, 2006, 2005 and 2004, respectively. As more fully discussed in Note D, the Company has increased it's per occurrence retention of risk related to trucking liability business over the past several years. The increased net retention per occurrence is reflected in the favorable developments during 2006, 2005 and 2004. These trends were considered in the establishment of the Company's reserves at December 31, 2006 and 2005.
The Company has not changed its original estimate for the loss sustained as a result of the terrorist attacks of September 11, 2001. Therefore, there is no impact on the loss developments shown in the above table except for payments against the original established reserves. The Company has paid $11.5 million to date and carries a remaining reserve of $8.5 million at December 31, 2006.
The Company participates in mandatory residual market pools in various states. The Company records the results from participation in these pools as the information is reported to the Company and also records an additional provision in the financial statements for operating periods unreported by the pools.
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, 2006 and 2005, loss reserves have been reduced by approximately $4,883 and $4,476, 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 $3,845 and $3,374 at December 31, 2006 and 2005, respectively.
NOTE D - 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. Management determines the amount of net exposure it is willing to accept generally on a product line basis. Certain treaties covering large fleet trucking include annual deductibles which must be exceeded before the Company can recover under the terms of the treaty. In these cases, the Company retains a higher percentage of the direct premium in consideration of the deductible provisions. The Company remains liable to the extent the reinsuring companies are unable to meet their obligations under reinsurance contracts.
The Company also serves as an assuming reinsurer under retrocessions from certain other reinsurers. These retrocessions include individual risks but are comprised primarily of high layer catastrophe treaties. Accordingly, the occurrence of catastrophic events can have a significant impact on the Company's operations. 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. Historically, the
NOTE D - REINSURANCE (CONTINUED)
operation of these assigned risk pools have resulted in net losses allocated to the Company although such losses have generally not been material in relation to the Company's direct and voluntary assumed operations.
Net losses and loss expenses incurred for 2006, 2005 and 2004 have been reduced by ceded reinsurance recoveries of approximately $14,026, $39,389 and $103,579, respectively. Ceded reinsurance premiums and loss recoveries for catastrophe reinsurance contracts were not material.
Net losses and loss expenses incurred for 2006, 2005 and 2004 include approximately $2,623, $20,152 and $6,349 relating to reinsurance assumed from non-affiliated insurance or reinsurance companies, including involuntary residual market pools. The assumed reinsurance losses in 2006 and 2005 included $1,457 and $17,595, respectively, related to hurricanes Katrina and Wilma and 2004 assumed losses included $5,000 related to hurricanes, all before reinstatement premium.
Components of reinsurance recoverable at December 31 are as follows:
NOTE E - INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities as of December 31 are as follows:
A summary of the difference between federal income tax expense computed at the statutory rate and that reported in the consolidated financial statements is as follows:
Federal income tax expense consists of the following:
NOTE E - INCOME TAXES (CONTINUED)
The components of the provision for deferred federal income taxes (credits) are as follows:
Cash flows related to federal income taxes paid, net of refunds received, for 2006, 2005 and 2004 were $16,097, $12,147 and $14,865, respectively.
The Company is required to establish a valuation allowance for any portion of the gross deferred tax asset that management believes will not be realized. Management has determined that no such valuation allowance is necessary at December 31, 2006. As of December 31, 2006, the Internal Revenue Service had completed examinations through the Company's 2004 tax year.
NOTE F - 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 $.04 per share.
Shareholders' equity at December 31, 2006 includes $347,434 representing GAAP shareholder's equity of insurance subsidiaries, of which $54,201 may be transferred by dividend or loan to the parent company during calendar year 2007 with proper notification to, but without approval from, regulatory authorities. An additional $219,284 of shareholder's equity of such insurance subsidiaries may be advanced or loaned to the parent 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 $26,632, $18,221 and $19,941 for 2006, 2005 and 2004, respectively. Consolidated statutory surplus for these subsidiaries was $343,974 and $331,738 at December 31, 2006 and 2005, respectively.
NOTE F - SHAREHOLDERS' EQUITY (CONTINUED)
Minimum statutory surplus necessary for the insurance subsidiaries to satisfy statutory risk based capital requirements was $70,043 at December 31, 2006.
NOTE G - OTHER OPERATING EXPENSES Details of other operating expenses for the years ended December 31:
NOTE H - 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 2006, 2005 and 2004 were $1,137, $1,093 and $1,053, respectively.
NOTE I - 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 have ever been repurchased under the 1981 Plan. At December 31, 2006 there were 158,503 shares (Class A) and 438,583 shares (Class B) outstanding which are eligible for repurchase by the Company.
The Company maintains two stock option plans which are described below. Compensation cost charged against income for those plans was $20, $197, and $256 for 2006, 2005, and 2004, respectively.
DIRECTOR OPTION PLAN:
Under the Director Option Plan (the Director Plan), which is shareholder approved, the Company has reserved 300,000 shares of Class B common stock for the granting of discounted and market value options to non-employee directors. Approximately 167,000 shares of Class B common stock are available for future grants. No options were granted to directors during 2006 and all discounted options outstanding at December 31, 2005 were exercised during 2006. Prior to May, 2005, discounted options were granted to non-employee directors in lieu of cash directors' fees. In addition, during 2005 and 2004, non-employee directors were each granted 1,500 options at market value on the date of grant as part of their regular annual directors' fees. During 2006, all market value options were terminated, without compensation to the directors, and all subsequent directors' fees have been paid in cash. The Director Plan provides that options granted to non-employee directors are not exercisable for one year from the date of grant. Discounted options expire ten years from the date of grant while market value options expire seven years from the date of grant.
The fair value of the market value options granted during 2005 and 2004 was determined using a Black-Scholes-Merton option pricing model with the following assumptions: risk-free interest rate of 3.0% and 1.0%, respectively; dividend yield of 1.6%; volatility factor of the expected market price of the Company's common stock of .30; and an expected life of the option of 7 years.
Note I - Stock Purchase and Option Plans (continued)
A summary of option activity under the Director Plan as of December 31, 2006, and changes during the year then ended, is presented below:
The weighted-average grant-date fair value of options granted during 2005 and 2004 at prices below market value were $25.10 and $25.71, respectively. The weighted-average grant-date fair value of options granted during 2005 and 2004, at market, were $5.33 and $4.70, respectively. The total intrinsic value of options exercised during 2006, 2005 and 2004 was $484, $27, and $1,641, respectively.
EMPLOYEE OPTION PLAN:
Under the Employee Option Plan (the Employee Plan), which is shareholder approved, the Company has reserved 1,125,000 shares of Class B common stock for the granting of discounted and market value options to employees. Approximately 259,000 shares of Class B common stock are available for future grants. No options were granted to employees during the three year period ended December 31, 2006. Discounted options granted to employees were exercisable immediately. Market value options granted to employees in the past vested over three years. All options expire ten years from the date of grant. All remaining options outstanding at December 31, 2006 are exercisable at $20.60 per share and expire December 18, 2007.
A summary of option activity under the Employee Plan as of December 31, 2006, and changes during the year then ended is presented below:
The total intrinsic value of options exercised during 2006, 2005 and 2004 was $1,684, $420, and $328, respectively.
Cash received from option exercise under all share-based payment arrangements for the years ended December 31, 2006, 2005, and 2004 was $6,804, $1,618, and $1,413, respectively. The federal tax benefit realized for the tax deductions from option exercise of the share-based payment arrangements totaled $759, $157, and $689, respectively, for the years ended December 31, 2006, 2005, and 2004. Under the terms of the Employee Plan, $589, $147 and $115, respectively, was paid or payable to employees in the form of cash for the years ended December 31, 2006, 2005 and 2004.
The Company's policy is to issue new shares to satisfy share option exercises.
During 2002 and 2001, the Company offered loans to certain employees for the sole purpose of purchasing the Company's Class B common stock in the open market. Principal and interest totaling $2,343 and $2,339 relating to such loans was outstanding at December 31, 2006 and 2005, respectively. Loans carry interest rates ranging from 4.75% to 6%, payable annually on the loan anniversary date. The underlying securities, with value in excess of the related debt, serve as collateral
NOTE I - STOCK PURCHASE AND OPTION PLANS (CONTINUED)
for these full-recourse loans, which must be repaid no later than 10 years from the date of issue. This loan program was terminated in 2002.
NOTE J - REPORTABLE SEGMENTS
The Company and its consolidated subsidiaries market and underwrite casualty insurance in four major specialty areas (reportable segments): (1) fleet trucking, (2) nonstandard private passenger automobile, (3) small fleet trucking and (4) the assumption of reinsurance. A fifth segment, small business workers' compensation, was placed in runoff status effective during the fourth quarter of 2004 and is shown in the following table only for comparative purposes. 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 nonstandard 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 formerly provided workers' compensation coverages to small businesses and other entities.
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 provided by the Company to assigned risks and residual markets as well as the runoff of discontinued product lines other than small business workers' compensation.
The Company evaluates performance and allocates resources based on gain or loss from insurance underwriting operations before income taxes. Underwriting gain or loss does not include net investment income or gains or losses on the Company's investment portfolio. All investment-related revenues are managed at the corporate level. Underwriting gain or loss for the fleet trucking segment includes revenue and expense from the Company's agency operations since the agency operations serve as an exclusive direct marketing facility for this segment. Underwriting gain or loss also includes fee income generated by each segment in the course of its underwriting operations. Management does not identify or allocate assets to reportable segments when evaluating segment performance and depreciation expense is not material for any of the reportable segments. The accounting policies of each reportable segment are the same as those described in the summary of significant accounting policies.
NOTE J - REPORTABLE SEGMENTS (CONTINUED)
The following table provides certain profit and loss information for each reportable segment for the years ended December 31:
The above amounts for voluntary reinsurance assumed include certain intersegment reinsurance agreements. Intersegment premiums earned during 2006, 2005 and 2004 were $2,283, $1,570 and $1,609, respectively. Intersegment losses and loss expenses incurred during 2006, 2005 and 2004 were $3,005, $1,595 and $1,270, respectively.
NOTE J - REPORTABLE SEGMENTS (CONTINUED)
The following tables are reconciliations of reportable segment revenues and profits to the Company's consolidated revenue and income before federal income taxes, respectively.
The Company, through its subsidiaries, is licensed to do business in all 50 states of the United States, all Canadian provinces and Bermuda. Canadian and Bermuda operations are currently not significant.
One customer of the fleet trucking segment represents approximately $69,636, $62,570 and $57,767 of the Company's consolidated direct and assumed premium written in 2006, 2005 and 2004, respectively.
NOTE K - EARNINGS PER SHARE
The following is a reconciliation of the denominators used in the calculation of basic and diluted earnings per share for the years ended December 31:
Options to purchase 35,422 shares of the Company's Class B common stock were excluded in 2005 from the above reconciliation in that inclusion would have an anti-dilutive effect.
NOTE L - CONCENTRATIONS OF CREDIT RISK
The Company writes policies of excess insurance attaching above a self-insured retention ("SIR") and also writes policies that contain large, per-claim deductibles. Those losses and claims that fall within the SIR or deductible are obligations of the insured. The Company also writes surety bonds in favor of various regulatory agencies guaranteeing the insured's payment of claims within the SIR. Losses and claims under a large deductible policy are payable by the Company with reimbursement due the Company from the insured. The Company requires collateral from its insureds to serve as a source of reimbursement if the Company is obligated to pay claims within the SIR by reason of an insured's default or if the insured fails to reimburse the Company for deductible amounts paid by the Company.
NOTE L - CONCENTRATIONS OF CREDIT RISK (CONTINUED)
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, 2006, the Company held collateral in the aggregate amount of $251,624.
The amount of collateral required of an insured is determined by the financial condition of the insured, the type of obligations guaranteed by the Company, estimated reserves for incurred losses within the SIR or deductible that have been reported to the insured or the Company, estimated incurred but not reported losses, and estimates for losses that are expected to occur, within the SIR or deductible, prior to the next collateral adjustment date. In general, the Company attempts to hold collateral equal to 100% of the ultimate losses that would be paid by or due the Company in the event of the insured's default. Periodic audits are conducted by the Company to evaluate its exposure and the collateral required. If a deficiency in collateral is noted as the result of an audit, additional collateral is requested immediately. Because collateral amounts contain numerous estimates of the Company's exposure, are adjusted only periodically and are sometimes adjusted based on the financial condition of the insured, the amount of collateral held by the Company at a given point in time may not be sufficient to fully reimburse the Company for all of its guarantees or amounts due in the event of an insured's default. Further, the Company is not fully collateralized for the guarantees made for, or the deductible amounts that may be due from, the Company's largest customer, and in the event of that customer's default, such default may have a material adverse impact on the Company. The Company estimates its uncollateralized exposure related to this Fortune 500 company to be as much as 35% of shareholders' equity at December 31, 2006.
In addition, the Company's balance sheet includes paid and unpaid amounts recoverable from reinsurers under various agreements totaling $163,426 at December 31, 2006, as more fully discussed in Note D - Reinsurance. With minor exception, these recoverables are uncollateralized. The largest estimated amount due from a single reinsurer totaled $19,859 at December 31, 2006. Included in the total recoverable amount are case basis and estimated IBNR losses of approximately $14.3 million due from Converium Insurance (North America) Inc. and $2.7 million due from PMA Re., each of which have reported substantial reserve strengthening and/or impairment of assets which have negatively affected their reported financial positions. All amounts due from these reinsurers on paid claims as of December 31, 2006 are current and the Company has no information at this time to indicate that all obligations of these reinsurers will not be met.
Investments in limited partnerships include an aggregate of $39,203 invested in three related partnerships, New Vernon India Fund, New Vernon Global Opportunity Fund and New Vernon North American Opportunity Fund.
NOTE M - NEW ACCOUNTING PRONOUNCEMENTS
In September 2005, the American Institute of Certified Public Accountants ("AICPA") released Statement of Position 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts" ("SOP 05-1"). SOP 05-1 requires identification of transactions that result in a substantial change in an insurance contract. If it is determined that a substantial change to an insurance contract has occurred, the related unamortized deferred policy acquisition costs, unearned premiums and other related balances must be written off. SOP 05-1 is effective on January 1, 2007 and it is expected that SOP 05-1 will not have a material effect on the Company's consolidated financial condition or results of operations.
In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes--an interpretation of FASB Statement No. 109" ("FIN 48"), which provides criteria for the recognition, measurement, presentation and disclosure of uncertain tax positions. A tax benefit from an uncertain position may be recognized only if it is "more likely than not" that the position is sustainable based on its technical merits. FIN 48 is effective on January 1, 2007 and it is expected that FIN 48 will not have a material effect on the Company's consolidated financial condition or results of operations.
In September 2006, the FASB issued Statement No. 157, "Fair Value Measurements" ("SFAS No. 157"), which provides a common definition of fair value and establishes a framework to make the measurement of fair value more consistent and comparable. SFAS No. 157 also requires expanded disclosures about (1) the extent to which companies measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value and (3) the effect of fair value measures on earnings. SFAS No. 157 is effective on January 1, 2008 and it is expected that SFAS No. 157 will not have a material effect on the Company's consolidated financial condition or results of operations.
NOTE N - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Quarterly results of operations are as follows:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ------------------------------------------------ ACCOUNTING AND FINANCIAL DISCLOSURE -----------------------------------
No response to this item is required.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES -----------------------
The Company's management, under the direction of our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), has performed an evaluation of its disclosure controls and procedures (as defined by Exchange Act rules 13a-15(e) and 15d-15(e)) within 90 days of the date of the filing of this report. Based on this evaluation, the Company's CEO and CFO have concluded that the Company's disclosure controls and procedures were effective in ensuring that information required to be disclosed by the company is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms. In addition, there have not been any significant changes in internal controls or other factors that could significantly affect internal controls subsequent to the date of the company's most recent evaluation.
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS
Management is responsible for the preparation of the Company's consolidated financial statements and related information appearing in this report. Management believes that the consolidated financial statements fairly reflect the form and substance of transactions and that the financial statements reasonably present the Company's financial position and results of operations in conformity with generally accepted accounting principles. Management has included in the Company's financial statements amounts that are based upon estimates and judgments which it believes are reasonable under the circumstances.
Ernst & Young LLP, an independent registered public accounting firm, audits the Company's consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board and provides an objective, independent review of the fairness of reported operating results and financial position.
The Board of Directors of the Company has an Audit Committee composed of three non-management Directors. The committee meets periodically with financial management, the internal auditors and the independent registered public accounting firm to review accounting, control, auditing and financial reporting matters.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Company's management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of management, including the chief executive officer and the chief financial officer, the Company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under this framework, management concluded that the Company's internal control over financial reporting was effective as of December 31, 2006. Management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Baldwin & Lyons, Inc.
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Baldwin & Lyons, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Baldwin & Lyons, Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Baldwin & Lyons, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Baldwin & Lyons, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2006 consolidated financial statements of Baldwin & Lyons, Inc. and subsidiaries and our report dated March 9, 2007 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP Indianapolis, Indiana March 9, 2007
PART III --------
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT --------------------------------------------------
The information with respect to the directors of the Registrant to be provided under this item is omitted from this Report because the Registrant will file with the Commission a definitive proxy statement pursuant to Regulation 14A involving the election of directors not later than 120 days after the close of its fiscal year.
The information required by Item 10 of this Report with respect to directors which will appear in the definitive proxy statement is incorporated by reference herein.
The executive officers of the Company will serve until the next annual meeting of the Board of Directors and until their respective successors are elected and qualified. Except as otherwise indicated, the occupation of each officer during the past five years has been in his current position with the Company.
The following summary sets forth certain information concerning the Company's executive officers:
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION * ------------------------
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL ---------------------------------------- OWNERS AND MANAGEMENT * -----------------------
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS, RELATED TRANSACTIONS AND DIRECTOR -------------------------------------------------------- INDEPENDENCE * --------------
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES * ----------------------------------------
* The information to be provided under Items 11, 12, 13 and 14 is omitted from this Report because the Registrant will file with the Commission a definitive proxy statement pursuant to Regulation 14A involving the election of directors not later than 120 days after the close of its fiscal year. The information required by these items of this Report which will appear in the definitive proxy statement is incorporated by reference herein.
PART IV -------
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K ---------------------------------------------------------------
(a) 1. List of Financial Statements--The following consolidated financial statements of the registrant and its subsidiaries (including the Report of Independent Registered Public Accounting Firm) are submitted in Item 8 of this report.
Consolidated Balance Sheets - December 31, 2006 and 2005
Consolidated Statements of Income and Retained Earnings - Years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Changes in Equity Other Than Capital - Years ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows - Years ended December 31, 2006, 2005 and 2004
Notes to Consolidated Financial Statements
2. List of Financial Statement Schedules--The following consolidated financial statement schedules of Baldwin & Lyons, Inc. and subsidiaries are included in Item 15(d):
Pursuant to Article 7:
Schedule I--Summary of Investments--Other than Investments in Related Parties
Schedule II--Condensed Financial Information of the Registrant
Schedule III--Supplementary Insurance Information
Schedule IV--Reinsurance
Schedule VI--Supplemental Information Concerning Property/Casualty Insurance Operations
All other schedules to the consolidated financial statements required by Article 7 and Article 5 of Regulation S-X are not required under the related instructions or are inapplicable and therefore have been omitted.
3. Listing of Exhibits:
NUMBER & CAPTION FROM EXHIBIT TABLE OF ITEM 601 OF REGULATION S-K EXHIBIT NUMBER AND DESCRIPTION - ----------------------- ----------------------------------------------------- (3) EXHIBIT 3(i)-- (Articles of Incorpor- Articles of Incorporation of Baldwin & Lyons, Inc., ation & By Laws) as amended (Incorporated as an exhibit by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986)
EXHIBIT 3(ii)-- By-Laws of Baldwin & Lyons, Inc., as restated (Incorporated as an exhibit by reference to Exhibit 99.1 to the Company's Current Report on Form 8-K dated May 4, 2004)
(10) EXHIBIT 10(a)-- (Material Contracts) 1981 Employee Stock Purchase Plan (Incorporated as an exhibit by reference to Exhibit A to the Company's definitive Proxy Statement for its Annual Meeting held May 5, 1981)
EXHIBIT 10(b)-- Baldwin & Lyons, Inc. Employee Discounted Stock Option Plan (Incorporated as an exhibit by reference to Appendix A to the Company's definitive Proxy Statement for its Annual Meeting held May 2, 1989)
EXHIBIT 10(c)-- Baldwin & Lyons, Inc. Deferred Directors Fee Option Plan (Incorporated as an exhibit by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989)
EXHIBIT 10(d)-- Baldwin & Lyons, Inc. Amended Employee Discounted Stock Option Plan (Incorporated as an exhibit by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992)
NUMBER & CAPTION FROM EXHIBIT TABLE OF ITEM 601 OF REGULATION S-K EXHIBIT NUMBER AND DESCRIPTION - ----------------------- -----------------------------------------------------
EXHIBIT 10(e)-- Baldwin & Lyons, Inc. Restated Employee Discounted Stock Option Plan. (Incorporated as an exhibit by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997)
(11) EXHIBIT 11-- (Statement regarding Computation of Per Share Earnings computation of per share earnings)
(14) EXHIBIT 14-- (Code of ethics) Code of Business Conduct of Baldwin & Lyons, Inc. (Incorporated as an exhibit by reference to Exhibit 14 to the Company's Annual Report on Form 10-K for the year ended December 31, 2005)
(21) EXHIBIT 21-- (Subsidiaries of the Subsidiaries of Baldwin & Lyons, Inc. registrant)
(23) EXHIBIT 23-- (Consents of experts Consent of Ernst & Young LLP and counsel)
(24) EXHIBIT 24-- (Powers of Attorney) Powers of Attorney for certain Officers and Directors
(31) EXHIBIT 31.1 (Certification) Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act
EXHIBIT 31.2 Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act
(32) EXHIBIT 32.1 (Certification) Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act and 18 U.S.C. 1350
EXHIBIT 32.2 Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act and 18 U.S.C. 1350
(b) A report on Form 8-K was filed by the Company in the fourth quarter of 2006 to announce its third quarter earnings press release.
(c) Exhibits. The response to this portion of Item 15 is submitted as a separate section of this report.
(d) Financial Statement Schedules. The response to this portion of Item 15 is submitted on pages 69 through 75 of this report.
See notes to condensed financial statements
See notes to condensed financial statements
See notes to condensed financial statements
NOTE TO CONDENSED FINANCIAL STATEMENTS--BASIS OF PRESENTATION
The Company's investment in subsidiaries is stated at cost plus equity in the undistributed earnings of subsidiaries since the date of acquisition. The Company's share of net income of its subsidiaries is included in income using the equity method. These financial statements should be read in conjunction with the Company's consolidated financial statements.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
BALDWIN & LYONS, INC.
March 14, 2007 By /s/ GARY W. MILLER -------------------------------------------- Gary W. Miller, Chairman and CEO (Chief Operating Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
March 14, 2007 By /s/ GARY W. MILLER -------------------------------------------- Gary W. Miller, Chairman and CEO; Director
March 14, 2007 By /s/ G. PATRICK CORYDON -------------------------------------------- G. Patrick Corydon, Senior Vice President - Finance and CFO (Principal Financial Officer and Principal Accounting Officer)
March 14, 2007 By /s/ JOSEPH DEVITO -------------------------------------------- Joseph DeVito, Director, President and Chief Operating Officer (appointed February 6, 2007)
March 14, 2007 By /s/ JAMES GOOD -------------------------------------------- James Good, Director and Executive Vice President
March 14, 2007 By /s/ STUART D. BILTON (*) -------------------------------------------- Stuart D. Bilton, Director
March 14, 2007 By /s/ OTTO N. FRENZEL III (*) -------------------------------------------- Otto N. Frenzel III, Director
SIGNATURES (CONTINUED)
March 14, 2007 By /s/ JOHN M. O'MARA (*) -------------------------------------------- John M. O'Mara, Director
March 14, 2007 By /s/ THOMAS H. PATRICK (*) -------------------------------------------- Thomas H. Patrick, Director
March 14, 2007 By /s/ NATHAN SHAPIRO (*) -------------------------------------------- Nathan Shapiro, Director
March 14, 2007 By /s/ NORTON SHAPIRO (*) -------------------------------------------- Norton Shapiro, Director
March 14, 2007 By /s/ JOHN D. WEIL (*) -------------------------------------------- John D. Weil, Director
March 14, 2007 By /s/ ROBERT SHAPIRO (*) -------------------------------------------- Robert Shapiro, Director
March 14, 2007 By /s/ JOHN PIGOTT (*) -------------------------------------------- John Pigott, Director
March 14, 2007 By /s/ JON MILLS (*) -------------------------------------------- Jon Mills, Director
(*) By Gary W. Miller, Attorney-in-Fact
ANNUAL REPORT ON FORM 10-K
- -------------------------------------------------------------------------------- ITEM 15(c)--CERTAIN EXHIBITS - --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2006
BALDWIN & LYONS, INC.
INDIANAPOLIS, INDIANA
BALDWIN & LYONS, INC. Form 10-K for the Fiscal Year Ended December 31, 2006
INDEX TO EXHIBITS -----------------
BEGINS ON SEQUENTIAL PAGE EXHIBIT NO. NUMBER OF FORM 10-K - ------------------------------------------- ------------------------- EXHIBIT 3(i)-- Articles of Incorporation of Baldwin & Lyons, Inc. as amended (Incorporated as an exhibit by reference to Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1986) N/A
EXHIBIT 3(ii)-- By-Laws of Baldwin & Lyons, Inc., as restated (Incorporated as an exhibit by reference to Exhibit 99.1 to the Company's Current Report on Form 8-K dated May 4, 2004) N/A
EXHIBIT 10(a)-- 1981 Employees Stock Purchase Plan (Incorporated as an exhibit by reference to Exhibit A to the Company's definitive Proxy Statement for itsAnnual Meeting held May 5, 1981) N/A
EXHIBIT 10(b)-- Baldwin & Lyons, Inc. Employee Discounted Stock Option Plan (Incorporated as an exhibit by reference to Appendix A to the Company's definitive Proxy Statement for its Annual Meeting held May 2, 1989) N/A
EXHIBIT 10(c)-- Baldwin & Lyons, Inc. Deferred Directors Fee Option Plan (Incorporated as an exhibit by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989) N/A
INDEX TO EXHIBITS (CONTINUED)
BEGINS ON SEQUENTIAL PAGE EXHIBIT NO. NUMBER OF FORM 10-K - ------------------------------------------- ------------------------------
EXHIBIT 10(d)-- Baldwin & Lyons, Inc. Amended Employee Discounted Stock Option Plan (Incorporated as an exhibit by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989) N/A
EXHIBIT 10(e)-- Baldwin & Lyons, Inc. Restated Employee Discounted Stock Option Plan (Incorporated as an exhibit by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1997) N/A
EXHIBIT 11-- Computation of Per Share Earnings Filed herewith electronically
EXHIBIT 14-- Code of Business Conduct, as amended May 3, 2005 (Incorporated as an exhibit by reference to Exhibit 14 to the Company's Annual Report on Form 10-K for the year ended December 31, 2005) N/A
EXHIBIT 21-- Subsidiaries of Baldwin & Lyons, Inc. Filed herewith electronically
EXHIBIT 23-- Consent of Ernst & Young LLP Filed herewith electronically
EXHIBIT 24-- Powers of Attorney for certain Officers and Directors Filed herewith electronically
EXHIBIT 31.1-- Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically
EXHIBIT 31.2-- Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically
EXHIBIT 32.1-- Certification of CEO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically
INDEX TO EXHIBITS (CONTINUED)
BEGINS ON SEQUENTIAL PAGE EXHIBIT NO. NUMBER OF FORM 10-K - ------------------------------------------- ------------------------------
EXHIBIT 32.2-- Certification of CFO pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically