Baldwin & Lyons Cl B (BWINB) - Description of 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 s 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 s 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.
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.
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.
As of December 31, 2006, the Company had 279 employees, representing an increase of 1 employee from December 31, 2005.
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. 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.