10-K 1 form10k.htm


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of
The Securities Exchange Act of 1934

                             For the fiscal year ended                                                                                                                                                                                                                                                                                                                             Commission file number 0-5534
                              December 31, 2016
BALDWIN & LYONS, INC.
(Exact name of registrant as specified in its charter)

Indiana
(State or other jurisdiction of
Incorporation or organization)
35-0160330
(I.R.S. Employer
Identification No.)
111 Congressional Boulevard, Carmel, Indiana
(Address of principal executive offices)
46032
(Zip Code)
 
Registrant's telephone number, including area code:  (317) 636-9800
Securities registered pursuant to Section 12(b) of the Act:
   (Title of class)                                                     Name of Each Exchange on which Registered
                                                                                      Class A Common Stock, No Par Value                                     The Nasdaq Stock Market, LLC
                                                                                      Class B Common Stock, No Par Value                                     The Nasdaq Stock Market, LLC

Securities registered pursuant to Section 12(g) of the Act:  None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    
 
Yes -___ No  
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
 
Yes -___ No  
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes -       No ___
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes       No__

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.         -   
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definitions of "large accelerated filer, "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer ____    Accelerated filer         Non-accelerated filer ____    Smaller Reporting Company____
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes -___ No  
 
The aggregate market value of Class A and Class B Common Stock held by non-affiliates of the Registrant as of June 30, 2016, based on the closing trade prices on that date, was approximately $254,086,000.
 
The number of shares outstanding of each of the issuer's classes of common stock as of March 1, 2017:
Common Stock, No Par Value:  Class A (voting)                                                       2,623,109
                                                                Class B (nonvoting)     12,481,081
                                                                                                                                               15,104,190

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Annual Meeting of Shareholders to be held on May 9, 2017 are incorporated by reference into Part III of this Annual Report on Form 10-K.
 
 
- 1 -

PART I

 
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") engages in marketing and underwriting property and casualty insurance, including a limited assumption of risks as a reinsurer of other companies.
 
B&L's principal subsidiaries are:
 
1.
 
Protective Insurance Company (referred to herein as "Protective"), which is licensed by insurance authorities in all 50 states, the District of Columbia, all Canadian provinces and Puerto Rico;
 
2.
 
Protective Specialty Insurance Company (referred to herein as "Protective Specialty"), which is currently approved for excess and surplus lines business by insurance authorities in 48 states and the District of Columbia and licensed in Indiana;
 
3.
 
Sagamore Insurance Company (referred to herein as "Sagamore"), which is licensed by insurance authorities in 49 states and the District of Columbia and approved for excess and surplus lines business in one additional state;
 
4.
 
B&L Brokerage Services, Inc. (referred to herein as "BLBS"), an Indiana domiciled insurance broker licensed in all 50 states and the District of Columbia; and
 
5.
 
B&L Insurance, Ltd. (referred to herein as "BLI"), which is domiciled and licensed in Bermuda.
 
Protective, Protective Specialty, Sagamore and BLI are collectively referred to herein as the "Insurance Subsidiaries."  The "Company", "we", "us" and "our", as used herein, refers to Baldwin & Lyons, Inc. and all its subsidiaries unless the context clearly indicates otherwise.

As is a common practice in the property and casualty insurance industry, the Insurance Subsidiaries share (referred to as "ceding") portions of their gross premiums written with several non-affiliated reinsurers under excess of loss and quota-share treaties covering predetermined groups of risks and by facultative (individual policy-by-policy) placements.  Reinsurance is ceded to spread the risk of loss from individual accidents or groups of accidents among several reinsurers and is an integral part of the Company's business.
 
In 2016, the Insurance Subsidiaries serve a variety of specialty markets as described below.  Continuing operations and targeted growth will occur mainly in fleet transportation.
 
 
- 2 -

 
Fleet Transportation

The Insurance Subsidiaries provide coverage for larger companies in the motor carrier industry that retain substantial amounts of self-insurance, for independent contractors utilized by trucking companies, for medium-sized and small trucking companies on a first dollar or small deductible basis and for public livery concerns, principally covering fleets of commercial buses.  This group of products is collectively referred to as fleet transportation.  Large fleet trucking products are marketed both by the B&L agency organization directly to fleet transportation clients and also through relationships with non-affiliated brokers and specialized independent agents.  Large fleet trucking products are marketed both by the B&L agency organization directly to fleet transportation clients and also through relationships with non-affiliated brokers and specialized independent agents.  Products for small and intermediate fleets, independent contractors, and non-trucking entities are marketed through relationships with non-affiliated brokers and specialized agents.  In some cases, the Company will provide specific product offerings to specialized markets through partnerships with brokers and program administrators.

The principal types of fleet transportation insurance marketed by the Insurance Subsidiaries are:
 
-
 
Commercial motor vehicle liability, physical damage and general liability insurance.
-
Workers' compensation insurance.
-
Specialized accident (medical and indemnity) insurance for independent contractors of trucking concerns.
-
Non-trucking motor vehicle liability insurance for independent contractors.
-
Fidelity and surety bonds.
-
Inland Marine insurance consisting principally of cargo insurance.

B&L also performs a variety of additional services, primarily for the Company's insureds, including risk surveys and analyses, safety program design and monitoring, government compliance assistance, loss control and cost studies and research, development, and consultation in connection with new insurance programs, including development of systems to assist customers in monitoring their accident data.  Claims handling services are also provided, primarily to clients with self-insurance programs.
 
Reinsurance Assumptions

In the first quarter of 2016, the Company discontinued its reinsurance assumed professional liability line of products.  These products are in run off and will continue earning premiums in 2017.  Prior to that, the Company accepted cessions and retrocessions from selected insurance and reinsurance companies, providing reinsurance coverage for both property and casualty events.  Participation in reinsurance markets fluctuated based on market conditions for these products.  In recent years, unfavorable pricing and terms available in reinsurance markets, particularly property markets, resulted in a significant decline in premium assumed by the Company.  The net reinsurance premiums earned during 2016 primarily related to professional liability coverages provided to domestic insurance companies and produced through a network of independent brokers.

Property reinsurance premium for 2015 was limited to the final runoff of United States wind and earthquake business produced through a single exclusive managing general agency partnership.    Effective July 1, 2014, this final property catastrophe exposure was not renewed and, as of June 30, 2015, no property reinsurance risk remained inforce.

Professional Liability

In the fourth quarter of 2016, the Company discontinued its professional liability line of products.  Prior to that, the Company marketed a variety of professional liability products through wholesale and retail agents on both an admitted and surplus lines basis throughout the United States, specializing in smaller insureds.  Some professional liability policies will renew in 2017 as required by state regulations and existing policies will remain inforce through 2017.
 
 
- 3 -

 
Private Passenger Automobile Insurance

In the fourth quarter of 2015, the Company discontinued marketing private passenger automobile liability and physical damage coverages and substantially all business for this product line expired in 2016.


Property/Casualty Losses and Loss Adjustment Expenses
 
Losses and loss adjustment expenses incurred typically comprise approximately two-thirds of the Company's operating expenses.

The Company's consolidated balance sheets as of December 31, 2016 and 2015 set forth in Part II, Item 8 of this Annual Report on Form 10-K include the estimated liability for unpaid losses and loss adjustment expenses ("LAE") of the Insurance Subsidiaries before the application of reinsurance credits (gross reserves).  The liabilities for losses and LAE are determined using case basis evaluations and statistical projections and represent estimates of the Company's ultimate 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 as recorded.
 
The Company's reserves for losses and loss expenses are determined based on evaluations of individual reported claims and by actuarial estimation processes using historical experience, current economic information and, when necessary, available industry statistics.  "Case basis" loss reserves are evaluated on an individual case-by-case basis by experienced claims adjusters using established Company guidelines and are monitored by claims management.  Additionally, "bulk" reserves are established for (1) those losses which have occurred, but have not yet been reported to the Company ("incurred but not reported" claims), (2) provisions for any possible deficiencies in the case reserving process and (3) the expected external and internal costs to fully settle each claim ("loss adjustment expenses").  Common actuarial methods are employed in the establishment of bulk 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 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 relative 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 31 in Part II, Item 7, Management's Discussion and Analysis, of this Annual Report on Form 10-K.

The reserving process requires management to continuously monitor and evaluate the life cycle of claims.  Our claims range from the very routine "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 by the Company's fleet transportation 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.

For policies inforce at December 31, 2016, the maximum amount for which the Company insures a fleet transportation risk is $10 million, less applicable self-insured retentions, although for the majority of policies written, the maximum limits provided by the Company are $5 million or less.  Occasionally, limits above $10 million required by customers are placed directly by the Company with non-affiliated carriers or written by the Company but 100% reinsured with non-affiliated reinsurers.  Certain coverages, such as workers' compensation, do not have policy limits, although the Company protects itself to the extent believed prudent through the purchase of excess reinsurance for these coverages.  After giving effect to treaty and facultative reinsurance arrangements, the Company's maximum exposure to loss from a single occurrence for currently inforce business ranges from approximately $0.25 million to $1.3 million for the vast majority of risks insured although, for certain losses occurring within the past five policy years, maximum exposure could be as high as $2.5 million for a single occurrence.  Certain reinsurance agreements effective since June 3, 2005 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.
 

 
- 4 -

The Company is a cedent under numerous reinsurance treaties covering its varied product lines.  Treaties are typically written on an annual basis, each with its own renewal date.  However, treaty terms may occasionally be agreed to for periods beyond one year.  Treaty renewals are expected to largely continue to occur annually in the foreseeable future.  Because losses from certain of the Company's products can experience delays in being reported and can take years to settle, losses reported to the Company in the current year may be covered by a number of older reinsurance treaties with higher or lower net loss exposures than those provided by current treaty provisions.

The table on page 5 sets forth a reconciliation of beginning and ending loss and LAE liability balances for 2016, 2015 and 2014.  That table is presented net of reinsurance recoverable to correspond with our income statement presentation.  However, a reconciliation of beginning and ending loss and LAE liability gross of reinsurance recoverable, as presented in the balance sheet, is also shown.  The table on page 11 shows the development of the estimated liability, net of reinsurance recoverable, for the ten years prior to 2016.  The table on page 12 is a summary of the re-estimated liability, before consideration of reinsurance, for the ten years prior to 2016 as well as the related re-estimated reinsurance ceded for the same periods.


   
2016
   
2015
   
2014
 
Reserves at the beginning of the year
 
$
301,753
   
$
295,583
   
$
288,088
 
                         
Provision for losses and loss expenses:
                       
   Claims occurring during the current year
   
172,645
     
165,812
     
169,950
 
   Claims occurring during prior years
   
13,836
     
(10,062
)
   
(10,354
)
   Total incurred
   
186,481
     
155,750
     
159,596
 
                         
Loss and loss expense payments:
                       
   Claims occurring during the current year
   
54,239
     
56,710
     
59,826
 
   Claims occurring during prior years
   
109,228
     
92,870
     
92,275
 
   Total paid
   
163,467
     
149,580
     
152,101
 
                         
Reserves at the end of the year
   
324,767
     
301,753
     
295,583
 
                         
Reinsurance recoverable on unpaid losses at the end of the year
   
251,563
     
211,843
     
210,519
 
Reserves, gross of reinsurance
                       
    recoverable, at the end of the year
 
$
576,330
   
$
513,596
   
$
506,102
 
                         

The reconciliation above shows that the Company's estimate of net losses on 2015 and prior accidents is approximately $13.8 million higher at December 31, 2016 than was provided in loss reserves at December 31, 2015 (referred to as a "reserve deficiency").  In the two previous calendar years, the Company had reserve savings.


- 5 -


The following table is a summary of the 2016 calendar year reserve deficiency by accident year (dollars in thousands):


Years in Which Losses Were Incurred
 
Reserve at December 31, 2015
   
(Savings) Deficiency Recorded During 2016
   
% (Savings) Deficiency
 
             
2015
 
$
109,102
   
$
(4,183
)
   
(3.8
%)
2014
   
83,176
     
(2,186
)
   
(2.6
%)
2013
   
35,242
     
8,558
     
24.3
%
2012
   
20,807
     
4,429
     
21.3
%
2011
   
13,080
     
4,814
     
36.8
%
2010 & Prior
   
40,346
     
2,404
     
6.0
%
                         
   
$
301,753
   
$
13,836
     
4.6
%

The (savings) deficiency recorded for the above individual loss years was derived from varied sources, as follows (dollars in thousands):

 
   
2010 & Prior
   
2011
   
2012
   
2013
   
2014
   
2015
 
                                     
Losses and allocated loss expenses developed on cases known to exist at December 31, 2015
 
$
1,345
   
$
2,095
   
$
(505
)
 
$
1,237
   
$
(2,651
)
 
$
21,934
 
Losses and allocated loss expenses reported on cases unknown at December 31, 2015
   
17
     
124
     
484
     
152
     
4,564
     
9,656
 
Unallocated loss expenses paid
   
266
     
115
     
166
     
486
     
819
     
1,620
 
Change in reserves for incurred but not reported losses and allocated and unallocated loss expenses
   
(219
)
   
1,122
     
(77
)
   
665
     
(4,979
)
   
(32,995
)
Net deficiency (savings) on losses from directly-produced business
   
1,410
     
3,455
     
67
     
2,540
     
(2,247
)
   
216
 
                                                 
Deficiency (savings) reported under voluntary reinsurance assumption agreements and residual markets
   
994
     
1,359
     
4,362
     
6,018
     
61
     
(4,399
)
                                                 
Net deficiency (savings)
 
$
2,404
   
$
4,814
   
$
4,429
   
$
8,558
   
$
(2,186
)
 
$
(4,183
)

 
- 6 -


Loss and loss expense development deficiency (savings), presented separately by segment, were as follows for the years ended December 31 (dollars in thousands):
                   
   
2016
   
2015
   
2014
 
                   
Property and casualty insurance
 
$
5,441
   
$
(10,289
)
 
$
(5,423
)
Reinsurance
   
8,395
     
227
     
(4,931
)
      Totals
 
$
13,836
   
$
(10,062
)
 
$
(10,354
)
                         
Development as a percent of beginning loss and loss adjustment expense reserves deficiency (savings):
    Property and casualty insurance
    2.1   %     (4.3  %)      (2.9 %) 
    Reinsurance
     17.7  %      0.4  %      (6.3  %)
      Total
     4.6  %      (3.4  %)      (3.6  %)

 
In the first table above, the amounts identified as "Net deficiency (savings) on losses from directly-produced business" consist of development on cases known at December 31, 2015, losses reported which were previously unknown at December 31, 2015 (incurred but not reported), unallocated loss expense paid related to accident years 2015 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 table are amounts representing the "Deficiency (savings) reported under reinsurance assumption agreements and residual markets".  These amounts relate to the Company's participation in voluntary reinsurance policies and treaties.  The Company records its share of losses from these policies, treaties and pools based on reports from the reinsured companies and does not directly establish case reserves related to this portion of the Company's business.  The Company does, however, establish additional reserves for reinsurance losses to supplement case reserves reported by the ceding companies, when considered necessary.  Involuntary residual market premiums and losses are included in the property and casualty segment; however, claims are not administered by the Company but, rather, reserves on this business are established by the regulatory entities and, accordingly, development on these losses is largely dependent on the adequacy of loss reserving by these entities.  Historically, loss developments for involuntary assumed policies in prior accident years have been immaterial to the overall reserve position.
 
The property and casualty insurance segment has historically constituted the largest portion of net reserve development, as it has historically generated the majority of the Company's premium revenue.  As shown, the development from this segment ranged from a $10.3 million savings to a deficiency of $5.4 million during the past three years.  This fluctuation reflects the variability associated with higher premium volumes and, hence, the larger claims covered by the Company, as well as fluctuations in the Company's net retentions.  During 2016, the property and casualty segment was also affected by infrequent developments in the Company's workers' compensation and Public Transportation products.  The Company continues to incorporate more recent loss development data into its loss reserving formulae; however, the dynamic nature of losses associated with the fleet transportation business, as well as the timing of settlement of large claims, increases the likelihood of variability in loss developments from period to period.  As discussed elsewhere, the Company has historically experienced savings in its loss developments owing to, among other things, its long-standing policy of reserving for the ultimate value of losses quickly and 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.

The development for the reinsurance segment is heavily dependent on the establishment of case basis and incurred but not reported ("IBNR") reserves by other insurance and reinsurance companies.  However, the Company evaluates the sufficiency of such reserves and often adjusts reserves based on management's independent analysis, considering the number of different entities involved and the fact that the Company must rely on external sources of information and reserve development from these products is potentially subject to fluctuation from year to year.
 
 
- 7 -

 
Management's goal is to produce an overall estimate of reserves which is sufficient and as close to expected ultimate losses as possible.  The $13.8 million in net deficiency developed during 2016 represents approximately 70% of pre-tax net income before realized capital gains for 2016 but only 4.6% of December 31, 2015 net loss and LAE reserves, which is well within the acceptable range of variation for the Company's diverse and complex book of business.  The Company has maintained a consistent, conservative posture in its reserving process, which has proven to be fully adequate with no calendar year reserve deficiencies above 5% of prior year loss positions developed since 1985.  The Company constantly monitors changes in trends related to the numbers of claims incurred relative to correlative variances with premium volume, average settlement amounts, numbers of claims outstanding at period ends and the average value per claim outstanding and adjusts actuarial assumptions as necessary to accommodate observed trends.
 
As described on page 4, changes have occurred in the Company's net per accident retained exposure under reinsurance agreements in place during the periods presented in the previous 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 related to business which carries lower policy limits, such as private passenger automobile.  This is because there are fewer policy limit losses in the Company's historical loss database on which to project future loss developments, and the larger and more complex the loss, the greater the likelihood that litigation will become involved in the settlement process.  Consequently, the level of uncertainty in the reserving process is much greater when dealing with larger losses and will routinely result in fluctuations among accident year developments.
 
Ten Year Historical Development Tables:
 
The table on page 11 presents the development of GAAP balance sheet insurance reserves for each year-end from 2006 through 2015, as of December 31, 2016, 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 IBNR losses, to the Company.

 
The upper portion of the table shows the re-estimated 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, 2016.  For example, the 2006 liability has developed a $56.0 million redundancy over ten years.  That amount has been reflected in income over those ten years, as shown on the table.  The effect on calendar year 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 net loss developments have been favorable.  Reserve developments for all years ended in the period 1985 through 2011 have produced redundancies as of December 31, 2016, with only small deficiencies developing for periods from 2012 through 2014.  The $13.8 million deficiency developed through one year on the 2015 reserve position is considered infrequent for the Company.  In addition to a consistently conservative approach to reserving methods, loss reserve developments in recent years have been favorably affected by several other factors.  The most significant single factor has been the improvement in safety programs by the fleet transportation industry in general and by the Company's insureds specifically.  Statistics produced by a variety of sources show that driver quality in general and specifically as it relates to the type of transportation companies underwritten by the Company, 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 an impact on the frequency and severity of fleet transportation accidents and, more recently, the introduction of numerous safety devices using state-of-the-art technology has reduced rear end and cross over accidents which often produce the most serious injuries.  In addition, the expanded use of telematics to precisely measure driver behavior and provide focused training and remediation is positively impacting loss experience.  Significant trucking industry and regulatory initiatives, such as CSA 2010, have provided strong motivation to trucking companies to upgrade their driver roster, increase monitoring of driver behavior and improve equipment maintenance, all resulting in fewer accidents.  Higher self-insured retentions also play a part in reduced insurance losses.  Higher retentions not only raise the excess insurance entry point but also encourage fleet transportation company management to focus even more intensely on safety programs.
 
 
- 8 -

 
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 for most lines of business.  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 2016 is different, both in terms of exposures provided and rates charged, 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 transportation liability claims over the past several years.  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, any savings realized in recent years upon the closing of claims, as reflected in the tables on pages 6 and 12, are attributable to the Company's experience in specializing in the long-haul trucking business for over 50 years, as well as its long-standing policy of reserving for losses realistically and a willingness to settle claims based upon a seasoned evaluation of the underlying exposures.  However, over the past several years, the Company has experienced premium growth in areas outside of fleet trucking, where the Company has less experience in handling claims.  For these products, management relies more heavily on pricing assumptions, as well as industry data, to support the reserve positions.  Management will continue to review the trends in all products 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 11 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, 2016, the Company had paid $171.2 million of losses and LAE that had been incurred, but not paid, as of December 31, 2006; thus, an estimated $22.3 million (11.5%) of losses incurred through 2006 remain unpaid as of the current financial statement date ($193.5 million incurred less $171.2 million paid).  The payment patterns shown in this table demonstrate the "long-tail" nature of much of the Company's business, whereby portions of claims, principally in workers compensation coverages, do not fully pay out for more than ten years.
 
Readers should note that the table on page 11 does not present accident or policy year development data, which they 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.  In reviewing this information, it is important to understand that this method of presentation causes some development experience to be duplicated.  For example, the amount of any redundancy or deficiency related to losses settled in 2009, but incurred in 2006, will be included in the cumulative development amount for each of the years ending December 31, 2006, 2007, and 2008.  It is also 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 would not be appropriate to extrapolate future redundancies or deficiencies based on this table.
 
The table presented below presents loss development data on a gross (before consideration of reinsurance) basis for the same ten year period December 31, 2006 through December 31, 2015, as of December 31, 2016, with a reconciliation of the data to the net amounts shown in the table above.  Readers are reminded that the gross data presented below requires significantly more subjectivity in the estimation of IBNR and loss expense reserves because of the high limits provided by the Company to its fleet transportation customers, some of which has been covered by excess of loss and facultative reinsurance.  This is particularly true of excess of loss treaties where the Company 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.  The difference between loss developments before consideration of reinsurance, as presented below, and those net of reinsurance, as shown in the table above do not impact the Company's operating results as all such differences are borne by reinsurers.
 

Environmental Matters:
 
Given that the Company's principal business is insuring fleet transportation companies, on occasion claims involving a commercial automobile accident which has resulted in the spill of a pollutant are made.  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 and isolated spill of a pollutant.  These claims are typically reported, evaluated and fully resolved within a short period of time.
 
 
- 9 -

 
In general, establishing reserves for environmental claims, other than those associated with "sudden and accidental" losses, 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.
 
Very few environmental claims have historically been reported to the Company.  In addition, a review of the businesses of our past and current insureds indicates that exposure to claims of an environmental nature is limited because the vast majority 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 has, and is expected to, further limit exposure to such claims from that point forward.
 
The Company does not expect to have any significant environmental claims relating to asbestos exposure.
 
The Company's reserves for unpaid losses and loss expenses at December 31, 2016 did not include significant amounts for liability related to environmental damage claims.  The Company does not foresee significant future exposure to environmental damage claims and accordingly has established no reserve for IBNR environmental losses at December 31, 2016.
 
 
- 10 -

 

ANALYSIS OF LOSS AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT--GAAP BASIS
 
(Dollars in thousands)
 
                                                                   
Year Ended December 31
 
2006
   
2007
   
2008
   
2009
   
2010
   
2011
   
2012
   
2013
   
2014
   
2015
   
2016
 
                                                                   
Liability for Unpaid Losses
                                                                 
  and Loss Adjustment
                                                                 
  Expenses
 
$
249,495
   
$
244,500
   
$
231,633
   
$
203,253
   
$
218,629
   
$
290,092
   
$
289,236
   
$
288,088
   
$
295,583
   
$
301,753
   
$
324,767
 
                                                                                         
Liability Reestimated
                                                                                       
   as of:
                                                                                       
  One Year Later
   
228,211
     
227,423
     
222,049
     
194,430
     
208,933
     
280,217
     
283,673
     
277,734
     
285,521
     
315,589
         
  Two Years Later
   
207,818
     
216,730
     
208,702
     
198,220
     
201,745
     
272,285
     
282,381
     
268,757
     
303,540
                 
  Three Years Later
   
199,503
     
206,445
     
210,562
     
188,110
     
204,243
     
276,525
     
279,685
     
288,862
                         
  Four Years Later
   
192,678
     
210,170
     
205,519
     
192,195
     
202,078
     
268,299
     
291,332
                                 
  Five Years Later
   
198,023
     
208,132
     
208,398
     
187,792
     
198,518
     
275,517
                                         
  Six Years Later
   
196,101
     
210,446
     
205,986
     
181,547
     
200,922
                                                 
  Seven Years Later
   
197,898
     
209,288
     
200,460
     
181,998
                                                         
  Eight Years Later
   
196,421
     
205,179
     
200,808
                                                                 
  Nine Years Later
   
193,746
     
205,248
                                                                         
  Ten Years Later
   
193,453
                                                                                 
                                                                                         
                                                                                         
Cumulative Redundancy (Deficiency)
 
$
56,042
   
$
39,252
   
$
30,825
   
$
21,255
   
$
17,707
   
$
14,575
     
(2,096
)
   
(774
)
   
(7,957
)
   
(13,836
)
       
                                                                                         
Cumulative Amount of
                                                                                       
 Liability Paid
                                                                                       
 Through:
                                                                                       
  One Year Later
 
$
58,956
   
$
76,970
   
$
84,777
   
$
74,182
   
$
72,393
   
$
94,003
   
$
103,941
   
$
92,275
   
$
92,870
   
$
109,228
         
  Two Years Later
   
100,990
     
124,870
     
120,628
     
107,413
     
109,382
     
156,271
     
162,087
     
159,282
     
166,642
                 
  Three Years Later
   
127,011
     
145,857
     
142,731
     
125,038
     
133,507
     
193,566
     
205,452
     
166,642
                         
  Four Years Later
   
143,612
     
157,724
     
152,679
     
137,460
     
147,462
     
214,873
     
202,803
                                 
  Five Years Later
   
151,662
     
164,877
     
161,834
     
143,461
     
158,172
     
227,359
                                         
  Six Years Later
   
157,223
     
170,554
     
166,290
     
148,101
     
166,112
                                                 
  Seven Years Later
   
162,331
     
174,190
     
170,126
     
152,375
                                                         
  Eight Years Later
   
165,372
     
177,275
     
173,867
                                                                 
  Nine Years Later
   
168,157
     
180,569
                                                                         
  Ten Years Later
   
171,161
                                                                                 

 
- 11 -

 

ANALYSIS OF LOSS AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT--GAAP BASIS
 
(Dollars in thousands)
 
                                                                   
Year Ended December 31
 
2006
   
2007
   
2008
   
2009
   
2010
   
2011
   
2012
   
2013
   
2014
   
2015
   
2016
 
                                                                   
Direct and Assumed:
                                                                 
Liability for Unpaid Losses and Loss
                                                                 
  Adjustment Expenses
 
$
409,412
   
$
378,616
   
$
389,558
   
$
359,030
   
$
344,520
   
$
421,556
   
$
455,454
   
$
474,470
   
$
506,102
   
$
513,596
   
$
576,330
 
                                                                                         
Liability Reestimated as of
                                                                                       
  December 31, 2016
   
301,115
     
307,148
     
300,055
     
291,037
     
307,486
     
401,670
     
459,296
     
501,374
     
546,935
     
552,805
         
                                                                                         
Cumulative Redundancy (Deficiency)
   
108,297
     
71,468
     
89,503
     
67,993
     
37,034
     
19,886
     
(3,842
)
   
(26,904
)
   
(40,833
)
   
(39,209
)
       
                                                                                         
                                                                                         
Ceded:
                                                                                       
Liability for Unpaid Losses and Loss
                                                                                       
  Adjustment Expenses
   
159,917
     
134,116
     
157,925
     
155,777
     
125,891
     
131,464
     
166,218
     
186,382
     
210,519
     
211,843
     
251,563
 
                                                                                         
Liability Reestimated as of
                                                                                       
  December 31, 2016
   
107,662
     
101,900
     
99,247
     
109,039
     
106,564
     
126,153
     
167,964
     
212,512
     
243,395
     
237,216
         
                                                                                         
Cumulative Redundancy (Deficiency)
   
52,255
     
32,216
     
58,678
     
46,738
     
19,327
     
5,311
     
(1,746
)
   
(26,130
)
   
(32,876
)
   
(25,373
)
       
                                                                                         
Net:
                                                                                       
Liability for Unpaid Losses and Loss
                                                                                       
  Adjustment Expenses
   
249,495
     
244,500
     
231,633
     
203,253
     
218,629
     
290,092
     
289,236
     
288,088
     
295,583
     
301,753
     
324,767
 
                                                                                         
Liability Reestimated as of
                                                                                       
  December 31, 2016
   
193,453
     
205,248
     
200,808
     
181,998
     
200,922
     
275,517
     
291,332
     
288,862
     
303,540
     
315,589
         
                                                                                         
Cumulative Redundancy (Deficiency)
   
56,042
     
39,252
     
30,825
     
21,255
     
17,707
     
14,575
     
(2,096
)
   
(774
)
   
(7,957
)
   
(13,836
)
       

 
- 12 -

Marketing

Historically, the Company has primarily focused its fleet transportation marketing efforts on large and medium trucking fleets, with its biggest market share in larger trucking fleets (over 150 power units).  The largest of these fleets (over 250 power units) self-insure a significant portion of their risk, and self-insurance plans are a specialty of the Company.  The indemnity contract provided to self-insured customers is designed to cover all aspects of fleet transportation 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 which do not allow for self-insurance of this coverage.  Fleets with fewer than 250 power units typically purchase full insurance coverage or retain small deductibles on each claim.  The Company's fleet transportation offerings also include public livery risks, principally large and medium- sized operators of bus fleets.  The Company's fleet transportation offerings include work-related accident insurance, on a group or individual basis, to independent contractors under contract to a fleet sponsor, as well as workers' compensation coverage to employees of independent contractor fleet owners. Large fleet trucking products are marketed both by the B&L agency organization directly to fleet transportation clients and also through relationships with non-affiliated brokers and specialized independent agents.
 
In addition, the Company offers a program of coverages for "small fleet" trucking concerns (owner-operators generally with one to six power units) and "medium fleet" trucking concerns (7-149 power units). Products for small and medium fleets, independent contractors, and non-trucking entities are marketed through relationships with non-affiliated brokers and specialized agents.  In some cases, the Company will provide specific product offerings to specialized markets through partnerships with brokers and program administrators.
 
In 2016, fleet transportation products generated approximately 96% of direct premiums written by the property and casualty insurance segment.
 
In 2016, the Company discontinued its professional liability line of products.  Prior to that, the Company marketed and underwrote a variety of professional liability products through wholesale and retail agents on both an admitted and surplus lines basis throughout the United States, specializing in smaller insureds.

Prior to 2016, the Company had accepted reinsurance cessions and retrocessions covering property and casualty risks from selected insurers and reinsurers.  Participation in this market had varied over the years depending on the adequacy of pricing.  Effective June 30, 2015, no property reinsurance risk remained inforce.
 
The Company terminated the marketing of its private passenger automobile insurance products in late 2015 and substantially all inforce business for this product line expired in 2016.


Investments
 
The Company's investment portfolio is essentially divided between (1) funds which are considered necessary to support insurance underwriting activities and (2) excess capital funds.  Management believes the funds invested in fixed maturity and short-term securities are more than sufficient to cover underwriting operations while equity securities and limited partnerships are utilized to invest excess capital funds to achieve higher long-term returns.  The following discussion will concentrate on the different investment strategies for these two major categories.
 
At December 31, 2016 the financial statement value of the Company's investment portfolio was approximately $749.5 million, including $61.2 million of short-term funds classified as cash equivalents.  The adjusted cost of the portfolio was $697.1 million, with the $52.4 million difference representing pre-tax unrealized appreciation.
 
- 13 -


A comparison of the allocation of assets within the Company's investment portfolio, using adjusted cost as a basis, is as follows as of December 31:
 
 
   
2016
   
2015
 
             
   Agency collateralized mortgage obligations
   
0.9
%
   
-
%
   Agency mortgage-backed securities
   
0.7
     
0.5
 
   Asset-backed securities
   
7.1
     
7.7
 
   Bank loans
   
1.6
     
0.9
 
   Certificates of deposit
   
0.5
     
0.5
 
   Collateralized mortgage obligations
   
1.4
     
1.6
 
   Corporate securities
   
22.5
     
18.8
 
   Mortgage-backed securities
   
3.8
     
4.0
 
   Municipal obligations
   
20.5
     
18.4
 
   Non-U.S. government obligations
   
4.2
     
4.3
 
   U.S. government obligations
   
14.5
     
17.3
 
      Total fixed maturities
   
77.7
     
74.0
 
   Limited partnerships (equity basis)
   
12.0
     
12.6
 
   Consumer
   
2.4
     
2.8
 
   Energy
   
0.9
     
1.0
 
   Financial
   
3.5
     
4.0
 
   Industrial
   
1.0
     
1.6
 
   Technology
   
0.6
     
1.0
 
   Mutual fund
   
1.1
     
1.8
 
   Other
   
0.8
     
1.2
 
      Total equity securities
   
10.3
     
13.4
 
     
100.0
%
   
100.0
%

 

Fixed Maturity and Short-Term Investments

Fixed maturity and short-term securities comprised 73.8% of the market value of the Company's total invested assets at December 31, 2016.  The fixed maturity portfolio is widely diversified with no concentrations in any single industry, geographic location or municipality.  The largest amount invested in any single issuer was $8.4 million (1.1% of total invested assets) although most individual investments, other than government obligations, are less than $750,000.  The Company's fixed maturity portfolio has a short duration compared to the duration of its insurance liabilities and, accordingly, the Company does not actively trade fixed maturity securities but typically holds such investments until maturity.  Exceptions exist in 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 following comparison of the Company's fixed maturity and short-term investment portfolios, using par value as a basis, shows the changes in contractual maturities in the portfolio during 2016.  Note that the expected average maturity of the portfolio is less than the contractual maturity 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.
 
   
2016
   
2015
 
Less than one year
   
27.7
%
   
28.4
%
1 to 5 years
   
52.7
     
49.6
 
5 to 10 years
   
9.7
     
8.8
 
More than 10 years
   
9.9
     
13.2
 
     
100.0
%
   
100.0
%
                 
Average contractual life of portfolio (years)
   
4.5
     
4.6
 

 

- 14 -

 
Approximately $69.1 million of our fixed maturity investments (9.2% of our total invested assets) consists of non-rated bonds and bonds rated as less than investment grade by the National Association of Insurance Commissioners at year end.  These investments include a diversified portfolio of over 40 investments with a cost basis of approximately $68.2 million.
 
The market value of the consolidated fixed maturity portfolio was $2.7 million lower than cost at December 31, 2016, before income taxes, which compares to a $5.4 million unrealized loss at December 31, 2015.  The Company analyzes fixed maturity securities for other-than-temporary impairment ("OTTI") in accordance with the Financial Accounting Standards Board ("FASB") OTTI guidance.  As has been the Company's consistent policy, other-than-temporary impairment is considered 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 six months, regardless of the evaluation of the creditworthiness of the issuer or the specific issue.  Additionally, the Company takes into account any known subjective information in evaluating for impairment without consideration of the Company's 20% threshold.  In 2016, the net effect of OTTI adjustments to fixed maturity securities was an increase to investment gains of $3.3 million before taxes.  The current net unrealized gain on fixed maturity securities consists of $4.6 million of gross unrealized gains and $7.3 million of gross unrealized losses.  The gross unrealized loss equals approximately 1.5% of the cost of all fixed maturity securities.
 
 
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 16.0% of the market value of the consolidated investment portfolio at December 31, 2016, but only 9.3% of the related adjusted cost basis, as long-term holdings have appreciated significantly.  The Company's equity securities portfolio consists of over 200 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 $7.3 million at December 31, 2016 (1.0% of our total invested assets) although the average equity holding of an individual issuer is less than $150,000.
 
 
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, which accounts for the fact that the portfolio, in total, carries a net $55.0 million pre-tax unrealized gain at the current year end.  An individual equity security will be disposed of when it is determined by the Company's external investment managers or the Board of Director's - Investment Committee that there is little potential for future appreciation.  All equity securities are considered to be available for sale although portfolio turnover has historically been very low.  Securities are not sold to meet any quarterly or annual earnings quotas but, rather, are disposed of only when market conditions dictate, regardless of the impact, positively or negatively, on current period earnings.  In addition, equity securities may be sold when realignment of the portfolio is considered beneficial or when valuations are considered excessive compared to alternative investments.  Sales of equity securities during 2016 generated both gains and losses but netted to a realized gain of $23.9 million before taxes.
 
The net effect of other-than-temporary impairment adjustments, including recovery of prior year write downs upon sale or disposal, increased investment gains from equity securities by $3.2 million for the year before taxes.  The reclassification of unrealized losses to realized losses 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 six months at the date of write-down, regardless of the evaluation of the issuer or the potential for recovery.  Additionally, for any equity security where the decline has existed for a period of at least one year, the decline is treated as an other-than-temporary impairment, regardless of the percentage decline.  Further, the Company takes into account any known subjective information in evaluating for impairment without consideration to the Company's 20% threshold.  Net unrealized gains on the equity security portfolio were $55.0 million before tax at December 31, 2016 compared to $65.3 million at December 31, 2015.  The current net unrealized gain consists of $56.0 million of gross unrealized gains and $1.0 million of gross unrealized losses.
 

- 15 -

 
Limited Partnerships
 
 
The Company invests in various limited partnerships engaged in securities trading activities, real estate development or small venture capital funding, as an alternative to direct equity investments.  The funds used for these investments are part of the Company's excess capital strategy.  At December 31, 2016, aggregate funds invested in limited partnerships was $29.8 million and the aggregate carrying value was $76.5 million, comprising 10.2% of the market value of our invested assets.
 
As a group, these investments experienced increases in value during 2016, with the aggregate of the Company's share of such gains reported by the limited partnerships totaling approximately $2.5 million.  On an inception-to-date basis, active limited partnerships have produced estimated income of $46.6 million.
 
The Company follows the equity method of accounting for its limited partnership investments and, accordingly, records the total change in value as a component of net gains or losses on investments.  Readers are cautioned that reported increases in equity value can be subsequently reduced or eliminated quickly by volatile market conditions.  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.  Limited partnerships also are highly illiquid investments, and the Company's ability to withdraw funds is generally subject to significant restrictions.
 
 
Investment Yields
 
Interest rates, particularly those on the short end of the yield curve where the vast majority of the Company's fixed maturity investments are maintained, continued at historically low levels during 2016.  Pre-tax net investment income increased $2.0 million, or 16%, and after tax income increased $1.4 million, or 15%, during 2016 reflecting a larger concentration in high-yield bonds and higher average invested assets from continuing positive cash flow from operations.  A comparison of consolidated investment yields, before consideration of investment management expenses, is as follows:
   
2016
   
2015
 
Before federal tax:
           
     Investment income
   
2.9
%
   
2.5
%
     Investment income plus investment gains
   
6.8
     
2.3
 
                 
After federal tax:
               
     Investment income
   
2.2
     
1.8
 
     Investment income plus investment gains
   
6.1
     
1.7
 

See also Results of Operations in Part II, Item 7 of this Annual Report on Form 10-K for additional details of our investment operations.
 

Regulatory Framework
 
 
The Company's businesses are currently subject to insurance industry regulation by each of the fifty states in which the Company's subsidiaries are licensed.  In addition, minor portions of the Company's business are subject to regulation by Bermudian and Canadian federal and provincial authorities.  There can be no assurance that laws and regulations will not be changed by one or more of these regulatory bodies in ways that will require the Company to modify its business models and objectives.  In particular, the United States federal government continues to undertake a substantial review and revision of the regulation and supervision of financial institutions, including insurance companies as well as tax laws and regulation, which could impact the Company's operations and performance.  While it is currently expected that federal government regulation will be focused on the largest financial companies, additional regulations are likely to increase the cost of compliance to the Company.  Further, while management is not aware of any significant pending changes, the Company is also subject to regulatory risks from changes to state and federal tax laws that may affect the treatment of insurance related deductions or income recognition.
 
 
- 16 -

 
Additionally, changes in laws and regulations governing the insurance industry could have an impact on the Company's ability to generate historical levels of income from its insurance operations.  The Company is obligated to comply with numerous complex and varied governmental regulations in order to maintain its authority to write insurance business.  While the Company has continuously maintained each of its licenses without exception, failure to maintain compliance could result in governmental regulators temporarily preventing the Company from writing new business, thus having a detrimental effect on the Company.  Also, the ability of the Company's Insurance Subsidiaries to modify insurance rates is heavily regulated for significant portions of the Company's business, and such rate increases are often denied or delayed for substantial periods by regulators.
 
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 statutory capital of each of the Insurance Subsidiaries substantially exceeds minimum risk- based capital requirements set by the National Association of Insurance Commissioners.  State regulatory authorities prescribe calculations of the minimum amount of statutory capital and surplus necessary for each insurance company to remain authorized.  These computations are referred to as Risk Based Capital ("RBC") requirements and are based on a number of complex factors taking into consideration the quality and nature of assets, the historical adequacy of recorded liabilities and the specific nature of business conducted.  At December 31, 2016, the minimum statutory capital and surplus requirements of the insurance subsidiaries was $85,842.  Actual consolidated statutory capital and surplus at December 31, 2016 exceeded this requirement by $313,473.
 

Employees
 
As of December 31, 2016, the Company had 455 employees, an increase of 17 employees from the prior year end.
 
 
Revenue Concentration
 
The Company derives a significant percentage of its direct premium volume from certain FedEx subsidiaries and operating companies ("FedEx"), and from property and casualty insurance coverage provided to FedEx's contracted service providers.  FedEx represented approximately $18.3 million, $17.8 million and $19.0 million of the Company's consolidated gross premiums written in 2016, 2015 and 2014, respectively.  An additional $202.2 million, $209.4 million and $197.8 million in 2016, 2015 and 2014, respectively, was placed with the Company by a non-affiliated broker on behalf of contracted service providers of FedEx but this additional business was not dependent upon the Company's direct business with FedEx.
 
 
Competition
 
Insurance underwriting is 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 significantly 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 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 its management and staff, its service and products, its willingness to custom build insurance programs for its customers, its centralized location with ready access to management, its extensive proprietary databases and the 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.
 
 
- 17 -

 
Availability of Documents
 
The Company is an accelerated filer as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and is required, pursuant to Item 101 of Regulation S-K, to provide certain information regarding its website and the availability of certain documents filed with or furnished to the U.S. Securities and Exchange Commission (the "SEC"). The Company's Internet website is www.baldwinandlyons.com. The Company has included its Internet website address throughout this Annual Report on Form 10-K as textual reference only. The information contained on, or accessible through, the Company's Internet website is not incorporated into this Annual Report on Form 10-K.

The Company makes available, free of charge, by mail or through its Internet website, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after it electronically files such material with or furnishes it to the SEC. The Company also includes on its Internet website its Code of Business Conduct and the charter of each standing committee of its Board of Directors. In addition, the Company intends to disclose on its Internet website any amendments to, or waivers from, its Code of Business Conduct that are required to be publicly disclosed pursuant to rules of the SEC and the Nasdaq Stock Market, LLC ("Nasdaq").

Shareholders may obtain, without charge, a copy of this Annual Report on Form 10-K, including the consolidated financial statements and schedules thereto, without the accompanying exhibits, upon written request to Baldwin & Lyons, Inc., 111 Congressional Boulevard, Carmel, Indiana 46032, Attention:  Investor Relations. A list of exhibits is included in this Annual Report on Form 10-K, and exhibits are available from the Company upon payment to the Company of the cost of furnishing the exhibits.

 
Financial Information about Segments and Geographic Areas:
 
Reference is made to Note J of the consolidated financial statements, which provides financial information concerning our segments in Part II, Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.
 

Item 1A.  RISK FACTORS

The following is a description of the risk factors that could cause the Company's actual results to differ materially from those contained in forward-looking statements made in this Annual Report on Form 10-K and presented elsewhere by management from time to time.  Such factors may have a material adverse effect on the Company's business, financial condition and results of operations, and you should carefully consider them before deciding to invest in, or retain, shares of the Company's common stock.  These risk factors do not identify all risks that the Company faces; its operations could also be affected by factors that are not presently known to the Company or that the Company currently considers to be immaterial to its operations. Due to risks and uncertainties, known and unknown, the Company's past financial results may not be a reliable indicator of future performance, and historical trends should not be used to anticipate results or trends in future periods. 
 

- 18 -

 
We compete with a large number of companies in the insurance industry for underwriting revenues.
 
We compete with a large number of other companies in our selected lines of business. During periods of intense competition for premium, we are vulnerable to the actions of other companies who may seek to write business without the appropriate regard for ultimate profitability. During these times, it is very difficult to grow or maintain premium volume without sacrificing underwriting discipline and income.
 
Insurance underwriting is highly competitive.  We 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 us.  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 significantly greater financial resources than us.  In many cases, competitors are willing to provide coverage for rates lower than those charged by us.  Many potential clients self-insure workers' compensation and other risks for which we offer coverage, and some 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 us.
 
We may incur increased costs in competing for underwriting revenues. If we are unable to compete effectively in the markets in which we operate or to expand our operations into new markets, our underwriting revenues may decline, as well as our overall business results.
 
New competition could cause the supply and/or demand for insurance or reinsurance to change, which could affect our ability to price our coverages at attractive rates and thereby adversely affect our underwriting results.
 
Changes in laws and regulations governing the insurance industry could have a negative impact on our ability to generate income from our insurance operations.
 
One or more of our Insurance Subsidiaries are regulated and licensed in all 50 of the United States, the District of Columbia, all Canadian provinces, Puerto Rico and Bermuda.  We are obligated to comply with numerous complex and varied governmental regulations in order to maintain our authority to write insurance business.  Failure to maintain compliance could result in governmental regulators preventing us from writing new business, which would have a material adverse impact on us, our results of operations and our financial condition.  Further, the ability for our Insurance Subsidiaries to adjust insurance rates is regulated for significant portions of our business and needed rate adjustments can be denied or delayed for substantial periods by regulators.
 
A material decline in our financial strength rating could adversely affect our position in the insurance market and cause a significant reduction in our premiums and earnings.
 
Our main insurance subsidiary, Protective, currently has a financial strength rating of "A+" (Superior) by A.M. Best.    Financial ratings are an important factor influencing the competitive position of insurance companies. A.M. Best ratings, which are commonly used in the insurance industry, currently range from "A++" (Superior) to "F" (In Liquidation).  The objective of A.M. Best's rating system is to provide potential policyholders and other interested parties with an expert independent opinion of an insurer's financial strength and ability to meet ongoing obligations, including paying claims.  This rating is subject to periodic review and may be revised downward, upward or revoked at the sole discretion of A.M. Best.  A downgrade in rating could result in a loss of a number of insurance contracts we write and in a substantial loss of business to other competitors, which would have a material adverse effect on our results of operations.
 
We have two classes of common stock with unequal voting rights and are effectively controlled by our principal shareholders and management, which limits other shareholders' ability to influence our operations.
 
Our executive officers, directors and principal shareholders and their affiliates control approximately 57% of the outstanding shares of voting Class A common stock and approximately 26% of the outstanding shares of non-voting Class B common stock.  These parties effectively control us, direct our affairs, and exert significant influence in the election of directors and approval of significant corporate transactions.  The interests of these shareholders may conflict with those of other shareholders, and this concentration of voting power may limit marketability of our stock and has the potential to delay, defer or prevent a change in control.
 
We are subject to credit risk relating to our ability to recover amounts due from reinsurers.
 
We limit our risk of loss from policies of insurance issued by our Insurance Subsidiaries through the purchase of reinsurance coverage from other insurance companies.  Such reinsurance does not relieve us of our responsibility to policyholders should the reinsurers be unable to meet their obligations to us under the terms of the underlying reinsurance agreements.  While we have not experienced any significant reinsurance losses for over 25 years, a small number of our less significant historical reinsurance carriers have experienced deteriorating financial conditions or have been downgraded by rating agencies, and provisions for potential uncollectible balances from these reinsurers have been established.  If we are unable to collect the amounts due to us from reinsurers, any unreserved credit losses could adversely affect our results of operations, equity, business and insurer financial strength.
 
 
- 19 -

 
We may incur additional losses if our loss reserves are inadequate.
 
A large portion of our provision for losses recorded is composed of estimates of future loss payments to be made.  Such estimates of future loss payments may prove to be inadequate.  Loss and loss expense reserves represent our best estimate at a given point in time but are not an exact calculation of ultimate liability.  Rather, they are complex estimates derived by utilizing a variety of reserve estimation techniques from numerous assumptions and expectations about future events, many of which are highly uncertain, such as estimates of claims severity, frequency of claims, inflation, claims handling, case reserving policies and procedures, underwriting and pricing policies, changes in the legal and regulatory environment and the lag time between the occurrence of an insured event and the time of its ultimate settlement.  Many of these uncertainties are not precisely quantifiable and require significant judgment on our part.  As trends in underlying claims develop, particularly in so-called "long tail" lines where the adjudication of claims can take many years, management is sometimes required to revise reserves.  This results in a charge to our earnings in the amount of the adjusted reserves, recorded in the period the change in estimate is made.  These charges can be substantial and can potentially have a material impact, either positively or negatively, on results of operations and shareholders' equity.
 
The loss of our major customer could severely impact our revenue and earnings potential and A.M. Best rating.
 
We derive a significant percentage of our direct premium volume from certain FedEx subsidiaries and related entities, and from insurance coverage provided to FedEx's contracted service providers.  The loss of this major customer could materially adversely impact our revenue and earnings potential, as well as our A.M. Best rating.
 
Our collateral held may prove to be insufficient.
 
We require collateral from our insureds covering the insureds' obligations for self-insured retentions or deductibles related to policies of insurance provided.  Should we, as surety, become responsible for such insured obligations, the collateral held may prove to be insufficient.  In this regard, FedEx utilizes significant self-insured retentions and deductibles under policies of insurance provided by us.  In the case of FedEx, we have determined that the financial strength of the customer is sufficient to allow for holding only partial collateral at this time.  Should we become responsible for this customer's entire self-insured retention and deductible obligations, the collateral held would be insufficient, and we would sustain a significant operating loss.
 
A material drop in interest rates could have an adverse impact on our earnings and, potentially, our financial position.
 
Our income from these investments could be materially reduced, and reduce our results of operations, equity, business and insurer financial strength.  The functioning of the fixed income markets, the values of the investments we hold and our ability to liquidate them may be adversely affected if those markets are disrupted by a change in interest rates or otherwise affected by significant negative factors, including, without limitation: local, national, or international events, such as regulatory changes, wars, or terrorist attacks; a recession, depression, or other adverse developments in either the U.S. or other economies that adversely affects the value of securities held in our portfolio; financial weakness or failure of one or more financial institutions that play a prominent role in securities markets or act as a counterparty for various financial instruments, which could further disrupt the markets; inactive markets for specific kinds of securities, or for the securities of certain issuers or in certain sectors, which could result in decreased valuations and impact our ability to sell a specific security or a group of securities at a reasonable price when desired; a significant change in inflation expectations, or the onset of deflation or stagflation.
 
Our investment portfolio is subject to market and credit risks, which could affect our financial results and ability to conduct business
 
We have a large portfolio of securities and limited partnership investments which can fluctuate in value with a wide variety of market conditions.  A decline in the aggregate value of the securities and limited partnership investments would result in a commensurate decline in our shareholders' equity, either through the income statement or directly to equity.  The resultant decline could, at least temporarily, materially adversely affect our results of operations, equity, business and insurer financial strength ratings.
 
 
- 20 -

 
Technological advances, including those specific to the transportation industry, could present us with added competitive risks.
 
An increase in accident prevention technologies and the growth of autonomous or partially autonomous vehicles could reduce the amount of accidents over time and shift the liability from the owner of the vehicle to the manufacturer, which would cause automobile insurance to become a smaller portion of our overall property and casualty insurance book of business.  Innovations in telematics and the increase in usage-based information have become more important and will likely change the way premiums are determined in the future.  These advances in technology could materially change the way products in the transportation industry are designed, priced and underwritten, and it will take time for us to adjust to these changes.
 
Our information technology systems and other operational systems may fail to operate properly or become disabled as a result of events or circumstances wholly or partly beyond our control.
 
We rely upon our information technology systems and other operational systems and on the integrity and timeliness of our data to run our businesses and service our customers.  These information technology and other systems could be subject to physical or electronic break-ins, unauthorized tampering or other cyber security breaches, resulting in a failure to maintain the security, confidentiality or privacy of sensitive data, including personal information relating to customers, or in theft of intellectual property or proprietary information.  A failure to maintain proper security, confidentiality or privacy of sensitive data residing on such systems could delay or disrupt our ability to do business and service customers, harm our reputation, subject us to litigation, regulatory fines, a loss of customers and revenues or otherwise adversely affect our business.
 
Our operations rely upon complex and expensive information technology systems for interacting with policyholders, brokers and employers.  The pace at which information systems must be upgraded is continually increasing, requiring an ongoing commitment of significant resources to maintain or upgrade to current standards.  Our success may be impacted if we are not able to develop and expand the effectiveness of existing systems and to continue to enhance information systems that support our operations in a cost effective manner.
 
Changes in current accounting practices and future pronouncements may materially impact our reported financial results.
 
Developments in accounting practices may require us to incur considerable additional expenses to comply with such developments, particularly if we are required to prepare information relating to prior periods for comparative purposes or to apply the new requirements retroactively.  The impact of changes in current accounting practices and future pronouncements cannot be predicted but may affect the calculation of net income, net equity and other historical financial statement line items that are important to users of our financial statements.  Changes could also introduce significant volatility in our results of operations, equity, business and insurer financial strength.
 
We may be unable to attract and retain qualified employees.
 
We depend on our ability to attract and retain qualified executive officers, experienced underwriters, claims professionals and other skilled employees who are knowledgeable about our specialty lines of business. If we are unable to attract and retain such individuals, we may be unable to maintain our current competitive position in the specialty markets in which we operate and may be unable to expand our operations into new specialty markets.
 
 
Item 1B.  UNRESOLVED STAFF COMMENTS

None.
 
- 21 -

Item 2.  PROPERTIES

The Company owns its home office building and the adjacent real estate in Carmel, Indiana, approximately 14 miles from downtown Indianapolis.  The home office building contains a total of 181,000 usable square feet, and the Company currently occupies approximately 72% of this space, with the remainder being leased to non-affiliated entities on short-term leases expiring in 2017 through 2023.

The Company also owns a building and the adjacent real estate in Indianapolis, approximately nine miles from its main office in Carmel.  The building contains approximately 15,000 square feet of usable space, and is used primarily for off-site data storage and as a contingent back up and disaster recovery site.

The Company's entire operations are conducted from these two facilities.  The current facilities are expected to be adequate for the Company's operations for the foreseeable future.

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. MINE SAFETY DISCLOSURES

Not applicable.


- 22 -


 
PART II


Item 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES


The Company's Class A and Class B common stocks are traded on Nasdaq 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, 2016 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 2016 and 2015, as reported by Nasdaq and published in the financial press, as well as the cash dividends paid by the Company.


                           
Cash
 
   
Class A
   
Class B
   
Dividends
 
   
High
   
Low
   
High
   
Low
   
Declared
 
                               
2016:
                             
Fourth Quarter
 
$
26.10
   
$
23.21
   
$
27.70
   
$
23.45
   
$
.26
 
Third Quarter
   
26.50
     
23.04
     
27.25
     
24.43
     
.26
 
Second Quarter
   
24.90
     
22.50
     
25.28
     
23.33
     
.26
 
First Quarter
   
24.02
     
22.00
     
25.10
     
22.11
     
.26
 
                                         
2015:
                                       
Fourth Quarter
   
24.89
     
22.43
     
24.99
     
21.27
     
.25
 
Third Quarter
   
24.40
     
21.04
     
23.69
     
21.85
     
.25
 
Second Quarter
   
24.40
     
22.50
     
24.36
     
22.02
     
.25
 
First Quarter
   
27.63
     
22.57
     
25.80
     
23.00
     
.25
 


The Company has paid quarterly cash dividends continuously since 1974.  The current regular quarterly dividend rate was increased to $.26 per share, effective February 2016 and was increased to $.27 per share, effective February 2017.  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.  At December 31, 2016, $85.8 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 do not currently pose any material dividend payment concerns for the Company.  The Board intends to address the subject of dividends at each of its future meetings and will consider the Company's earnings, returns on investments and its capital needs.


- 23 -

 
Corporate Performance
 
The following graph shows a five year comparison of cumulative total return for the Company's Class B common shares, the Nasdaq Insurance Stock Index, the Russell 2000 Index and the Company's peer group as determined by management.  The basis of comparison is a $100 investment at December 31, 2011, in each of (i) Baldwin & Lyons, Inc., (ii) Nasdaq Insurance Stocks, (iii) the Russell 2000 Index and (iv) the BWINB Peer Group.  All dividends are assumed to be reinvested.


 

         
Period Ending
       
Index
 
12/31/11
   
12/31/12
   
12/31/13
   
12/31/14
   
12/31/15
   
12/31/16
 
Baldwin & Lyons, Inc.
   
100.00
     
114.53
     
136.59
     
134.10
     
130.46
     
142.57
 
NASDAQ Insurance Index
   
100.00
     
116.83
     
153.22
     
169.39
     
184.16
     
216.67
 
Russell 2000
   
100.00
     
116.35
     
161.52
     
169.43
     
161.95
     
196.45
 
BWINB Peer Group
   
100.00
     
123.59
     
183.80
     
202.39
     
217.16
     
265.37
 



Baldwin & Lyons, Inc. Peer Group
     
Amerisafe, Inc.
 
Heritage Insurance Holdings, Inc.
Atlas Financial Holdings, Inc.
 
James River Group Holdings, Ltd.
Donegal Group Inc.
 
NMI Holdings, Inc.
EMC Insurance Group Inc.
 
National Interstate Insurance Company
Employers Holdings, Inc.
 
Safety Insurance Group, Inc.
Federated National Holding Company
 
United Insurance Holdings Corp.
HCI Group, Inc.
 
Universal Insurance Holdings, Inc.
Hallmark Financial Services, Inc.
   



- 24 -


Item 6.  SELECTED FINANCIAL DATA

The table below provides selected consolidated financial data of the Company.   The information has been derived from our consolidated financial statements for each of the years in the five year period ended December 31, 2016.  You should read this selected consolidated financial data in conjunction with the audited consolidated financial statements and notes as of and for the year ended December 31, 2016 included in Part II, Item 8 "Financial Statements and Supplementary Data", and Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in this Annual Report on Form 10-K.

 
   
Year Ended December 31
 
   
2016
   
2015
   
2014
   
2013
   
2012
 
   
(Dollars in thousands, except per share data)
 
                               
Gross premiums written
 
$
403,004
   
$
383,553
   
$
382,388
   
$
369,476
   
$
341,286
 
                                         
Net premiums earned
   
276,011
     
263,335
     
261,627
     
252,743
     
237,461
 
                                         
Net investment income
   
14,483
     
12,498
     
9,055
     
8,770
     
9,930
 
                                         
Net realized gains (losses) on investments
   
23,228
     
(1,261
)
   
14,930
     
23,515
     
9,011
 
                                         
Losses and loss expenses incurred
   
186,481
     
155,750
     
159,596
     
150,701
     
138,088
 
                                         
Net income
   
28,945
     
23,283
     
29,717
     
36,588
     
31,919
 
                                         
Earnings per share -- net income 1
   
1.92
     
1.55
     
1.98
     
2.45
     
2.15
 
                                         
Cash dividends per share
   
1.04
     
1.00
     
1.00
     
1.00
     
1.00
 
                                         
Investment portfolio 2
   
749,501
     
729,877
     
757,421
     
703,259
     
681,856
 
 
                                       
Total assets
   
1,154,137
     
1,085,771
     
1,144,247
     
1,072,270
     
983,024
 
                                         
Shareholders' equity
   
404,345
     
394,498
     
399,496
     
381,724
     
346,712
 
                                         
Book value per share 1
   
26.81
     
26.25
     
26.67
     
25.57
     
23.25
 
                                         
Underwriting ratios 3
                                       
 
                                       
   Losses and loss expenses
   
67.6
%
   
59.2
%
   
61.0
%
   
59.6
%
   
58.1
%
                                         
   Underwriting expenses
   
30.9
%
   
32.2
%
   
32.0
%
   
32.4
%
   
30.8
%
                                         
   Combined
   
98.5
%
   
91.4
%
   
93.0
%
   
92.0
%
   
88.9
%

 
1   Earnings and book value per share are adjusted for the dilutive effect of stock options outstanding.
 
2   Includes money market instruments classified with cash in the Consolidated Balance Sheets.
 
3   Data is for all coverages combined, does not include fee income and is presented based upon U.S. generally accepted accounting principles.
 

- 25 -


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 33% of net 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, become negative as loss settlements on claim reserves established in prior years exceed current revenues.  During 2016, cash flow from operations totaled $32.4 million compared to the $38.2 million total for 2015.  The decrease in operating cash flow resulted mainly from increased loss and loss adjustment expenses in 2016.  During 2015, the $38.2 million cash flow from operations compared to $30.2 million during 2014, an increase that resulted from decreased loss, LAE and other operating expense payments as well as higher premium volume in 2015.
 
As a result of the cash flow from operations noted above, net cash used in investing activities totaled $27.4 million and $12.8 million for the years ended December 31, 2016 and 2015, respectively.
 
Financing activity for 2016 and 2015 consisted solely of regular cash dividend payments to shareholders of $15.8 million ($1.04 per share) and $15.0 million ($1.00 per share), respectively.

For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds with superior quality and liquidity.  As flat yield curves have not provided incentive to lengthen maturities in recent years, the Company has continued to maintain its fixed maturity portfolio at short-term levels.  The average contractual life of the Company's fixed maturity and short-term investment portfolio decreased slightly to 4.5 years during 2016. The average duration of the Company's fixed maturity portfolio remains much shorter than both the contractual maturity average and 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, 2016 included $61.2 million in short-term and cash equivalent investments that are readily convertible to cash without market penalty and an additional $98.6 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 premium collections, are more than sufficient to provide for projected claim payments and operating cost demands.  In the event competitive conditions 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 significant cash outlays that accompany large losses.
 
The Company maintains a revolving line of credit with a $40.0 million limit and an expiration date of September 23, 2018.  Interest on this line of credit is referenced to LIBOR and can be fixed for periods of up to one year at the Company's option.  Outstanding drawings on this line of credit were $20.0 million as of both December 31, 2016 and December 31, 2015.  At December 31, 2016, the effective interest rate was 1.86%.  The Company had $20.0 million remaining unused under the line of credit at December 31, 2016.  The Company's revolving line of credit has three financial covenants, each of which were met as of December 31, 2016.  The three financial covenants relate to a minimum GAAP net worth, a minimum Statutory surplus and a minimum A.M. Best rating.
 
 
- 26 -

 
Net premiums written by the Company's Insurance Subsidiaries for 2016 equaled approximately 68% of the combined statutory surplus of these subsidiaries, a level consistent with the past several years.  Premium writings of up to 100% and in some cases up to 200% 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.
 
At December 31, 2016, $85.8 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 do not currently pose any material liquidity concerns for the Company.  The financial strength and stability of the Insurance Subsidiaries permit access by the parent company to short-term and long-term sources of credit when needed.
 
Results of Operations

2016 Compared to 2015

Premiums written by the Property and Casualty Insurance segment for 2016 totaled $395.6 million, an increase of $29.0 million (8%) from 2015.  This increase was attributable to a $32.3 million (9%) increase in premiums generated by fleet transportation products resulting from the addition of several new accounts during 2016, rate increases and increased revenue and miles driven by our insureds, which is immediately reflected in premium.  This increase was partially offset by decreases of $0.5 million and $8.5 million in premiums generated by primary professional liability and personal automobile, respectively, reflecting the Company's strategic initiatives of reducing exposures in these products.  Premiums ceded to reinsurers on Property and Casualty Insurance segment business averaged 33.2% of gross written premiums for 2016, compared to 35.0% for 2015, with the variation attributable to a fluctuation in the mix of business as well as reinsurance treaty placement changes.
 
Premiums written by the Reinsurance segment totaled $7.4 million during 2016, a decrease of $9.5 million (56%) from 2015.  Premiums generated by property reinsurance products decreased $2.2 million (91%), reflective of management's decision to completely withdraw from the property catastrophe market.  As of June 30, 2015, all exposure to catastrophic losses had expired.  Further contributing to the Reinsurance segment premium written decrease was a $7.3 million (51%) decline in the Company's book of professional liability reinsurance assumed, reflective of the Company's decision not to renew certain business in response to deteriorating rates and treaty terms.
 
After giving effect to changes in unearned premiums, consolidated net premiums earned totaled $276.0 million for 2016 compared to $263.3 million for 2015, an increase of 4.8%.  The net premium earned increase reflected a 12.5% increase in premium earned from the fleet transportation products mentioned above, partially offset by decreased premium written from primary professional liability and personal automobile products and in the Reinsurance segment.
 
Pre-tax investment income of $14.5 million during 2016 was 16% higher than 2015, reflecting an increased allocation to higher-yielding bonds and increases in average invested assets.  After tax investment income increased by 15% during 2016 compared to the prior year reflecting the mix between taxable and tax-exempt investment income.
 
Net gains on investments, before taxes, totaled $23.2 million in 2016 compared to net pre-tax losses on investments of $1.3 million during 2015.  The 2016 results were heavily influenced by direct trading results, with gains of $13.3 million in 2016 compared to direct trading gains of $4.5 million in 2015.  In addition, our investments in limited partnerships produced gains of $2.5 million in 2016, compared to losses of $1.7 million during the prior year.  Limited partnership ventures utilized by the Company are primarily engaged in the trading of public and private securities, including foreign securities and, to a lesser extent, small venture capital activities and real estate development.  The aggregate of the Company's share of gains and losses in these entities represented a 3.3% appreciation in value for 2016, compared to a 2% decrease in value for 2015.  During 2016, our investments in limited partnerships produced $2.5 million in net realized gains.  Other-than-temporary impairments of $5.7 million, netted with losses of $12.3 million on previously impaired available-for-sale securities that were sold in 2016, are included in the net gains stated above.
 
 
- 27 -

 
Losses and loss expenses incurred during 2016 increased $30.7 million (19.7%) from 2015 to $186.5 million, due primarily to prior accident year development and growth.  The 2016 consolidated loss and loss expense ratio was 67.6%, compared to 59.2% for 2015.  The Company's loss and loss expense ratios for major product lines are summarized in the following table:
 
 
   
2016
   
2015
 
Fleet transportation
   
63.4
%
   
55.7
%
All other
   
95.5
     
96.4
 
All lines
   
67.6
     
59.2
 

 
The higher loss ratio for fleet transportation during 2016 was the result of less favorable developments related to prior accident year losses.  The prior year reserve deficiency in 2016 increased the 2016 calendar year fleet transportation loss ratio by 5.0 percentage points compared to a 4.3 percentage point decrease experienced in 2015 due to the prior year reserve savings in 2015.
 
The Company produced an overall reserve deficiency on prior year claims during 2016 of $13.8 million.  This net deficiency is included in the computation of loss ratios shown in the previous table, as is the $10.1 million savings produced during 2015 on prior year claims.  Separated by segment, a $5.4 million net deficiency attributable to the property and casualty insurance segment during 2016 was primarily attributable to the Company's Fleet Transportation business, a described in the previous paragraph.  An $8.4 million deficiency attributable to the reinsurance segment in 2016 was related primarily to professional liability assumed losses.  Because of the high limits provided by the Company to its fleet transportation insureds, the length of time necessary to settle larger, more complex claims and the volatility of the fleet transportation liability insurance business, the Company believes it is important to take a conservative posture in its reserving process.  Changes in both gross premium volumes and the Company's reinsurance structure for its fleet transportation business 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 2016, before credits for ceding allowances from reinsurers, increased $3.4 million (3%) to $123.0 million, generally in line with increases in property and casualty insurance segment premium written.  This increase was due primarily to an increase in salary and salary related expenses, reflective of the Company's increased workforce in response to the continued expansion of the Company's products and services.   Reinsurance ceded credits were 16% higher in 2016, resulting primarily from favorable changes to the terms of certain reinsurance treaties.  After consideration of these expense offsets, operating expenses decreased $1.1 million, or 1%, from the prior year.

A portion of the Company's fleet transportation business is produced by the direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis.  Rather, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. are included in operating expenses.  The ratio of net operating expenses of the Insurance Subsidiaries to net premiums earned was 30.9% in 2016 and 32.2% in 2015.  Including the agency operations and corporate expenses, and after elimination of inter-company commissions, the ratio of operating expenses to operating revenue (defined as total revenue less gains or losses on investments) was 30.2% for 2016 compared with 32.2% for 2015.

The effective federal tax rate on the consolidated pre-tax income for 2016 was 32.8% as compared to 31.4% in 2015.  The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.

Net income for 2016 of $28.9 million compares to net income of $23.3 million during 2015 with the increase primarily attributable to realized investment gains.  Diluted earnings per share of $1.92 were recorded in 2016 compared to diluted earnings per share of $1.55 in 2015.
 
 
- 28 -

2015 Compared to 2014

Premiums written by the Property and Casualty Insurance segment for 2015 totaled $366.7 million, an increase of $23.5 million (7%) from 2014.  This increase was attributable to a $30.1 million (10%) increase in premiums generated by fleet transportation products resulting from the addition of several new accounts during 2015, rate increases, and increased revenue and miles driven by our insureds, which is immediately reflected in premium.  This increase was partially offset by decreases of $4.7 million and $4.1 million in premiums generated by primary professional liability and personal automobile, respectively, reflecting the Company's strategic initiatives of reducing exposures in these products.  Premiums ceded to reinsurers on Property and Casualty Insurance segment business averaged 35.0% of gross written premium for 2015, compared to 34.7% for 2014, with the small variation attributable to a fluctuation in the mix of business as well reinsurance treaty placement changes.
 
Premiums written by the Reinsurance segment totaled $16.9 million during 2015, a decrease of $22.3 million (57%) from 2014.  Premiums generated by property reinsurance products decreased $13.4 million (85%), reflective of management's decision to completely withdraw from the property catastrophe market.  As of June 30, 2015, all exposure to catastrophic losses had expired.  Further contributing to the Reinsurance segment premium written decrease was an $8.9 million (38%) decline in the Company's book of professional liability reinsurance assumed, reflective of the Company's decision not to renew certain business in 2015 in response to deteriorating rates and treaty terms.
 
After giving effect to changes in unearned premiums, consolidated net premiums earned totaled $263.3 million for 2015 compared to $261.6 million for 2014, an increase of 0.7%.  The small net premium earned increase reflected a 10.3% increase in premium earned from the fleet transportation products mentioned above, partially offset by decreased premium written from primary professional liability and personal automobile products and in the Reinsurance segment.
 
Pre-tax investment income of $12.5 million during 2015 was 38% higher than 2014, reflecting an increased allocation to high-yield bonds and increases in average invested assets.  After tax investment income increased by 32% during 2015 compared to the prior year, reflecting the mix between taxable and tax-exempt investment income.
 
Net pre-tax losses on investments, before taxes, totaled $1.3 million in 2015 compared to net pre-tax gains on investments of $14.9 million during 2014.  The 2015 results were heavily influenced by direct trading results, with gains of $4.5 million in 2015 compared to direct trading gains of $7.9 million in 2014.  In addition, our investments in limited partnerships produced losses of $1.7 million in 2015 compared to gains of $7.1 million during the prior year.  Limited partnership ventures utilized by the Company are primarily engaged in the trading of public and private securities, including foreign securities and, to a lesser extent, small venture capital activities and real estate development.  The aggregate of the Company's share of gains and losses in these entities represented a 2% decrease in value for 2015 compared to a 10% appreciation in value for 2014.  During 2015, our investments in limited partnerships produced $1.7 million in net realized losses.  Other-than-temporary impairments of $7.7 million, netted with losses of $4.4 million on previously impaired available-for-sale securities that were sold in 2015, are included in the net losses stated above.
 
 
- 29 -

 
Losses and loss expenses incurred during 2015 decreased $3.8 million (2.4%) from 2014 to $155.8 million, a decrease generally consistent with the decreased reinsurance exposure described above.  The 2015 consolidated loss and loss expense ratio was 59.2% compared to 61.0% for 2014.  The Company's loss and loss expense ratios for major product lines are summarized in the following table:
 
 
   
2015
   
2014
 
Fleet transportation
   
55.7
%
   
58.8
%
All other
   
96.4
     
93.9
 
All lines
   
59.2
     
61.0
 

 
The lower loss ratio for Fleet Transportation during 2015 was the result of more favorable frequency and severity related to then-current accident year losses.  Prior year reserve savings lowered the 2015 calendar year Fleet Transportation loss ratio by 4.3 percentage points compared to a 4.4 percentage point decrease experienced in 2014.
 
The Company produced an overall savings on the handling of prior year claims during 2015 of $10.1 million.  This net savings is included in the computation of loss ratios shown in the previous table, as is the $10.4 million savings produced during 2014 on prior year claims.  Separated by segment, a $10.3 million net savings attributable to the property and casualty insurance segment during 2015 was primarily attributable to the Company's Fleet Transportation business, a described in the previous paragraph.  A $0.2 million deficiency attributable to the reinsurance segment in 2015 was related primarily to professional liability assumed losses.  Because of the high limits provided by the Company to its fleet transportation insureds, the length of time necessary to settle larger, more complex claims and the volatility of the fleet transportation liability insurance business, the Company believes it is important to take 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 fleet transportation business 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 2015, before credits for ceding allowances from reinsurers, increased $7.7 million (7%) to $119.5 million, generally in line with increases in Property and Casualty Insurance segment premium written.  This increase was due primarily to (1) an increase in salary and salary-related expenses, reflective of the Company's increased workforce in response to the expansion of the Company's products and services, (2) a non-recurring recovery during 2014 of a substantial previously written off reinsurance recovery and (3) increased commissions related to business produced by non-affiliated agents and brokers.  Reinsurance ceded credits were 22% higher in 2015, resulting primarily from favorable changes to the terms of certain reinsurance treaties.  After consideration of these expense offsets, operating expenses increased $2.5 million, or 3%, from the prior year.

A portion of the Company's fleet transportation business is produced by the direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis.  Rather, 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 the property and casualty insurance business.  The ratio of net operating expenses of the Insurance Subsidiaries to net premiums earned was 32.2% in 2015 and 32.0% in 2014.  Including the agency operations and corporate expenses, and after elimination of inter-company commissions, the ratio of operating expenses to operating revenue (defined as total revenue less gains or losses on investments) was 32.2% for 2015 compared with 31.8% for 2014.

The effective federal tax rate on the consolidated pre-tax income for 2015 was 31.4%, as compared to 33.1% in 2014.  The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.

Net income for 2015 of $23.3 million compared to net income of $29.7 million during 2014, with the decline attributable to realized investment losses.  Diluted earnings per share of $1.55 were recorded in 2015 compared to diluted earnings per share of $1.98 in 2014.

 
- 30 -

 
Critical Accounting Policies
 
The Company's significant accounting policies which are material and/or subject to significant degrees of judgment are highlighted below.
 
Investment Valuation
 
All marketable securities are included in the Company's balance sheets at current fair market value.

Approximately 65% of the Company's assets are composed of investments at December 31, 2016.  Approximately 90% of these investments are publicly-traded, owned directly and have readily-ascertainable market values.  The remaining 10% of investments are composed primarily 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 values recorded are those provided to the Company by the respective partnerships based on the underlying assets of the partnerships.  While a substantial portion of the underlying assets are publicly-traded securities, those which are not publically traded have been valued by the respective partnerships using their experience and judgment.

Under FASB guidance, if a fixed maturity security is in an unrealized loss position and the Company has the intent to sell the security, or it is more likely than not that the Company will have to sell the security before recovery of its amortized cost basis, the decline in value is deemed to be other-than-temporary and is recorded to net realized losses on investments in the consolidated statements of operations.   For impaired fixed maturity securities that the Company does not intend to sell or it is more likely than not that the Company will not have to sell such securities, but the Company expects that it will not fully recover the amortized cost basis, the credit component of the other-than-temporary impairment is recognized in net realized losses on investments in the consolidated statements of operations and the non-credit component of the other-than-temporary impairment is recognized directly in shareholder's equity (accumulated other comprehensive income).

In determining if and when an equity security's decline in market value below cost is other-than-temporary, we first make an objective analysis of each individual equity security where current market value is less than cost.  For any equity 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 equity investments until recovery can be reasonably expected.  Additionally, for any equity security where the decline has existed for a period of at least one year, the decline is treated as an other-than-temporary impairment.  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 available for sale securities 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, as described above, does not change these valuations but, rather, determines when a decline in value will be recognized in the income statement (other-than-temporary decline) as opposed to a charge to shareholders' equity (temporary decline).  Another seemingly inconsistent aspect of this accounting policy which is important to understand is that any subsequent recoveries in value of investments which have incurred other-than-temporary impairment adjustments are accounted for as unrealized gains (with credits to equity but not reflected in the income statement) until the security is actually disposed of or sold.  At December 31, 2016, unrealized gains included $2.1 million of appreciation on investments previously adjusted for other-than-temporary impairment, compared to a cumulative total of $4.0 million of impairment write-downs at that date.  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 as described above.  However, to the extent that certain declines in value are reported as unrealized at December 31, 2016, 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, 2016, the total gross unrealized loss included in the Company's investment portfolio was approximately $8.2 million.  No individual issue constituted a material amount of this total.  Had this entire amount been considered other-than-temporary at December 31, 2016, there would have been no impact on total shareholders' equity or book value since the decline in value of these securities was previously recognized as a reduction to shareholders' equity.
 
- 31 -


Reinsurance Recoverable
 
Reinsurance ceded transactions were as follows for the years ended December 31 (dollars in thousands):
 
   
2016
   
2015
   
2014
 
Reinsurance recoverable
 
$
255,024
   
$
215,888
   
$
220,221
 
Premium ceded (reduction to premium earned)
   
130,012
     
133,548
     
119,248
 
Losses ceded (reduction to losses incurred)
   
108,656
     
75,581
     
105,891
 
Commissions from reinsurers (reduction to operating expenses)
   
33,512
     
28,956
     
23,797
 

A discussion of the Company's reinsurance strategies is presented in Part I, Item 1, Business, on page 3 of this Annual Report on Form 10-K.

Amounts recoverable under the terms of reinsurance contracts comprised approximately 22% of total Company assets as of December 31, 2016.  In order to be able to provide the high limits required by the Company's insureds, the Company shares 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 certain of the Company's insurance policies for fleet transportation liability, workers' compensation and professional liability risks 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 gross underlying loss that is critical.

As with any receivable, credit risk exists in the recoverability of reinsurance.  This may be 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 to satisfy the reinsurer's portion of the loss.  The financial condition of each of the Company's reinsurers is vetted upon the execution of a given treaty and only reinsurers with superior credit ratings 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 frequently 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 loss rather than a deficiency associated with the loss reserving process.
 
 
- 32 -

 
Loss and Loss Expense Reserves
 
The Company's loss and loss expense reserves for each segment are shown in the following table on both a gross (before consideration of reinsurance) and on a net of reinsurance basis at December 31, 2016 and 2015 (dollars in thousands).
 
 
Gross
 
Net
 
Line of Business (Segment)
2016
 
2015
 
2016
 
2015
 
                 
Property and casualty insurance
 
$
531,008
   
$
464,305
   
$
280,899
   
$
254,299
 
Reinsurance
   
45,322
     
49,291
     
43,868
     
47,454
 
                                 
   
$
576,330
   
$
513,596
   
$
324,767
   
$
301,753
 
 
 
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.  The Company's claims range from the very routine "fender benders" 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 many of the Company's 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 periods.
 
 
A detailed analysis and discussion for each of the above basic reserve categories follows.
 
Reserves for known losses (Case reserves)
 
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, is established.  For very routine "short-tail" claims, such as physical damage, the Company records an initial 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 initial 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 frequently monitored and the recorded reserve is increased or decreased relative to information gathered during the settlement life cycle.
 
Reserves for IBNR losses
 
The Company uses both standard actuarial techniques common to most insurance companies as well as proprietary 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 IBNR losses for its short-tail lines.
 
 
- 33 -

 
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 IBNR losses.  A minimum of 20 accident years is used for long-tail workers' compensation reserve projections.  Significant emphasis is placed on the use of tail factors for the Company's long-tail lines of business.
 
For the Company's fleet transportation risks, which are covered by regularly changing reinsurance agreements and which contain wide-ranging self-insured retentions ("SIR"), traditional actuarial methods are supplemented by other methods, as described below, 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 enough 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 the Company's extensive, proprietary databases to arrive at the reserve for losses IBNR for the calendar/accident period under review.  As losses for a given calendar/accident period develop with the passage of time, management evaluates such development on a monthly and quarterly basis and adjusts 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
 
While certain of the Company's products involve case basis reserving for allocated loss adjustment expenses, the majority of such reserves are determined on a bulk basis.  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 applicable to each affected product.  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 loss adjustment expenses) 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 the individual losses.  As previously noted, our claims vary widely in scope and complexity.  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 certain of the Company's fleet transportation 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 estimations, as necessary, in an effort to achieve the best possible estimate of the ultimate remaining loss costs at any point in time.
 
 
- 34 -

 
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.  Savings 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 losses at a point in time and, due to the unique nature of our exposures, particularly in the large fleet transportation excess product, 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:
 
 
Consistency in the individual case reserving processes
 
 
The selection of loss development factors in the establishment of bulk reserves for incurred but not reported losses and loss expenses
 
 
Projected future loss trend
 
 
Expected loss ratios for the current book of business, particularly the Company's fleet transportation products, where the number of accounts insured, selected self-insured retentions, policy limits and reinsurance structures may vary widely from period to period
 
 
Under reasonably possible scenarios, it is conceivable that the Company's selected loss estimates could be 10% or more redundant or deficient.  The majority of the Company's reserves for losses and loss expenses, on a net of reinsurance basis, relate to its fleet transportation products.  Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company's fleet transportation products for policies subject to certain major reinsurance treaties.  The following table presents the approximate impacts on gross and net loss reserves of both a hypothetical 10 percentage point and a hypothetical 20 percentage point increase or decrease in the loss factors actually utilized in the Company's reserve determination at December 31, 2016 for the prior six treaty periods, covering exposures earned on policies written between July 3, 2011 and December 31, 2016.  The Company's selection of the range of values presented should not be construed as the Company's prediction of future events, but rather simply an illustration of the impact of such events, should they occur.
 

The variation in impact from loss ratio increases and decreases is attributable to minimum and maximum premium rate factors included in the various reinsurance contracts.  In between the minimum and maximum ceded premium provisions within the treaty terms, net premiums earned can be increased or decreased based on a change in loss expectation.  The total impact to profitability in the same scenarios is shown below ($ in millions):


   
10% Loss Ratio Increase
   
10% Loss Ratio Decrease
   
20% Loss Ratio Increase
   
20% Loss Ratio Decrease
 
Gross Reserves
 
$
43.4
   
$
(32.0
)
 
$
86.8
   
$
(49.7
)
Net Reserves
 
$
11.8
   
$
(8.4
)
 
$
23.6
   
$
(12.8
)
                                 
Net premiums earned
 
$
(22.0
)
 
$
23.3
   
$
(32.3
)
 
$
40.8
 
Total Net Underwriting Income (Loss)
 
$
(33.8
)
 
$
31.7
   
$
(55.9
)
 
$
53.6
 

 
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 is based on items of income and expense that are reported in different years in the financial statements and tax returns and are measured at the tax rate in effect in the year the difference originated.  Net deferred tax liabilities reported at December 31 are as follows (dollars in thousands):


   
2016
   
2015
 
      Total deferred tax liabilities
 
$
(24,969
)
 
$
(27,833
)
      Total deferred tax assets
   
13,557
     
16,635
 
      Net deferred tax liabilities
 
$
(11,412
)
 
$
(11,198
)


- 35 -

 
Deferred tax assets at December 31, 2016 include approximately $9.5 million related to the timing of deductibility of loss and loss expense reserves, the majority of which relate 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, in the aggregate, reverse to a material degree in the foreseeable future.  An additional $0.9 million 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.  Unearned premiums discount and deferred ceding commissions represent $1.3 and $0.5 million of deferred tax assets, respectively.  The balance of deferred tax assets consists of various normal operating expense accruals and is not considered to be material.  As a result of its analysis, management has determined that no valuation allowance is necessary at December 31, 2016.
 
FASB provides guidance for recognizing and measuring uncertain tax positions and prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Based on this guidance, management regularly analyzes tax positions taken or expected to be taken in a tax return based on the threshold condition prescribed.  Tax positions that do not meet or exceed this threshold condition are considered uncertain tax positions.  Interest related to uncertain tax positions, if any, would be recognized in income tax expense.  Penalties, if any, related to uncertain tax positions would be recorded in income tax expenses.  

 
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 are based on current expectations and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from such forward-looking statements.  These risks and uncertainties include 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 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; (iii) other risks and uncertainties indicated from time to time in the Company's filings with the Securities and Exchange Commission including in Part I, Item 1A, Risk Factors, in this Annual Report on Form 10-K; and (iv) other risks and factors which may be beyond the control or foresight of the Company.  Readers of this report are cautioned not to place undue reliance on these forward-looking statements.  While the Company believes the assumptions on which the forward-looking statements are based are reasonable, there can be no assurance that these forward-looking statements will prove to be accurate.  The Company expressly disclaims any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
 
 
Impact of Inflation
 
To the extent possible, the Company attempts to recover the impact of inflation on loss costs and operating expenses by increasing the premiums it charges.  Within the fleet transportation business, a majority of the Company's accounts are charged as a percentage of an insured's gross revenue, mileage 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 additional comments in Part II, Item 7A, Quantitative and Qualitative Disclosures about Market Risk, in this Annual Report on Form 10-K).

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.

 
- 36 -

 
Contractual Obligations
 
The table below sets forth the amounts of the Company's contractual obligations at December 31, 2016.


   
Payments Due by Period
 
   
Total
   
Less than 1 year
   
1 - 3 Years
   
3 - 5 Years
   
More Than 5 Years
 
   
(dollars in millions)
 
Loss and loss expense reserves
 
$
576.3
   
$
196.0
   
$
196.0
   
$
71.4
   
$
112.9
 
                                         
Investment commitments
   
1.6
     
1.6
     
-
     
-
     
-
 
                                         
Operating leases
   
0.8
     
0.4
     
0.4
     
-
     
-
 
                                         
Borrowings
   
20.0
     
20.0
     
-
     
-
     
-
 
                                         
Total
 
$
598.7
   
$
218.0
   
$
196.4
   
$
71.4
   
$
112.9
 


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, the above table presents an estimate of when we might expect our direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid.  Timing of the collection of the related reinsurance recoverable, estimated to be $255.0 million at December 31, 2016, or 43% of the amounts presented in the above table, would approximate that of the above projected direct reserve payout but could lag such payments by several months in some instances.

The investment commitments in the above table relate to maximum unfunded capital obligations for limited partnership investments at December 31, 2016.  The actual call dates for such funding could vary from that presented.

Borrowings made under the Company's line of credit can be called by the bank, under certain circumstances, with short notice.  The Company's line of credit has a current expiration of September 23, 2018; however, management expects that this line of credit will be renewed for a multiple year period prior to maturity.
 
 
Off-Balance Sheet Arrangements
 
The Company has no off-balance sheet arrangements.
 

 
Item 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company operates 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, credit risks, equity security market prices and, to a 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.
 
Based on the structure of the Company's investment portfolio, the most potentially significant of the four identified market risks relates to prices in the equity security market.  Although 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, 2016 was $119.9 million, or approximately 16% of invested assets.  This market valuation includes $55.0 million of appreciation over the adjusted 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.
 
 
- 37 -

Reference is made to the discussion of limited partnership investments in "Critical Accounting Policies" in Part II, Item 7 of this Annual Report on Form 10-K.  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 often includes 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 appreciation is recognized as income only when a security is actually sold.

The Company's fixed maturity portfolio totaled $491.9 million at December 31, 2016.  Approximately 45% of this portfolio is made up of U.S. Government and municipal debt securities, and the average contractual maturity of the Company's fixed maturity investments is approximately 4.5 years with an average modified duration of approximately 2.1 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 and would, in fact, result in significantly higher investment income in a relatively short period of time, as short term investments and maturing bonds could be reinvested in the higher yielding securities very quickly.

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, currency fluctuations for non-U.S. debt holdings 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.

The following tables present the estimated effects on the fair value of financial instruments at December 31 that would result from an instantaneous change in yield rates of varying magnitudes on a static balance sheet to determine the effect such a change in rates would have on current fair value. The analysis presents the sensitivity of the fair value of the Company's financial instruments to selected changes in market rates and prices. The range of change chosen reflects the Company's view of changes that the Company believes are reasonably possible over a one-year period.  The Company's selection of the range of values chosen to represent changes in interest rates should not be construed as the Company's prediction of future market events, but rather, as an illustration of the impact of such events, should they occur.  The equity portfolio was compared to the S&P 500 index due to its correlation with the vast majority of the Company's current equity portfolio.  The limited partnership portfolio was compared to the S&P 500 and Indian BSE 500 indices due to their significant correlation with the vast majority of our limited partnership portfolio.  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 below.


- 38 -


The following tables present the estimated effects on the fair value of financial instruments at December 31 due to an instantaneous change in yield rates of 100 basis points and a 10% decline in the S&P 500 and Indian BSE 500 indices (dollars in thousands).

         
Increase (Decrease)
 
   
Fair
   
Interest
   
Equity
 
   
Value
   
Rate Risk
   
Risk
 
2016:
                 
Fixed maturities
                 
   Agency collateralized mortgage obligations
 
$
6,171
   
$
-
   
$
-
 
   Agency mortgage-backed securities
   
4,770
     
(202
)
   
-
 
   Asset-backed securities
   
45,183
     
(1,577
)
   
-
 
   Bank loans
   
10,349
     
-
     
-
 
   Certificates of deposit
   
3,117
     
(111
)
   
-
 
   Collateralized mortgage obligations
   
9,104
     
(302
)
   
-
 
   Corporate securities
   
142,683
     
(4,026
)
   
-
 
   Mortgage-backed securities
   
24,571
     
(780
)
   
-
 
   Municipal obligations
   
129,335
     
(3,028
)
   
-
 
   Non-U.S. government obligations
   
24,681
     
(458
)
   
-
 
   U.S. government obligations
   
91,940
     
(1,249
)
   
-
 
      Total fixed maturities
   
491,904
     
(11,733
)
   
-
 
Equity securities:
                       
   Consumer
   
32,576
     
-
     
(3,258
)
   Energy
   
12,842
     
-
     
(1,284
)
   Financial
   
31,186
     
-
     
(3,119
)