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BALDWIN & LYONS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 7, 2014

Liquidity and Capital Resources

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 property/casualty insurance subsidiaries, other than loss and loss expense payments and commissions paid to related agency companies, generally average less than 33% of premiums earned and the remaining amount is available for investment for varying periods of time pending the settlement of claims relating to the insurance coverage provided. The Company's cash flow relating to premiums is significantly affected by reinsurance programs in effect from time-to-time whereby the Company cedes both premium and risk to other insurance and reinsurance companies. These programs vary significantly among products.

For the first six months of 2014, the Company produced positive cash flow from operations totaling $13.6 million, which compares to positive cash flow from operations of $10.9 million generated during the first six months of 2013. The increase in cash flow from the 2013 period is primarily due to increased premium volume and timing of premium receipts and reinsurance ceded payments. The Company has achieved positive cash flow in 19 of the past 20 quarters averaging $12.8 million per quarter.

The Company's investment philosophy has emphasized the purchase of relatively short-term instruments with maximum quality and liquidity. The average life of the Company's fixed income (bond and short-term investment) portfolio, using contractual maturities applied to par value, was 4.36 years at June 30, 2014, which is shorter than the average life of the Company's liabilities.

Financing activity for the first six months of 2014 included regular dividend payments to shareholders of $7.5 million ($.50 per share).

The Company's assets at June 30, 2014 included $70.5 million in investments classified as cash equivalents that were readily convertible to cash without significant market penalty. An additional $126.4 million of fixed maturity investments (at par) will mature within the twelve-month period following June 30, 2014. The Company believes that these liquid investments are more than sufficient to provide for projected claim payments and operating cost demands.

Consolidated shareholders' equity is composed largely of GAAP shareholders' equity of the insurance subsidiaries. As such, there are statutory restrictions on the transfer of substantial portions of this equity to the parent company. At June 30, 2014, $67.6 million may be transferred by dividend or loan to the parent company during the remainder of 2014 without approval by, or prior notification to, regulatory authorities. An additional $236.5 million of shareholder's equity of the insurance subsidiaries could, theoretically, be advanced or loaned to the parent company with prior notification to, and approval from, regulatory authorities, although it is unlikely that transfers of this size would be practical. The Company believes that these restrictions pose no material liquidity concerns to the Company. The Company also believes that the financial strength and stability of the subsidiaries would permit ready access by the parent company to short-term and long-term sources of credit. The parent company had cash and marketable securities valued at $12.2 million at June 30, 2014.

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The Company's annualized net premium writing to surplus ratio for the first six months of 2014 was approximately 64%. Regulatory guidelines generally allow for writings of between 100% and 300% of surplus, depending on the line of business. Accordingly, the Company could increase net premium writings significantly with no need to raise additional capital. Further, the insurance subsidiaries' individual capital levels are several times higher than the minimum amounts designated by the National Association of Insurance Commissioners.

Results of Operations

Comparison of Second Quarter, 2014 to Second Quarter, 2013

Direct and assumed premiums written during the second quarter of 2014 increased $2.3 million (2.4%), while net premiums earned increased $1.1 million (1.8%), as compared to the same period of 2013. The Company's Property and Casualty Insurance segment reported an increase in premium written of 6.3% and an increase in earned premiums of 10.5% while the Reinsurance segment reported a decrease in premium written of 23.2% and a decrease in premium earned of 34.4%. In the Property and Casualty Insurance segment, direct and assumed premiums written were impacted principally by an increase in premium from the Company's core fleet transportation products partially offset by a reduction in professional liability volume resulting from the termination of certain classes of business. The difference in the percentage changes for premium written compared to earned is reflective of the normal differences in the recognition of earned premium compared to written as well as the differences in reinsurance ceding rates on the mix of business inforce. The decreases from the Reinsurance segment relates to the continued impact of strategic reduction in global property catastrophe risk exposure begun in 2012 and continuing with the termination of the final international retrocession effective January 1, 2014. The following table provides information regarding premiums written and earned for each segment for the quarter ended June 30 (dollars in thousands):

Direct and Assumed Premium Net Premium Net Premium Written Written Earned 2014 Property & Casualty Insurance $ 85,826$ 54,976$ 55,057 Reinsurance 9,272 8,936 7,848 Totals $ 95,098$ 63,912$ 62,905 2013 Property & Casualty Insurance $ 80,756$ 50,703$ 49,803 Reinsurance 12,074 11,411 11,972 Totals $ 92,830$ 62,114$ 61,775 - 20 -



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Premium ceded to reinsurers on insurance business produced by the Property and Casualty Insurance segment averaged 35.9% of premium written for the current quarter compared to 37.2% in the 2013 second quarter, with the decrease associated principally with changes in the mix of premium earned. There were no significant changes in the Company's reinsurance treaty terms during the quarter.

Net investment income, before tax, during the second quarter of 2014 was 5% higher than the second quarter of 2013 due primarily to increased dividend income on equity security investments. Overall investment portfolio after tax yields remained flat compared to the 2013 second quarter while average invested funds increased 2%.

The second quarter 2014 net realized investment gains of $8.1 million resulted primarily from $5.2 million in gains reported from limited partnerships and an additional $2.4 million in gains from direct trading. Comparative second quarter 2013 overall net realized investment gains were $0.7 million, consisting primarily of $1.6 million in gains from direct trading and $1.3 million in losses from limited partnerships. Realized investment gains and losses result from decisions regarding the sale of individual securities and the change in total value of limited partnerships and, as such, should not be expected to be consistent from period to period.

Losses and loss expenses incurred during the second quarter of 2014 increased $1.9 million (5.1%). The loss ratios for each segment were as follows:

2014 2013 Property and Casualty Insurance 61.8% 68.7% Reinsurance 79.9 34.9 Total 64.1 62.1



The decrease in loss ratio for the Property and Casualty Insurance segment primarily relates to the Company's core fleet transportation products. The increase in the Reinsurance segment loss ratio reflects higher than normal Midwest storm losses in second quarter of 2014 while the 2013 second quarter experienced extraordinarily favorable results.

Other operating expenses, for the second quarter of 2014, increased $0.1 million, or 0.4%, from the second quarter of 2013. The ratio of consolidated other operating expenses to operating revenue was 30.7% during the second quarter of 2014 compared to 31.3% for the 2013 second quarter. The lower expense ratio in 2014 resulted from the reversal of profit sharing contingencies related to the property losses reported during the quarter.

The effective federal tax rate on consolidated income for the second quarter of 2014 was 33.5%. The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.

As a result of the factors mentioned above, and principally higher realized gains on investments, net income increased $4.4 million during the second quarter of 2014 as compared to the 2013 period.

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Comparison of Six Months Ended June 30, 2014 to Six Months Ended June 30, 2013

Direct and assumed premiums written during the first six months of 2014 increased $13.1 million (7.4%), while net premiums earned increased $3.9 million (3.2%), as compared to the same period of 2013. The Company's Property and Casualty Insurance segment reported an increase in premium written of 11.8% and an increase in earned premiums of 9.1% while the Reinsurance segment reported a decrease in premium written of 18.1% and a decrease in premium earned of 19.8%. In the Property and Casualty Insurance segment, direct and assumed premiums written were impacted principally by an increase in premium from the Company's core fleet transportation products partially offset by a reduction in professional liability volume resulting from the termination of certain classes of business. The difference in the percentage changes for premium written compared to earned is reflective of the normal differences in the recognition of earned premium compared to written as well as the differences in reinsurance ceding rates on the mix of business inforce. The decreases from the Reinsurance segment relates to the continued impact of strategic reduction in global property catastrophe risk exposure begun in 2012 and continuing with the termination of the final international retrocession effective January 1, 2014. The following table provides information regarding premiums written and earned for each segment for the quarter ended June 30 (dollars in thousands):

Direct and Assumed Premium Net Premium Net Premium Written Written Earned 2014 Property & Casualty Insurance $ 168,750$ 106,981$ 106,516 Reinsurance 21,102 20,430 20,231 Totals $ 189,852$ 127,411$ 126,747 2013 Property & Casualty Insurance $ 150,945$ 96,168$ 97,663 Reinsurance 25,776 24,451 25,210 Totals $ 176,721$ 120,619$ 122,873



Premium ceded to reinsurers on insurance business produced by the Property and Casualty Insurance segment averaged 36.6% of premium written for the current year period compared to 36.3% a year earlier with the increase associated with changes in the mix of premium earned. There were no significant changes in the Company's reinsurance treaty terms during the quarter.

Net investment income, before tax, during the first six months of 2014 was flat compared to the first six months of 2013. Overall pre-tax and after tax yields were essentially flat compared to the prior year period while average funds invested were slightly higher in the 2014 period.

Net realized investment gains for the first six months of 2014 totaled $12.2 million and resulted primarily from $8.3 million in gains from limited partnerships and an additional $3.6 million in gains from direct trading. For the same period of 2013, overall net realized investment gains were $15.1 million, consisting primarily of $10.8 million in gains from direct trading and $2.4 million in additional gains from limited partnerships. Realized investment gains and losses result from decisions regarding the sale of individual securities and the change in total value of limited partnerships and, as such, should not be expected to be consistent from period to period.

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Losses and loss expenses incurred during the first six months of 2014 were $6.7 million (9.2%) higher than that experienced during the first six months of 2013. The loss ratios for each segment were as follows:

2014 2013 Property and Casualty Insurance 64.2% 67.2% Reinsurance 55.1 28.7 Total 62.8 59.3



The decrease in loss ratio for the Property and Casualty Insurance segment primarily relates to the Company's core fleet transportation products. The increase in the Reinsurance segment loss ratio reflects the second quarter, 2014, storm losses mentioned above while the first six months of 2013 experienced no significant property losses.

Other operating expenses, for the first six months of 2014, increased $0.9 million, or 2.1%, from the 2013 six-month period. The ratio of consolidated other operating expenses to operating revenue was 32.3% during the 2014 period compared to 32.6% for the 2013 period.

The effective federal tax rate on consolidated income for the first six months of 2014 was 33.1%. The effective rate differs from the normal statutory rate primarily as a result of tax-exempt investment income.

As a result of the factors mentioned above, net income decreased $4.1 million as compared to the 2013 period.

Forward-Looking Information



Any forward-looking statements in this report, including without limitation, statements relating to the Company's plans, strategies, objectives, expectations, intentions and adequacy of resources, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that such forward-looking statements involve risks and uncertainties including without limitation the following: (i) the Company's plans, strategies, objectives, expectations and intentions are subject to change at any time at the discretion of the Company; (ii) the Company's business is highly competitive and the entrance of new competitors into or the expansion of the operations by existing competitors in the Company's markets and other changes in the market for insurance products could adversely affect the Company's plans and results of operations; (iii) other risks and uncertainties indicated from time to time in the Company's filings with the Securities and Exchange Commission; and (iv) other risks and factors which may be beyond the control or foresight of the Company. Readers are encouraged to review the Company's annual report for its full statement regarding forward-looking information.

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Critical Accounting Policies

There have been no changes in the Company's critical accounting policies as disclosed in the Form 10-K filed for the year ended December 31, 2013.

Concentrations of Credit Risk

The insurance subsidiaries cede portions of their gross premiums to numerous reinsurers under quota share and excess of loss treaties as well as facultative placements. These reinsurers assume commensurate portions of the risk of loss covered by the contracts. As losses are reported and reserved, portions of the gross losses attributable to reinsurers are established as receivable assets and losses incurred are reduced. At June 30, 2014, amounts due from reinsurers on paid and unpaid losses, are estimated to total approximately $204 million. Of this total, approximately $47 million (23%) represents the Company's provision for incurred but not reported losses and loss adjustment expenses attributable to reinsurers. Because of the large policy limits reinsured by the Company, the ultimate amount of incurred but not reported losses and loss adjustment expenses attributable to reinsurers could vary significantly from the estimate provided; however, absent the inability to collect from reinsurers, such variance would not result in changes in net claim losses incurred by the Company.

At June 30, 2014, limited partnership investments include approximately $44.9 million consisting of two partnerships which are managed by organizations in which certain of the Company's directors are officers, directors, general partners or owners. Each of these investments contains profit sharing agreements to the affiliated organizations.


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Source: Edgar Glimpses


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