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Article by DailyStocks_admin    (05-27-08 03:31 AM)

Filed with the SEC from May 15 to May 21:

Baldwin & Lyons (BWINB)
In a letter, Loeb Partners called Baldwin & Lyons' capital-allocation process "flawed," resulting in poor stock performance. Loeb suggested that excess capital be returned to shareholders via a special dividend. Loeb and its affiliates own about 674,000 Class B shares (5.4%).

BUSINESS OVERVIEW

Baldwin & Lyons, Inc. was incorporated under the laws of the State of Indiana in 1930. Through its divisions and subsidiaries, Baldwin & Lyons, Inc. (referred to herein as "B&L") specializes in marketing and underwriting property and casualty insurance. B&L's subsidiaries are: Protective Insurance Company (referred to herein as "Protective"), with licenses in all 50 states, the District of Columbia and all Canadian provinces; Sagamore Insurance Company (referred to herein as "Sagamore"), which is currently licensed in 47 states; and B & L Insurance, Ltd. (referred to herein as "BLI"), which is domiciled and licensed in Bermuda. These subsidiaries are collectively referred to herein as the "Insurance Subsidiaries." The "Company", as used herein, refers to Baldwin & Lyons, Inc. and all its subsidiaries unless the context indicates otherwise.

Approximately 70% of the gross direct premiums written and assumed by the Insurance Subsidiaries during 2004 was attributable to business produced directly by B & L. Approximately 4% of gross premium is assumed from several non-affiliated insurance and reinsurance companies through retrocessions. The remaining 26% consists primarily of business written by Sagamore which was originated through an extensive network of independent agents.

The Insurance Subsidiaries cede portions of their gross premiums written to several non-affiliated reinsurers under excess of loss and quota-share treaties and by facultative (individual policy-by-policy) placements. Reinsurance is ceded to spread the risk of loss among several reinsurers. In addition to the assumption of non-affiliated reinsurance, described below, the Insurance Subsidiaries participate in numerous mandatory government-operated reinsurance pools which require insurance companies to provide coverages on assigned risks. These assigned risk pools allocate participation to all insurers based upon each insurer's portion of premium writings on a state or national level. Assigned risk premium typically comprises less than 1% of gross direct premium written and assumed.

The Insurance Subsidiaries serve various specialty markets as follows:
FLEET TRUCKING INSURANCE

Protective provides coverage for larger customers in the motor carrier industry which retain substantial amounts of self-insurance as well as for medium-sized trucking companies on a first dollar or small deductible basis. Large fleet trucking products are marketed exclusively by the B&L agency organization directly to trucking clients although broker or agent intermediaries are used on a limited basis for smaller accounts. The principal types of insurance marketed by Protective are:

- Casualty insurance including motor vehicle liability, physical damage and other liability insurance.
- Workers' compensation insurance.
- Specialized accident (medical and indemnity) insurance for independent contractors.
- Fidelity and surety bonds.
- Inland Marine consisting principally of cargo insurance.
- "Captive" insurance company products, which are provided through BLI in Bermuda.

B&L also performs a variety of additional services, primarily for Protective's insureds, including risk surveys and analyses, government compliance assistance, loss control and cost studies and research, development, and consultation in connection with new insurance programs including development of computerized systems to assist in monitoring accident data. Extensive claims handling services are also provided, primarily to clients with self-insurance programs.

NON-AFFILIATED ASSUMPTION REINSURANCE

Protective accepts cessions and retrocessions from selected insurance and reinsurance companies, principally reinsuring against catastrophes. Exposures under these retrocessions are generally in high upper layers, are spread among several geographic regions and are limited so that only a major catastrophic event or series of major events would have a material affect on the Company's operations or financial position. The events of September 11, 2001 materially impacted the Company's operating results in 2001. See Note E to the consolidated financial statements for further discussion.
PRIVATE PASSENGER AUTOMOBILE INSURANCE

Sagamore markets nonstandard private passenger automobile liability and physical damage coverages to individuals through a network of independent agents in twenty-six states.
SMALL FLEET TRUCKING INSURANCE

Sagamore provides commercial automobile liability, physical damage and cargo insurance to truck owner-operators generally with six or fewer power units. These products are marketed through independent agents in thirty states.
SMALL BUSINESS WORKERS' COMPENSATION

The Company discontinued marketing this product in the fourth quarter of 2004.
PROPERTY/CASUALTY LOSSES AND LOSS ADJUSTMENT EXPENSES

The consolidated financial statements include the estimated liability for unpaid losses and loss adjustment expenses ("LAE") of the Insurance Subsidiaries. The liabilities for losses and LAE are determined using case basis evaluations and statistical projections and represent estimates of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates are subject to the effects of trends in claim severity and frequency and are continually reviewed and, as experience develops and new information becomes known, the liability is adjusted as necessary. Such adjustments, either positive or negative, are reflected in current operations.

The Company uses case-basis reserving on the majority of its outstanding losses (approximately 68% of net outstanding reserves at December 31, 2004). Standard actuarial methods are employed to determine reserves for incurred but not reported losses and for loss expenses using the Company's historical data. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and LAE. In addition, frequency and severity of claims must be projected. The average severity of claims is influenced by a number of factors that vary with the individual type of policy written. Future average severities are projected based on historical trends adjusted for anticipated changes in underwriting standards, policy provisions, and general economic and social trends. These anticipated trends are monitored based on actual development and are modified as new conditions would suggest that changes are necessary. These actuarial processes are a combination of objective mathematical calculations and the application of subjective factors, based on experience and knowledge of the specific risks being evaluated, to arrive at selected ultimate reserve amounts. The Company attempts to build conservatism into all subjective aspects of the actuarial reserving process.

Loss reserves related to certain permanent total disability (PTD) workers' compensation claims have been discounted to present value using tables provided by the National Council on Compensation Insurance which are based upon a pretax interest rate of 3.5% and adjusted for losses retained by the insured. The loss and LAE reserves at December 31, 2004 have been reduced by approximately $3.9 million as a result of such discounting. Had the Company not discounted loss and LAE reserves, pretax income would have been approximately $1.6 million higher for the year ended December 31, 2004.

The maximum amount for which Protective insures a trucking risk is $10 million although, occasionally, limits above $10 million are provided but are 100% reinsured. Certain coverages, such as workers' compensation, provide essentially unlimited exposure although the Company protects itself to the extent believed prudent through the purchase of excess reinsurance for these coverages. After giving effect to current treaty reinsurance arrangements, for the majority of risks insured, Protective's maximum exposure to loss from a single occurrence is approximately $2.0 million (excepting reinsurance assumed). The current excess of loss treaty also includes an aggregate deductible that must be exceeded before the Company can recover under the terms of the treaty. The Company retains a higher percentage of the direct premium (and, therefore, cedes less premium to reinsurers) in consideration of this deductible provision. 2004 net premium earned and losses incurred each include $2,278 relative to this deductible provision. Protective has revised its treaty arrangements several times in prior years in response to changing market conditions. The current treaty arrangements are effective until June 3, 2005 and cover the entire policy period for all business written through that date. Treaty renewals are expected to occur annually in the foreseeable future. During the past ten years, Protective's maximum exposure to a single occurrence has ranged from less than $100,000 to approximately $2 million. Because Protective, on occasion, writes multiple year policies and because losses from trucking business take years to develop, losses reported in the current year may be covered by a number of older reinsurance treaties with higher or lower loss retention by Protective than those provided by current treaty provisions.

Certain of the previous reinsurance treaties contained aggregate recovery limitations. To the extent that losses in these layers, in the aggregate, exceed these limitations, the Company could be liable for amounts that would otherwise be covered under these reinsurance treaties. No such aggregate limits have been exceeded as of December 31, 2004.

With respect to Sagamore's private passenger automobile and small fleet trucking business, the Company's maximum net exposure for a single occurrence is $100,000 through December 31, 2002 and $250,000 thereafter. Sagamore's retention for workers' compensation coverages is $100,000 for a single occurrence. Sagamore's retention on prior year's business has never exceeded $250,000 per occurrence.

The following table on page 5 sets forth a reconciliation of beginning and ending loss and LAE liability balances, for 2004, 2003 and 2002. That table is presented net of reinsurance recoverable to correspond with income statement presentation. However, a reconciliation of these net reserves to those gross of reinsurance recoverable, as presented in the balance sheet, is also shown. The table on page 10 shows the development of the estimated liability, net of reinsurance recoverable, for the ten years prior to 2004. The table on page 11 is a summary of the reestimated liability, before consideration of reinsurance, for the ten years prior to 2004 and the related reestimated reinsurance recoverable for the same periods.

The reconciliation above shows a $15.0 million (9.1%) savings in the liability for losses and LAE recorded at December 31, 2003. The net savings is reflected in 2004 underwriting income. All major product groups produced redundancies during each of the years 2004, 2003 and 2002 with the exception of reinsurance assumed and small business worker's compensation in 2003. The increase in reserve redundancy from 2003 results primarily from more favorable development from the Company's participation in catastrophe reinsurance pools. The Company's small business workers' compensation product also experienced more favorable loss development during 2004. The following table is a summary of the above $15.0 million reserve savings by accident year.

The Company approaches the reserving process from a conservative standpoint. The Company has not altered any of the key assumptions used in the reserving process since the mid-1980's and this process has proven to be fully adequate with no overall deficiencies developed since 1985. There were no significant changes in trends related to the numbers of claims incurred, average settlement amounts, numbers of claims outstanding at period ends or the averages per claim outstanding during the year ended December 31, 2004 for most lines of business. However, the average settlement amounts of severe trucking claims have tended to increase significantly over the past two years.

In the above table, the amounts identified as "net (savings) deficiency on losses from directly-produced business" consist of development on cases known at December 31, 2003, losses reported which were previously unknown at December 31, 2003 (incurred but not reported), unallocated loss expense paid related to accident years 2003 and prior and changes in the reserves for incurred but not reported losses and loss expenses.

Reserves for incurred but not reported losses are established to provide for future development on cases known to the Company at the time the reserve is established as well as for cases unknown at the reserve date. Changes in the reserves for incurred but not reported losses and loss expenses occur based upon information received on known and newly reported cases during the current year and the effect of that development on the application of standard actuarial methods used by the Company.

Also shown in the above table are amounts representing the "(savings) deficiency reported under reinsurance assumption agreements". These amounts relate primarily to the Company's participation in property catastrophe treaties. The Company records its share of losses from these treaties based on reports from the retrocessionaires and has no control over the establishment of case reserves related to this segment of the Company's business. The Company does, however, establish additional reserves for reinsurance assumed losses to supplement case reserves reported by the ceding companies, when considered necessary.

As described on pages 3 and 4, changes have occurred in the Company's net per accident exposure under reinsurance agreements in place during the periods presented in the above table. It is much more difficult to reserve for losses where policy limits are as high as $10 million per accident than it is for losses in the lower layers. There are fewer policy limit losses in the Company's historical loss database on which to project future loss developments and the larger the loss, the greater the likelihood that the courts will become involved in the settlement process. As such, the level of uncertainty in the reserving process is much greater when dealing with larger losses and will often result in fluctuations among accident year developments. However, in spite of the significant changes in product mix and reinsurance structure over the past ten years, the Company's reserving process has produced consistently favorable net developments on an overall basis.

The provision for loss reserves ceded attributable to insolvent reinsurers is treated as a separate liability for SAP purposes but is classified as an addition to loss reserves in the GAAP consolidated balance sheets. This classification was used for GAAP since the uncollectible amounts are, in effect, a reversal of reinsurance credits taken against gross loss and LAE reserves. Losses incurred, however, do not include charges for uncollectible reinsurance, nor do the tables on pages 5, 6 and 10, since the inability to recover these amounts from insolvent reinsurers is considered to be a credit loss and is not associated with the Company's reserving process. Accordingly, loss and LAE developments would be distorted if amounts related to insolvent reinsurance were included.

The table on page 10 presents the development of GAAP balance sheet liabilities for each year-end 1994 through 2004, 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. The liabilities shown on this line for each year-end have been reduced by amounts relating to loss reserves ceded attributable to insolvent reinsurers, as discussed in the immediately preceding paragraph. This liability represents the estimated amount of losses and LAE for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred, but not yet reported, to the Company.

The upper portion of the table shows the reestimated amount of the previously recorded liability based on additional information available to the Company as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of individual claims and as claims are settled and paid.

The "cumulative redundancy" represents the aggregate change in the estimates over all prior years. For example, the 1994 liability has developed a $35.6 million redundancy over ten years. That amount has been reflected in income over the ten years, as shown on the table. The effect on income of changes in estimates of the liability for losses and LAE during each of the past three years is shown in the table on page 5.

Historically, the Company's loss developments have been favorable. Reserve developments for all years ended in the period 1986 through 2003 have produced redundancies as of December 31, 2004. In addition to improvements in reserving methods, loss reserve developments since 1985 have been favorably affected by several other factors. Perhaps the most significant single factor has been the improvement in safety programs by the trucking industry in general and by the Company's insureds specifically. Statistics produced by the American Trucking Association show that driver quality has improved markedly in the past decade resulting in fewer fatalities and serious accidents. The Company's experience also shows that improved safety and hiring programs have a dramatic impact on the frequency and severity of trucking accidents. Higher self-insured retentions also played a part in reduced insurance losses during portions of this period. Higher retentions not only raise the excess insurance entry point but also encourage trucking company management to focus even more intensely on safety programs. Further, reserve savings have been achieved by the use of structured settlements on certain workers' compensation and liability claims of a long-term liability nature.

The establishment of reserves requires the use of historical data where available and generally a minimum of ten years of such data is required to provide statistically valid samples. As previously mentioned, numerous factors must be considered in reviewing historical data including inflation, tort reform (or lack thereof), 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 2004 is different from that which generated much of the ten-year historical loss data used to establish reserves in the past few years. In recent years, management has noted trends toward significantly higher settlements and jury awards associated with the more serious trucking liability claims. The inflationary factors affecting these claims appear to be more subjective in nature and not in line with compensatory equity. Savings realized in recent years upon the closing of claims, as reflected in the tables on pages 5 and 10, are attributable to the Company's long-standing policy of reserving for losses realistically and a willingness to settle claims based upon a seasoned evaluation of the underlying exposures. The Company will continue to review the trends noted and, should it appear that such trends are permanent and projectable, they will be reflected in future reserving method refinements.

The lower section of the table on page 10 shows the cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. For example, as of December 31, 2004, the Company had paid $110.6 million of losses and LAE that had been incurred, but not paid, as of December 31, 1994; thus an estimated $28.8 million in losses incurred through 1994 remain unpaid as of the current financial statement date ($139.4 million incurred less $110.6 million paid).

In evaluating this information, it is important to note that the method of presentation causes some development experience to be duplicated. For example, the amount of any redundancy or deficiency related to losses settled in 1997, but incurred in 1994, will be included in the cumulative development amount for years-end 1994, 1995, and 1996. As such, this table does not present accident or policy year development data which readers may be more accustomed to analyzing. Rather, this table is intended to present an evaluation of the Company's ability to establish its liability for losses and loss expenses at a given balance sheet date. It is important to note that conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.

The table presented on page 11 presents loss development data on a gross (before consideration of reinsurance) basis for each of the ten years December 31, 1994 through December 31, 2003 as of December 31, 2004 with a reconciliation of the data to the net amounts shown in the table on page 10.

Environmental Matters: The Company's reserves for unpaid losses and loss expenses at December 31, 2004 included amounts for liability related to environmental damage claims. Given the Company's principal business is insuring trucking companies; it does on occasion receive claims involving a trucking accident which has resulted in the spill of a pollutant. Certain of the Company's policies may cover these situations on the basis that they were caused by an accident that resulted in the immediate spill of a pollutant. These claims are typically reported and resolved within a short period of time.

However, the Company has also received a few environmental claims that did not result from a "sudden and accidental" event. Some of these claims fall under policies issued in the 1970's primarily to one account which was involved in the business of hauling and disposing of hazardous waste. Although the Company had pollution exclusions in its policies during that period, the courts have ignored such exclusions in many environmental cases. Beginning with the year 1994 and through the year ended December 31, 2004, the Company has recorded a total of $7.0 million in losses incurred with respect to environmental claims. Incurred losses to date include a reserve for incurred but not reported environmental losses of $2.0 million at December 31, 2004.

Establishing reserves for environmental claims is subject to uncertainties that are greater than those represented by other types of claims. Factors contributing to those uncertainties include a lack of historical data, long reporting delays, uncertainty as to the number and identity of insureds with potential exposure, unresolved legal issues regarding policy coverage, and the extent and timing of any such contractual liability. Courts have reached different and sometimes inconsistent conclusions as to when the loss occurred and what policies provide coverage, what claims are covered, whether there is an insured obligation to defend, how policy limits are determined, how policy exclusions are applied and interpreted, and whether cleanup costs represent insured property damage. Management believes that those issues are not likely to be resolved in the near future.

However, to date, very few environmental claims have been reported to the Company. In addition, a review of the businesses of our past and current insureds indicates that exposure to further claims of an environmental nature is limited because most of the Company's accounts are not currently, and have not in the past been, involved in the hauling of hazardous substances. Also, the revision of the pollution exclusion in the Company's policies since 1986 is expected to further limit exposure to claims from that point forward.

The Company has never been presented with an environmental claim relating to asbestos and, based on the types of business the Company has insured over the years, it is not expected that the Company will have any significant asbestos exposure.

COMPENSATION

Executive Compensation Policy

The Compensation Committee (“the Committee” or “we”) bases its executive compensation policy on the same principles that guide the Corporation in establishing all its compensation programs. The Corporation designs programs to attract, retain, and motivate highly talented individuals at all levels of the organization. The goal of the Corporation’s executive compensation policy is to ensure that an appropriate relationship exists between executive pay and the creation of shareholder value, while, at the same time, motivating and retaining key employees. To achieve this goal, the Corporation’s executive compensation policies integrate annual base compensation with cash bonuses based upon both individual and corporate performance, as discussed in the following paragraph. The Corporation also utilizes long-term incentive compensation, tied to the increase in the Corporation’s book value, to ensure that executives, and management in general, have a continuing stake in the long-term success of the Corporation.



The Committee sets the CEO’s, as well as the other executive officers’, compensation in light of the standards mentioned above as well as the performance of the Corporation in relation to expectations of the Board. Because of the unique and cyclical nature of the markets which the Corporation serves, the Committee does not believe that there are individual companies or industry measures to which it can reliably compare the performance of the Corporation over a limited period of time. Thus, while the Committee considers the Corporation’s financial results in light of industry standards, prevailing market conditions for the Corporation’s products and expectations regarding future performance, corporate performance is evaluated primarily against flexible, internally created goals and expectations which must be adjusted frequently in order to react to the numerous external factors which affect the Corporation. In general, profitability from operations in relation to market conditions is the most important factor considered by the Committee in its deliberations.



Components of Executive Compensation for 2007

Annual Compensation

Annual cash compensation for 2007 consisted of base salary and a cash bonus. We determined base salaries based on Corporation and individual performance for the previous year, internal relativity, and market conditions. We used general comparison data to test for reasonableness and competitiveness of base salaries, but we also exercised significant subjective judgment in view of our compensation objectives. Beginning in 2006, we redesigned the bonus program whereby base salaries comprise a larger portion of total annual compensation than in prior years. We believe that this change was important to reduce the volatility of annual compensation given the cyclical nature of the Corporation’s business and the fact that, as a relatively small specialty insurance underwriter operating within very narrow markets, the Corporation must, from time-to-time, sacrifice short-term profits for the expectation of long-term financial growth. In addition, this approach recognizes the stability and unique knowledge base of the executive management team which has essentially been in place since 1985.



Cash bonuses for all management employees for 2007 were determined using a preset formula-based bonus program which provides targets for profitability. Under the plan, bonus target amounts, expressed as a dollar amount, are established for participants at the beginning of each year based on job responsibilities and each individual’s base salary. Final bonus payouts for 2007 were determined by the Corporation’s actual financial results for the year relative to predetermined performance measures of operating income. A more detailed description of the Executive Bonus Plan is included starting on page 15 of this document.



Stock Options

Portions of annual compensation to management personnel have, in the past, been paid in the form of stock options. However, the Committee has determined that, given the thinly-traded nature of the Corporation’s common stock, this form of compensation is not an effective means to compensate all management personnel and, accordingly, has not widely granted stock options since 1997. While stock options may be used in the future, it is likely that they will only be used on a limited basis for executive management.



Long-Term Incentives

We have utilized what we refer to as “equity appreciation rights” as our sole form of long-term incentives for all management personnel for several years. Equity appreciation rights provide deferred compensation to employees, including Executive Officers, based on the increase in the Corporation’s book value, with certain adjustments for extra dividends paid to shareholders, over a five year period. This program results in compensation which is directly linked to the Corporation’s performance and increases in shareholder value.



Equity appreciation vest over a three year period, rights can not be exercised until near their expiration date and, further, termination of employment for reasons other than death, disability or retirement results in forfeit of vested rights. These plan provisions provide employee retention benefits to the Corporation. Equity appreciation rights are widely distributed to all salaried employees in amounts proportional to their job responsibilities and annual salary bases. A more detailed description of the Employee Equity Appreciation Rights Plan is included starting on page 17 of this document.



Employee Benefits and Perquisites

We offer our executive officers standard employee benefits, including the ability to participate in our group life, health, dental and disability insurance and our 401(k) Plan. We match contributions made by our executive officers to our 401(k) Plan consistent with the matching contribution for all participants of the plan. The Committee has also approved arrangements providing executive officers with the use of a Corporation-owned automobile, including maintenance costs, insurance coverage and partial gas allowance. As part of a stock option grant during 1997, all employees, including the executive officers, were granted pass through of any tax savings provided to the Company by the exercise of options by the employees. Amounts are paid to the employee in the year following the option exercise year after the computation of actual tax savings is completed. A listing of the total costs incurred for perquisites on behalf of named executive officers is set forth in the Summary Compensation Table on Page 12.

In its deliberations regarding calendar year 2007, the Committee considered its long-term approach regarding the goals and performance of the Corporation and the performance and present compensation of each executive officer of the Corporation. Base salaries of all management personnel, including the executive officers, were increased and bonus amounts were determined by the provisions of the Executive Bonus Plan described above. No stock options were granted during 2007 but a grant of equity appreciation rights was approved by the Committee and distributed effective April 30, 2007. This grant totaled 571,500 units and was widely distributed to all salaried employees in amounts proportional to their job responsibilities and annual salary bases. Equity appreciation rights grants to the Named Executive Officers are shown in the Grants of Plan-Based Awards Table on page 13.



The Committee believes that the salaries and bonuses approved, as well as the grant of incentive compensation in the form of equity appreciation rights, are consistent with a long-term view of both the performance of the Corporation and of its executive officers.


MANAGEMENT DISCUSSION FROM LATEST 10K

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 resulting from the fact that premiums are collected on insurance policies in advance of the disbursement of funds in payment of claims. Operating costs of the insurance subsidiaries, other than loss and loss expense payments, generally average less than 30% of premiums earned on a consolidated basis and the remaining amount is available for investment for varying periods of time depending on the type of insurance coverage provided. Because losses are often settled in periods different from when they are incurred, at times, operating cash flows may turn negative as loss settlements on claim reserves established in prior years exceed net premium revenue and receipts of investment income. During 2004, positive cash flow from operations totaled $72.3 million compared to $56.9 million in 2003, generally in line with the increase in net premium earned during 2004.

For several years, the Company's investment philosophy has emphasized the purchase of short-term bonds with maximum quality and liquidity. As interest rates have declined and yield curves have not provided a strong incentive to lengthen maturities in recent years, the Company has maintained and, during 2004, increased its short-term position with respect to the vast majority of its fixed maturity investments in anticipation of rate increases expected to occur in 2005. The average life of the Company's bond and short-term investment portfolio was 2.2 years and 2.8 years at December 31, 2004 and 2003, respectively. The Company also remains an active participant in the equity securities market using capital which is not 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, 2004 included $97.2 million in short-term and cash equivalent investments which are readily convertible to cash without market penalty and an additional $144.9 million of fixed income investments (at par) maturing in less than one year. The Company believes that these liquid investments, plus the expected cash flow from current operations, are more than sufficient to provide for projected claim payments and operating cost demands. In the event competitive conditions produce inadequate premium rates and the Company chooses to restrict volume, the liquidity of its investment portfolio would permit it to continue to pay claims as settlements are reached without requiring the disposal of investments at a loss, regardless of interest rates in effect at the time. In addition, the Company's reinsurance program is structured to avoid serious cash drains that might accompany catastrophic losses.

Net premiums written by the Company's U.S. insurance subsidiaries for 2004 equaled approximately 41% of the combined statutory surplus of these subsidiaries. Premium writings of 200% to 300% of surplus are generally considered acceptable by regulatory authorities. Further, the statutory capital of each of the insurance subsidiaries substantially exceeds minimum risk based capital requirements set by the National Association of Insurance Commissioners. Accordingly, the Company has the ability to significantly increase its business without seeking additional capital to meet regulatory guidelines.

As more fully discussed in Note F to the consolidated financial statements, at December 31, 2004, $79.2 million, or 24% of shareholders' equity, represented net assets of the Company's insurance subsidiaries which, at that time, could not be transferred in the form of dividends, loans or advances to the parent company because of minimum statutory capital requirements. However, management believes that these restrictions pose no material liquidity concerns for the Company. The financial strength and stability of the subsidiaries permit ready access by the parent company to short-term and long-term sources of credit. The Company has no long-term debt outstanding at December 31, 2004. Short-term borrowing totaled $6.0 million at December 31, 2004.
RESULTS OF OPERATIONS

2004 COMPARED TO 2003

Direct premiums written for 2004 totaled $237.1 million, an increase of $21.5 million (10%) from 2003. This increase is primarily attributable to an increase in fleet trucking liability premiums of $16.7 million (15%) from 2003 levels. Direct premium writings from the Company's independent contractor program also increased by $7.2 million (18%). These increases were partially offset by decreases in the Company's private passenger automobile, small business workers' compensation and small fleet trucking programs of $1.4 million (3%), $.6 million (6%) and $.4 million (3%), respectively. Large trucking fleet volume increased primarily from the addition of new accounts during 2004, increased revenues from renewal accounts and, to a lesser degree, premium rate increases. The higher premium volume from the independent contractor program resulted from the addition of contractors by existing accounts. Increased competitive pressures are responsible for the decline in premium volume from the Sagamore personal automobile and small fleet trucking programs. The decline in small business workers' compensation premium resulted from management's decision to discontinue marketing this business during the fourth quarter of 2004.

Premiums assumed from other insurers and reinsurers totaled $8.7 million during 2004, a decrease of $2.4 million (21%) from 2003 reflecting the discontinuance of a single large program for which renewal pricing was not considered to be favorable. Premium volume from reinsurance assumed will fluctuate depending on the favorability of pricing for the coverages provided. Further, premium volume for this segment is limited by the Company's self-imposed limitation to loss from a single catastrophic event.

Premiums ceded to reinsurers increased $5.1 million (7%) during 2004 to $78.6 million. However, the consolidated percentage of premiums ceded to direct premiums written decreased to 33% for 2004 from 34% for 2003. This decrease is reflective of the Company's increased exposure under reinsurance treaties effective in 2003 and 2004 covering large fleet trucking risks. The Company's maximum retained loss under these treaties has increased over the last two years and, as a result, a lower percentage of the direct premiums are ceded to reinsurers. There were no other significant changes to reinsurance treaties during 2004.

After giving effect to changes in unearned premiums, net premiums earned increased 18% to $172.1 million for 2004 from $146.2 million for 2003. Excluding inter-company reinsurance arrangements, net premiums earned from all trucking-related insurance products increased by $21.7 million (24%). Net premiums earned from the Company's private passenger automobile and small workers' compensation programs also increased $3.4 million (9%) and $1.9 million (31%), respectively. These increases were partially offset by a decrease in net premium earned from non-affiliated reinsurance assumed of $1.3 million (12%) from 2003.

Net investment income decreased $.6 million (5%) during 2004 reflecting lower overall pre-tax yields while average invested assets increased 11%. The average pre-tax yield on invested assets dropped to 2.9% this year from 3.3% during 2003 (13%). The decline in yields occurred entirely within the bond portfolio which averaged 3.2% during 2004 compared to 3.9% last year. A portion of this decline in pre-tax yield is attributable to the increased use of tax-exempt bonds during 2004. Yields on equity securities and short-term investments increased to 3.3% and 1.2%, respectively, from 3.1% and 1.0%, respectively, during 2003, partially offsetting the decline in bond yields. After-tax yields were 2.2% and 2.4% for 2004 and 2003, respectively. As discussed in the Liquidity and Capital Resources section, the Company has maintained its bond portfolio at an increasingly short-term level during the past several years as long-term interest rates were not considered to be sufficient to commit funds for extended periods. Increases in short-term rates during 2004 did not have a dramatic impact on longer-term rates, providing no incentive to lengthen maturities. Consequently, the average yield on maturing bonds exceeded the reinvestment rate during 2004 as shorter-term instruments were utilized in anticipation of more dramatic increases in long-term rates in 2005 and beyond.

Realized net capital gains were $9.8 million in 2004 compared to gains of $10.0 million for 2003. The current year's net gain consisted of gains on equity securities of $8.5 million, gains on fixed maturities of $1.9 million, and losses on other investments of $.6 million. Capital gains for the current year include a net gain of $1.2 million attributable to the process of accounting for "other than temporary impairment" in the investment portfolio. The net gain includes $2.4 million representing subsequent appreciation on previously written down securities disposed of during 2004 offset by additional write downs during the year. See the Investment Valuation section under the caption Critical Accounting Policies and Note B to the consolidated financial statements for further information with respect to the other than temporary impairment adjustment process.

Losses and loss expenses incurred during 2004 increased $30.6 million (32%) to $126.3 million. The increase in losses incurred is reflective of the 18% increase in net premiums earned, and primarily the 24% increase in premiums from trucking-related products, as previously discussed, and from $5.0 million of losses attributable to the Florida hurricanes during September, 2004. The 2004 consolidated loss and loss expense ratio was 73.4% compared to 65.5% for 2003. The Company's loss and loss expense ratios for individual product lines are summarized in the following table.

The loss and loss expense ratio for fleet trucking products for 2004 reflects an increase in severity of accidents, particularly in the large fleet excess product. While overall frequency in the trucking lines has not increased significantly, the frequency of severe losses was higher in 2004. Part of the increase in severity is attributable to social inflation factors which result in higher jury awards and settlements on serious accidents. The Company's higher retention under recent reinsurance treaty renewals also allows for more net volatility in this line of business. The loss and loss expense ratio for reinsurance assumed increased by 8 percentage points, and relates primarily to hurricane losses in 2004. The small business workers' compensation program continued to perform poorly. This continued unsatisfactory performance prompted management to discontinue this product in the current year fourth quarter.

The Company produced an overall savings on the handling of prior year claims during 2004 of $15.0 million. This net savings is included in the computation of loss ratios shown in the table insert. Because of the high limits provided by the Company to its large trucking fleet insureds, the length of time required to settle larger, more complex claims and the volatility of the trucking liability insurance business, the Company believes it is important to have a high degree of conservatism in its reserving process. As claims are settled in years subsequent to their occurrence, the Company's claim handling process has, historically, tended to produce savings from the reserves provided. The Company believes that favorable loss developments are attributable to the Company's long-standing policy of reserving for losses realistically and a willingness to settle claims based upon a seasoned evaluation of its exposures. Changes in both gross premium volumes and the Company's reinsurance structure for its large trucking fleets can have a significant impact on future loss developments and, as a result, loss and loss expense ratios and prior year reserve development may not be consistent year to year.

Other operating expenses for 2004, before credits for allowances from reinsurers, increased $.9 million (2%) to $51.5 million. Gross expenses increased at a lower rate than the increase in premium volume because much of the Company's expense structure is fixed and does not vary directly with volume. In general, only commissions to independent agents, premium taxes and other acquisition costs vary directly with premium volume. Direct commission expense increased $.8 million (7%) due to growth in business produced by outside agents. Resulting primarily from the increase in premium earned, taxes other than federal income and salary-related taxes increased $.7 million (12%) from 2003. Most other expense categories were level or down from the prior year as the investment in automation during the past several years has allowed for the handling of higher premium volume without the addition of employees.

Reinsurance ceded credits were $.4 million (2%) higher in 2004, in line with higher reinsurance ceded premiums. While the dollars of reinsurance ceded credits were higher this year, the ratio of reinsurance ceded credits to gross acquisition costs declined because Protective is retaining a greater percentage of the gross premium for its own account under recent reinsurance treaties.

Substantially all fleet trucking business is produced by direct sales efforts of Baldwin & Lyons, Inc. employees and, accordingly, this business does not incur commission expense on a consolidated basis. Instead, the expenses of the agency operations, including salaries and bonuses of salesmen, travel expenses, etc. are included in operating expenses. In general, commissions paid by the insurance subsidiaries to the parent company exceed related acquisition costs incurred in the production of fleet trucking business. The ratio of net operating expenses of the insurance subsidiaries to net premiums earned was 24.0% during 2004 compared to 26.5% for 2003. Including the agency operations, and after elimination of inter-company commissions, the ratio of other operating expenses to operating revenue (defined as total revenue less realized gains on investments) was 16.2% for 2004 compared with 18.4% for 2003, and reflects the fixed nature of certain of the Company's expenses, as discussed above.

The effective federal tax rate for consolidated operations for 2004 was 31.1%. This rate is lower than the statutory rate primarily because of tax-exempt investment income.

As a result of the factors mentioned above, net income for 2004 was $30.3 million compared to $33.1 million for 2003. Diluted earnings per share decreased to $2.05 in 2004 from $2.25 in 2003. Earnings per share from operations, before realized gains or losses on investments, was $1.62 in 2004 compared to $1.81 in 2003.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

RESULTS OF OPERATIONS
COMPARISONS OF FIRST QUARTER, 2005 TO FIRST QUARTER, 2004

Net premiums earned during the first quarter of 2005 increased $8.2 million (21%) as compared to the same period of 2004. The increase is due primarily to a 48% increase in premiums from the Company's fleet trucking program. This increase results from increased premium retained under current reinsurance agreements, increases in trucking revenues of insureds, upon which the majority of fleet trucking premiums are based, and, to a small degree, rate increases. Partially offsetting this increase were decreases in premiums from the Company's reinsurance assumed, small fleet trucking and private passenger automobile programs of 21%, 11% and 3%, reflecting the competitive nature of the markets in which the Company operates. In addition, premium from the Company's discontinued small business workers' compensation product decreased 27%.

Direct premiums written and assumed increased to $64.6 million from $64.2 million reported a year earlier. This increase was due primarily to increases in fleet trucking premium and was partially offset by the decrease in premium writings due to the discontinuance of the small workers' compensation product. Premium ceded to reinsurers averaged 21.9% of direct premium production for the current quarter compared to 31.6% a year earlier.

Net investment income, before tax, during the first quarter of 2005 was 4% higher than the first quarter of 2004 due primarily to an increase in average invested assets resulting from positive cash flow. Also, pre-tax yields on short-term investments tripled from prior year levels to 2.2% during the current quarter. Overall after tax yields are mostly consistent with the prior year quarter.

The first quarter 2005 net realized gain of $4.9 million consisted of net gains on equity securities and limited partnership (equity and hedge fund) investments of $2.2 million and $2.8 million, respectively, partially offset by a $.1 million net loss on bonds.

Losses and loss expenses incurred during the first quarter of 2005 increased $6.4 million from that experienced during the first quarter of 2004, which is consistent with the increase in premium volume previously discussed.

Other operating expenses for the first quarter of 2005 increased 19% from the first quarter of 2004. Adjusted for ceding allowances, operating expenses decreased 4% from the first quarter of 2004 and compares favorably with the 21% increase in premiums earned from the 2004 quarter as many of the Company's expenses do not vary directly with premium volume. Ceding allowances as a percentage of direct expenses have declined due to changes in the Company's reinsurance structure whereby the Company now retains a greater percentage of the risk compared to prior periods, particularly within the Large and Medium Fleet trucking products. Available capacity within each of the Company's divisions has allowed for the expansion of business with only minimal additions to personnel and other fixed costs over the past year.

Management believes that significant additional capacity exists before most divisions would be obliged to incur meaningful increases in personnel or other fixed costs. Ceding allowances totaled $3.1 million for the 2005 quarter compared to $5.2 million for the 2004 quarter. The ratio of consolidated other operating expenses to operating revenue was 18.6% during each of the 2005 and 2004 first quarters.

The effective federal tax rate for consolidated operations for the first quarter of 2005 was 33.2% and is less than the statutory rate primarily because of tax exempt investment income.

As a result of the factors mentioned above, net income decreased $.6 million (5.1%) during the first quarter of 2005 as compared with the 2004 first quarter.

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