10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2006
or
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                                 to

Commission File Number  001-09463

RLI CORP.

(Exact name of registrant as specified in its charter)

Illinois	37-0889946
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
9025 North Lindbergh Drive, Peoria, Illinois	61615
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code (309) 692-1000

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name of each exchange on which registered
Common Stock $1.00 par value	New York Stock Exchange

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  x No  o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.

Yes  o No  x

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  x No  o

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.                                                                           x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  x Accelerated filer  o Non-accelerated filer  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o No  x

The aggregate market value of the registrant’s common stock held by non-affiliates of the Registrant as of June 30, 2006, based upon the closing sale price of the Common Stock on June 30, 2006 as reported on the New York Stock Exchange, was $1,011,588,725.  Shares of Common Stock held directly or indirectly by each officer and director along with shares held by the Company ESOP have been excluded in that such persons may be deemed to be affiliates.  This determination of affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares outstanding of the Registrant’s Common Stock, $1.00 par value, on February 23, 2007 was 24,084,305.

DOCUMENTS INCORPORATED BY REFERENCE.

Portions of the 2006 Financial Report to Shareholders for the past year ended December 31, 2006, are incorporated by reference into Parts I and II of this document.

Portions of the Registrant’s definitive Proxy Statement for the 2007 annual meeting of security holders to be held May 3, 2007, are incorporated herein by reference into Part III of this document.

Exhibit index is located on pages 51-52 of this document, which lists documents incorporated by reference herein.

PART I

Item 1.  Business

RLI Corp. underwrites selected property and casualty insurance through major subsidiaries collectively known as RLI Insurance Group.  We conduct operations principally through three insurance companies. RLI Insurance Company, our principal subsidiary, writes multiple lines insurance on an admitted basis in all 50 states, the District of Columbia and Puerto Rico. Mt. Hawley Insurance Company, a subsidiary of RLI Insurance Company, writes surplus lines insurance in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. RLI Indemnity Company, a subsidiary of Mt. Hawley Insurance Company, has authority to write multiple lines of insurance on an admitted basis in 49 states and the District of Columbia.  We are an Illinois corporation that was organized in 1965.  We have no material foreign operations.

We maintain an Internet website at http://www.rlicorp.com. We make available free of charge on our website our annual report on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed with or furnished to the Securities and Exchange Commission as soon as reasonably practicable after such materials are filed.

As a “niche” company, we offer specialty insurance coverages designed to meet specific insurance needs of targeted insured groups and underwrite particular types of coverage for certain markets that are underserved by the insurance industry, such as our commercial earthquake coverage and oil and gas surety bonds. We also provide types of coverages not generally offered by other companies, such as our stand-alone personal umbrella policy. The excess and surplus market, which unlike the standard admitted market is less regulated and more flexible in terms of policy forms and premium rates, provides an alternative market for customers with hard-to-place risks. When we underwrite within the surplus lines market, we are selective in the line of business and type of risks we choose to write.  Using our non-admitted status in this market allows us to tailor terms and conditions to manage these exposures more effectively than our admitted counterparts. Often the development of these specialty insurance coverages is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients. Once a proposal is submitted, underwriters determine whether it would be a viable product in keeping with our business objectives.

We initially wrote specialty property and casualty insurance through independent underwriting agents. We opened our first branch office in 1984, and began to shift from independent underwriting agents to wholly-owned branch offices that market to wholesale producers. We also market certain coverages to retail producers from several of our casualty, surety and property operations. We produce a limited amount of business under agreements with managing general agents under the direction of our product vice presidents. The majority of business is marketed through our branch offices located in Phoenix, Arizona; Los Angeles, California; Oakland, California; San Francisco, California; Glastonbury, Connecticut; Sarasota, Florida; Atlanta, Georgia; Alpharetta, Georgia; Honolulu, Hawaii; Chicago, Illinois; Peoria, Illinois; Indianapolis, Indiana; Boston, Massachusetts; Kansas City, Missouri; St. Louis, Missouri;  Lincoln, Nebraska; Montvale, New Jersey; Summit, New Jersey; New York, New York; Saratoga Springs, New York; Cleveland, Ohio; Philadelphia, Pennsylvania; Pittsburgh, Pennsylvania; Dallas, Texas; Houston, Texas; and Seattle, Washington.

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For the year ended December 31, 2006, the following table provides the geographic distribution of our risks insured as represented by direct premiums earned for all coverages. For the year ended December 31, 2006, no other state or territory accounted for 1.5 percent or more of total direct premiums earned for all coverages.

State	Direct Premiums Earned		Percent of Total
	(in thousands)
California	$	147,585	18.7	%
New York	110,261		14.0	%
Florida	109,146		13.8	%
Texas	72,824		9.2	%
New Jersey	32,486		4.1	%
Illinois	24,107		3.1	%
Washington	19,869		2.5	%
Pennsylvania	18,658		2.4	%
Georgia	15,673		2.0	%
Hawaii	15,205		1.9	%
Massachusetts	13,528		1.7	%
Michigan	13,346		1.7	%
Arizona	12,678		1.6	%
Tennessee	12,154		1.5	%
Ohio	11,934		1.5	%
All Other	159,450		20.3	%
Total direct premiums	$	788,904	100.0	%

In the ordinary course of business, we rely on other insurance companies to share risks through reinsurance. A large portion of the reinsurance is put into effect under contracts known as treaties and, in some instances, by negotiation on each individual risk (known as facultative reinsurance). We have quota share, excess of loss and catastrophe reinsurance contracts that protect against losses over stipulated amounts arising from any one occurrence or event. The arrangements allow us to pursue greater diversification of business and serve to limit the maximum net loss on catastrophes and large risks. Reinsurance is subject to certain risks, specifically market risk, which affects the cost of and the ability to secure these contracts, and collection risk, which is the risk that our reinsurers may not pay on losses in a timely fashion or at all. The following table illustrates, through premium volume, the degree to which we have utilized reinsurance during the past three years. For an expanded discussion of the impact of reinsurance on our operations, see Note 5 to our audited consolidated financial statements included in our 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.

Premiums Written	Year Ended December 31,
(in thousands)	2006			2005			2004
Direct & Assumed	$	799,013		$	756,012		$	752,588
Reinsurance ceded	(247,477		)	(261,447		)	(241,376		)
Net	$	551,536		$	494,565		$	511,212

Specialty Insurance Market Overview

The specialty insurance market differs significantly from the standard market. In the standard market, insurance rates and forms are highly regulated, products and coverage are largely uniform with relatively predictable exposures, and companies tend to compete for customers on the basis of price. In contrast, the specialty market provides coverage for risks that do not fit the underwriting criteria of the standard carriers. Competition tends to focus less on price and more on availability, service and other value-based considerations. While specialty market exposures may have higher insurance risks than their standard market counterparts, we manage these risks to achieve higher financial returns. To reach our financial and operational goals, we must have extensive knowledge and expertise in our markets. Most of our risks are considered on an individual basis and restricted limits, deductibles, exclusions and surcharges are employed in order to respond to distinctive risk characteristics.

We operate in the excess and surplus insurance market and the specialty admitted insurance market.

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Excess and Surplus Insurance Market

The excess and surplus market focuses on hard-to-place risks. Excess and surplus eligibility allows our insurance subsidiaries to underwrite nonstandard market risks with more flexible policy forms and unregulated premium rates. This typically results in coverages that are more restrictive and more expensive than in the standard admitted market. The excess and surplus lines regulatory environment and production model also effectively filters submission flow and matches market opportunities to our expertise and appetite.  The excess and surplus market represented approximately $28 billion, or 6 percent, of the entire $489 billion domestic property and casualty industry, as measured by direct premiums written. For 2006, our excess and surplus operation wrote gross premiums of $449.1 million representing approximately 56 percent of our total gross premiums written for the period.

Specialty Admitted Insurance Market

We also write business in the specialty admitted market. Most of these risks are unique and hard to place in the standard market, but for marketing and regulatory reasons, they must remain with an admitted insurance company. The specialty admitted market is subject to greater state regulation than the excess and surplus market, particularly with regard to rate and form filing requirements, restrictions on the ability to exit lines of business, premium tax payments and membership in various state associations, such as state guaranty funds and assigned risk plans. For 2006, our specialty admitted operations wrote gross premiums of $349.9 million representing approximately 44 percent of our total gross premiums written for the year.

Business Segment Overview

Our segment data is derived using the guidance set forth in Statement of Financial Accounting Standards (SFAS) 131, “Disclosures about Segments of an Enterprise and Related information.”  As prescribed by the pronouncement, reporting is based on the internal structure and reporting of information as it is used by management.  The segments of our insurance operations include property, casualty, and surety.  For additional information, see Note 11 to our audited consolidated financial statements included in our 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.

Casualty Segment

General Liability

Our general liability business consists primarily of coverage for third party liability of commercial insureds including manufacturers, contractors, apartments and mercantile. Net premiums earned from this business totaled $180.0 million, $180.3 million and $175.0 million, or 28 percent, 32 percent, and 30 percent of consolidated revenues for 2006, 2005, and 2004, respectively.

Commercial and Personal Umbrella Liability

Our commercial umbrella coverage is principally written in excess of primary liability insurance provided by other carriers and, to a modest degree, in excess of primary liability written by us. The personal umbrella coverage is written in excess of the homeowners and automobile liability coverage provided by other carriers, except in Hawaii, where some underlying homeowners coverage is written by us. Net premiums earned from this business totaled $64.7 million, $59.8 million and $53.5 million, or 10 percent, 11 percent, and 9 percent of consolidated revenues for 2006, 2005, and 2004, respectively.

Executive Products

We sell financial coverages, such as directors’ and officers’ (D&O) liability and other miscellaneous professional liability, for a variety of low to moderate classes of risks. Events affecting the economy over the past few years resulted in several insurers ceasing to write D&O coverage, which created an opportunity to raise rates significantly and reduce exposures. This situation rapidly changed in early 2004 with the return of price competition, particularly in the large account sector.  As a consequence, we shifted our focus to smaller accounts.  Our target accounts include publicly traded companies with market capitalization below $5 billion (where we are writing part of the traditional D&O program), Clause 1 (also known as “Side A” coverage) opportunities for investment-grade publicly traded companies, private companies, nonprofit organizations, and sole-sponsored and multi-employer fiduciary liability accounts.  We are currently successfully transitioning from primarily writing high layers of excess D&O for publicly traded companies to writing more Clause 1 coverage.  Additionally, we are having success rounding out our portfolio by writing more fiduciary liability coverage, primary and excess D&O coverage for private companies and non-profit organizations.  Net premiums earned from this business totaled $13.0 million, $9.8 million, and $13.1 million, or 2 percent of consolidated revenues for 2006, 2005, and 2004.

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Specialty Program Business

We offer program business in a variety of areas.  Our program coverages include: commercial property, general liability, inland marine, and crime. Often, these coverages are combined into a package or portfolio policy. We have recently moved to a strategy of bringing most risk underwriting “in house” while continuing to rely upon program administrators for policy servicing and sales. We continue to develop new programs for a variety of affinity groups.  Net premiums earned from this business totaled $25.5 million, $38.3 million, and $47.1 million for 2006, 2005, and 2004, respectively. These amounts represent 4 percent, 7 percent, and 8 percent of consolidated revenues for 2006, 2005, and 2004, respectively.

Commercial Transportation

Our transportation insurance facility in Atlanta provides automobile liability and physical damage insurance to local, intermediate and long haul truckers, public transportation risks and equipment dealers. In early 2005, we expanded our focus to include other types of commercial automobile risks. We also offer incidental, related insurance coverages, including general liability, commercial umbrella and excess liability, and motor truck cargo. The facility is staffed by highly experienced transportation underwriters who produce business through independent agents and brokers nationwide. Net premiums earned from this business totaled $48.3 million, $51.7 million, and $56.0 million, or 8 percent, 9 percent, and 10 percent of consolidated revenues for 2006, 2005, and 2004, respectively.

Other

We offer a variety of other smaller programs in our casualty segment, including deductible buy-back, at-home business, and employer’s excess indemnity. Net premiums earned from these lines totaled $16.6 million, $19.0 million, and $20.9 million, or 3 percent, 3 percent, and 4 percent of consolidated revenues for 2006, 2005, and 2004, respectively.

Property Segment

Commercial and Construction

Our commercial property coverage consists primarily of excess and surplus lines and specialty insurance such as fire, earthquake and “difference in conditions,” which can include earthquake, wind, flood and collapse coverages, and inland marine.  We provide insurance for a wide range of commercial and industrial risks, such as office buildings, apartments, condominiums, and certain industrial and mercantile structures. We also write boiler and machinery coverage under the same management as commercial property.  Net premiums earned from commercial property business totaled $91.5 million, $66.4 million, and $69.2 million, or 14 percent, 11.5 percent, and 12 percent of consolidated revenues for 2006, 2005, and 2004, respectively.

In late 2005, we began to exit the retail construction market, due to continued poor performance in this line.  We have continued to wind down this coverage through 2006, which we expect to complete in 2007.  In 2006, 2005, and 2004, construction net premiums earned totaled $4.5 million, $2.5 million, and $21.6 million, or 1 percent, 0.5 percent, and 4 percent, respectively, of consolidated revenues.

Marine

In 2005, we launched a new marine operation serving the marine business marketplace.  The focus of this operation is on “brown water” ocean marine (near shore, river and Great Lakes) coverages including hull, cargo and P&I.  This unit continues to meet expectations and has expanded its reach to a limited number of inland marine coverages including builder’s risk and contractors’ equipment.  In 2006 and 2005, marine net premiums earned totaled $16.8 million and $3.3 million, or 3 percent and 1 percent, respectively, of consolidated revenues.

Other

We offer a limited amount of homeowners and dwelling fire insurance in Hawaii.  Recently, we have curtailed our wind exposure through a more restrictive policy, which limits wind coverage on new business.  Net premiums earned from this business totaled $9.8 million, $8.3 million, and $7.2 million, or 2 percent, 1 percent, and 1 percent of consolidated revenues for 2006, 2005, and 2004, respectively.

Surety Segment

Our surety segment specializes in providing coverage for individuals, contractors, small business owners, small to large

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corporations, and businesses operating in the energy, petrochemical and refining industries. We also offer miscellaneous and contract surety bonds, including fidelity and court sureties.  These bonds are written through independent agencies as well as regional and national brokers. Net earned premium totaled $59.5 million, $51.9 million, and $47.7 million, or 9 percent, 9 percent and 8 percent of consolidated revenues for 2006, 2005, and 2004, respectively.

Competition

Our specialty property and casualty insurance subsidiaries are part of an extremely competitive industry that is cyclical and historically characterized by periods of high premium rates and shortages of underwriting capacity followed by periods of severe competition and excess underwriting capacity. Within the United States alone, approximately 2,400 companies, both stock and mutual, actively market property and casualty coverages. Our primary competitors in our casualty segment are, among others, AIG, St. Paul/Travelers, Scottsdale Insurance, Lexington Insurance Company, General Star, CNA, Chubb, and Great West Casualty Company. Our primary competitors in our property segment are, among others, Lexington Insurance Company, ARCH Insurance Company, General Star, Philadelphia Insurance, Markel, and St. Paul/Travelers. Our primary competitors in our surety segment are, among others, North American Specialty Insurance Co., CNA Surety, and St. Paul/Travelers. Many of these competitors have significantly more financial and other resources than RLI.  The combination of coverages, service, pricing and other methods of competition vary from line to line. Our principal methods of meeting this competition are innovative coverages, marketing structure and quality service to the agents and policyholders at a fair price. We compete favorably in part because of our sound financial base and reputation, as well as our broad geographic penetration into all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. In the property and casualty area, we have acquired experienced underwriting specialists in our branch and home offices. We have continued to maintain our underwriting and marketing standards by not seeking market share at the expense of earnings. We have a track record of withdrawing from markets when conditions become overly adverse. We offer new coverages and new programs where the opportunity exists to provide needed insurance coverage with exceptional service on a profitable basis.

Ratings

A.M. Best ratings for the industry range from “A++” (Superior) to “F” (In Liquidation) with some companies not being rated. Standard & Poor’s ratings for the industry range from “AAA” (Superior) to “R” (Regulatory Action). Moody’s ratings for the industry range from “Aaa” (Exceptional) to “C” (Lowest).  The following table illustrates the range of ratings assigned by each of the three major rating companies that has issued a financial strength rating on our insurance companies:

A.M. Best		Standard & Poor’s		Moody’s
SECURE		SECURE		STRONG
A++, A+	Superior	AAA	Extremely strong	Aaa	Exceptional
A,A-	Excellent	AA	Very strong	Aa	Excellent
B++, B+	Very good	A	Strong	A	Good
		BBB	Good	Baa	Adequate
VULNERABLE		VULNERABLE		WEAK
B,B-	Fair	BB	Marginal	Ba	Questionable
C++,C+	Marginal	B	Weak	B	Poor
C,C-	Weak	CCC	Very weak	Caa	Very poor
D	Poor	CC	Extremely weak	Ca	Extremely poor
E	Under regulatory supervision	R	Regulatory action	C	Lowest
F	In liquidation
S	Rating suspended
Within-category modifiers		+,-		1,2,3 (1 high, 3 low)

Publications of A.M. Best,  Standard & Poor’s and Moody’s indicate that “A” and “A+” ratings are assigned to those companies that, in their opinion, have achieved excellent overall performance when compared to the standards established by these firms and have a strong ability to meet their obligations to policyholders over a long period of time. In evaluating a company’s financial and operating performance, each of the firms reviews the company’s profitability, leverage and liquidity, as well as the company’s spread of risk, the quality and appropriateness of its reinsurance, the quality and diversification of its assets, the adequacy of its policy and loss reserves, the adequacy of its surplus, its capital structure, its risk

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management practices and the experience and objectives of its management. These ratings are based on factors relevant to policyholders, agents, insurance brokers and intermediaries and are not directed to the protection of investors.

At December 31, 2006, the following ratings were assigned to our insurance companies:

A.M. Best
RLI Insurance, Mt. Hawley Insurance, and	A+, Superior
RLI Indemnity (RLI Group)
Standard & Poor's
RLI Insurance and Mt. Hawley Insurance	A+, Strong
Moody's
RLI Insurance, Mt. Hawley Insurance and
RLI Indemnity	A2, Good

For A.M Best, Standard & Poor’s and Moody’s, the financial strength ratings represented above are affirmations of previously assigned ratings.  A.M. Best, in addition to assigning a financial strength rating, also assigns financial size categories.  During 2006, RLI Insurance Company, Mt. Hawley Insurance Company and RLI Indemnity Company, collectively referred to as RLI Group, were assigned a financial size category of “X” (adjusted policyholders’ surplus of between $500 and $750 million).  As of December 31, 2006, the policyholders’ surplus of RLI Group reached $746.9 million.

RLI Corp’s existing $100 million of senior notes maturing in 2014 maintains a Standard & Poor’s rating of  “BBB+”, Moody’s “Baa2”, and an A.M. Best rating of “A-.”

Reinsurance

We reinsure a significant portion of our property and casualty insurance exposure, paying or ceding to the reinsurer a portion of the premiums received on such policies. Earned premiums ceded to non-affiliated reinsurers totaled $265 million, $248 million and $242 million in 2006, 2005, and 2004, respectively. Insurance is ceded principally to reduce net liability on individual risks and to protect against catastrophic losses. Although reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, it does make the assuming reinsurer liable to the insurer to the extent of the insurance ceded.

We attempt to purchase reinsurance from a limited number of financially strong reinsurers. Retention levels are adjusted each year to maintain a balance between the growth in surplus and the cost of reinsurance. Each of the top 10 largest reinsurers (listed below and ranked based on amounts recoverable) are rated “A-” or better by A.M. Best and Standard and Poor’s rating services. Additionally, over 94 percent of our reinsurance recoverables are due from companies rated “A-” or better by A.M. Best and Standard & Poor’s rating services.

The following table sets forth the ten largest reinsurers in terms of amounts recoverable, net of collateral we are holding from such reinsurers, as of December 31, 2006. Also shown are the amounts of written premium ceded to these reinsurers during the calendar year 2006.

			Net Reinsurer				Ceded
	A.M. Best	S & P	Exposure as of		Percent of		Premiums		Percent of
(dollars in thousands)	Rating	Rating	12/31/2006		Total		Written		Total
Munich Re America	A	A-	$	136,069	23.2	%	$	24,773	10.0	%
General Rein Corp	A++	AAA	55,704		9.5	%	2,797		1.1	%
Swiss Reinsurance	A+	AA-	44,693		7.6	%	12,565		5.1	%
Berkley Insurance Company	A	A+	36,397		6.2	%	18,193		7.4	%
Lloyds of London	A	A	32,525		5.6	%	20,262		8.2	%
Endurance Reinsurance Corp.	A-	A	30,275		5.2	%	19,398		7.8	%
Toa-Re	A	A+	30,014		5.1	%	13,288		5.4	%
Employers Reinsurance Corp.	A+	AA-	25,473		4.3	%	1,639		0.7	%
Everest Reinsurance	A+	AA-	24,870		4.2	%	16,379		6.6	%
Liberty Mutual Insurance	A	A	20,780		3.5	%	1,278		0.5	%
All other reinsurers			149,573		25.6	%	116,905		47.2	%
Total ceded exposure			$	586,373	100.0	%	$	247,477	100.0	%

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Reinsurance is subject to certain risks, specifically market risk (which affects the cost of and the ability to secure reinsurance contracts) and collection risk (which relates to the ability to collect from the reinsurer on our claims). Much of our reinsurance is purchased on an excess of loss basis. Under an excess of loss arrangement, we retain losses on a risk up to a specified amount and the reinsurers assume any losses above that amount. It is common to find conditions in excess of loss covers such as occurrence limits, aggregate limits and reinstatement premium charges.

We analyze our reinsurance covers in conjunction with our three segments: property, casualty and surety.

In the property segment, the reinsurance structure is divided into three categories: commercial property, catastrophe earthquake and catastrophe other than earthquake which could include such events as hurricanes, windstorm, hailstorms, explosions, severe winter weather, fires, etc.

Commercial Property Reinsurance

We utilize both treaty and facultative coverage for our property risks. Treaty coverage refers to a reinsurance contract that is applied to a group or class of business where all the risks written meet the criteria for that class.  Facultative coverage is applied to individual risks as opposed to a group or class of business. It is used for a variety of reasons including supplementing the limits provided by the treaty coverage or covering risks or perils excluded from treaty reinsurance.

In 2007, for most risks, we retain the first $1.0 million in losses.  Reinsurance covers the following:

·85% of the next $4.0 million in losses (we retain 15% of that $4.0 million); and

·100% of the next $5.0 million in losses — bringing our total retention to $1.6 million.

In 2006, for most risks, we retained the first $1.0 million in losses.  Reinsurance then covered the following:

·75% of the next $4.0 million in losses (we retained 25% of that $4.0 million); and

·100% of the next $5.0 million in losses — bringing our total retention to $2.0 million

In 2005, for most risks, we retained the first $0.5 million in losses.  Reinsurance then covered the following:

·100% of the next $0.5 million in losses;

·85% of the next $4.0 million in losses (we retained 15% of that $4.0 million); and

·100% of the next $5.0 million in losses — bringing our total retention to $1.1 million.

Property Reinsurance- Catastrophe (CAT) Coverage

Our property catastrophe reinsurance reduces the financial impact a catastrophe could have on our property segment.  Catastrophes involve multiple claims and policyholders.  Over the three years presented, CAT premium costs increased as additional limits were purchased.  For 2007, we purchased an additional $50.0 million in limit, bringing our total limit up to $500.0 million from $450.0 million.  Our cost for catastrophe reinsurance for 2007 increased approximately 26% over 2006.  We also purchased an additional $50.0 million in catastrophe reinsurance in 2006, bringing our total limits in 2006 to $450.0 million.  In 2005, an additional $25.0 million in limit was added, bringing the total limit to $400.0 million for that year.  These CAT limits are in addition to the per-occurrence coverage provided by facultative and treaty coverages.

Our property catastrophe program continues to be on an excess of loss basis.   It attaches after all other reinsurance has been considered.   Although covered in one program, limits and attachment points differ for California earthquakes and all other perils. The following charts use information from our catastrophe modeling software to illustrate our net retention resulting from particular events that would generate the listed levels of gross losses:

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Catastrophe - - California Earthquake

(in thousands)

	2007				2006				2005
Projected	Ceded		Net		Ceded		Net		Ceded		Net
Gross Loss	Losses		Losses		Losses		Losses		Losses		Losses
$50,000	$	6,000	$	44,000	$	6,000	$	44,000	$	30,000	$	20,000
100,000	53,000		47,000		53,000		47,000		68,000		32,000
250,000	187,000		63,000		176,000		74,000		202,000		48,000
500,000	417,000		83,000		385,000		115,000		390,000		110,000

Catastrophe - - Wind

(in thousands)

	2007				2006				2005
Projected	Ceded		Net		Ceded		Net		Ceded		Net
Gross Loss	Losses		Losses		Losses		Losses		Losses		Losses
$10,000	$	2,000	$	8,000	$	2,000	$	8,000	$	2,000	$	8,000
50,000	29,000		21,000		41,000		9,000		40,000		10,000
100,000	75,000		25,000		82,000		18,000		80,000		20,000
250,000	206,000		44,000		206,000		44,000		206,000		44,000

These tables were generated using theoretical probabilities of events occurring in areas where our portfolio of currently in-force policies could generate the level of loss shown. Actual results could vary significantly from these tables as the actual nature or severity of a particular event cannot be predicted with any reasonable degree of accuracy.

Our catastrophe program includes one prepaid reinstatement for the first two layers of coverage for a catastrophe other than California earthquake.  A reinstatement must be purchased for the remaining limits.  For a California earthquake, there is a prepaid reinstatement for the $50.0 million excess $50.0 million layer (placed at 92%) and a reinstatement must be purchased for the remaining limits.

Casualty Reinsurance

Our 2007 casualty reinsurance includes both excess of loss treaties and quota share treaties, as was the case in 2006, and 2005.  With respect to our 2007 Combined Casualty Treaty, we retain between $0.9 million and $2.0 million of the full losses, depending on type of policy or risk.  This was also the case in 2006.  In 2005, we retained between $0.6 and $1.8 million of the full losses.  For our Executive Products Group (EPG) coverage, our maximum retained loss on a policy in 2007 will not exceed $4.0 million.  In 2006 and 2005, our maximum retained loss on any EPG policy was $3.0 million.  Over the three years presented, casualty reinsurance rates have been fairly stable.

Surety Reinsurance

Our surety reinsurance treaty is on an excess of loss basis for 2007, as it was in 2006 and 2005.  Under the current treaty, we retain the first $1.0 million in loss (as was the case in 2006 and 2005).  Reinsurance covers the following:

·100% of the next $4.0 million in losses;

·90% of the next $10.0 million in losses, we retain 10%; and

·50% of the next $10.0 million in losses, we retain 50%.

Our maximum net loss for any one principal will not exceed $7.0 million.   For most risks, our net loss does not exceed $2.0 million.

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Catastrophe Management

We continuously monitor and quantify our exposure to catastrophes, including earthquakes, hurricanes, terrorist acts, and other catastrophic events.  In the normal course of business, we manage our concentrations of exposures to catastrophic events, primarily by limiting concentrations of exposure to acceptable levels, and by purchasing reinsurance.  We use third party catastrophe exposure models and internally developed analysis to assess each risk and ensure we include an appropriate charge for assumed catastrophe risks.  For the application of the catastrophe exposure models, exposure and coverage detail is recorded for each risk location. Catastrophe exposure modeling is inherently uncertain due to the model’s reliance on a large number of data points, increasing the importance of capturing accurate policy coverage data.  The model results are used both in the underwriting analysis of individual risks, and at a corporate level for the aggregate book of catastrophe-exposed business. From both perspectives, we consider the potential loss produced by individual events that represent moderate-to-high loss potential at varying return periods and magnitudes. In calculating potential losses, we select appropriate assumptions, including but not limited to loss amplification and storm surge.  We establish risk tolerances at the portfolio level based on market conditions, the level of reinsurance available, changes to the assumptions in the catastrophe models, rating agency constraints, underwriting guidelines and coverages, and internal preferences.  Our risk tolerances for each type of catastrophe, and for all perils in aggregate, change over time as these internal and external conditions change.

Marketing and Distribution

We distribute our coverages primarily through branch offices throughout the country that market to wholesale and retail brokers and through independent agents.  We also market through agencies and more recently through e-commerce channels.

Broker Business

The largest volume of broker-generated premium is in our commercial property, general liability, commercial surety, commercial umbrella and commercial automobile coverages. This business is produced through wholesale and retail brokers who are not affiliated with us.

Independent Agent Business

Our surety segment offers its business through a variety of independent agents. Additionally, we write program business, such as at-home business and personal umbrella, through independent agents. Homeowners and dwelling fire is produced through independent agents in Hawaii. Each of these programs involves detailed eligibility criteria, which are incorporated into strict underwriting guidelines, and prequalification of each risk using a system accessible by the independent agent. The independent agent cannot bind the risk unless they receive approval through our system.

Underwriting Agents

We contract with certain underwriting agencies who have limited authority to bind or underwrite business on our behalf. These agencies may receive some compensation through contingent profit commission.

E-commerce

We are actively employing e-commerce to produce and efficiently process and service business, including package policies for limited service motel/hotel operations, restaurant/bar/tavern operations and at-home businesses, small commercial and personal umbrella risks,  earthquake property coverage and surety bonding.

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Environmental, Asbestos, and Mass Tort Exposures

We are subject to environmental site cleanup, asbestos removal, and mass tort claims and exposures through our commercial umbrella, general liability, and discontinued assumed reinsurance lines of business.  The majority of the exposure is in the excess layers of our commercial umbrella and assumed reinsurance books of business.

The following table represents inception-to-date paid and unpaid environmental claims data (including incurred but not reported losses) for the periods ended 2006, 2005, and 2004:

	Inception-to-date at
	December 31,
(dollars in thousands)	2006			2005			2004
Loss and Loss Adjustment
Expense (LAE) payments
Gross	$	53,323		$	46,685		$	44,360
Ceded	(29,853		)	(26,888		)	(25,590		)
Net	$	23,470		$	19,797		$	18,770
Unpaid losses and LAE at end of year
Gross	$	48,541		$	47,391		$	43,716
Ceded	(25,720		)	(30,950		)	(28,998		)
Net	$	22,821		$	16,441		$	14,718

Our environmental, asbestos, and mass tort exposure is limited, relative to that of other insurers, as a result of entering the affected liability lines after the insurance industry had already recognized environmental and asbestos exposure as a problem and adopted appropriate coverage exclusions. During 2006, we reviewed our reserves for these exposures relative to industry benchmarks and re-evaluated its emergence patterns. As a result, net reserves for these exposures were increased $6.4 million. Other significant activity during 2006 was payment for the settlement of a large claim associated with a Superfund site. The claim arose out of commercial umbrella business written in the early 1980s. Gross payments of $4.0 million and net payments of $2.1 million for this claim caused the majority of the 2006 increase, reflected in the table above. This claim had no effect on 2006 incurred losses, however, because an adequate case reserve estimate had been established for it in 2004.

While our environmental exposure is limited, the ultimate liability for this exposure is difficult to assess because of the extensive and complicated litigation involved in the settlement of claims and evolving legislation on such issues as joint and several liability, retroactive liability, and standards of cleanup. Additionally, we participate primarily in the excess layers of coverage, where accurate estimates of ultimate loss are more difficult to derive than for primary coverage.

Losses and Settlement Expenses

Overview

Loss and loss adjustment expense reserves represent our best estimate of ultimate amounts for losses and related settlement expenses from claims that have been reported but not paid, and those losses that have occurred but have not yet been reported to us.  Loss reserves do not represent an exact calculation of liability, but instead represent our estimates, generally utilizing individual claim estimates and actuarial expertise and estimation techniques at a given accounting date.  The loss reserve estimates are expectations of what ultimate settlement and administration of claims will cost upon final resolution.  These estimates are based on facts and circumstances then known to us, review of historical settlement patterns, estimates of trends in claims frequency and severity, projections of loss costs, expected interpretations of legal theories of liability, and many other factors.  In establishing reserves, we also take into account estimated recoveries, reinsurance, salvage, and subrogation.  The reserves are reviewed regularly by a team of actuaries we employ with periodic review by outside independent actuarial firms.

The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables.  These variables can be affected by both internal and external events, such as changes in claims handling procedures, claim personnel, economic inflation, legal trends, and legislative changes, among others.  The impact of many of these items on ultimate costs for loss and loss adjustment expense is difficult to estimate.  Loss reserve estimations also differ significantly by coverage due to differences in claim complexity, the volume of claims, the policy limits written, the terms and conditions of

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the underlying policies, the potential severity of individual claims, the determination of occurrence date for a claim, and

reporting lags (the time between the occurrence of the policyholder events and when it is actually reported to the insurer).  Informed judgment is applied throughout the process.  We continually refine our loss reserve estimates as historical loss experience develops and additional claims are reported and settled.  We rigorously attempt to consider all significant facts and circumstances known at the time loss reserves are established.

Due to inherent uncertainty underlying loss reserve estimates, including but not limited to the future settlement environment, final resolution of the estimated liability will be different from that anticipated at the reporting date.  Therefore, actual paid losses in the future may yield a materially different amount than currently reserved — favorable and unfavorable.

The amount by which estimated losses differ from those originally reported for a period is known as “development”.  Development is unfavorable when the losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims.  Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims.   We reflect favorable or unfavorable developments of loss reserves in the results of operations in the period the estimates are changed.

We record two categories of loss and loss adjustment expense reserves — case-specific reserves and incurred but not reported (IBNR) reserves.

Within a reasonable period of time after a claim is reported, our claim department completes an initial investigation and establishes a case reserve.  This case-specific reserve is an estimate of the ultimate amount we will have to pay for the claim, including related legal expenses and other costs associated with resolving and settling a particular claim.  The estimate reflects all of the current information available regarding the claim, the informed judgment of our professional claim personnel, our reserving practices and experience, and the knowledge of such personnel regarding the nature and value of the specific type of claim.  During the life cycle of a particular claim, more information may materialize that causes us to revise the estimate of the ultimate value of the claim either upward or downward.   We may determine that it is appropriate to pay portions of the reserve to the claimant or related settlement expenses before final resolution of the claim.  The amount of the individual claim reserve will be adjusted accordingly and is based on the most recent information available.

 We establish Incurred But Not Reported (IBNR) reserves to estimate the amount we will have to pay for claims that have occurred, but have not yet been reported to us; claims that have been reported to us that may ultimately be paid out differently than expected by our case-specific reserves; and claims that have been paid and closed, but may reopen and require future payment.

Our IBNR reserving process involves three steps including an initial IBNR generation process that is prospective in nature; a loss and loss adjustment expense reserve estimation process that occurs retrospectively; and a subsequent discussion and reconciliation between our prospective and retrospective IBNR estimates which includes changes in our provisions for IBNR where deemed appropriate.  These three processes are discussed in more detail in the following sections.

Loss adjustment expense (LAE) represents the cost involved in adjusting and administering losses from policies we sold.  The LAE reserves are frequently separated into two components: allocated and unallocated.  Allocated loss adjustment expense (ALAE) reserves represent an estimate of claims settlement expenses that can be identified with a specific claim or case.  Examples of ALAE would be the hiring of an outside adjuster to investigate a claim or an outside attorney to defend our insured. The claims professional typically estimates this cost separately from the loss component in the case reserve.  Unallocated loss adjustment expense (ULAE) reserves represent an estimate of claims settlement expenses that cannot be identified with a specific claim.   An example of ULAE would be the cost of an internal claims examiner to manage or investigate a reported claim.

All decisions regarding our best estimate of ultimate loss and LAE reserves are made by our Loss Reserve Committee (LRC).  The LRC is made up of the management team including the chief executive officer, chief operating officer, chief financial officer, chief actuary, vice president of claims, vice president of underwriting, and other selected executives.

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Loss and loss adjustment reserves by product line at year-end 2006 and 2005 were as follows:

(as of December 31, in $millions)	2006						2005
Product Line	Case		IBNR		Total		Case		IBNR		Total
Casualty segment loss and ALAE reserves
Commercial umbrella	$	12,513	$	49,667	$	62,180	$	15,038	$	41,730	$	56,768
Personal umbrella	20,771		34,010		54,781		16,159		30,759		46,918
General liability	78,290		251,287		329,577		69,612		220,645		290,257
Transportation	60,725		21,911		82,636		59,260		20,448		79,708
Executive products	5,645		27,229		32,874		8,495		27,382		35,877
Other casualty	25,075		57,676		82,751		31,952		65,698		97,650
Property segment loss and ALAE reserves
Difference in conditions	648		6,250		6,898		1,057		6,240		7,297
Marine	4,942		4,374		9,316		987		366		1,353
Other property	31,846		17,165		49,011		29,218		22,954		52,172
Surety segment loss and ALAE reserves	2,828		28,298		31,126		1,631		25,275		26,906
Latent liability loss and ALAE reserves	10,754		12,068		22,822		10,300		6,100		16,400
Total loss and ALAE reserves	254,037		509,935		763,972		243,709		467,597		711,306
ULAE reserves	—		29,134		29,134		—		27,351		27,351
Total loss and LAE reserves	$	254,037	$	539,069	$	793,106	$	243,709	$	494,948	$	738,657

We do not use discounting (recognition of the time value of money) in reporting our estimated reserves for losses and settlement expenses.   Based on current assumptions used in calculating reserves, we believe that our overall reserve levels at December 31, 2006, make a reasonable provision to meet our future obligations.

Initial IBNR Generation Process

Initial carried IBNR reserves are determined through a reserve generation process.   The intent of this process is to establish an initial total reserve that will provide a reasonable provision for the ultimate value of all unpaid loss and allocated loss adjustment expense liabilities.  For most casualty and surety products, this process involves the use of an initial loss and ALAE ratio that is applied to the earned premium for a given period.  The result is our best initial estimate of the expected amount of ultimate loss and ALAE for the period by product.  Paid and case reserves are subtracted from this initial estimate of ultimate loss and ALAE to determine a carried IBNR reserve.

For most property products, we use an alternative method of determining an appropriate provision for initial IBNR.  Since this segment is characterized by a shorter period of time between claim occurrence and claim settlement, the IBNR reserve is determined by an initial loss percentage applied to the rolling twelve month’s premium earned.  No deductions for paid or case reserves are made.  This alternative method of determining initial IBNR reacts more quickly to the actual loss emergence and is more appropriate for our property products where final claim resolution occurs quickly.

The initial loss and ALAE ratios that are applied to earned premium are reviewed at least semi-annually.  Prospective estimates are made based on historical loss experience adjusted for price change and loss cost inflation.  The initial loss and ALAE ratios also reflect estimation risk.  We consider estimation risk by segment and product line.  A segment with greater overall volatility and uncertainty has greater estimation risk.  Characteristics of segments and products with higher estimation risk, include those exhibiting, but not limited to, the following characteristics:

·              significant changes in underlying policy terms and conditions,

·              consisting of a new business,

·              undergoing significant exposure growth or turnover,

·              small volume or lacking internal data requiring significant reliance on external data,

·              longer emergence patterns with exposures to latent unforeseen mass tort,

·              high severity and/or low frequency,

·              operational processes undergoing significant change, and/or

·              high sensitivity to significant swings in loss trends or economic change.

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Following is a table of significant risk factors by major product line.  We distinguish between expected loss ratio risk and reserve estimation risk.  Expected loss ratio risk refers to the possible dispersion of loss ratios from year to year due to inherent volatility in the business such as high severity or aggregating exposures.  Reserve estimation risk recognizes the difficulty in estimating a given year’s ultimate loss liability.  As an example, our property catastrophe business (identified below as “Difference in conditions”) has significant variance in year-over-year results; however its reserving estimation risk is relatively low.

Significant Risk Factors

Product line	Length of Reserve Tail	Emergence patterns relied upon	Other risk factors	Expected loss ratio variability	Reserve estimation variability
Commercial umbrella	Long	Internal	Low frequency High severity Loss trend volatility Unforeseen tort potential Exposure changes/mix	High	High
Personal umbrella	Medium	Internal	Low frequency	Medium	Medium
General liability	Long	Internal	Exposure growth/mix Unforeseen tort potential	Medium	Medium
Transportation	Medium	Internal	High severity Exposure growth/mix	Medium	Medium
Executive products	Long	Internal & significant external reliances	Low frequency High severity Loss trend volatility Economic volatility Unforeseen tort potential Small volume	High	High
Other casualty	Medium	Internal & external	Small volume	Medium	Medium
Difference in conditions	Short	Internal	Catastrophe aggregation exposure Low frequency High severity	High	Medium
Marine	Medium	Significant external reliances	New business Small volume	High	High
Other property	Short	Internal	Catastrophe aggregation exposure	Medium	Low
Surety	Medium	Internal & external reliances	Economic volatility Uniqueness of exposure	Medium	Medium
Runoff including asbestos & environmental	Long	Internal & external reliances	Loss trend volatility Mass tort/latent exposure	High	High

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The historical and prospective loss and ALAE estimates along with the risks identified in the table are the basis for determining our initial and subsequent carried reserves. Adjustments in the initial loss ratio by product and segment are made where necessary and reflect updated assumptions regarding loss experience and prevailing risk factors.  The Loss Reserve Committee makes all final decisions regarding changes in the initial loss and ALAE ratios.

Loss and LAE Reserve Estimation Process

A full analysis of our loss reserves takes place at least semi-annually.  The purpose of these analyses is to provide validation of our carried loss reserves.  Estimates of the expected value of the unpaid loss and loss adjustment expense are derived using actuarial methodologies.  These estimates are then compared to the carried loss reserves to determine the appropriateness of the current reserve balance.

The process of estimating ultimate payment for claims and claims expenses begins with the collection and analysis of current and historical claim data.  Data on individual reported claims including paid amounts and individual claim adjuster estimates are grouped by common characteristics.  There is judgment involved in this grouping.  Considerations when grouping data include the volume of the data available, the credibility of the data available, the homogeneity of the risks in each cohort, and both settlement and payment pattern consistency.  We use this data to determine historical claim reporting and payment patterns which are used in the analysis of ultimate claim liabilities.  For portions of the business without sufficiently large numbers of policies or that have not accumulated sufficient historical statistics, our own data is supplemented with external or industry average data as available and when appropriate.   For our executive products and marine business, we utilize external data extensively.

In addition to the review of historical claim reporting and payment patterns, we also incorporate an estimate of expected losses relative to premium by year into the analysis.  The expected losses are based on a review of historical loss performance, trends in frequency and severity, and price level changes.  The estimation of expected losses is subject to judgment including consideration given to internal and industry data available, growth and policy turnover, changes in policy limits, changes in underlying policy provisions, changes in legal and regulatory interpretations of policy provisions, and changes in reinsurance structure.

We use historical development patterns, estimations of the expected loss ratios, and standard actuarial methods to derive an estimate of the ultimate level of loss and loss adjustment expense payments necessary to settle all the claims occurring as of the end of the evaluation period.  Once an estimate of the ultimate level of claim payments has been derived, the amount of paid loss and loss adjustment expense and case reserve through the evaluation date is subtracted to reveal the resulting level of IBNR.

Our reserve processes include multiple standard actuarial methods for determining estimates of IBNR reserves.  Other supplementary methodologies are incorporated as deemed necessary.  Mass tort and latent liabilities are examples of exposures where supplementary methodologies are used.  Each method produces an estimate of ultimate loss by accident year.  We review all of these various estimates and the actuaries assign weight to each based on the characteristics of the product being reviewed.  The result is a single actuarial point estimate by product by accident year.

The methodologies we have chosen to incorporate are a function of data availability and appropriately reflective of our own book of business.  There are a number of additional actuarial methods that are available but are not currently being utilized because of data constraints or the methods were either deemed redundant or not predictive for our book of business.  From time to time, we evaluate the need to add supplementary methodologies.  New methods are incorporated if it is believed that they improve the estimate of our ultimate loss and loss adjustment expense liability.  All of the actuarial methods tend to converge to the same estimate as an accident year matures.  Our core methodologies are listed below with a short description and their relative strengths and weaknesses:

Paid Loss Development – Historical payment patterns for prior claims are used to estimate future payment patterns for current claims.  These patterns are applied to current payments by accident year to yield expected ultimate loss.

Strengths:  The method reflects only the claim dollars that have been paid and is not subject to case-basis reserve changes or changes in case reserve practices.

Weaknesses:  External claims environment changes can impact the rate at which claims are settled and losses paid (e.g., increase in attorney involvement or legal precedent).  Adjustments to reflect changes in payment patterns on a prospective basis are difficult to quantify.  For losses that have occurred recently, payments can be minimal and thus early estimates are subject to significant instability.

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Incurred Loss Development – Historical case-incurred patterns (paid losses plus case reserves) for past claims are used to estimate future case-incurred amounts for current claims.  These patterns are applied to current case-incurred losses by accident year to yield an expected ultimate loss.

Strengths:  Losses are reported more quickly than paid, therefore, the estimates stabilize sooner.  The method reflects more information (claims department case reserve) in the analysis than the paid loss development method.

Weaknesses:  Method involves additional estimation risk if significant changes to case reserving practices have occurred.

Expected Loss Ratio – Historical loss ratios, in combination with projections of frequency and severity trends as well as estimates of price and exposure changes, are analyzed to produce an estimate of the expected loss ratio for each accident year.  The expected loss ratio is then applied to the earned premium for each year to estimate the expected ultimate losses.  The current accident year expected loss ratio is also used as the input into the determination of the prospective loss and ALAE ratio used in our initial IBNR generation process.

Strengths:  Reflects an estimate independent of how losses are emerging on either a paid or a case reserve basis.  Method is particularly useful in absence of historical development patterns or where losses take a long time to emerge.

Weaknesses:  Ignores how losses are actually emerging and thus produces the same estimate of ultimate loss regardless of favorable/unfavorable emergence.

Paid and Incurred Bornhuetter/Ferguson (BF) – This approach blends the expected loss ratio method with either the paid or incurred loss development method.  In effect, the BF methods produce weighted average indications for each accident year.  As an example, if the current accident year for commercial automobile liability is estimated to be 20% paid, then the paid loss development method would receive a weight of 20%, and the expected loss ratio method would receive an 80% weight.  Over time, this method will converge with the ultimate estimated in the respective loss development method.

Strengths:  Reflects actual emergence that is favorable/unfavorable, but assumes remaining emergence will continue as previously expected.   Does not overreact to the early emergence (or lack of emergence) where patterns are most unstable.

Weaknesses:  Could potentially understate favorable or unfavorable development by putting some weight on the expected loss ratio.

In most cases, multiple estimation methods will be valid for the particular facts and circumstances of the claim liabilities being evaluated.  Each estimation method has its own set of assumption variables and its own advantages and disadvantages, with no single estimation method being better than the others in all situations and no one set of assumption variables being meaningful for all product line components.  The relative strengths and weaknesses of the particular estimation methods, when applied to a particular group of claims, can also change over time; therefore, the weight given to each estimation method will likely change by accident year and with each evaluation.

The actuarial point estimates typically follow a progression that places significant weight on the BF methods when accident years are younger and claims emergence is immature.  As accident years mature and claims emerge over time, increasing weight is placed on the incurred development method and the paid development method.  For product lines with faster loss emergence, the progression to greater weight on the incurred and paid development methods occurs more quickly.

For our long- and medium-tail products, the BF methods are typically given the most weight for the first 36 months of evaluation.  These methods are also predominant for the first 12 months of evaluation for short-tail lines.  Beyond these time periods, our actuaries apply their professional judgment when weighting the estimates from the various methods deployed.

Judgment can supersede this natural progression if risk factors and assumptions change, or if a situation occurs that amplifies a particular strength or weakness of a methodology.  Extreme projections are critically analyzed and may be adjusted, given less credence, or discarded all together.  Internal documentation is maintained that records any substantial changes in methods or assumptions from one loss reserve study to another.

Our estimates of ultimate loss and LAE reserves are subject to change as additional data emerge.  This could occur as a result of change in loss development patterns; a revision in expected loss ratios; the emergence of exceptional loss activity; a change in weightings between actuarial methods; the addition of new actuarial methodologies or new information that merits inclusion; or the emergence of internal variables or external factors that would alter their view.

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There is uncertainty in the estimates of ultimate losses.  Significant risk factors to the reserve estimate include, but are not limited to, unforeseen or unquantifiable changes in:

·              loss payment patterns,

·              loss reporting patterns,

·              frequency and severity trends,

·              underlying policy terms and conditions,

·              business or exposure mix,

·              operational or internal process changes affecting timing of recording transactions,

·              regulatory and legal environment, and/or

·              economic environment.

Our actuaries engage in discussions with senior management, underwriting, and the claims department on a regular basis to attempt to ascertain any substantial changes in operations or other assumptions that are necessary to consider in the reserving analysis.

A considerable degree of judgment in the evaluation of all these factors is involved in the analysis of reserves.  The human element in the application of judgment is unavoidable when faced with material uncertainty.  Different experts will choose different assumptions when faced with such uncertainty, based on their individual backgrounds, professional experiences, and areas of focus.  Hence, the estimate selected by the various qualified experts may differ materially from each other.  We consider this uncertainty by examining our historic reserve accuracy.

Given the significant impact of the reserve estimates on our financial statements, we subject the reserving process to significant diagnostic testing and outside review.  Multiple outside reserving specialists periodically review the reserving estimation process and the resulting estimates.  We give consideration to these outside opinions and implement recommended improvements as deemed appropriate.  We have incorporated data validity checks and balances into our front-end processes.  Leading indicators such as actual versus expected emergence and other diagnostics are also incorporated into the reserving processes.

Determination of Our Best Estimate

Upon completion of our full loss and loss adjustment expense estimation analysis, the results are discussed with the Loss Reserve Committee (LRC).  As part of this discussion, the analysis supporting an indicated point estimate of the IBNR loss reserve by product is reviewed.  The actuaries also present explanations supporting any changes to the underlying assumptions used to calculate the indicated point estimate.  Review of the variance between the indicated reserves and the carried reserves determined from the initial IBNR generation process takes place.  After discussion of these analyses and all relevant risk factors, the LRC determines whether the reserve balances require adjustment.

As a predominantly excess and surplus lines and specialty insurer servicing niche markets, we believe that there are several reasons to carry – on an overall basis – reserves above the actuarial point estimate.  We believe we are subject to above average variation in estimates and that this variation is not symmetrical around the actuarial point estimate.

  One reason for large variation is the above average policyholder turnover and changes in the underlying mix of exposures typical of an excess and surplus lines business.  This constant change can cause estimates based on prior experience to be less reliable than estimates for more stable, admitted books of business.  Also, as a niche market writer, there is little industry-level information for direct comparisons of current and prior experience and other reserving parameters.  These unknowns create greater than average variation in the actuarial point estimates.

Actuarial methods attempt to quantify future events. Insurance companies are subject to unique exposures that are difficult to foresee at the point coverage is initiated and often many years subsequent. Judicial and regulatory bodies involved in interpretation of insurance contracts have increasingly found opportunities to expand coverage beyond what was intended or

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contemplated at the time the policy was issued.  Many of these policies are issued on an “all risk” and occurrence basis.  Aggressive plaintiff attorneys have often sought coverage beyond the insurer’s original intent.  Some examples would be the industry’s ongoing asbestos and environmental litigation, court interpretations of exclusionary language on mold and construction defect, and debates over wind versus flood as the cause of loss from major hurricane events.

We believe that because of the inherent variation and the likelihood that there are unforeseen and under-quantified liabilities absent from the actuarial estimate, it is prudent to carry loss reserves above the actuarial point estimate.  Most of our variance between the carried reserve and the actuarial point estimate is in the most recent accident years for our casualty segment where the most significant estimation risks reside.   These estimation risks are considered when setting the initial loss ratio for the product and segment.  In the cases where these risks fail to materialize, favorable loss development will likely occur over subsequent accounting periods.  It is also possible that the risks materialize in an amount above what we considered when booking our initial loss reserves.  In this case, unfavorable loss development is likely to occur over subsequent accounting periods.

Our best estimate of our loss and LAE reserves may change depending on a revision in the actuarial point estimate, the actuary’s certainty in the estimates and processes, and our overall view of the underlying risks.  From time to time, we benchmark our reserving policies and procedures and update them by adopting industry best practices where appropriate.  No significant changes were made in 2006.

We have undergone significant changes over the last several years including rapid growth in exposures, diversification in our product portfolio, and changes in our actuarial leadership.  Although we believe our existing reserving methodologies produce appropriate results, we likewise believe in continual review and enhancement of our critical reserving processes.  As a result, we are benchmarking and evaluating several of our key operational and actuarial processes against other industry best practices, considering what is the most appropriate for us.  Changes in our reserving methodologies and processes, possibly significant, could result once our review is completed.  Although the precise nature of any new process is uncertain at this time, one important change being considered involves the refinement of our reserve estimation process to include additional recognition of risks within our actuarial point estimate.  If implemented, this revision would likely change the point estimate and result in a corresponding revision in our variation from the point estimate.  This change would not be anticipated to have a significant impact on carried reserves, but rather would impact the calculated variance between our carried reserves and the actuarial point estimate.

Reserve Sensitivities

A reserve estimate implies a pattern of expected loss emergence.  If this emergence does not occur as expected, it may cause us to challenge our previous assumptions.  We may change loss development patterns, the various method weights, and/or expected loss ratios used in our analysis.  The impact can be much greater and more leveraged for products with longer emergence patterns.  Our General Liability product is an example of a product with a relatively long emergence pattern.  A $1 deviation from expected emergence and its effects on other assumptions may result in a change in estimated ultimate loss and ALAE as large as $3.

There are often significant inter-relationships between our reserving assumptions that have offsetting or compounding effects on the reserve estimate.  Thus, in almost all cases, it is impossible to discretely measure the effect of a single assumption or construct a meaningful sensitivity expectation that holds true in all cases.  Our overall reserve estimates for General Liability in 2005 and 2006 were impacted by very favorable loss and ALAE emergence.  The favorable emergence created a cascading impact on other assumptions and an overall reduction in our reserves.  In 2005 and 2006, prior accident year losses emerged approximately $13.9 million and $17.1 million better than expected, respectively.  As a result, booked reserves were decreased $36.8 million in 2005 and $25.4 million in 2006.   The 2006 favorable emergence was concentrated in the three most recent accident years.  The company experienced unfavorable emergence in several older accident years that caused us to reevaluate the loss development patterns and thus resulted in some offset to the overall favorable 2006 emergence.

It is difficult for us to predict whether the favorable loss development observed in 2005 and 2006 will continue for any of our products in the future.  We have reviewed historical data detailing the development of our total balance sheet reserves for each of the last 10 years.  Based on this analysis and our understanding of loss reserve uncertainty, we believe fluctuations will occur in our estimate of ultimate reserve liabilities over time.  During 2007, it would be reasonably likely for us to observe development relating to prior years’ reserve estimates ranging from approximately $50 million favorable to $25 million unfavorable.

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Historical Loss and LAE Development

The table which follows is a reconciliation of our unpaid losses and settlement expenses (LAE) for the years 2006, 2005, and 2004.

	Year Ended December 31,
(Dollars in thousands)	2006			2005			2004
Unpaid losses and LAE at beginning of year:
Gross	$	1,331,866		$	1,132,599		$	903,441
Ceded	(593,209		)	(464,180		)	(372,048		)
Net	$	738,657		$	668,419		$	531,393
Increase (decrease) in incurred losses and LAE:
Current accident year	$	300,292		$	313,643		$	316,948
Prior accident years	(43,403		)	(62,473		)	(10,817		)
Total incurred	$	256,889		$	251,170		$	306,131
Loss and LAE payments for claims incurred:
Current accident year	$	(47,994	)	$	(43,062	)	$	(39,206	)
Prior accident years	(154,446		)	(137,870		)	(129,899		)
Total paid	$	(202,440	)	$	(180,932	)	$	(169,105	)
Net unpaid losses and LAE at end of year	$	793,106		$	738,657		$	668,419
Unpaid losses and LAE at end of year:
Gross	$	1,318,777		$	1,331,866		$	1,132,599
Ceded	(525,671		)	(593,209		)	(464,180		)
Net	$	793,106		$	738,657		$	668,419

The deviations from our initial reserve estimates appeared as changes in our ultimate loss estimates as we updated those estimates through our reserve analysis process. The recognition of the changes in initial reserve estimates occurred over time as claims were reported, initial case reserves were established, initial reserves were reviewed in light of additional information, and ultimate payments were made on the collective set of claims incurred as of that evaluation date. The new information on the ultimate settlement value of claims is therefore continually updated and revised as this process takes place until all claims in a defined set of claims are settled. As a relatively small insurer, our experience will ordinarily exhibit fluctuations from period to period. While we attempt to identify and react to systematic changes in the loss environment, we also must consider the volume of experience directly available to us, and interpret any particular period’s indications with a realistic technical understanding of the reliability of those observations.

The table below summarizes our prior accident years’ loss reserve development by segment for 2006, 2005, and 2004.

(in thousands)	2006			2005			2004
(Favorable)/Unfavorable reserve development by segment
Casualty	$	(40,030	)	$	(57,505	)	$	(11,813	)
Property	(1,784		)	(7,581		)	(5,137		)
Surety	(1,589		)	2,613			6,133
Total	$	(43,403	)	$	(62,473	)	$	(10,817	)

A discussion of significant components of reserve development for the three most recent calendar years follows:

2006.  During 2006, we continued to experience favorable loss development and a reduction in its prior years’ loss reserve estimates.  Pricing increased substantially and policy terms and conditions became more favorable for most of our products during the 2001-2004 policy years.  Many of the improvements in market conditions were difficult to quantify at the time of the original estimate.  Our significant growth in premium and exposures made precise quantification

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of these changes even more challenging.  In 2006, losses continued to emerge on the prior accident years much more favorably than the company expected when making its original estimates.  We experienced favorable development of $43.4 in aggregate on prior years’ estimates.

Of this decrease to prior years’ loss reserve estimates, approximately $40.0 million occurred in the casualty segment.  The development is primarily from our general liability, executive products liability, and Texas employer’s indemnity products.  In our general liability product we experienced $25.4 million of favorable development.  Most of this development came from the 2004 and 2005 accident years.   As part of our normal reserving process, we reviewed the expected loss ratios used in several of its reserving methods.  This review confirmed the favorable emergence from 2002-2005 accident years.  As a result of this study, the expected loss ratios were reduced for 2004-2006 with the most significant change occurring to the 2005 accident year.  Approximately $15.4 million of the favorable general liability development can be attributed to this update in expected loss ratios.  The remaining portion of the decrease in prior year’s loss reserve estimate was the result of the continued favorable loss emergence and the natural progression of shifting more weight to our incurred and paid development methods as accident years get older.   In our executive products liability business, we experienced $7.4 million of favorable development.  Most of this change can be attributed to accident years 2001, 2003, and 2004.  The estimates improved as a result of lower than expected loss severity in those accident years.  For our Texas employer’s indemnity product, we experienced $5.7 million of favorable development.  We experienced significantly less loss emergence than expected for accident years prior to 2003 and benefited from favorable settlements on several claims in accident years 2001-2003.

Overall, our property and surety segments experienced relatively small changes in prior years’ estimates of reserves.  However, we experienced $4.2 million of favorable development from 2004 and 2005 hurricane estimates.  We also saw $7.2 million of unfavorable development on our construction product that is in runoff.  Most of this development came from accident years 2002-2005.  The construction emergence pattern revealed itself to be longer than originally anticipated and has not behaved consistent with reporting patterns expected from a property segment.  We do not anticipate any further deterioration in our estimates.

2005. During 2005, we experienced an aggregate of $62.5 million of favorable development. Of this total, approximately $57.5 million of this reserve development occurred in the casualty segment. It was primarily from accident years 2002, 2003, and 2004 for our general liability, specialty programs, and transportation products. Pricing and policy terms and conditions rapidly became more favorable for most of our products beginning in 2002.  Many of the improvements in market conditions were difficult to quantify at the time of our original estimate.  Our significant growth in premium and exposures over this same time period made precise quantification of these changes more challenging because of the resulting mix changes, new exposures underwritten for the first time, and uncertainty in whether the new exposures would have similar emergence patterns as those reflected in our historical data.   We appropriately reflected these significant risks in our 2002-2004 initial carried reserves for this business.  During 2005, we regularly observed emergence of losses lower than expected for these accident years as the anticipated risks failed to materialize.  This resulted in a re-evaluation and corresponding reduction in expected loss ratios used in the loss reserving analysis for these products.  The lower than expected emergence, lower expected loss ratios, and the natural progression of increased weighting on the incurred and paid development actuarial methods caused the reserve estimate to decrease.  In response to the reduction in reserve estimates, we released $36.8 million, $11.6 million, and $6.3 million of IBNR loss and LAE reserves to general liability, specialty programs, and transportation, respectively.  The release for these products was consistent with our loss reserving processes.    These releases comprise a majority of the favorable development within our casualty segment.

The property segment also experienced $7.6 million of favorable development. A portion of this positive development is due to the claims department reassessing and decreasing the estimated ultimate level of loss payments for the 2004 hurricanes. Overall, the surety segment experienced $2.6 million in adverse development. Reserve additions on surety products for the 2002 accident year exceeded favorable experience on surety products for accident years prior to 2002.

2004. During 2004, we experienced an aggregate of $10.8 million of favorable development. Of this total, approximately $5.1 million of favorable development occurred in the property segment. Approximately half of the favorable development within our property segment was due to a favorable settlement of an outstanding claim from the Northridge, California earthquake of 1994. The remainder relates primarily to favorable development on losses that occurred during 2003.

In 2004 the cumulative experience attributable to many of our casualty products for mature accident years was materially lower than the IBNR reserves originally booked. Due to the low emergence of loss and LAE, we released $9.7 million of IBNR reserves during the fourth quarter of 2004, which accounted for the majority of the favorable development within our casualty segment. While we had been experiencing robust price improvements in this segment for several years, we also produced significant new business with new exposures. Our reserving evaluation process requires adequate time periods to elapse to assess the impact of such changes in marketplace conditions on our book of casualty business.

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The surety segment experienced $6.1 million in adverse development. A portion of this development comes from contract bond products, where we increased IBNR reserves on bonds primarily written before 2003. Additionally, we experienced adverse development on reserves for other surety products, primarily related to the 2002 accident year.

The following table presents the development of our balance sheet reserves from 1996 through 2006. The top line of the table shows the net reserves at the balance sheet date for each of the indicated periods. This represents the estimated amount of net losses and settlement expenses arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to us. The lower portion of the table shows the re-estimated amount of the previously recorded gross and net reserves based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual periods.

Adverse loss and loss adjustment expense reserve development can be observed in the table for years ending 2000-2002 on a net basis, and 1999-2003 on a gross basis.  This development is related to unexpectedly large increases in loss frequency and severity and unquantifiable expansion of policy terms and conditions that took place in accident years 1997-2001 for our casualty segment.  These causes widely impacted the property and casualty insurance industry during this time as soft market conditions were prevalent.  These factors, combined with our rapid growth during 1999-2002, caused significant estimation risk, and thus had a related impact on our reserve liabilities for those years.

As the table displays, variations exist between our cumulative loss experience on a gross and net basis, due to the application of reinsurance. On certain products, our net retention (after applying reinsurance) is significantly less than our gross retention (before applying reinsurance). Additionally, the relationship of our gross to net retention changes over time. For example, we changed underwriting criteria to increase gross retentions (gross policy limits) on certain products written in 1999 through 2001, while leaving net retention unchanged. These products contained gross retentions of up to $50.0 million, while the relating net retention remained at $0.5 million. Loss severity on certain of these products exceeded original expectations. As shown in the table that follows, on a re-estimated basis, this poor loss experience resulted in significant indicated gross deficiencies, with substantially less deficiency indicated on a net basis, as many losses were initially recorded at their full net retention. In 2002, we reduced our gross policy limits on many of these products to $15.0 million, while net retention increased to $1.0 million. As the relationship of our gross to net retention changes over time, re-estimation of loss reserves will result in variations between our cumulative loss experience on a gross and net basis.

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	Year Ended December 31,
(Dollars in thousands)	1996			1997			1998			1999			2000			2001			2002			2003			2004			2005			2006
	& Prior
Net Liability for unpaid losses and Settlement expenses at end of the year	$	247,806		$	248,552		$	247,262		$	274,914		$	300,054		$	327,250		$	391,952		$	531,393		$	668,419		$	738,657		$	793,106
Paid cumulative as of:
One year later	47,999			54,927			53,892			65,216			92,788			98,953			94,465			129,899			137,870			154,446
Two years later	85,342			98,188			88,567			113,693			155,790			159,501			182,742			212,166			239,734
Three years later	112,083			120,994			114,465			149,989			192,630			211,075			234,231			273,019
Four years later	129,846			136,896			132,796			172,443			222,870			238,972			269,446
Five years later	139,006			149,324			145,888			191,229			237,464			260,618
Six years later	146,765			159,048			159,153			200,610			250,092
Seven years later	154,082			168,984			165,277			209,288
Eight years later	161,418			173,367			171,709
Nine years later	165,138			178,528
Ten years later	169,935
Liability re-estimated as of:
One year later	240,264			245,150			243,270			273,230			309,021			340,775			393,347			520,576			605,946			695,254
Two years later	242,865			248,762			233,041			263,122			301,172			335,772			394,297			485,146			577,709
Three years later	233,084			232,774			229,750			263,639			314,401			344,668			397,772			478,113
Four years later	219,888			220,128			217,476			262,156			319,923			355,997			409,597
Five years later	207,148			218,888			207,571			264,383			323,698			359,161
Six years later	201,245			209,884			205,563			264,569			323,642
Seven years later	193,793			210,843			204,002			264,305
Eight years later	195,471			213,095			204,597
Nine years later	199,156			214,226
Ten years later	201,384
Net cumulative redundancy (deficiency)	$	46,422		$	34,326		$	42,665		$	10,609		$	(23,588	)	$	(31,911	)	$	(17,645	)	$	53,280		$	90,710		$	43,403
Gross liability	$	405,801		$	404,263		$	415,523		$	520,494		$	539,750		$	604,505		$	732,838		$	903,441		$	1,132,599		$	1,331,866		$	1,318,777
Reinsurance recoverable	(157,995		)	(155,711		)	(168,261		)	(245,580		)	(239,696		)	(277,255		)	(340,886		)	(372,048		)	(464,180		)	(593,209		)	(525,671		)
Net liability	$	247,806		$	248,552		$	247,262		$	274,914		$	300,054		$	327,250		$	391,952		$	531,393		$	668,419		$	738,657		$	793,106
Gross re-estimated liability	$	374,898		$	425,346		$	381,691		$	634,766		$	791,626		$	805,870		$	917,066		$	987,045		$	1,103,882		$	1,294,311
Re-estimated recoverable	(173,514		)	(211,120		)	(177,094		)	(370,461		)	(467,984		)	(446,709		)	(507,469		)	(508,932		)	(526,173		)	(599,057		)
Net re-estimated liability	$	201,384		$	214,226		$	204,597		$	264,305		$	323,642		$	359,161		$	409,597		$	478,113		$	577,709		$	695,254
Gross cumulative redundancy (deficiency)	$	30,903		$	(21,083	)	$	33,832		$	(114,272	)	$	(251,876	)	$	(201,365	)	$	(184,228	)	$	(83,604	)	$	28,717		$	37,555

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Operating Ratios

Premiums to Surplus Ratio

The following table shows, for the periods indicated, our insurance subsidiaries’ statutory ratios of net premiums written to policyholders’ surplus. While there is no statutory requirement applicable to us that establishes a permissible net premiums written to surplus ratio, guidelines established by the National Association of Insurance Commissioners, or NAIC, provide that this ratio should generally be no greater than 3 to 1.  While the NAIC provides this general guideline, rating agencies often require a more conservative ratio to maintain strong or superior ratings.

	Year Ended December 31,
(Dollars in thousands)	2006		2005		2004		2003		2002
Statutory net premiums written	$	551,536	$	494,565	$	511,212	$	474,094	$	413,638
Policyholders’ surplus	746,905		690,547		605,967		546,586		401,269
Ratio	0.7 to 1		0.7 to 1		0.8 to 1		0.9 to 1		1.0 to 1

GAAP and Statutory Combined Ratios

Our underwriting experience is best indicated by our GAAP combined ratio, which is the sum of (a) the ratio of incurred losses and settlement expenses to net premiums earned (loss ratio) and (b) the ratio of policy acquisition costs and other operating expenses to net premiums earned (expense ratio).

	Year Ended December 31,
GAAP	2006	2005	2004	2003	2002
Loss ratio	48.4	51.1	59.9	60.2	58.4
Expense ratio	35.7	34.9	32.3	31.8	37.2
Combined ratio	84.1	86.0	92.2	92.0	95.6

We also calculate the statutory combined ratio, which is not indicative of GAAP underwriting income due to accounting for policy acquisition costs differently for statutory accounting purposes compared to GAAP. The statutory combined ratio is the sum of (a) the ratio of statutory loss and settlement expenses incurred to statutory net premiums earned (loss ratio) and (b) the ratio of statutory policy acquisition costs and other underwriting expenses to statutory net premiums written (expense ratio).

	Year Ended December 31,
Statutory	2006		2005		2004		2003		2002
Loss ratio	48.4		51.1		59.9		60.2		58.4
Expense ratio	35.6		35.6		33.9		32.9		34.0
Combined ratio	84.0		86.7		93.8		93.1		92.4
Industry combined ratio	94.3	(1)	100.9	(2)	98.5	(2)	100.2	(2)	107.3	(2)

(1)           Source:  Insurance Information Institute.  Estimated for the year ended December 31, 2006

(2)           Source:  A.M. Best Aggregate & Averages – Property-Casualty (2006 Edition) statutory basis.

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Investments

Oversight of our investment policies is conducted by our board of directors and officers. We follow an investment policy that is reviewed quarterly and revised periodically.

Our investment portfolio serves primarily as the funding source for loss reserves and secondly as a source of income and appreciation. For these reasons, our primary investment criteria are quality and liquidity, followed by yield and potential for appreciation. Investments of the highest quality and marketability are critical for preserving our claims-paying ability. Common stock investments are limited to securities listed on the national exchanges and rated by the Securities Valuation Office of the NAIC. Our portfolio contains no derivatives or off-balance sheet structured investments. In addition, we employ stringent diversification rules and balance our investment credit risk and related underwriting risks to minimize total potential exposure to any one security. Despite its low volatility, our overall portfolio’s fairly conservative approach has contributed significantly to our historic growth in book value.

During 2006, we allocated the majority of available cash flows to the purchase of fixed income securities. The mix of instruments within the portfolio is decided at the time of purchase on the basis of fundamental analysis and relative value.  As of December 31, 2006, 96 percent of the fixed income portfolio was rated A or better and 87 percent was rated AA or better.

As of December 31, 2006, the municipal bond component of the fixed income portfolio decreased $21.5 million, to $500.9 million and comprised 37 percent of our total fixed income portfolio, versus 39 percent of the total portfolio at year-end 2005.  Investment grade corporate securities totaled $352.4 million compared to $323.4 million at year-end 2005 and comprised 26 percent of our total fixed income portfolio versus 24 percent at year-end 2005.  The taxable U.S. government and agency portion of the fixed income portfolio increased by $16.9 million to $502.5 million, or 37 percent, of the total for both year-ends 2006 and 2005.

We currently classify 8 percent of the securities in our fixed income portfolio as held-to-maturity, meaning they are carried at amortized cost and are intended to be held until their contractual maturity. Other portions of the fixed income portfolio are classified as available-for-sale (91 percent) or trading (1 percent) and are carried at fair value. As of December 31, 2006, we maintained $1.25 billion in fixed income securities within the available-for-sale and trading classifications. The available-for-sale portfolio provides an additional source of liquidity and can be used to address potential future changes in our asset/liability structure.

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Aggregate maturities for the fixed-income portfolio as of December 31, 2006, are as follows:

	Par		Amortized		Fair		Carrying
(thousands)	Value		Cost		Value		Value
2007	$	18,990	$	18,999	$	19,105	$	19,001
2008	39,657		39,897		39,953		39,795
2009	66,057		66,878		67,029		66,698
2010	64,484		65,880		65,804		65,463
2011	141,570		145,279		145,368		144,839
2012	150,180		154,441		154,725		154,602
2013	127,735		132,538		133,372		132,845
2014	106,095		111,188		110,641		110,465
2015	140,636		142,199		141,204		141,076
2016	98,882		100,443		100,590		100,585
2017	32,219		33,659		33,362		33,364
2018	29,137		31,018		30,607		30,607
2019	28,388		30,195		29,719		29,719
2020	12,839		13,298		13,405		13,405
2021	6,857		7,304		7,422		7,422
2022	10,988		11,208		11,290		11,290
2023	20,185		21,846		21,775		21,775
2024	7,205		7,437		7,513		7,513
2025	3,469		3,467		3,400		3,400
2026	0		0		0		0
2027	3,000		3,004		3,039		3,039
2028	8		8		9		9
2029	7		7		7		7
2030	8,696		8,710		8,471		8,471
2031	4,534		4,510		4,576		4,576
2032	9,015		9,118		9,017		9,017
2033	48,238		48,542		47,161		47,161
2034	25,648		25,748		25,408		25,408
2035	23,091		23,358		23,136		23,136
2036	42,246		42,423		42,487		42,487
2037	2,000		2,005		1,988		1,988
2038	8,234		8,242		8,220		8,220
2039	9,100		9,186		9,272		9,272
2040	8,000		7,906		7,639		7,639
2041	12,348		12,519		12,459		12,459
2042	9,200		9,757		9,683		9,683
2043	2,000		2,026		1,988		1,988
2044	3,000		3,016		3,084		3,084
2045	4,150		4,196		4,333		4,333
	$	1,328,088	$	1,361,455	$	1,358,261	$	1,355,841

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At December 31, 2006, our equity securities were valued at $368.2 million, an increase of $47.1 million from the $321.1 million held at the end of 2005. During 2006, the pretax change in unrealized gains on equity securities was $32.1 million. Equity securities represented 20 percent of cash and invested assets at the end of 2006, an increase from the 19 percent at year-end 2005. As of the year-end 2006, total equity investments held represented 49 percent of our shareholders’ equity. The securities within the equity portfolio remain primarily invested in large-cap issues with strong dividend performance. Our strategy remains one of value investing, with security selection taking precedence over market timing. A buy-and-hold strategy is used, minimizing both transaction costs and taxes.

We had short-term investments and fixed income securities maturing within one year of $123.2 million at year-end 2006. This total represented 7 percent of cash and invested assets versus 3 percent the prior year.  Our short-term investments consist of money market funds.

Our investment results are summarized in the following table:

	Year ended December 31,
(Dollars in Thousands)	2006			2005			2004			2003			2002
Average Invested Assets (1)	$	1,763,016		$	1,633,755		$	1,451,539		$	1,166,694		$	896,785
Net Investment Income (2)(3)	71,325			61,641			54,087			44,151			37,640
Net Realized Gains/(Losses)	31,045			16,354			13,365			12,138			(3,552		)
Change in Unrealized Appreciation/(Depreciation) (3)(4)	34,395			(35,788		)	13,200			40,096			(34,091		)
Annualized Return on Average Invested Assets	7.8		%	2.6		%	5.6		%	8.3		%	0.0		%

(1) Average of amounts at beginning and end of each year.

(2) Investment income, net of investment expenses, including non-debt interest expense

(3) Before income taxes.

(4) Relates to available-for-sale fixed income and equity securities.

Regulation

State and Federal Legislation

As an insurance holding company, we, as well as our insurance company subsidiaries, are subject to regulation by the states and territories in which the insurance subsidiaries are domiciled or transact business. Holding company registration in each insurer’s state of domicile requires periodic reporting to the state regulatory authority of the financial, operational and management data of the insurers within the holding company system. All transactions within a holding company system affecting insurers must have fair and reasonable terms, and the insurer’s policyholder surplus following any transaction must be both reasonable in relation to its outstanding liabilities and adequate for its needs. Notice to regulators is required prior to the consummation of certain transactions affecting insurance company subsidiaries of the holding company system.

The insurance holding company laws also require that ordinary dividends be reported to the insurer’s domiciliary regulator prior to payment of the dividend and that extraordinary dividends may not be paid without such regulator’s prior approval. An extraordinary dividend is generally defined as a dividend that, together with all other dividends made within the past 12 months, exceeds the greater of 100 percent of the insurer’s statutory net income for the most recent calendar year, or 10 percent of its statutory policyholders’ surplus as of the preceding year end. Insurance regulators have broad powers to prevent the reduction of statutory surplus to inadequate levels, and there is no assurance that extraordinary dividend payments would be permitted.

In addition, the insurance holding company laws require advance approval by state insurance commissioners of any change in control of an insurance company that is domiciled (or, in some cases, having such substantial business that it is deemed to be commercially domiciled) in that state. “Control” is generally presumed to exist through the ownership of 10 percent or more of the voting securities of a domestic insurance company or of any company that controls a domestic insurance company. In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states. Any future transactions that would constitute a change in control of our insurance company subsidiaries,

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including a change of control of us, would generally require the party acquiring control to obtain the prior approval by the insurance departments of the insurance company subsidiaries’ states of domicile or commercial domicile, if any, and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions. Obtaining these approvals could result in material delay of, or deter, any such transaction.

Other regulations impose restrictions on the amount and type of investments our insurance company subsidiaries may have. Regulations designed to ensure financial solvency of insurers and to require fair and adequate treatment and service for policyholders are enforced by filing, reporting and examination requirements. Marketplace oversight is conducted by monitoring and periodically examining trade practices, approving policy forms, licensing of agents and brokers, and requiring the filing and in some cases, approval, of premiums and commission rates to ensure they are fair and equitable. Such restrictions may limit the ability of our insurance company subsidiaries to introduce new coverages or implement desired changes to current premium rates or policy forms. Financial solvency is monitored by minimum reserve and capital requirements (including risk-based capital requirements), periodic reporting procedures (annually, quarterly, or more frequently if necessary), and periodic examinations.

The quarterly and annual financial reports to the states utilize statutory accounting principles that are different from GAAP, which show the business as a going concern. The statutory accounting principles used by regulators, in keeping with the intent to assure policyholder protection, are generally based on a solvency concept.

Under state insurance laws, our insurance company subsidiaries cannot treat reinsurance ceded to an unlicensed or non-accredited reinsurer as an asset or as a deduction from its liabilities in their statutory financial statements, except to the extent that the reinsurer has provided collateral security in an approved form, such as a letter of credit. As of December 31, 2006, $1.6 million of our reinsurance recoverables were due from unlicensed or non-accredited reinsurers that had not provided us with approved collateral.

Many jurisdictions have laws and regulations that limit an insurer’s ability to withdraw from a particular market. For example, states may limit an insurer’s ability to cancel or not renew policies. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance department may disapprove a plan that may lead to marketplace disruption. Laws and regulations that limit cancellation and non-renewal and that subject program withdrawals to prior approval requirements may restrict our ability to exit unprofitable marketplaces. For example, the state of Florida passed legislation in early 2007 seeking to make residential homeowners’ insurance in Florida more accessible and affordable by imposing regulatory changes and restrictions on many aspects of the insurance market in that state. The near-term impact to us is not expected to be material since we currently write a relatively small amount of residential homeowners’ insurance in that state. However, such legislation is new, and thus its full impact, as well as the reaction of any other coastal state, is not yet certain. We will continue to carefully monitor the legislative and regulatory activity in this area.

Virtually all states require licensed insurers to participate in various forms of guaranty associations in order to bear a portion of the loss suffered by the policyholders of insurance companies that become insolvent. Depending upon state law, licensed insurers can be assessed an amount that is generally equal to between 1 percent and 2 percent of the annual premiums written for the relevant lines of insurance in that state to pay the claims of an insolvent insurer. These assessments may increase or decrease in the future, depending upon the rate of insolvencies of insurance companies. In some states, these assessments may be wholly or partially recovered through policy fees paid by insureds.

In addition to monitoring our existing regulatory obligations, we are also monitoring developments in the following areas to determine the potential effect on our business and to comply with our legal obligations.

Broker Contingent Commissions

In 2004, the New York attorney general began an investigation into insurance broker and insurance company activities connected with contingent commission arrangements. The investigation led to lawsuits, both private suits and suits by attorneys general, and prompted other attorneys general and state insurance departments to conduct further investigations. We have responded to all inquiries from state attorneys general and insurance departments, and have not been subject to any regulatory actions or paid any fees or fines as a result. We also conducted an internal investigation of our contingent commission arrangements and related underwriting practices and found no improper actions. We have also established a corporate policy regarding the proper use and authorization of contingent commission agreements. The National Association of Insurance Commissioners (NAIC) has created a model act on these agreements for agents

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and brokers, and statutes have been proposed or enacted in several states. We continue to closely monitor all legislative developments.

Terrorism Exclusion Regulatory Activity

After the events of September 11, 2001, the NAIC urged states to grant conditional approval to commercial lines endorsements that excluded coverage for acts of terrorism consistent with language developed by the Insurance Services Office, Inc (ISO). The ISO endorsement included certain coverage limitations. Many states allowed the endorsements for commercial lines, but rejected such exclusions for personal exposures.

On November 26, 2002, the federal Terrorism Risk Insurance Act of 2002 (TRIA) became law. TRIA was set to expire on December 31, 2005, but the law has been extended until December 31, 2007. The act, as extended and amended, provides for a federal backstop for terrorism losses as defined by the act and certified by the secretary of the treasury in concurrence with the secretary of state and the U.S. attorney general. Under TRIA, coverage provided for losses caused by acts of terrorism is partially reimbursed by the United States under a formula whereby the government pays 90 percent in 2006 and 85 percent in 2007 of covered terrorism losses exceeding a prescribed deductible to the insurance company providing the coverage. The deductible is calculated as 17.5 percent in 2006 and 20 percent in 2007 of gross earned premium net of a few excludable lines. Coverage under the act must be made available to policyholders, with certain specified exceptions, in commercial property and casualty policies. The immediate effect, as regards state regulation, was to nullify terrorism exclusions to the extent they exclude losses that would otherwise be covered under the act. We are in compliance with the requirements of TRIA and have made terrorism coverage available to policyholders. Given the challenges associated with attempting to assess the possibility of future acts of terror exposures and assign an appropriate price to the risk, we have taken a conservative underwriting position on most of our affected coverages.  Congress is currently considering an extension of TRIA, although such action is not certain.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 presents a significant expansion of securities law regulation of corporate governance and compliance, accounting practices, reporting, and disclosure that affects publicly traded companies. The act, in part, sets forth requirements for certification by CEOs and CFOs of certain reports filed with the Securities and Exchange Commission (SEC), disclosures pertaining to the adoption of a code of ethics applicable to certain management personnel, and safeguards against actions to fraudulently influence, manipulate or mislead independent public or certified accountants of the issuer’s financial statements. It also provides stronger requirements for development and evaluation of internal control procedures, as well as provisions pertaining to a company’s audit committee of the board of directors. As required by the act and under the supervision from and participation of management, we annually complete an evaluation of our internal control system including all design, assessment, documentation, and testing phases. This evaluation is intended to identify any deficiencies, measure their materiality, and implement procedures, where necessary, to remediate them.

The annual certification of our CEO with respect to compliance with the New York Stock Exchange corporate governance listing standards has been submitted to the New York Stock Exchange and the annual certifications of our CEO and CFO required by the Sarbanes-Oxley Act of 2002 with respect to the our 2006 fiscal year have been filed with the SEC as an exhibit to our annual report on Form 10-K for 2006.

Asbestos Litigation Reform

Congress has considered, but not yet enacted, asbestos litigation reform legislation. Alternatives range from a proposal requiring manufacturers and insurers to fund liabilities for asbestos exposure to provide for a remedy for all asbestos-related claims, to a proposal requiring victims to document their medical condition before suing for damages. We continue to monitor our expected exposure and do not perceive a significant risk.

Federal Regulation of Insurance

In 2006, two separate bills were introduced in Congress that would provide significant federal regulation in the insurance industry. One bill provides for an optional federal charter, and the other seeks to streamline and reduce the state regulatory burden for non-admitted/surplus lines of insurance. This proposed legislation would have a significant

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impact on the insurance industry, and we continue to monitor all proposals.

Also, in early 2007, bills were introduced in Congress to repeal the antitrust exemption for the insurance industry in the McCarran-Ferguson Act.  We will monitor this proposed legislation, but we cannot predict if such bills will become law or the impact of such legislation on the company or the industry.

Corporate Compliance

We have a code of conduct, corporate governance guidelines, and compliance manual, which provide directors, officers, and employees with guidance and requirements for complying with a variety of federal and state laws and company policies. Electronic versions of these documents, as well as the following documents, are, or will be, available on our web site (www.rlicorp.com): 2006 summary annual report; 2006 financial report; 2007 proxy statement; annual report on Form 10-K for 2006; and charters of the executive resources, audit, finance and investment, strategy, and nominating/corporate governance committees of the board of directors. Printed copies of these documents will be made available upon request without charge to any shareholder.

Licenses and Trademarks

We have a software license and services agreement with Risk Management Solutions, Inc. for the modeling of natural hazard catastrophes. The license is renewed on an annual basis. RLI Insurance Company has a perpetual license with AIG Technology Enterprises, Inc. for policy management, claims processing, premium accounting, file maintenance, financial/management reporting, reinsurance processing, and statistical reporting. We also enter into other software licensing agreements in the ordinary course of business.

We obtained U.S. federal service mark registration of our corporate logo “RLI”, “eRLI”, “e-Submissions”, “RLINK,” and other company service mark and trade names with the U.S. Patent and Trademark Office. Such registrations protect the marks nationwide from deceptively similar use. The duration of these registrations is 10 years unless renewed.

Employees

As of December 31, 2006, we employed a total of 724 associates. Of the 724 total associates, 75 were part-time and 649 were full-time.

Forward Looking Statements

Forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 appear throughout this report. These statements relate to our current expectations, beliefs, intentions, goals or strategies regarding the future and are based on certain underlying assumptions by us. These forward looking statements generally include words such as “expect,” “will,” “should,” “anticipate,” and similar expressions.  Such assumptions are, in turn, based on information available and internal estimates and analyses of general economic conditions, competitive factors, conditions specific to the property and casualty insurance industry, claims development, and the impact thereof on our loss reserves, the adequacy of our reinsurance programs, developments in the securities market and the impact on our investment portfolio, regulatory changes and conditions, and other factors and are subject to various risks, uncertainties, and other factors, including, without limitation those set forth below in “Item 1A Risk Factors.”  Actual results could differ materially from those expressed in, or implied by, these forward looking statements. We assume no obligation to update any such statements.  You should review the various risks, uncertainties, and other factors listed from time to time in our Securities and Exchange Commission filings.

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Item 1A.  Risk Factors

Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance industry, which may cause the price of our securities to be volatile.

The results of operations of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by:

·  rising levels of loss costs that we cannot anticipate at the time we price our coverages;

·   volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks;

·  changes in the level of reinsurance capacity;

·  changes in the amount of loss reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers’ liabilities; and

·  fluctuations in equity markets and interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses.

In addition, the demand for property and casualty insurance can vary significantly, rising as the overall level of economic activity increases and falling as that activity decreases, causing our revenues to fluctuate. These fluctuations in results of operations and revenues may cause the price of our securities to be volatile.

Catastrophic losses, including those caused by natural disasters, such as earthquakes and hurricanes, or man-made events such as terrorist attacks, are inherently unpredictable and could cause us to suffer material financial losses.

The greatest potential risk of loss we face in the ordinary course of our business is property damage resulting from catastrophic events, particularly earthquakes on the West Coast and hurricanes and tropical storms affecting Hawaii or the U.S. mainland.  Most of our past catastrophe-related claims have resulted from earthquakes and hurricanes. For example, we incurred a pre-tax net loss of $64.3 million related to the 1994 Northridge earthquake. In recent years, hurricanes have had a significant impact on our results.  We incurred a pre-tax loss of $22.5 million from the 2005 hurricanes, Katrina, Rita, and Wilma.  We also incurred a pre-tax loss of $9.9 million from the 2004 hurricanes, Charley, Frances, and Ivan.  Catastrophes can also be caused by various events, including windstorms, hailstorms, explosions, severe winter weather, and fires and may include terrorist events such as the attacks on the World Trade Center and the Pentagon on September 11, 2001.

The incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to fairly specific geographic areas; however, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. Catastrophes can cause losses in a variety of our property and casualty segments, and it is possible that a catastrophic event or multiple catastrophic events could cause us to suffer material financial losses.

Actual insured losses may be greater than our loss reserves, which would negatively impact our profitability.

Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of that loss. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and the related loss adjustment expenses. Loss reserves are just an estimate of what we anticipate the ultimate costs of claims to be and do not represent an exact calculation of liability. Estimating loss reserves is a difficult and complex process involving many variables and subjective judgments. As part of the reserving process, we review historical data and consider the impact of various factors such as:

·  loss emergence patterns;

·  underlying policy terms and conditions;

·  business and exposure mix;

·  trends in claim frequency and severity;

·  changes in operations;

·  emerging economic and social trends;

·  inflation; and

·  changes in the regulatory and litigation environments.

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This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves, and actual results are likely to differ from original estimates. If the actual amount of insured losses is greater than the amount we have reserved for these losses, our profitability could suffer.

We may suffer losses from litigation, which could materially and adversely affect our financial condition and business operations.

As is typical in our industry, we face risks associated with litigation.  For example, we are currently involved in a complex litigation arising out of an equipment and vehicle leasing program of Commercial Money Center. We are also a defendant in complex litigation brought against insurance brokers and insurance companies which alleges injury from the payment of contingent commissions by insurers to brokers.  These lawsuits are described in further detail in Item 3, Legal Proceedings. While it is impossible to ascertain the ultimate outcome of these matters at this time, we believe, based upon facts known to date, that our positions are meritorious and that the final resolution of these matters will not have a material adverse effect on our financial position or results of operations, taken as a whole. However, litigation is subject to inherent uncertainties, and if there were an outcome unfavorable to us, there exists the possibility of a material adverse impact on our results of operations in the period in which the outcome occurs.

Our reinsurers may not pay on losses in a timely fashion, or at all, which may increase our costs.

We purchase reinsurance by transferring part of the risk we have assumed (known as ceding) to a reinsurance company in exchange for part of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us (the reinsured) of our liability to our policyholders. Accordingly, we bear credit risk with respect to our reinsurers. That is, our reinsurers may not pay claims made by us on a timely basis, or they may not pay some or all of these claims, for a variety of reasons. Either of these events would increase our costs and could have a materially adverse effect on our business.

If we cannot obtain adequate reinsurance protection for the risks we have underwritten, we may be exposed to greater losses from these risks or we may reduce the amount of business we underwrite, which will reduce our revenues.

Market conditions beyond our control determine the availability and cost of the reinsurance protection that we purchase. In addition, the historical results of reinsurance programs and the availability of capital also affect the availability of reinsurance. Our reinsurance facilities are generally subject to annual renewal. We cannot be sure that we can maintain our current reinsurance facilities or that we can obtain other reinsurance facilities in adequate amounts and at favorable rates. In certain lines we have seen, and expect to continue to see, significant tightening in pricing and terms and conditions for the reinsurance that we purchase.  If we are unable to renew our expiring facilities or to obtain new reinsurance facilities on terms we deem acceptable, either our net exposures would increase - which could increase our costs - or, if we were unwilling to bear an increase in net exposures, we would have to reduce the level of our underwriting commitments - especially catastrophe exposed risks - which would reduce our revenues.

Our investment results and, therefore, our financial condition may be impacted by changes in the business, financial condition or operating results of the entities in which we invest, as well as changes in interest rates, government monetary policies, general economic conditions and overall market conditions.

We invest the premiums we receive from customers until they are needed to pay policyholder claims or until they are recognized as profits. At December 31, 2006, our investment portfolio consisted of $1.4 billion in fixed maturity securities, $368.2 million in equity securities and $104.2 million in short-term investments. For the 12 months ended December 31, 2006, we experienced a $34.4 million pre-tax unrealized gain on our investment portfolio. However, for the fiscal year ended December 31, 2005, we experienced $35.8 million in pre-tax unrealized losses on our investment portfolio. The 2006 gain and the 2005 loss reflect primarily the overall stock market and bond market fluctuations experienced during those periods. Fluctuations in the value of our investment portfolio can occur as a result of changes in the business, financial condition or operating results of the entities in which we invest, as well as changes in interest rates, government monetary policies and general economic conditions. These fluctuations may, in turn, negatively impact our financial condition.

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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. We face competition both from specialty insurance companies, underwriting agencies and intermediaries, as well as diversified financial services companies that are significantly larger than we are and that have significantly greater financial, marketing, management and other resources than we do. Some of these competitors also have significantly greater experience and market recognition than we do. 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 overall business results.

A number of new, proposed or potential legislative or industry developments could further increase competition in our industry. These developments include:

·an increase in capital-raising by companies in our lines of business, which could result in new entrants to our markets and an excess of capital in the industry;

·  the deregulation of commercial insurance lines in certain states and the possibility of federal regulatory reform of the insurance industry, which could increase competition from standard carriers for our excess and surplus lines of insurance business;

·  programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other “alternative markets” types of coverage; and

·  changing practices caused by the Internet, which may lead to greater competition in the insurance business.

New competition from these developments 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.

A downgrade in our ratings from A.M. Best, Standard & Poor’s, or Moody’s could negatively affect our business.

Ratings are a critical factor in establishing the competitive position of insurance companies. Our insurance companies are rated by A.M. Best, Standard & Poor’s, and Moody’s. A.M. Best, Standard & Poor’s, and Moody’s ratings reflect their opinions of an insurance company’s and an insurance holding company’s financial strength, operating performance, strategic position and ability to meet its obligations to policyholders, and are not evaluations directed to investors. Our ratings are subject to periodic review by such firms, and we cannot assure the continued maintenance of our current ratings. In 2006, A.M. Best reaffirmed its “A+, Superior” rating for the combined entity of RLI Insurance Company, Mt. Hawley Insurance Company, and RLI Indemnity Company (RLI Group). In 2006, Standard and Poor’s reaffirmed our “A+, Strong” rating. In 2006, Moody’s reaffirmed our group rating of “A2, Good” for RLI Group.  Because these ratings have become an increasingly important factor in establishing the competitive position of insurance companies, if our ratings are reduced from their current levels by any of A.M. Best, Standard & Poor’s, or Moody’s, our competitive position in the industry, and therefore our business, could be adversely affected. A significant downgrade could result in a substantial loss of business as policyholders might move to other companies with higher claims-paying and financial strength ratings.

We are subject to extensive regulation, which may adversely affect our ability to achieve our business objectives. Moreover, if we fail to comply with these regulations, we may be subject to penalties, including fines and suspensions, which may adversely affect our financial condition and results of operations.

We are subject to extensive governmental regulation and supervision. Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. These regulations, generally administered by a department of insurance in each state in which we do business, relate to, among other things:

·  approval of policy forms and premium rates;

·  standards of solvency, including risk-based capital measurements;

·  licensing of insurers and their producers;

·  restrictions on the nature, quality and concentration of investments;

·  restrictions on the ability of our insurance company subsidiaries to pay dividends to us;

·  restrictions on transactions between insurance company subsidiaries and their affiliates;

·  restrictions on the size of risks insurable under a single policy;

·  requiring deposits for the benefit of policyholders;

·  requiring certain methods of accounting;

·  periodic examinations of our operations and finances;

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·  prescribing the form and content of records of financial condition required to be filed; and

·  requiring reserves for unearned premium, losses and other purposes.

State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives.

In addition, regulatory authorities have relatively broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. In some instances, we follow practices based on our interpretations of regulations or practices that we believe may be generally followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. This could adversely affect our ability to operate our business. Further, changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect our ability to operate our business.

We may be unable to attract and retain qualified key employees.

We depend on our ability to attract and retain qualified executive officers, experienced underwriting talent and other skilled employees who are knowledgeable about our business. If we cannot attract or retain top-performing executive officers, underwriters, and other personnel, or if the quality of their performance decreases, we may be unable to maintain our current competitive position in the specialized markets in which we operate and unable to expand our operations into new markets.

We are an insurance holding company and, therefore, may not be able to receive dividends from our insurance subsidiaries in needed amounts.

RLI Corp. is the holding company for our three principal insurance operating companies.  At the holding company level, our principal assets are the shares of capital stock of our insurance company subsidiaries. We may rely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt obligations, dividends to shareholders and corporate expenses. The payment of dividends by our insurance company subsidiaries will depend on the surplus and future earnings of these subsidiaries and is also subject to regulatory restrictions. The maximum dividend distribution is limited by Illinois law to the greater of 10 percent of RLI Insurance Company’s policyholder surplus as of December 31 of the preceding year or its net income for the 12-month period ending December 31 of the preceding year. Therefore, the maximum dividend distribution that can be paid by RLI Insurance Company during 2007 without prior insurance department approval is $75.7 million, or RLI Insurance Company’s 2006 net income. As a result, we may not be able to receive dividends from our subsidiaries at times and in amounts necessary to meet our debt service obligations or to pay dividends to our shareholders or corporate expenses. During 2006, RLI Insurance Company paid total dividends of $59.5 million to RLI Corp.

Anti-takeover provisions affecting us could prevent or delay a change of control that is beneficial to you.

Provisions of our articles of incorporation and by-laws, and provisions of applicable Illinois law and applicable federal and state regulations may discourage, delay or prevent a merger, tender offer or other change of control that holders of our securities may consider favorable. Certain of these provisions impose various procedural and other requirements that could make it more difficult for shareholders to effect certain corporate actions. These provisions could:

·  have the effect of delaying, deferring or preventing a change in control of us;

·  discourage bids for our securities at a premium over the market price;

·  adversely affect the market price of, and the voting and other rights of the holders of, our securities; or

·  impede the ability of the holders of our securities to change our management.

Item 1B. Unresolved Staff Comments

None

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Item 2.  Properties

We own five commercial buildings in Peoria, Illinois.  Our primary building is a two-story 80,000 square foot office building, which serves as our corporate headquarters.  Located on the same 19 acre campus is a 24,000 square foot building which is used by two branch offices of RLI Insurance Company, and a supporting department. We also own a 25,400 square foot multi-story building, used for record storage, a training center and office space.  Our corporate campus also includes a 12,800 square foot building used as storage for furniture and equipment and office space.  We share ownership with Maui Jim, Inc. of a 16,800 square foot airplane hangar located at the Greater Peoria Regional Airport.

Most of our branch offices and other company operations lease the office space throughout the country.

Item 3.  Legal Proceedings

The following is a description of a complex set of litigation wherein we are both a plaintiff and a defendant. While it is impossible to ascertain the ultimate outcome of this matter at this time, we believe, based upon facts known to date, that our position is meritorious. Management’s opinion is that the final resolution of these matters will not have a material adverse effect on our financial statements taken as a whole.

We are the plaintiff in an action captioned RLI Insurance Co. v. Commercial Money Center, which was filed in U.S. District Court, Southern District of California (San Diego) on February 1, 2002. Other defendants in that action are Commercial Servicing Corporation (“CSC”), Sterling Wayne Pirtle, Anita Pirtle, Americana Bank & Trust, Atlantic Coast Federal Bank, Lakeland Bank and Sky Bank. We filed a similar complaint against the Bank of Waukegan in San Diego, California Superior Court. Americana Bank & Trust, Atlantic Coast Federal Bank, Lakeland Bank, Sky Bank and Bank of Waukegan are referred to here as the “investor banks.” The litigation arises out of the equipment and vehicle leasing program of Commercial Money Center (“CMC”). CMC originated leases, procured bonds pertaining to the performance of obligations of each lessee under each lease, and then formed “pools” of such leases that it marketed to banks and other institutional investors. We sued for rescission and/or exoneration of the bonds we issued to CMC and sale and servicing agreements we entered into with CMC and the investor banks, which had invested in CMC’s equipment leasing program. We contend we were fraudulently induced to issue the bonds and enter into the agreements by CMC, who misrepresented and concealed the true nature of its program and the underlying leases originated by CMC (for which bonds were procured). We also sued for declaratory relief to determine our rights and obligations, if any, under the instruments. Each investor bank disputes our claims for relief. CMC is currently in Chapter 7 bankruptcy proceedings.

Between the dates of April 4 and April 18, 2002, each investor bank subsequently filed a complaint against us in various state courts, which we removed to U.S. District Courts. Each investor bank sued us on certain bonds we issued to CMC as well as a sale and servicing agreement between the investor bank, CMC and us. Each investor bank sued for breach of contract, bad faith and other extra-contractual theories. We have answered and deny each investor bank’s claim to entitlement to relief. The investor banks claim entitlement to aggregate payment of approximately $53 million under either the surety bonds or the sale and servicing agreements, plus unknown extra-contractual damages, attorney’s fees and interest. On October 25, 2002, the judicial panel for multi-district litigation (“MDL Panel”) transferred 23 actions pending in five federal districts involving numerous investor banks, five insurance companies and CMC to the Federal District Court for the Northern District of Ohio for consolidated pre-trial proceedings, assigning the litigation to the Honorable Kathleen O’Malley.

In the third quarter of 2005, RLI reached a confidential settlement agreement with Lakeland Bank. This settlement ends our litigation with Lakeland, but does not resolve our pending litigation with the four other investor banks. The settlement with Lakeland relates to surety bonds representing approximately 17 percent of the amount to which the five investor banks had claimed entitlement. The settlement did not have a material adverse effect on our financial statements taken as a whole. In addition, in August 2005, the Federal District Court denied outright the investor banks’ motion for judgment on the pleadings as to RLI and subsequently ordered all remaining cases to mandatory mediation. Mediations held in January 2006 between RLI and each of the four remaining investor banks did not resolve the claims of those investor banks. In September 2006, the Court issued a case management order governing expert witness discovery and future motion practice.  While we cannot predict the ultimate outcome of the pending litigation between RLI and the remaining four investor banks at this time, RLI continues to believe it has meritorious defenses with respect to each of the banks making claims against it and will continue to vigorously assert those defenses in the pending litigation.

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Our financial statements contain an accrual for defense costs relating to this matter, included in unpaid losses and settlement expenses, as well as an accrual to cover rescission of collected premium related to the program. In our opinion, final resolution of this matter will not have a material adverse effect on our financial condition, results of operations or cash flows. However, litigation is subject to inherent uncertainties, and if there were an outcome unfavorable to us, there exists the possibility of a material adverse impact on our financial condition, results of operation or cash flows in the period in which the outcome occurred.

In addition to the CMC litigation, RLI Corp., RLI Insurance Company and Mt. Hawley Insurance Company are defendants in an ongoing lawsuit that is seeking class-action status in federal court in New Jersey, which was brought in October 2004 against over 100 insurance brokers and insurance companies by a putative class of plaintiffs who purchased insurance from the defendants.  This lawsuit alleges injury through state and federal antitrust violations, RICO violations, breach of fiduciary duties and unjust enrichment resulting from the payment of contingent commissions by the defendant insurers to the defendant brokers. The complaint seeks unspecified amounts in damages, including punitive damages, as well as other legal and equitable relief.  We deny the allegations made and are vigorously contesting this suit.

In addition, we are party to numerous claims and losses that arise in the normal course of our business. Many of such claims or losses involve claims under policies that we underwrite as an insurer. We believe that the resolution of these claims and losses will not have a material adverse effect on our financial condition, results of operations or cash flows.

Item 4.  Submission of Matters to a Vote of Security Holders

No matters were submitted by the Company to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

PART II

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Refer to the Corporate Data on page 59 of the 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.

Item 6.  Selected Financial Data

Refer to the Selected Financial Data on pages 60 through 61 of the 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

Refer to the Management’s Discussion and Analysis of Financial Condition and Results of Operations on pages 1 through 23 of the 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.  Certain accounting policies are viewed by Management to be “critical accounting policies.”  These policies relate to unpaid loss and settlement expenses, investment valuation, recoverability of reinsurance balances and deferred policy acquisition costs. A detailed discussion of these critical accounting policies can be found on pages 3 through 8 of the 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.

Throughout this report (including portions incorporated by reference herein), we present our operations in the way we believe will be most meaningful, useful and transparent to anyone using this financial information to evaluate our performance. In addition to the GAAP presentation of net income and certain statutory reporting information, we show certain non-GAAP financial measures that are valuable in managing our business, including underwriting income, gross premiums written, net written premiums and combined ratios. A detailed discussion of these measures can be found on pages 2 through 3 of the 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.

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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Refer to the Management’s Discussion and Analysis of Financial Condition and Results of Operations on pages 1 through 23 of the 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.

Item 8.  Financial Statements and Supplementary Data

Refer to the consolidated financial statements and supplementary data included on pages 24 through 58 of the 2006 Financial Report to Shareholders, attached as Exhibit 13 and incorporated by reference herein.  (See also Index to Financial Statements and Schedules attached on page 40.)

Item 9.  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

There were no changes in accountants or disagreements with accountants on any matters of accounting principles or practices or financial statement disclosure.

Item 9A. Controls and Procedures

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act). Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of December 31, 2006.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Based on our evaluation under the framework in Internal Control — Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.

Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report on page 54 of the 2006 Financial Report to Shareholders, attached as Exhibit 13.

There was no change in our internal control over financial reporting during our fourth fiscal quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Item 9B.  Other Information

None

36

PART III

Items 10 to 14.

Pursuant to General Instructions G(3) of Form 10-K, Items 10 to 14, inclusive, have not been restated or answered since the Company intends to file within 120 days after the close of its fiscal year with the Securities and Exchange Commission a definitive proxy statement pursuant to Regulation 14A under the Securities Exchange Act of 1934, which proxy statement involves the election of directors.  The information required in these items 10 to 14, inclusive, is incorporated by reference to that proxy statement.

PART IV

Item 15. Exhibits and Financial Statement Schedules

(a)(l-2) Consolidated Financial Statements and Schedules.  See Index to Financial Statements and Schedules attached.

(3) Exhibits.  See Exhibit Index on pages 51-52

(b)           Exhibits.  See Exhibit Index on pages 51-52

(c)Financial Statement Schedules.  The schedules included on attached pages 42 through 50 as required by Regulation S-X are excluded from the Company’s 2006 Financial Report to Shareholders.  See Index to Financial Statements and Schedules on page 40.  There is no other financial information required by Regulation S-X that is excluded from the Company’s 2006 Financial Report to Shareholders.

37

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

RLI Corp.

(Registrant)

By:	/s/Joseph E. Dondanville
	Joseph E. Dondanville
	Senior Vice President, Chief Financial Officer
Date:	February 28, 2007

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

By:	/s/Jonathan E. Michael
	Jonathan E. Michael, President, CEO
	(Principal Executive Officer)
Date:	February 28, 2007
By	/s/Joseph E. Dondanville
	Joseph E. Dondanville, Senior Vice President,
	Chief Financial Officer
	(Principal Financial and Accounting Officer)
Date:	February 28, 2007
By:	/s/Gerald D. Stephens
	Gerald D. Stephens, Director
Date	February 28, 2007
By:	/s/Barbara R. Allen
	Barbara R. Allen, Director
Date:	February 28, 2007
By:	/s/John T. Baily
	John T. Baily, Director
Date:	February 28, 2007
By:	/s/Richard H. Blum
	Richard H. Blum, Director
Date:	February 28, 2007

38

By:	/s/Jordan W. Graham
	Jordan W. Graham, Director
Date:	February 28, 2007
By:	/s/Gerald I. Lenrow
	Gerald I. Lenrow, Director
Date	February 28, 2007
By:	/s/Charles M. Linke
	Charles M. Linke, Director
Date:	February 28, 2007
By:	/s/F. Lynn McPheeters
	F. Lynn McPheeters, Director
Date:	February 28, 2007
By:	/s/Jonathan E. Michael
	Jonathan E. Michael, Director
Date:	February 28, 2007
By:	/s/Edward F. Sutkowski
	Edward F. Sutkowski, Director
Date:	February 28, 2007
By:	/s/Robert O. Viets
	Robert O. Viets, Director
Date:	February 28, 2007

39

INDEX TO FINANCIAL STATEMENTS AND SCHEDULES

		Reference (page)
Data Submitted Herewith:
Report of Independent Registered Public Accounting Firm		41
Schedules:
I.	Summary of Investments - Other than Investments in Related Parties at December 31, 2006.	42
II.	Condensed Financial Information of Registrant for the three years ended December 31, 2006.	43-45
III.	Supplementary Insurance Information for the three years ended December 31, 2006.	46-47
IV.	Reinsurance for the three years ended December 31, 2006.	48
V.	Valuation and Qualifying Accounts	49
VI.	Supplementary Information Concerning Property-Casualty Insurance Operations for the three years ended December 31, 2006.	50

Schedules other than those listed are omitted for the reason that they are not required, are not applicable or that equivalent information has been included in the financial statements, and notes thereto, or elsewhere herein.

40

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

RLI Corp.:

Under date of February 28, 2007, we reported on the consolidated balance sheets of RLI Corp. and Subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of earnings and comprehensive earnings, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006, as contained in the 2006 Financial Report to Shareholders.  These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 2006.  In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed in the accompanying index.  These financial statement schedules are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statement schedules based on our audits.

In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

/s/ KPMG LLP

Chicago, Illinois

February 28, 2007

41

RLI CORP. AND SUBSIDIARIES

SCHEDULE I–SUMMARY OF INVESTMENTS–OTHER THAN INVESTMENTS

IN RELATED PARTIES

December 31, 2006

Column A	Column B		Column C		Column D
(in thousands)					Amount at
					which shown in
Type of Investment	Cost (1)		Fair Value		the balance sheet
Fixed maturities:
Bonds:
Available-for-sale
U.S. Government	$	8,792	$	8,541	$	8,541
U.S. Agencies	465,629		461,831		461,831
Mtge/ABS/CMO*	109,538		109,272		109,272
Corporate	237,905		235,291		235,291
States, political subdivisions, and revenues	418,156		419,636		419,636
Total available-for-sale	$	1,240,020	$	1,234,571	$	1,234,571
Held-to-maturity
U.S. Government	$	6,291	$	6,309	$	6,291
U.S. Agencies	18,850		19,415		18,850
State, political subdivisions, and revenues	81,169		83,006		81,169
Total held-to-maturity	$	106,310	$	108,730	$	106,310
Trading
U.S. Government	$	2,438	$	2,399	$	2,399
U.S. Agencies	4,679		4,630		4,630
Mtge/ABS/CMO*	3,015		2,979		2,979
Corporate	4,893		4,848		4,848
States, political subdivisions, and revenues	100		104		104
Total trading	$	15,125	$	14,960	$	14,960
Total fixed maturities	$	1,361,455	$	1,358,261	$	1,355,841
Equity securities, available-for-sale
Common stock
Public utilities	$	45,958	$	73,331	$	73,331
Banks, trusts and insurance companies	27,287		67,083		67,083
Industrial, miscellaneous and all other	128,198		227,781		227,781
Total equity securities	$	201,443	$	368,195	$	368,195
Short-term investments	104,205		104,205		104,205
Total investments	$	1,667,103	$	1,830,661	$	1,828,241

*Mortgage-backed, asset-backed & collaterialzed mortgage obligations.

Note: See notes 1C and 2 of Notes to Consolidated Financial Statements, as attached in Exhibit 13.  See also the accompanying report of independent registered accounting firm on page 41 of this report.

(1)  Original cost of equity securities and, as to fixed maturities, original cost reduced by repayments and adjusted for amortization of premiums or accrual of discounts.

42

RLI CORP. AND SUBSIDIARIES

SCHEDULE II–CONDENSED FINANCIAL INFORMATION OF REGISTRANT

(PARENT COMPANY)

CONDENSED BALANCE SHEETS

December 31,

(in thousands, except share data)	2006			2005
ASSETS
Cash	$	14		$	63
Short-term investments, at cost which approximates fair value	34,250			748
Investments in subsidiaries/investees, at equity value	841,715			764,611
Equity securities available-for-sale, at fair value (cost—$33,992 in 2005)	0			37,160
Property and equipment, at cost, net of accumulated depreciation of $1,303 in 2006 and $1,042 in 2005	6,024			6,265
Deferred debt costs	754			861
Other assets	1,848			1,237
Total assets	$	884,605		$	810,945
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Accounts payable, affiliates	$	1,670		$	2,493
Dividends payable	5,254			4,533
Income taxes payable—current	8,526			1,279
Income taxes payable—deferred	9,508			6,411
Bonds payable, long-term debt	100,000			100,000
Interest payable, long-term debt	2,727			2,727
Other liabilities	400			561
Total liabilities	$	128,085		$	118,004
Shareholders’ equity:
Common stock ($1 par value, authorized 50,000,000 shares, issued 31,689,740 shares in 2006 and 31,344,058 shares in 2005)	31,690			31,344
Paid in capital	187,632			181,794
Accumulated other comprehensive earnings, net of tax	105,145			82,785
Retained earnings	594,147			478,043
Deferred compensation	7,744			7,735
Treasury shares at cost (7,416,762 shares in 2006 and 5,792,753 shares in 2005)	(169,838		)	(88,760
Total shareholders’ equity	$	756,520		$	692,941
Total liabilities and shareholders’ equity	$	884,605		$	810,945

See Notes to Consolidated Financial Statements, as attached in Exhibit 13.  See also the accompanying report of independent registered accounting firm on page 41 of this report.

43

RLI CORP. AND SUBSIDIARIES

SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Parent Company) - (continued)

CONDENSED STATEMENTS OF EARNINGS AND COMPREHENSIVE EARNINGS

Years ended December 31,

(in thousands)	2006			2005			2004
Net investment income	$	913		$	1,236		$	1,034
Net realized investment gains	24,417			5,417			519
Equity in earnings of unconsolidated investees	13,702			0			0
Selling, general and administrative expenses	(8,070		)	(6,780		)	(5,537		)
Interest expense on debt	(6,040		)	(6,056		)	(6,130		)
Earnings (loss) before income taxes	24,922			(6,183		)	(10,114		)
Income tax expense (benefit)	7,477			(3,933		)	(5,274		)
Net earnings (loss) before equity in net earnings of subsidiaries	17,445			(2,250		)	(4,840		)
Equity in net earnings of subsidiaries	117,194			109,384			77,876
Net earnings	$	134,639		$	107,134		$	73,036
Other comprehensive earnings(loss), net of tax
Unrealized gains on securities:
Unrealized holding gains arising during the period	$	837		$	283		$	3,095
Less: reclassification adjustment for gains included in net earnings	(2,896		)	(1,896		)	(337		)
Other comprehensive earnings(loss)-parent only	(2,059		)	(1,613		)	2,758
Equity in other comprehensive earnings (loss) of subsidiaries/investees	24,419			(21,619		)	5,560
Other comprehensive earnings (loss)	22,360			(23,232		)	8,318
Comprehensive earnings	$	156,999		$	83,902		$	81,354

See Notes to Consolidated Financial Statements, as attached in Exhibit 13.  See also the accompanying report of independent registered accounting firm on page 41 of this report.

44

RLI CORP. AND SUBSIDIARIES

SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Parent Company) - (continued)

CONDENSED STATEMENTS OF CASH FLOWS

Years ended December 31,

(in thousands)	2006			2005			2004
Cash flows from operating activities
Earnings (loss) before equity in net earnings of subsidiaries	$	17,445		$	(2,250	)	$	(4,840	)
Adjustments to reconcile net losses to net cash provided by operating activities:
Net realized investment gains	(24,417		)	(5,417		)	(519		)
Depreciation	261			259			253
Other items, net	(695		)	(124		)	178
Change in:
Affiliate balances payable	(822		)	869			4,246
Interest payable, long-term debt	0			0			2,479
Federal income taxes	6,656			814			(512		)
Stock option excess tax benefit	(2,930		)	0			0
Changes in investment in unconsolidated investees:
Undistributed earnings	(13,702		)	0			0
Dividends received	16,500			0			0
Net cash provided by (used in) operating activities	$	(1,704	)	$	(5,849	)	$	1,285
Cash flows from investing activities
Purchase of:
Equity securities, available-for-sale	(64,180		)	(41,727		)	(24,930		)
Short-term investments, net	(33,502		)	0			(15,006		)
Property and equipment	(20		)	(97		)	(286		)
Sale of:
Fixed maturities, available-for-sale	0			0			39,921
Equity securities, available-for-sale	106,353			34,959			5,939
Short-term investments, net	0			14,260			0
Property and equipment	0			3			220
Investment in unconsolidated investee	32,499			0			0
Capital contributions to subsidiaries	0			(50		)	(15,000		)
Cash dividends received-subsidiaries	10,928			13,037			19,586
Net cash provided by (used in) investing activities	52,078			20,385			10,444
Cash flows from financing activities
Stock option excess tax benefit	2,930			0			0
Proceeds from stock option exercises	3,254			1,437			1,059
Treasury shares purchased	(37,600		)	0			(10		)
Cash dividends paid	(19,007		)	(15,928		)	(12,636		)
Net cash used in financing activities	(50,423		)	(14,491		)	(11,587		)
Net (decrease) increase in cash	(49		)	45			142
Cash at beginning of year	63			18			(124		)
Cash at end of year	$	14		$	63		$	18

Interest paid on outstanding debt for 2006, 2005, and 2004 amounted to $6.0 million, $6.0 million and $3.5 million, respectively.  See Notes to Consolidated Financial Statements, as attached in Exhibit 13.  See also the accompanying report of independent registered accounting firm on page 41 of this report.

45

RLI CORP. AND SUBSIDIARIES

SCHEDULE III–SUPPLEMENTARY INSURANCE INFORMATION

Years ended December 31, 2006, 2005, and 2004

(in thousands)									Incurred Losses
	Deferred policy		Unpaid losses		Unearned				and settlement
	Acquisition		and settlement		premiums,		Premiums		expenses
Segment	Costs		expenses, gross		gross		Earned		current year
Year ended December 31, 2006
Casualty segment	$	33,958	$	1,153,509	$	241,900	$	348,217	$	217,956
Property segment	19,808		117,950		107,246		122,581		70,452
Surety segment	20,051		47,318		38,665		59,540		11,884
RLI Insurance Group	$	73,817	$	1,318,777	$	387,811	$	530,338	$	300,292
Year ended December 31, 2005
Casualty segment	$	32,456	$	1,104,800	$	249,043	$	358,893	$	239,004
Property segment	18,600		184,133		98,644		80,528		62,925
Surety segment	18,421		42,933		35,996		51,886		11,714
RLI Insurance Group	$	69,477	$	1,331,866	$	383,683	$	491,307	$	313,643
Year ended December 31, 2004
Casualty segment	$	35,721	$	1,011,299	$	247,580	$	365,617	$	257,854
Property segment	15,200		82,922		87,675		98,043		46,872
Surety segment	16,225		38,378		31,950		47,688		12,222
RLI Insurance Group	$	67,146	$	1,132,599	$	367,205	$	511,348	$	316,948

NOTE 1:  Investment income is not allocated to the segments, therefore net investment income has not been provided.

See the accompanying report of independent registered accounting firm on page 41 of this report.

46

RLI CORP. AND SUBSIDIARIES

SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION (continued)

Years ended December 31, 2006, 2005, and 2004

(in thousands)	Incurred
	losses and
	settlement			Policy		Other		Net
	expenses			acquisition		operating		premiums
Segment	prior year			costs		expenses		written
Year ended December 31, 2006
Casualty segment	$	(40,030	)	$	75,972	$	25,926	$	349,834
Property segment	(1,784		)	37,590		11,335		139,061
Surety segment	(1,589		)	32,214		6,356		62,641
RLI Insurance Group	$	(43,403	)	$	145,776	$	43,617	$	551,536
Year ended December 31, 2005
Casualty segment	$	(57,505	)	$	83,824	$	21,546	$	349,465
Property segment	(7,581		)	24,281		9,245		89,089
Surety segment	2,613			27,953		4,405		56,011
RLI Insurance Group	$	(62,473	)	$	136,058	$	35,196	$	494,565
Year ended December 31, 2004
Casualty segment	$	(11,813	)	$	81,206	$	18,810	$	370,449
Property segment	(5,137		)	27,555		8,353		91,549
Surety segment	6,133			25,834		3,568		49,214
RLI Insurance Group	$	(10,817	)	$	134,595	$	30,731	$	511,212

See the accompanying report of independent registered accounting firm on page 41 of this report.

47

RLI CORP. AND SUBSIDIARIES

SCHEDULE IV—REINSURANCE

Years ended December 31, 2006, 2005, and 2004

(in thousands)									Percentage
			Ceded to		Assumed				of amount
	Direct		other		from other		Net		assumed
Segment	amount		companies		companies		amount		to net
2006
Casualty	$	510,840	$	165,813	$	3,190	$	348,217	0.9	%
Property	214,909		94,428		2,100		$	122,581	1.7	%
Surety	63,155		4,307		692		$	59,540	1.2	%
RLI Insurance Group
Premiums earned	$	788,904	$	264,548	$	5,982	$	530,338	1.1	%
2005
Casualty	$	512,242	$	158,337	$	4,988	$	358,893	1.4	%
Property	163,138		84,731		2,121		80,528		2.6	%
Surety	56,103		4,737		520		51,886		1.0	%
RLI Insurance Group
Premiums earned	$	731,483	$	247,805	$	7,629	$	491,307	1.6	%
2004
Casualty	$	507,972	$	147,248	$	4,893	$	365,617	1.3	%
Property	185,417		89,896		2,522		98,043		2.6	%
Surety	51,207		4,409		890		47,688		1.9	%
RLI Insurance Group
Premiums earned	$	744,596	$	241,553	$	8,305	$	511,348	1.6	%

See the accompanying report of independent registered accounting firm on page 41 of this report.

48

RLI CORP. AND SUBSIDIARIES

SCHEDULE V–VALUATION AND QUALIFYING ACCOUNTS

Years ended December 31, 2006, 2005, and 2004

	Balance		Amounts		Amounts			Balance
	at beginning		charged		recovered			at end of
(in thousands)	of period		to expense		(written off)			period
2006 Allowance for uncollectible reinsurance	$	36,855	$	2,092	$	(2,389	)	$	36,558
2005 Allowance for uncollectible reinsurance	$	28,169	$	8,990	$	(304	)	$	36,855
2004 Allowance for uncollectible reinsurance	$	23,013	$	5,610	$	(454	)	$	28,169

See the accompanying report of independent registered accounting firm on page 41 of this report.

49

RLI CORP. AND SUBSIDIARIES

SCHEDULE VI–SUPPLEMENTARY INFORMATION CONCERNING

PROPERTY-CASUALTY INSURANCE OPERATIONS

Years ended December 31, 2006, 2005, and 2004

(in thousands)
	Deferred Policy		Claims and		Unearned		Net		Net
Affiliation with	Acquisition		Claim Adjustment		Premiums,		Premiums		Investment
Registrant (1)	Costs		Expense Reserves		Gross		Earned		Income
2006	$	73,817	$	1,318,777	$	387,811	$	530,338	$	71,325
2005	$	69,477	$	1,331,866	$	383,683	$	491,307	$	61,641
2004	$	67,146	$	1,132,599	$	367,205	$	511,348	$	54,087

	Claims and Claim Adjustment
	Expenses Incurred Related to:					Amortization		Paid Claims and		Net
	Current		Prior			of Deferred		Claim Adjustment		Premiums
	Year		Year			Acquisition Costs		Expenses		Written
2006	$	300,292	$	(43,403	)	$	145,776	$	202,440	$	551,536
2005	$	313,643	$	(62,473	)	$	136,058	$	180,932	$	494,565
2004	$	316,948	$	(10,817	)	$	134,595	$	169,105	$	511,212

(1)Consolidated property-casualty insurance operations.

See the accompanying report of independent registered accounting firm on page 41 of this report.

50

EXHIBIT INDEX

Exhibit No.	Description of Document	Reference (page)
3.1	Articles of Incorporation	Incorporated by reference to the Company’s
		Quarterly Form 10-Q for the Second Quarter
		ended June 30, 1997
3.2	By-Laws	Attached as Exhibit 3.2.
4.1	Senior Indenture dated as of	Incorporated by reference to the company’s
	December 9, 2003	Form 8-K filed December 10, 2003.
10.1	The RLI Corp. Directors’ Irrevocable	Incorporated by reference to the Company’s
	Trust Agreement	Quarterly Form 10-Q for the Second Quarter
		ended June 30, 1993.
10.2	RLI Corp. Incentive Stock	Incorporated by reference to Company’s
	Option Plan	Registration Statement on Form S-8 filed on
		March 11, 1996, File No. 333-01637
10.3	Directors’ Stock Option Plan	Incorporated by reference to the Company’s
		Registration Statement on Form S-8 filed on
		June 6, 1997, File No. 333-28625.
10.4	RLI Corp. Nonemployee Directors’	Incorporated by reference to the Company’s
	Stock Plan	Form S-8 filed on July 28, 2004,
		File No. 333-117714.
10.5	RLI Corp. Nonemployee Directors’	Incorporated by reference to the Company’s
	Deferred Compensation Plan	Annual Form 10-K for the year ended
		December 31, 2004.
10.6	RLI Corp. Executive Deferred	Incorporated by reference to the Company’s
	Compensation Plan	Annual Form 10-K for the year ended
		December 31, 2004.
10.7	Key Employee Excess Benefit Plan	Incorporated by reference to the Company’s
		Annual Form 10-K for the year ended
		December 31, 2004.
10.8	RLI Corp. Omnibus Stock Plan	Incorporated by reference to the Company’s
		Registration Statement on Form S-8 filed on
		May 31, 2005, File No. 333-125354.
10.9	RLI Incentive Compensation Plan	Incorporated by reference to the Company’s Form
		8-K filed on May 9, 2006.
11.0	Statement re: computation of per	Refer to the Note 1L, “Earnings per share,”
	share earnings	on pages 31-32 of the 2006 Financial Report to
		Shareholders, attached as Exhibit 13.
13.0	2006 Financial Report to Shareholders	Attached as Exhibit 13.

51

EXHIBIT INDEX

Exhibit No.	Description of Document	Reference Page
21.1	Subsidiaries of the Registrant	Page 53
23.1	Consent of KPMG LLP	Page 54
31.1	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	Page 55
31.2	Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	Page 56
32.1	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	Page 57
32.2	Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002	Page 58

52

EX-3.2

Exhibit 3.2

By-Laws of RLI Corp.

Restated February 28, 2007

THESE BY-LAWS OF RLI CORP., an Illinois corporation (“Corporation”), were adopted by the Board of Directors of the Corporation pursuant to the provisions of the Illinois Business Corporation Act of 1983, as periodically amended (“Act”).

1.Offices

1.1Registered Office

The registered office of the Corporation in the State of Illinois shall be located at 9025 North Lindbergh Drive, Peoria, Illinois 61615.  The name of its registered agent is Daniel O. Kennedy.  The registered office and agent may be periodically changed by the Board of Directors.

1.2Other Offices

The Corporation may also have offices at such other places both within or without the State of Illinois as the Board of Directors may periodically determine or the business of the Corporation may require.

2.Meetings of Shareholders

2.1Annual Meeting

The annual meeting of the shareholders shall be held prior to June 30 of each year at the date and time as determined by the Board of Directors, for the purpose of electing directors and for the transaction of such other business as may come before the meeting.  If the election of directors shall not be held on the day designated for the annual meeting, or at any adjournment thereof, the Board of Directors shall cause such election to be held at a special meeting of shareholders.

2.2Special Meetings

Any special meeting of the shareholders may be called by the Chairman of the Board, by the Board of Directors or the President, or by the holders of not less than 20% of the outstanding shares entitled to vote on the matter for which the meeting is called.

2.3Place of Meetings

Any meeting of the shareholders for the election of directors shall be held at the office of the Corporation in Peoria, Illinois, unless the Board of Directors shall, by resolution, designate any other location, within or without the State of Illinois, as the place of such meeting.

Any meeting of shareholders for any other purpose may be held at such place, within or without the State of Illinois, and at such time as shall be determined pursuant to Section 2.2 Special Meetings.

2.4Notice of Meetings

Written notice stating the place, day and hour of the meeting and, in the case of a special meeting, the purpose for which the meeting is called, shall be delivered not

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less than ten (10) nor more than sixty (60) days before the date of the meeting, or in the case of a merger, consolidation, share exchange, dissolution or sale, lease or exchange of assets not less than twenty (20) nor more than sixty (60) days before the date of the meeting, either personally or by mail, by or at the direction of the President, the Secretary or the officer or persons calling the meeting, to each shareholder of record entitled to vote at such meeting.  If mailed, such notice shall be deemed to be delivered when deposited in the United States mail addressed to the shareholder at such shareholder’s address as it appears on the records of the Corporation, with postage thereon prepaid.

When a meeting is adjourned to another time or place, no notice of the adjourned meeting, other than an announcement at the meeting, need be given unless the adjournment is for more than thirty (30) days or a new record date is fixed for the adjourned meeting after such adjournment.

2.5Shareholder List

At least ten (10) days before every meeting of shareholders, a complete list of the shareholders entitled to vote at such meeting, arranged in alphabetical order, and showing the address of each such shareholder and the number of shares registered in the name of each such shareholder, shall be prepared by the Secretary.

The list shall be open to examination of any shareholder of the Corporation, and to copying at the shareholder’s expense, during ordinary business hours, for any purpose germane to the meeting during the ten (10) day period ending on the date of the meeting, at the office of the Corporation in Peoria, Illinois. The list shall be produced and kept at the time and place of meeting during the meeting and be subject to inspection by any shareholder for any purpose germane to the meeting.

2.6Quorum

Except as otherwise provided by statute, the articles of incorporation or By-Laws, the holders of shares of the Corporation having a majority of the voting power thereof, present in person or represented by proxy, shall be requisite for, and shall constitute, a quorum at all meetings of the shareholders of the Corporation for the transaction of business.  If such quorum shall not be present or represented at any meeting of the shareholders, the shareholders entitled to vote, present in person or represented by proxy, shall have power to adjourn the meeting from time to time until a quorum shall be present or represented.  At such adjourned meeting at which a quorum shall be present or represented, any business may be transacted which might have been transacted at the meeting as originally notified.

2.7Proxies

A shareholder may vote such shareholder’s shares in person or may appoint a proxy to vote or otherwise act for such shareholder by signing an appointment form and delivering it to the person so appointed.

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No such proxy shall be valid after the expiration of eleven (11) months from the date thereof unless otherwise provided in the proxy.  Every proxy continues in full force and effect until revoked by the person executing it prior to the vote pursuant thereto, except as otherwise provided in this Section.  Such revocation may be affected by a writing delivered to the Corporation stating that the proxy is revoked or by a subsequent proxy executed by, or by attendance at the meeting and voting in person by, the person executing the proxy.  The dates contained on the forms of proxy presumptively determine the order of execution, regardless of the postmark dates on the envelopes in which they are mailed.

An appointment of a proxy is revocable by the shareholder unless the appointment form conspicuously states that it is irrevocable and the appointment is coupled with an interest, as such term is defined by applicable law.  A transferee for value of shares subject to an irrevocable appointment may revoke the appointment if the transferee was ignorant of its existence when the shares were acquired and both the existence of the appointment and its irrevocability were not noted conspicuously on the certificate, or information statement for shares without certificates, representing the shares.

The death or incapacity of the shareholder appointing a proxy does not revoke the proxy’s authority unless notice of the death or incapacity is received by the officer or agent who maintains the Corporation’s share transfer book before the proxy exercises such shareholder’s authority under the appointment.

Unless the appointment of a proxy contains an express limitation on the proxy’s authority, the Corporation may accept the proxy’s vote or other action as that of the shareholder making the appointment.  If the proxy appointed fails to vote or otherwise act in accordance with the appointment, the shareholder is entitled to such legal or equitable relief as is appropriate in the circumstances.

2.8Voting

Except as otherwise provided by the articles of incorporation, each shareholder shall be entitled to one (1) vote for each share of the Corporation entitled to vote thereat and registered in the name of such shareholder on the books of the Corporation on the referent record date.  No holder of any class or series of shares of this Corporation shall have cumulative voting rights with respect to any matter voted upon by the holders of such shares.

When a quorum is present at any meeting of the shareholders, the vote of the holders of a majority of the shares having voting power which is present in person or represented by proxy shall, except for the election of Directors and as otherwise required by applicable law, the articles of incorporation, or these By-Laws, decide any question brought before such meeting.

2.9Voting of Certain Shares

Shares standing in the name of another corporation, and entitled to vote may be

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voted by such officer, agent, or proxy as the by-laws of such corporation may prescribe or, in the absence of such provision, as the board of directors of such corporation may determine.  Shares standing in the name of a deceased person, a minor or an incompetent and entitled to vote may be voted by such person’s administrator, executor, guardian or conservator, as the case may be, either in person or by proxy.  Shares standing in the name of a trustee, receiver or pledgee and entitled to vote may be voted by such trustee, receiver or pledgee either in person or by proxy as provided by applicable law.

2.10Action Without Meeting

Unless otherwise provided in the articles of incorporation, any action required to be taken at any annual or special meeting of the shareholders, or any action which may be taken at a meeting of the shareholders, may be taken without a meeting and without a vote if a consent in writing, expressing the action so taken, shall be signed: if five (5) days prior notice of the proposed action is given in writing to all of the shareholders entitled to vote with respect to the subject matter thereof, by the holders of outstanding shares having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voting; or, by all of the shareholders entitled to vote with respect to the subject matter thereof.

Prompt notice of the taking of Corporation action without a meeting by less than unanimous written consent shall be given in writing to those shareholders who have not consented in writing.  If the action which is consented to is such as would have required the filing of a certificate under applicable law if such action had been voted on by the shareholders at a meeting thereof, the certificate filed shall state, in lieu of any statement required by applicable law, concerning any vote of shareholders, that written consent has been given in accordance with the provisions of this Section and that written notice has been given as provided in this Section.

3.Directors

3.1Number and Election

The number of directors of this Corporation shall be not less than nine (9) nor more than thirteen (13).  The members of the Board of Directors shall be divided into three (3) classes, each class to be as nearly equal in number as is possible.

The term of office of directors of the first class shall expire at the first annual meeting of shareholders after their election, that of the second class shall expire at the second annual meeting of shareholders after their election, and that of the third class shall expire at the third annual meeting of the shareholders after their election.  At each annual meeting, the number of directors equal to the number of the class whose terms expire at the time of such meeting shall be elected to hold office until the third succeeding annual meeting of the shareholders.

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Except for vacancies filled pursuant to Section 3.4 Vacancies, the directors shall be elected by the shareholders of the Corporation, and at each election the persons receiving the greatest number of votes, up to the number of directors then to be elected, shall be the persons then elected.  The election of directors is subject to any provisions contained in the articles of incorporation relating thereto.

3.2Resignations

Any director may resign at any time by giving written notice to the Board of Directors, its Chairman, the President or the Secretary of the Corporation, provided that the party to whom such notice is given is other than the individual director giving the notice.  Any such resignation shall take effect at the date of the receipt of such notice or at any later time specified therein.  Unless otherwise specified in such resignation, the acceptance of such resignation shall not be necessary to make it effective.

3.3Removal

Except as otherwise provided in the following sentence, a director of the Corporation may be removed only for cause by the affirmative vote of a majority of the outstanding shares then entitled to vote at an election of directors.  No director shall be removed at a meeting of shareholders unless the notice of such meeting shall state that a purpose of such meeting is to vote upon the removal of the director named in the notice, and only the named director may be removed at such meeting.

3.4Vacancies

Except as otherwise provided in the articles of incorporation, any vacancy in the Board, whether because of death, resignation, disqualification, an increase in the number of directors or any other cause, may be filled by the vote of the majority of the remaining directors, although less than a quorum.  Each director so chosen to fill a vacancy shall hold office until such director’s successor shall have been elected and shall qualify or until such director shall resign or shall have been removed.  No decrease in the number of directors constituting the Board of Directors shall shorten the term of any incumbent director.

3.5Retirement

The term of a director, except a current director as of August 24, 2000, shall expire at the beginning of the first annual meeting of shareholders of this Corporation on or after such director shall have attained age seventy-two (72).

3.6Management of Affairs of Corporation

The business and affairs of the Corporation shall be managed under the direction of its Board of Directors, which may exercise any such power of the Corporation and do any such lawful act as are not by applicable law, the articles of incorporation or these By-Laws directed or required to be exercised or done by shareholders.

3.7Dividends and Reserves

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Dividends upon shares may be declared by the Board of Directors at any regular or special meeting. Dividends may be paid in cash, in property, in shares or otherwise in the form, and to the extent, permitted by applicable law.  The Board of Directors may set apart, out of any funds of the Corporation available for dividends, a reserve or reserves for working capital or for any other lawful purpose, and also may abolish any such reserve in the manner in which it was created.

3.8Regular Meetings

An annual meeting of the Board of Directors shall be held, without notice other than as provided in these By-Laws, immediately after and at the same place as, the annual meeting of the shareholders, unless otherwise determined by the Board of Directors.  The Board of Directors may provide, by resolution, the time and place, either within or without the State of Illinois, for the holding of additional regular meetings without notice other than such resolution.

3.9Special Meetings

Special meetings of the Board of Directors may be called by the President and shall be called by the Secretary at the request of any two directors, to be held at such time and place, either within or without the State of Illinois, as shall be designated by the call.

3.10Notice of Special Meetings

Except as otherwise prescribed by statute, written or actual oral notice of the time and place of each special meeting of the Board of Directors shall be given at least two (2) day prior to the time of holding the meeting.  Any director may waive notice of any meeting as to such director.

3.11Quorum

The presence of not less than a majority of the Board of Directors shall be necessary and sufficient to constitute a quorum for the transaction of business.  Except as otherwise provided by applicable law, the articles of incorporation or these By-Laws, the act of a majority of the directors present at any meeting at which there is a quorum shall be the act of the Board of Directors.  If a quorum shall not be present at any meeting of directors, the directors present may adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum shall be present.

Unless otherwise provided by the articles of incorporation, any member of the Board of Directors or of any committee designated by the Board may participate in a meeting of the directors or committee by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other, and participation in a meeting by means of such equipment shall constitute presence in person at such meeting.

3.12Presumption of Assent

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Unless otherwise provided by applicable law, a director of the Corporation who is present at a meeting of the Board of Directors at which action is taken on any corporate matter shall be presumed to have assented to the action taken unless such director’s dissent shall be entered in the minutes of the meeting or unless such director shall file such director’s written dissent to such action with the person acting as secretary of the meeting before the adjournment thereof or shall forward such dissent by registered mail to the Secretary of the Corporation immediately after the adjournment of the meeting. Such right to dissent shall not apply to a director who voted in favor of such action.

3.13Action Without Meeting

Except as otherwise provided by applicable law, the articles of incorporation or these By-Laws, any action required or permitted to be taken at any meeting of the Board of Directors, or of any committee thereof, may be taken without a meeting, if a written consent thereto, setting forth the action so taken, is signed by all members of the board or of such committee entitled to vote, as the case may be, and such written consent is filed with the minutes of proceedings of the board or committee.

3.14Chairman of the Board.

The Board of Directors may, by resolution passed by a majority of the directors present at the meeting, annually elect a director to serve as Chairman of the Board.   Such Director shall serve as Chairman until the first to occur of the election of such Chairman’s successor, or such Chairman’s death, resignation or removal.   If a Chairman of the Board is elected, he or she shall preside at all meetings of the shareholders and directors at which he or she may be present. Other duties shall include, but not necessarily be limited to: 1) Approval of Board agendas, 2) Attendance at Board Committee meetings if requested by the Chair, 3) Review with Committee Chairs the Board and Committee evaluations, 4) Provide support for management, based on Board input, in developing Company strategy, and 5) Assist in identifying candidates for Board membership.

Annually the Nominating/Corporate Governance Committee and the Board of Directors shall review and adjust, if appropriate, the compensation paid to the Chairman of the Board.

3.15Executive Committee

The Board of Directors may, by resolution passed by a majority of the number of directors fixed by these By-Laws, designate two or more directors of the Corporation to constitute an executive committee.  The executive committee shall, to the extent provided in the resolution and by applicable law, have and may exercise any power and authority of the Board of Directors in the management of the business and affairs of the Corporation.

3.16Other Committees

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The Board of Directors may, by resolution passed by a majority of the number of directors, designate such other committees as it may periodically determine, but at a minimum shall include all committees as required by the New York Stock Exchange and the Securities and Exchange Commission.  Any committee shall consist of such number of directors, shall serve for such term and shall have and may exercise, during intervals between meetings of the Board of Directors, such duties, functions and powers as the Board of Directors may periodically prescribe, except that a committee may not authorize distributions; approve or recommend to shareholders any act required by applicable law to be approved by shareholders; fill vacancies on the board or on any of its committees; elect or remove officers or fix the compensation of any member of the committee; adopt, amend or repeal these By-Laws; approve a plan of merger not requiring shareholder approval; authorize or approve reacquisition of shares, except according to a general formula or method prescribed by the Board of Directors; authorize or approve the issuance or sale, or contract for sale, of shares or determine the designation and relative rights, preferences and limitations of a series of shares, except that the board may direct a committee to fix the specific terms of the issuance or sale or contract for sale or the number of shares to be allocated to particular employees under an employee benefit plan; or amend, alter, repeal or take action inconsistent with any resolution or action of the Board of Directors when the resolution or action of the Board of Directors provides by its terms that it shall not be amended, altered or repealed by action of a committee.

3.17Quorum and Manner of Acting – Committees

The presence of a majority of members of any committee shall constitute a quorum for the transaction of business at any meeting of such committee, and the act of a majority of those present shall be necessary for the taking of any action.

3.18Committee Chairman, Books and Records

The Chairman of any committee shall be selected from among the members of the committee by the Board of Directors.  Any committee shall keep a record of its acts and proceedings, and any action of each committee shall be reported to the Board of Directors at its next meeting.  Any committee shall fix its own rules of procedure not inconsistent with applicable law, these By-Laws or the resolution of the Board of Directors designating such committee and shall meet at such times and places and upon such call or notice as shall be provided by such designation.

3.19Fees and Compensation of Directors

The Board of Directors shall, by the affirmative vote of a majority of directors then in office, and irrespective of any personal interest of any of its members, have the authority to establish reasonable compensation of all directors for services to the Corporation as directors, including expenses incurred.

3.20Reliance Upon Records

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Each director of the Corporation, or member of any committee designated by the Board of Directors shall be fully protected in relying in good faith upon the books of account or reports made to the Corporation by any of its officials, by an independent certified public accountant, by an appraiser selected with reasonable care by the Board of Directors or by such committee, or in relying in good faith upon other records of the Corporation, including the records expressing or relating to the value and amount of assets, liabilities and profits of the Corporation or any other facts pertinent to the existence and amount of surplus or other funds from which dividends may properly be declared or paid or with which shares of the Corporation might lawfully be purchased or redeemed.

4.Notices

4.1Manner of Notice

Whenever notice is required to be given to any shareholder, director or member of any committee designated by the Board of Directors, such notice may be given by any commercially acceptable means in writing or otherwise, including by depositing such notice in a sealed envelope, in the United States mail, postage prepaid, addressed to such addressee at the address of such addressee as it appears on the books of the Corporation or, in the case of a director, at such director’s last known address. Notice shall be deemed to be given at the time when deposited in the United States mail or otherwise delivered to the director by commercially acceptable means of communication.

Except in the case of written shareholder notice, any notice requirement shall be deemed satisfied if actual notice is received by the person entitled thereto as far in advance of the event with respect to which notice is given as the minimum notice period required by applicable law or these By-Laws.

4.2Waiver of Notice

Any notice requirement may be waived in writing signed by the person entitled to such notice, whether before, at or after the time stated therein.  Except where a person attends a meeting for the purpose of objecting to such meeting, or for the purpose of objecting to the transaction of any business because such notice is not lawfully called or convened, attendance at a meeting by a person who is the subject of a notice requirement shall constitute a waiver of notice of such meeting.

Except as otherwise required by applicable law, the articles of incorporation or these By-Laws, neither the business to be transacted at, nor the purpose of, any regular or special meeting of the shareholders, directors or committee of directors need be specified in any written waiver of notice.

5.Officers

5.1Office and Official Positions

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The officers of the Corporation shall be a President, one or more Vice Presidents, a Secretary, a Treasurer, and such Assistant Secretaries, Assistant Treasurer, and other officers as the Board of Directors shall periodically determine to be appropriate.

Any two or more offices may be held by the same person.  None of the officers need be a director, a shareholder of the Corporation or a resident of the State of Illinois.  The Board of Directors may periodically establish, and abolish, official positions within the divisions into which the business and operations of the Corporation are divided and assign titles and duties to such positions.  A person appointed to any official position within any division need not be an officer of the Corporation.

The Board of Directors may periodically appoint officers to official positions within a division and remove any person so appointed with or without cause.  The authority incident to an official position within a division shall be limited to acts and transactions within the scope of the business and operations of such division.

5.2Election and Term of Office

The officers of the Corporation shall be elected annually by the Board of Directors.  Any officer shall hold office until the first to occur of the election of such officer’s successor, or such officer’s death, resignation or removal.

5.3Removal and Resignation

Any officer may be removed, with or without cause, by a majority of the directors then in office at any regular or special meeting of the board.

Any officer may resign upon written notice to the Board of Directors, to the President or to the Secretary.  Except as otherwise specified in such resignation, any resignation shall be effective on the date received and need not be accepted by the Corporation.

5.4Vacancies

A vacancy in any office because of death, resignation, removal, or any other cause may be filled for the unexpired portion of the term by the Board of Directors.

5.5President

The President shall be the chief executive officer of the Corporation and, if a Chairman of the Board is not elected or is absent, shall preside at all meetings of the shareholders, the Board of Directors or any committee of the Board if such President is a member.  The President shall have the overall supervision of the business of the Corporation and shall direct the affairs and policies of the Corporation, subject to such policies and directions as may periodically be promulgated by the Board of Directors.  The President shall have authority to designate the duties and powers of other officers and delegate special powers

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and duties to specified officers, so long as such designation shall not be inconsistent with applicable law, the articles of incorporation, these By-Laws or action of the Board of Directors.  The President may execute any deed, mortgage, bond, contract or other instrument of the Corporation except where required or permitted by law to be otherwise signed and executed and except where the signing and execution thereof shall be expressly delegated by the Board of Directors or by the President to some other officer or agent of the Corporation.

The President may sign with the Secretary or any Assistant Secretary or the Treasurer or any Assistant Treasurer, any certificate for shares, the issuance of which shall have been duly authorized by the Board of Directors, and shall vote, or give a proxy to any other person to vote, all shares of any other corporation standing in the name of the Corporation.

Subject to the limitations and satisfaction of the conditions expressed in the preceding paragraphs, the President shall have all powers and shall perform all duties which are incident to the chief executive office of a Corporation or as may periodically be prescribed by the Board of Directors.

5.6Vice Presidents

Absent the President, the Vice Presidents in order of their rank as fixed by the Board of Directors or, if not ranked, the Vice President designated by the Board of Directors or the President, shall perform all duties and shall have all powers of the President.

The Vice Presidents shall have such other powers and perform such other duties, not inconsistent with applicable law, the articles of incorporation, these By-Laws, or action of the Board of Directors, as may periodically be prescribed for them, respectively, by the Board of Directors or the President.  Any Vice President may sign, with the Secretary or an Assistant Secretary, or the Treasurer or an Assistant Treasurer, certificates for shares of the Corporation, the issuance of which shall have been duly authorized by the Board of Directors.

5.7Secretary

The Secretary shall:

(a)keep the minutes of the meetings of the shareholders, the Board of Directors and committees of directors, in one or more books provided for such purpose;

(b)see that all notices are fully given in accordance with the provisions of these By-Laws or as required by applicable law;

(c)have charge of the corporate records and of the seal of the Corporation;

(d)affix the seal of the Corporation or a facsimile thereof, or cause it to be affixed, to all certificates for shares prior to the issue thereof and to all documents the execution of which on behalf of the Corporation under its

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seal is duly authorized by the Board of Directors or otherwise in accordance with the provisions of these By-Laws;

(e)               keep a register of the post office address of each shareholder, director and committee member which shall periodically be furnished to the Secretary by such shareholder, director or member;

(f)                sign with the President, or a Vice President, certificates for shares of the Corporation, the issuance of which shall have been duly authorized by resolution of the Board of Directors;

(g)               have general charge of the stock transfer books of the Corporation; and

(h)               perform all duties incident to the office of Secretary and such other duties as may periodically be assigned to the Secretary by the President or by the Board of Directors.  The Secretary may delegate such details of the performance of duties of the Secretary’s office as may be appropriate in the exercise of reasonable care to one or more persons, but shall not be relieved of responsibility for the performance of such duties.

5.8          Treasurer

The Treasurer shall:

(a)        be responsible to the Board of Directors for the receipt, custody and disbursements of all funds and securities of the Corporation;

(b)        receive and give receipts for moneys due and payable to the Corporation from any source whatsoever and deposit all such moneys in the name of the Corporation in such banks, trust companies or other depositories as shall from time to time be selected in accordance with the provisions of these By-Laws;

(c)        disburse the funds of the Corporation as ordered by the Board of Directors or the President or as otherwise required in the conduct of the business of the Corporation;

(d)        render to the President or Board of Directors, upon request, an account of all transactions as Treasurer and on the financial condition of the Corporation;

(e)        perform all the duties incident to the office of Treasurer and such other duties as may periodically be assigned to the Treasurer by the President, by the Board of Directors or these By-Laws.  The Treasurer may sign, with the President, or a Vice President, certificates for shares of the Corporation, the issuance of which shall have been duly authorized by resolution of the Board of Directors.  The Treasurer may delegate such details of the performance of duties of the Treasurer’s office as may be appropriate in the exercise of

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reasonable care to one or more persons, but shall not be relieved of responsibility for the performance of such duties.

5.9          Assistant Treasurers and Assistant Secretaries

The Assistant Treasurers and Assistant Secretaries shall perform all functions and duties which the Secretary or Treasurer, as the case may be, may assign or delegate.

5.10        Salaries

The salaries of the officers shall be periodically determined by the Board of Directors or as it shall otherwise direct.  No officer shall be prevented from receiving a salary or other compensation by reason of the fact that such officer is also a director of the Corporation.

6.             Divisions

6.1          Divisions of the Corporation

The Board of Directors may periodically establish such operating divisions of the Corporation as the Board of Directors periodically determines to be appropriate.

6.2          Official Positions Within a Division

Except as otherwise periodically provided by the Board of Directors, the President may appoint and remove, with or without cause, any individual as an officer within a division.

7.             Contracts, Loans, Checks and Deposits

7.1          Contracts and Other Instruments

The Board of Directors may periodically authorize any person to enter into any contract or execute and deliver any instrument in the name of and on behalf of the Corporation, or of any division thereof and such authorization may be general or confined to specific instances.

7.2          Loans

No loan shall be contracted on behalf of the Corporation, or any division thereof, and no evidence of indebtedness shall be issued in the name of the Corporation, or any division thereof, unless authorized by a resolution of the Board of Directors and such authorization may be general or confined to specific instances.

7.3          Checks, Drafts

Any check, demand, draft or other order for the payment of money, note or other evidence of indebtedness issued in the name of the Corporation, or any division thereof, shall be signed by such person as the Board of Directors shall periodically designate.

7.4          Deposits

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Any funds of the Corporation, or any division thereof, not otherwise employed shall be periodically deposited to the credit of the Corporation in such bank, trust company or other depository as the Board of Directors may periodically designate.

8.             Shares and Their Transfer

8.1          Shares Represented by Certificates and Uncertificated Shares

Shares either shall be represented by certificates or shall be uncertificated shares.  The certificates of shares shall be in such form as may be periodically determined by the Board of Directors, shall be numbered and entered in the books of the Corporation as they are issued, and shall exhibit the holder’s name and number of shares, that the Corporation is organized under the Act, and shall be signed by the President or a Vice President and by the Treasurer or an Assistant Treasurer or the Secretary or an Assistant Secretary.

If any share certificate is signed by a transfer agent and a registrar, the signature of any officer of the Corporation may be facsimile.  If any officer whose facsimile signature has been used on any certificate, and such officer shall cease to act in such capacity before such certificate is delivered by the Corporation, such certificate may nevertheless be delivered by the Corporation without regard to the cessation of such officer.

Any certificate surrendered to the Corporation or transfer agent for transfer shall be cancelled and no new certificate shall be issued to evidence transferred shares until the former certificate shall have been surrendered.

Unless prohibited by the articles of incorporation, the Board of Directors may provide by resolution that some or all of any class or series of shares shall be uncertificated shares.  Any such resolution shall not apply to shares represented by a certificate until the certificate has been surrendered to the Corporation.  Within a reasonable time after the issuance or transfer of uncertificated shares, the Corporation or transfer agent shall send the registered owner thereof a written notice of all information that would appear on a certificate.  Except as otherwise expressly provided by law, the rights and obligations of the holders of uncertificated shares shall be identical to those of the holders of certificates representing shares of the same class and series.  The name and address of each shareholder, the number and class of shares held and the date on which the uncertificated shares were issued shall be entered on the books of the Corporation.  The person in whose name uncertificated shares stand on the books of the Corporation shall be deemed the owner thereof for all purposes as regards the Corporation.

8.2          Lost, Stolen or Destroyed Certificate

The Board of Directors may periodically promulgate procedures to be followed in connection with the issuance of new certificates in replacement of any certificate previously issued by the Corporation.

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8.3          Transfers of Shares

Subject to the satisfaction of the conditions periodically expressed by the Board of Directors, upon the surrender to the Corporation or transfer agent of a certificate representing shares of the Corporation, the Corporation or transfer agent shall issue a new certificate to the person entitled thereto, cancel the old certificate and record the transaction upon its books or make appropriate entries for uncertificated shares.  Transfers of certificated or uncertificated shares shall be made only on the books of the Corporation by the registered holder thereof or by its attorney or successor duly authorized as evidenced by documents filed with the Secretary or transfer agent of the Corporation.  The person in whose name shares stand on the books of the Corporation shall be deemed the owner thereof for all purposes.

8.4          Restrictions on Transfer

Subject to such conditions and limitations as the Board of Directors may periodically promulgate, and except as otherwise provided by any applicable law, the articles of incorporation or these By-Laws, any shareholder or the Corporation may enter into any agreement restricting the transferability of any shares of the Corporation, granting put, call, or other rights or responsibilities with respect to such shares on such terms and conditions as are equally applicable to any other shareholder of the Corporation.  Any restriction on the transferability of any shares may be expressed on the certificate representing such shares, or entered on the books of the Corporation for uncertificated shares.

8.5          No Fractional Shares

Fractional shares shall not be issued.

8.6          Fixing Record Date

The Board of Directors may fix in advance a date, not exceeding sixty (60) days, nor less than ten (10) days, preceding the date of any meeting of shareholders, or the date for the payment of any dividend, or the date for the allotment of rights, or the date when any change or conversion or exchange of shares shall be effective, or a date in connection with obtaining any consent, as a record date for the determination of the shareholders entitled to notice of, and to vote at, any such meeting, or adjournment thereof, or entitled to receive payment of any such dividend, or to any such allotment of rights, or to exercise the rights in respect of any such change, conversion or exchange of shares, or to give such consent, and in such case such shareholders and only such shareholders as shall be shareholders of record on the date so fixed shall be entitled to notice of, and to vote at, such meeting and any adjournment thereof, or to receive payment of such dividend, or to receive such allotment of rights, or to exercise such rights, or to give such consent, as the case may be, notwithstanding any transfer of any shares on the books of the Corporation after any such record date.

8.7          Shareholders of Record

Except as otherwise required by applicable law, the Corporation may treat the holder of record of any share as the holder in fact thereof.

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9.             General Provisions

9.1          Fiscal Year

The fiscal year of the Corporation shall begin on January 1 and shall end on December 31.

9.2          Seal

The Board of Directors may provide a corporate seal which shall have inscribed thereon the name of the Corporation, and the words “CORPORATE SEAL” and “Illinois;” and it shall otherwise be in the form approved by the Board of Directors.  The seal may be used by causing it, or a facsimile thereof, to be impressed or affixed or otherwise reproduced.

9.3          Director Emeritus

The Board may, subject to the following limitations and conditions, periodically appoint such one or more individuals to serve as a Director Emeritus to the Corporation:  (a) the individual shall have served as a director of the Corporation for more than ten (10) calendar years, (b) the term of the individual shall expire on the first to occur of (i) the removal of such individual, (ii) the disability, as conclusively determined by the Board of the Corporation, of such individual, (iii) the resignation of the individual, and (iv) at such time as the Board of the Corporation shall determined to be appropriate, (c) the individual shall be encouraged to attend the annual meeting of the shareholders and directors of the Corporation, (d) the individual shall not be compensated for any service provided; however, the Corporation shall pay any reasonable transportation, food and lodging expense paid or incurred by such individual in attending the annual meeting of the shareholders and directors of the Corporation, (e) the individual shall be invited to attend such portions of the annual meeting of the directors of the Corporation as the Board periodically determines to be appropriate and all or any portion of the annual meeting of the shareholders of the Corporation as such individual shall periodically determine to be appropriate, and (f) the individual shall have no vote on any matter brought before the Board of the Corporation.

10.          Indemnification

10.1        Third Party Action

The Corporation shall indemnify and hold harmless to the fullest extent authorized by the Illinois Business Corporation Act, as the same exists or may hereafter be amended (but, in the case of any such amendment, only to the extent that such amendment permits the Corporation to provide broader indemnification rights than said law permitted the Corporation to provide prior to such amendment) any person who was or is a party, or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than an action by

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or in the right of the Corporation) by reason of the fact that such person is or was a director, officer, employee or agent of the Corporation, or who is or was serving at the request of the Corporation as a director, officer, employee, trustee, fiduciary or agent of another corporation, partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans, against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such person in connection with such action, suit or proceeding.

10.2        Corporation Action

The Corporation shall indemnify and hold harmless to the fullest extent authorized by the Illinois Business Corporation Act, as the same exists or may hereafter be amended (but, in the case of any such amendment, only to the extent that such amendment permits the Corporation to provide broader indemnification rights than said law permitted the Corporation to provide prior to such amendment) any person who was or is a party, or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the Corporation to procure a judgment in its favor by reason of the fact that such person is or was a director, officer, employee, trustee, fiduciary or agent of the Corporation, or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans, against expenses (including attorneys’ fees) actually and reasonably incurred by such person in connection with the defense or settlement of such action or suit.

10.3        Expenses

Expenses incurred in defending a civil or criminal action, suit or proceeding may be paid by the Corporation in advance of the final disposition of such action, suit or proceeding, as authorized by the board of directors in the specific case, upon receipt of an undertaking by or on behalf of the director, officer, employee or agent to repay such amount, unless it shall ultimately be determined that he or she is entitled to be indemnified by the Corporation as authorized in this Article.

10.4        Non-Exclusivity

The indemnification provided by this Article shall not be deemed exclusive of any other rights to which those seeking indemnification may be entitled under any by-law, the articles of incorporation, agreement, vote of shareholders or disinterested directors or otherwise, both as to action in such person’s official capacity and as to action in another capacity while holding such office, and shall continue as to a person who has ceased to be a director, officer, employee or agent, and shall inure to the benefit of the heirs, executors and administrators of such a person.

10.5        Insurance

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The Corporation may purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the Corporation or who is or was serving at the request of the corporation as a director, officer, employee, trustee, fiduciary or agent of another corporation, partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans, against any liability asserted against such person and incurred by such person in any such capacity, or arising out of such person’s status as such, whether or not the Corporation would have the power to indemnify such person against such liability under the provisions of this Section.

10.6        Reporting

If the Corporation has paid indemnity or has advanced expenses to a director, officer, employee or agent, the Corporation shall report the indemnification or advance in writing to the shareholders with or before the notice of the next shareholders meeting.

10.7        Definitions

For purposes of this Article, references to “the Corporation” or “this Corporation” shall include, in addition to any surviving corporation, any merging corporation (including any corporation having merged with a merging corporation) absorbed in a merger which, if its separate existence had continued, would have had the power and authority to indemnify its directors, officers and employees or agents, so that any person who was a director, officer, employee or agent of such merging corporation, or was serving at the request of such merging corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprises, shall stand in the same position under the provisions of this Article with respect to the surviving corporation as such person would have with respect to such merging corporation if its separate existence had continued.

For purposes of this Article, references to “other enterprises” shall include employee benefit plans; references to “fines” shall include any excise taxes assessed on a person with respect to an employee benefit plan; and references to “serving at the request of the Corporation” shall include any service as a director, officer, employee or agent of the Corporation which imposes duties on, or involves services by such director, officer, employee or agent with respect to an employee benefit plan, its participants or beneficiaries. A person who acted in good faith and in a manner he or she reasonably believed to be in the best interests of the participants and beneficiaries of an employee benefit plan shall be deemed to have acted in a manner “not opposed to the best interest of the Corporation” as referred to in this Article.

11.          Amendments

These By-Laws may be made, altered, amended or repealed by the shareholders or the Board of Directors.  Any By-Law made, altered, amended or repealed by the shareholders may be altered, amended or repealed by the Board of Directors, or by the shareholders.

*   *   *   *   *   *   *   *   *   *

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EX-13

Exhibit 13

OWNERS MANUAL  |  THE PRINCIPLES THAT DRIVE OUR SUCCESS	0
RLI CORP. FINANCIAL REPORT	6

		1	MANAGEMENT’S DISCUSSION AND ANALYSIS
		24	CONSOLIDATED BALANCE SHEETS
		25	CONSOLIDATED STATEMENTS OF EARNINGS
			AND COMPREHENSIVE EARNINGS
		26	CONSOLIDATED STATEMENTS OF CASH FLOWS
		28	CONSOLIDATED STATEMENTS OF
			SHAREHOLDERS’ EQUITY
		29	NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
		54	LETTERS OF RESPONSIBILITY
		58	GLOSSARY
		59	INVESTOR INFORMATION
		60	SELECTED FINANCIAL DATA
0	FINANCIAL REPORT  |  THE PRINCIPLES THAT DRIVE OUR SUCCESS
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MANAGEMENT’S DISCUSSION AND ANALYSIS

OVERVIEW

RLI Corp. underwrites selected property and casualty insurance through major subsidiaries collectively known as RLI Insurance Group. As a “niche” company, we offer specialty insurance coverages designed to meet specific insurance needs of targeted insured groups and underwrite particular types of coverage for certain markets that are underserved by the insurance industry, such as our commercial earthquake coverage or oil and gas surety bonds. We also provide types of coverages not generally offered by other companies, such as our stand-alone personal umbrella policy. The excess and surplus market, which unlike the standard admitted market is less regulated and more flexible in terms of policy forms and premium rates, provides an alternative for customers with hard-to-place risks. When we underwrite within the surplus lines market, we are selective in the line of business and type of risks we choose to write. Using our non-admitted status in this market allows us to tailor terms and conditions to manage these exposures more effectively than our admitted counterparts. Often the development of these specialty insurance coverages is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients. Once a proposal is submitted, underwriters determine whether it would be a viable product in keeping with our business objectives.

The foundation of our overall business strategy is to underwrite for profit, and we have achieved this for 11 consecutive years averaging a 90.5 combined ratio over that period of time. This drives our ability to provide shareholder returns in three different ways: the underwriting income itself, net investment income from our investment portfolio, and long-term appreciation in our equity portfolio. Our investment strategy is based on preservation of capital as the first priority, with a secondary focus on generating total return. The fixed income portfolio consists primarily of highly rated, investment grade securities to protect invested assets. Regular underwriting income allows a portion of our shareholders’ equity to be invested in value-based equities, including a core portfolio weighted toward dividend-paying stocks, including REITs. Private equity investments, primarily our minority ownership in Maui Jim, Inc. (Maui Jim), have also enhanced overall returns. Additional asset classes for diversification are also being considered. In addition, we employ stringent diversification rules and balance our investment credit risk and related underwriting risks to minimize total potential exposure to any one security. Despite occasional fluctuations of realized and unrealized gains and losses in the equity portfolio, our investment in stocks as part of a long-term asset allocation strategy has contributed significantly to our historic growth in book value.

We measure the results of our insurance operations by monitoring certain measures of growth and profitability across three distinct business segments: casualty, property, and surety. Growth is measured in terms of gross premiums written and profitability is analyzed through combined ratios, which are further subdivided into their respective loss and expense components. The combined ratios represent the income generated from our individual segments.

The casualty portion of our business consists largely of general liability, transportation, multi-peril program business, commercial umbrella, personal umbrella, executive products, and other specialty coverages. In addition, we provide employers’ indemnity and in-home business owners coverage. The casualty business is subject to the risk of estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty segment may also be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses.

Our property segment primarily underwrites commercial fire, earthquake, difference in conditions, marine, and in the state of Hawaii, select personal lines policies. Property insurance results are subject to the variability introduced by perils such as earthquakes, fires, and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, primarily in the state of California. Our second largest catastrophe exposure is to losses caused by hurricanes to commercial properties throughout the Gulf and East Coasts, as well as to homes we insure in Hawaii. We limit our net aggregate

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exposure to a catastrophic event by purchasing reinsurance and through extensive use of computer-assisted modeling techniques. These techniques provide estimates of the concentration of risks exposed to catastrophic events.

The surety segment specializes in writing small-to-large commercial and small contract surety coverages, as well as those for the energy (plugging and abandonment of oil wells), petrochemical, and refining industries. Our surety coverages usually involve a statutory requirement for bonds. While these bonds have maintained a relatively low loss ratio, losses may fluctuate due to adverse economic conditions that may affect the financial viability of an insured. The contract surety marketplace guarantees the construction work of a commercial contractor for a specific project. Generally, losses occur due to adverse economic conditions, inclement weather conditions or the deterioration of a contractor’s financial condition. As such, this line has historically produced marginally higher loss ratios than other surety lines.

The insurance marketplace softened over the last three years, meaning that the marketplace became more competitive and prices were generally flat to falling, even as coverage terms became less restrictive. Nevertheless, we believe that our business model is geared to create underwriting income by focusing on sound underwriting discipline. Our primary focus will continue to be on underwriting profitability as opposed to premium growth or market share measurements.

GAAP AND NON-GAAP FINANCIAL PERFORMANCE METRICS

Throughout this annual report, we present our operations in the way we believe will be most meaningful, useful, and transparent to anyone using this financial information to evaluate our performance. In addition to the GAAP presentation of net income and certain statutory reporting information, we show certain non-GAAP financial measures that we believe are valuable in managing our business and drawing comparisons to our peers. These measures are underwriting income, gross premiums written, net premiums written, combined ratios, and net unpaid loss and settlement expenses.

Following is a list of non-GAAP measures found throughout this report with their definitions, relationships to GAAP measures, and explanations of their importance to our operations.

Underwriting Income

Underwriting income or profit represents the pretax profitability of our insurance operations and is derived by subtracting losses and settlement expenses, policy acquisition costs, and insurance operating expenses from net premium earned. Each of these captions is presented in the statements of earnings but not subtotaled. However, this information is available in total and by segment in note 11 to the financial statements, regarding industry segment information. The nearest comparable GAAP measure is earnings before income taxes which, in addition to underwriting income, includes net investment income, general corporate expenses, debt costs, and unconsolidated investee earnings.

Gross premiums written

While net premiums earned is the related GAAP measure used in the statements of earnings, gross premiums written is the component of net premiums earned that measures insurance business produced before the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an overall gauge of gross business volume in our insurance underwriting operations with some indication of profit potential subject to the levels of our retentions, expenses, and loss costs.

Net premiums written

While net premiums earned is the related GAAP measure used in the statements of earnings, net premiums written is the component of net premiums earned that measures the difference between gross premiums written and the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an indication of retained or net business volume in our insurance underwriting operations. It is an indicator of future earnings potential subject to our expenses and loss costs.

Combined ratios

This ratio is a common industry measure of profitability for any underwriting operation, and is calculated in two components. First, the loss ratio is losses and

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settlement expenses divided by net premiums earned. The second component, the expense ratio, reflects the sum of policy acquisition costs and insurance operating expenses, divided by net premiums earned. The sum of the loss and expense ratios is the combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of underwriting income or loss. For example, a combined ratio of 85 implies that for every $100 of premium we earn, we record $15 of underwriting income.

Net unpaid loss and settlement expenses

Unpaid losses and settlement expenses, as shown in the liabilities section of our balance sheet, represents the total obligations to claimants for both estimates of known claims and estimates for incurred but not reported (IBNR) claims. The related asset item, reinsurance balances recoverable on unpaid losses and settlement expense, is the estimate of known claims and estimates of IBNR that we expect to recover from reinsurers. The net of these two items is generally referred to as net unpaid loss and settlement expenses and is commonly referred to in our disclosures regarding the process of establishing these various estimated amounts.

In preparing the consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.

The most critical accounting policies involve significant estimates and include those used in determining the liability for unpaid losses and settlement expenses, investment valuation, recoverability of reinsurance balances, and deferred policy acquisition costs.

CRITICAL ACCOUNTING POLICIES

LOSSES AND SETTLEMENT EXPENSES

Overview

Loss and loss adjustment expense reserves represent our best estimate of ultimate amounts for losses and related settlement expenses from claims that have been reported but not paid, and those losses that have occurred but have not yet been reported to us. Loss reserves do not represent an exact calculation of liability, but instead represent our estimates, generally utilizing individual claim estimates and actuarial expertise and estimation techniques at a given accounting date. The loss reserve estimates are expectations of what ultimate settlement and administration of claims will cost upon final resolution. These estimates are based on facts and circumstances then known to us, review of historical settlement patterns, estimates of trends in claims frequency and severity, projections of loss costs, expected interpretations of legal theories of liability, and many other factors. In establishing reserves, we also take into account estimated recoveries, reinsurance, salvage, and subrogation. The reserves are reviewed regularly by a team of actuaries we employ with periodic review by outside independent actuarial firms.

The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables. These variables can be affected by both internal and external events, such as changes in claims handling procedures, claim personnel, economic inflation, legal trends, and legislative changes, among others. The impact of many of these items on ultimate costs for loss and loss adjustment expense is difficult to estimate. Loss reserve estimations also differ significantly by coverage due to differences in claim complexity, the volume of claims, the policy limits written, the terms and conditions of the underlying policies, the potential severity of individual claims, the determination of occurrence date for a claim, and reporting lags (the time between the occurrence of the policyholder events and when it is actually reported to the insurer). Informed judgment is applied throughout the process. We continually refine our loss reserve estimates as historical loss experience develops and additional claims are reported and settled. We rigorously attempt to consider all significant facts and circumstances known at the time loss reserves are established.

Due to inherent uncertainty underlying loss reserve estimates, including but not limited to the future settlement environment, final resolution of the estimated liability will be different from that anticipated at the reporting date. Therefore, actual paid losses in the future may yield a materially

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different amount than currently reserved — favorable and unfavorable.

The amount by which estimated losses differ from those originally reported for a period is known as “development.” Development is unfavorable when the losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable developments of loss reserves in the results of operations in the period the estimates are changed.

We record two categories of loss and loss adjustment expense reserves — case-specific reserves and incurred but not reported (IBNR) reserves.

Within a reasonable period of time after a claim is reported, our claim department completes an initial investigation and establishes a case reserve. This case-specific reserve is an estimate of the ultimate amount we will have to pay for the claim, including related legal expenses and other costs associated with resolving and settling a particular claim. The estimate reflects all of the current information available regarding the claim, the informed judgment of our professional claim personnel, our reserving practices and experience, and the knowledge of such personnel regarding the nature and value of the specific type of claim. During the life cycle of a particular claim, more information may materialize that causes us to revise the estimate of the ultimate value of the claim either upward or downward. We may determine that it is appropriate to pay portions of the reserve to the claimant or related settlement expenses before final resolution of the claim. The amount of the individual claim reserve will be adjusted accordingly and is based on the most recent information available.

We establish Incurred But Not Reported (IBNR) reserves to estimate the amount we will have to pay for claims that have occurred, but have not yet been reported to us; claims that have been reported to us that may ultimately be paid out differently than expected by our case-specific reserves; and claims that have been paid and closed, but may reopen and require future payment.

Our IBNR reserving process involves three steps including an initial IBNR generation process that is prospective in nature; a loss and loss adjustment expense reserve estimation process that occurs retrospectively; and a subsequent discussion and reconciliation between our prospective and retrospective IBNR estimates which includes changes in our provisions for IBNR where deemed appropriate. These three processes are discussed in more detail in the following sections.

Loss adjustment expense (LAE) represents the cost involved in adjusting and administering losses from policies we sold. The LAE reserves are frequently separated into two components: allocated and unallocated. Allocated loss adjustment expense (ALAE) reserves represent an estimate of claims settlement expenses that can be identified with a specific claim or case. Examples of ALAE would be the hiring of an outside adjuster to investigate a claim or an outside attorney to defend our insured. The claims professional typically estimates this cost separately from the loss component in the case reserve. Unallocated loss adjustment expense (ULAE) reserves represent an estimate of claims settlement expenses that cannot be identified with a specific claim. An example of ULAE would be the cost of an internal claims examiner to manage or investigate a reported claim.

All decisions regarding our best estimate of ultimate loss and LAE reserves are made by our Loss Reserve Committee (LRC). The LRC is made up of the management team including the chief executive officer, chief operating officer, chief financial officer, chief actuary, vice president of claims, vice president of underwriting, and other selected executives.

We do not use discounting (recognition of the time value of money) in reporting our estimated reserves for losses and settlement expenses. Based on current assumptions used in calculating reserves, we believe that our overall reserve levels at December 31, 2006, make a reasonable provision to meet our future obligations.

Initial IBNR Generation Process

Initial carried IBNR reserves are determined through a reserve generation process. The intent of this process is to establish an initial total reserve that will provide a reasonable provision for the ultimate

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value of all unpaid loss and allocated loss adjustment expense liabilities. For most casualty and surety products, this process involves the use of an initial loss and ALAE ratio that is applied to the earned premium for a given period. The result is our best initial estimate of the expected amount of ultimate loss and ALAE for the period by product. Paid and case reserves are subtracted from this initial estimate of ultimate loss and ALAE to determine a carried IBNR reserve.

For most property products, we use an alternative method of determining an appropriate provision for initial IBNR. Since this segment is characterized by a shorter period of time between claim occurrence and claim settlement, the IBNR reserve is determined by an initial loss percentage applied to the rolling twelve month’s premium earned. No deductions for paid or case reserves are made. This alternative method of determining initial IBNR reacts more quickly to the actual loss emergence and is more appropriate for our property products where final claim resolution occurs quickly.

The initial loss and ALAE ratios that are applied to earned premium are reviewed at least semi-annually. Prospective estimates are made based on historical loss performance adjusted for price change and loss cost inflation. The initial loss and ALAE ratios also reflect estimation risk. We consider estimation risk by segment and product line. A segment with greater overall volatility and uncertainty has greater estimation risk. Characteristics of segments and products with higher estimation risk, include those exhibiting, but not limited to, the following characteristics:

·      significant changes in underlying policy terms and conditions,

·      consisting of a new business,

·      undergoing significant exposure growth or turnover,

·      small volume or lacking internal data requiring significant reliance on external data,

·      longer emergence patterns with exposures to latent unforeseen mass tort,

·      high severity and/or low frequency,

·      operational processes undergoing significant change, and/or

·      high sensitivity to significant swings in loss trends or economic change.

The historical and prospective loss and ALAE estimates along with the applicable risk factors identified above are the bases for determining our initial and subsequent carried reserves. Adjustments in the initial loss ratio by product and segment are made where necessary and reflect updated assumptions regarding loss experience and prevailing risk factors. The Loss Reserve Committee makes all final decisions regarding changes in the initial loss and ALAE ratios.

Loss and LAE Reserve Estimating Process

A full analysis of our loss reserves takes place at least semi-annually. The purpose of these analyses is to provide validation of our carried loss reserves. Estimates of the expected value of the unpaid loss and loss adjustment expense are derived using actuarial methodologies. These estimates are then compared to the carried loss reserves to determine the appropriateness of the current reserve balance.

The actuarial process of estimating ultimate payment for claims and claims expenses begins with the collection and analysis of current and historical claim data. Data on individual reported claims including paid amounts and individual claim adjuster estimates are grouped by common characteristics. There is judgment involved in this grouping. Considerations when grouping data include the volume of the data available, the credibility of the data available, the homogeneity of the risks in each cohort, and both settlement and payment pattern consistency. We use this data to determine historical claim reporting and payment patterns which are used in the analysis of ultimate claim liabilities. For portions of the business without sufficiently large numbers of policies or that have not accumulated sufficient historical statistics, our own data is supplemented with external or industry average data as available and when appropriate. For our executive products and marine business, we utilize external data extensively.

In addition to the review of historical claim reporting and payment patterns, we also incorporate an estimate of expected losses relative to premium by year into the analysis. The expected losses are based on a review of historical loss performance, trends in frequency and severity, and price level changes. The estimation of expected losses is subject to judgment including consideration given to internal and industry

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data available, growth and policy turnover, changes in policy limits, changes in underlying policy provisions, changes in legal and regulatory interpretations of policy provisions, and changes in reinsurance structure.

We use historical development patterns, estimations of the expected loss ratios, and standard actuarial methods to derive an estimate of the ultimate level of loss and loss adjustment expense payments necessary to settle all the claims occurring as of the end of the evaluation period. Once an estimate of the ultimate level of claim payments has been derived, the amount of paid loss and loss adjustment expense and case reserve through the evaluation date is subtracted to reveal the resulting level of IBNR.

Our reserve processes include multiple standard actuarial methods for determining estimates of IBNR reserves. Other supplementary methodologies are incorporated as deemed necessary. Mass tort and latent liabilities are examples of exposures where supplementary methodologies are used. Each method produces an estimate of ultimate loss by accident year. We review all of these various estimates and the actuaries assign weight to each based on the characteristics of the product being reviewed. The result is a single actuarial point estimate by product by accident year.

Our estimates of ultimate loss and LAE reserves are subject to change as additional data emerge. This could occur as a result of change in loss development patterns; a revision in expected loss ratios; the emergence of exceptional loss activity; a change in weightings between actuarial methods; the addition of new actuarial methodologies or new information that merits inclusion; or the emergence of internal variables or external factors that would alter their view.

There is uncertainty in the estimates of ultimate losses. Significant risk factors to the reserve estimate include, but are not limited to, unforeseen or unquantifiable changes in:

·      loss payment patterns,

·      loss reporting patterns,

·      frequency and severity trends,

·      underlying policy terms and conditions,

·      business or exposure mix,

·      operational or internal process changes affecting timing of recording transactions,

·      regulatory and legal environment, and/or

·      economic environment.

Our actuaries engage in discussions with senior management, underwriting, and the claims department on a regular basis to attempt to ascertain any substantial changes in operations or other assumptions that are necessary to consider in the reserving analysis.

A considerable degree of judgment in the evaluation of all these factors is involved in the analysis of reserves. The human element in the application of judgment is unavoidable when faced with material uncertainty. Different experts will choose different assumptions when faced with such uncertainty, based on their individual backgrounds, professional experiences, and areas of focus. Hence, the estimate selected by the various qualified experts may differ materially from each other. We consider this uncertainty by examining our historic reserve accuracy.

Given the significant impact of the reserve estimates on our financial statements, we subject the reserving process to significant diagnostic testing and outside review. Multiple outside reserving specialists periodically review the reserve estimation process and the resulting estimates. We give consideration to these outside opinions and implement recommended improvements as deemed appropriate. We have incorporated data validity checks and balances into our front-end processes. Leading indicators such as actual versus expected emergence and other diagnostics are also incorporated into the reserving processes.

Determination of Our Best Estimate

Upon completion of our full loss and loss adjustment expense estimation analysis, the results are discussed with the Loss Reserve Committee (LRC). As part of this discussion, the analysis supporting an indicated point estimate of the IBNR loss reserve by product is reviewed. The actuaries also present explanations supporting any changes to the underlying assumptions used to calculate the indicated point estimate. Review of the variance between the indicated reserves and the carried reserves determined from the initial IBNR generation process takes place. After discussion of these analyses and all relevant risk factors, the LRC determines whether the reserve balances require adjustment.

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As a predominantly excess and surplus lines and specialty insurer servicing niche markets, we believe that there are several reasons to carry — on an overall basis — reserves above the actuarial point estimate. We believe we are subject to above average variation in estimates and that this variation is not symmetrical around the actuarial point estimate.

One reason for large variation is the above average policyholder turnover and changes in the underlying mix of exposures typical of all excess and surplus lines business. This constant change can cause estimates based on prior experience to be less reliable than estimates for more stable, admitted books of business. Also, as a niche market writer, there is little industry-level information for direct comparisons of current and prior experience and other reserving parameters. These unknowns create greater than average variation in the actuarial point estimates.

Actuarial methods attempt to quantify future events. Insurance companies are subject to unique exposures that are difficult to foresee at the point coverage is initiated and often many years subsequent. Judicial and regulatory bodies involved in interpretation of insurance contracts have increasingly found opportunities to expand coverage beyond what was intended or contemplated at the time the policy was issued. Many of these policies are issued on an “all risk” and occurrence basis. Aggressive plaintiff attorneys have often sought coverage beyond the insurer’s original intent. Some examples would be the industry’s ongoing asbestos and environmental litigation, court interpretations of exclusionary language on mold and construction defect, and debates over wind versus flood as the cause of loss from major hurricane events.

We believe that because of the inherent variation and the likelihood that there are unforeseen and under-quantified liabilities absent from the actuarial estimate, it is prudent to carry loss reserves above the actuarial point estimate. Most of our variance between the carried reserve and the actuarial point estimate is in the most recent accident years for our casualty segment where the most significant estimation risks reside. These estimation risks are considered when setting the initial loss ratio for the product and segment. In the cases where these risks fail to materialize, favorable loss development will likely occur over subsequent accounting periods. It is also possible that the risks materialize in an amount above what we considered when booking our initial loss reserves. In this case, unfavorable loss development is likely to occur over subsequent accounting periods.

Our best estimate of our loss and LAE reserves may change depending on a revision in the actuarial point estimate, the actuary’s certainty in the estimates and processes, and our overall view of the underlying risks. From time to time, we benchmark our reserving policies and procedures and update them by adopting industry best practices where appropriate. No significant changes were made in 2006.

INVESTMENT VALUATION

Throughout each year, we and our investment managers buy and sell securities to maximize overall investment returns in accordance with investment policies established and monitored by our board of directors and officers. This includes selling available-for-sale securities that have unrealized gains or losses when it is believed that future performance can be improved by buying other securities deemed to offer superior long-term return potential.

We classify our investments in debt and equity securities with readily determinable fair values into one of three categories. Held-to-maturity securities are carried at amortized cost. Available-for-sale securities are carried at fair value with unrealized gains/losses recorded as a component of comprehensive earnings and shareholders’ equity, net of deferred income taxes. Trading securities are carried at fair value with unrealized gains/losses included in earnings.

We regularly evaluate our fixed maturity and equity securities portfolio to determine impairment losses for other-than-temporary declines in the fair value of the investments. Criteria considered during this process include, but are not limited to: the current fair value as compared to the cost (amortized, in certain cases) of the security, degree and duration of the security’s fair value being below cost, credit quality, current economic conditions, the anticipated speed of cost recovery, and our decisions to hold or divest a security. Part of our evaluation of whether particular securities are other-than-temporarily impaired involves assessing whether we have both the intent and ability to continue to hold securities in an unrealized loss position. Impairment losses result in

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a reduction of the underlying investment’s cost basis. Significant changes in these factors could result in a considerable charge for impairment losses.

RECOVERABILITY OF REINSURANCE BALANCES

Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, rather than being netted with the related liabilities, since reinsurance does not relieve us of our liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and settlement expenses impact the estimates for the ceded portion of such liabilities. We continually monitor the financial condition of our reinsurers. Our policy is to periodically charge to earnings an estimate of unrecoverable amounts from reinsurers. Further discussion of the security of our recoverable reinsurance balances can be found in note 5 to the financial statements.

DEFERRED POLICY ACQUISITION COSTS

We defer commissions, premium taxes, and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. Acquisition-related costs may be deemed ineligible for deferral when they are based on contingent or performance criteria beyond the basic acquisition of the insurance contract. All eligible costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premiums to be earned and anticipated losses and settlement expenses, as well as certain other costs expected to be incurred as the premiums are earned. Judgments as to the ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the premiums written. This deferral methodology applies to both gross and ceded premiums and acquisition costs.

Additional discussion of other significant accounting policies may be found in note 1 to the financial statements.

RESULTS OF OPERATIONS

Consolidated revenue for 2006 was $632.7 million compared to $569.3 million in 2005 and $578.8 million in 2004. The drop in 2005 resulted largely from the decline in net premiums earned in the property segment. The current year benefited from gains in both the insurance operations’ premiums earned as well as the increase in net investment income. Realized gains also increased largely due to the sale of the equity in one of our investee holdings.

Consolidated revenue (in thousands)
Year ended December 31,	2006		2005		2004
Net premiums earned	$	530,338	$	491,307	$	511,348
Net investment income	71,325		61,641		54,087
Net realized investment gains	31,045		16,354		13,365
Total consolidated revenue	$	632,708	$	569,302	$	578,800

Net earnings reached an all-time high as increases were achieved in underwriting, investments and investee earnings. Debt interest declined as the amount outstanding was reduced in 2006. General corporate expenses moved up each of the last two years from increased director’s fees and legal costs, as well as increases in compensation related to financial performance.

Net earnings (in thousands)	2006			2005			2004
Underwriting income	$	84,056		$	68,883		$	39,891
Net investment income	71,325			61,641			54,087
Net realized investment gains	31,045			16,354			13,365
Debt interest	(6,581		)	(7,118		)	(6,894		)
Corporate expenses	(8,069		)	(6,780		)	(5,536		)
Investee earnings	15,117			10,896			5,429
Pretax earnings	$	186,893		$	143,876		$	100,342
Income tax	(52,254		)	(36,742		)	(27,306		)
Net earnings	$	134,639		$	107,134		$	73,036

Comprehensive earnings were $157.0 million in 2006 compared to $83.9 million a year ago and $81.4 million in 2004. For the equity portfolio, the change in unrealized gains was positive in 2006 and 2004, while the change was negative in 2005. In the bond portfolio, the unrealized change was positive in 2006, while the unrealized change was negative in both 2005 and 2004.

8

RLI INSURANCE GROUP

In general, we have experienced continued softening in the marketplace over the last three years. While the year did show moderate growth overall, the property segment saw significant premium increases through the first three quarters of 2006 as rates were up markedly in catastrophe-prone areas. Underwriting income was up considerably in our insurance operations. The casualty segment posted similar results to that of 2005 while the property segment benefited from a light hurricane season and reported underwriting income, compared to a loss in 2005. The surety segment continued its trend of growing profitability by more than doubling the 2005 result. The following table and narrative provide a more detailed look at individual segment performance over the last three years.

Gross premiums written

(in thousands)	2006		2005		2004
Casualty	$	506,887	$	519,115	$	519,817
Property	225,610		176,228		178,625
Surety	66,516		60,669		54,146
Total	$	799,013	$	756,012	$	752,588

Underwriting income (loss)

(in thousands)
Casualty	$	68,393	$	72,024		$	19,560
Property	4,988		(8,342		)	20,400
Surety	10,675		5,201			(69		)
Total	$	84,056	$	68,883		$	39,891

Combined ratio

Casualty	80.4	80.0	94.7
Property	95.9	110.3	79.2
Surety	82.1	90.0	100.2
Total	84.1	86.0	92.2

The following table further summarizes revenues (net premiums earned) by major coverage type within each segment:

(in thousands)	2006		2005		2004
Casualty
General liability	$	180,037	$	180,267	$	174,954
Commercial and personal umbrella	64,730		59,847		53,478
Executive coverages	13,040		9,807		13,074
Specialty program business	25,507		38,289		47,072
Commercial transportation	48,285		51,707		55,994
Other	16,618		18,976		21,045
Total	$	348,217	$	358,893	$	365,617
Property
Commercial property	$	91,507	$	66,410	$	69,169
Construction	4,493		2,521		21,633
Marine	16,785		3,286		—
Other property	9,796		8,311		7,241
Total	$	122,581	$	80,528	$	98,043
Surety	$	59,540	$	51,886	$	47,688
Grand total	$	530,338	$	491,307	$	511,348

Casualty

Casualty gross premiums written were down 2.4 percent in 2006 while virtually flat from 2004 to 2005. Only the umbrella and executive products experienced growth while all other lines were down by varying degrees as marketplace conditions for this segment continued to soften. Despite competitive pressures, we remained disciplined in writing only those accounts which we believe will provide adequate returns. This soft marketplace is likely to continue suppressing premium growth in 2007.

The 80.4 combined ratio for the casualty segment in 2006 was almost unchanged from the 2005 measure of 80.0. In each of these years, actuarial studies indicated that cumulative experience attributable to some casualty coverages for mature accident years was considerably lower than the reserves booked. Therefore, reserves were released in the amounts of $39.3 million and $51.8 million for 2006 and 2005, respectively. While we had been experiencing robust price improvements in this segment the last several years, we also produced significant new business with new exposures. Our reserving evaluation process requires adequate

9

time periods to elapse to assess the impact of such changes in marketplace conditions on our book of casualty business.

Property

Gross premiums written in the property segment rose 28.0 percent in 2006 compared to declines of 1.3 percent in 2005 and 7.6 percent in 2004. The turnaround occurred as a result of considerable rate increases in hurricane and earthquake-prone areas while our actual exposure to these events declined. Additionally, the marine division that launched in 2005 contributed increased gross premiums written of $16.2 million in 2006. In 2005, we experienced a significant decline in our construction coverage, which we exited during the fourth quarter of that year. Earthquake coverage premiums had dropped in 2005 as we focused on reducing our exposure. Segment revenues for 2005 decreased disproportionately as we incurred charges of approximately $10.0 million to meet minimum reinsurance premium requirements as well as to reinstate reinsurance coverage exhausted by loss activity on our construction coverage. Revenue bounced back in 2006, increasing by 52.2 percent.

Underwriting income was $5.0 million in 2006 compared to a loss of $8.3 million in 2005 and income of $20.4 million in 2004. Although we experienced a light hurricane season in 2006, other catastrophe losses such as tornadoes and hailstorms, along with increased severity of commercial fire losses, served to hamper the segment’s profitability. Favorable loss reserve development from the two prior years’ hurricane reserves contributed $4.2 million to profits in 2006. However, additional charges were incurred from the run-off of the previously exited construction coverage, which amounted to $13.7 million this year compared to charges of $13.5 million in 2005. The 2005 results were affected by the second straight year of severe hurricane activity, which negatively impacted the segment by $22.3 million. While the property charge in 2004 from hurricane activity was $10.1 million, there was some favorable development of those reserves in 2005 which provided a benefit of $2.2 million.

Surety

Surety gross premiums written increased for the third straight year. As was the case in 2005, all the major coverages in this segment produced increases in 2006. Total segment revenue followed suit, improving by 14.8 percent in 2006 compared to 8.8 percent and 2.8 percent in 2005 and 2004, respectively.

Underwriting income more than doubled in the surety segment in 2006 totalling $10.7 million compared to $5.2 million in 2005. These results reflect the benefit of re-underwriting efforts initiated during 2003 and 2004. Favorable development on prior accident years’ loss reserves resulted in a benefit of $2.6 million in 2006 and $2.1 million in 2005.

We are in litigation regarding certain commercial surety bond claims arising out of a specific bond program. We believe we have meritorious defenses to these claims and are vigorously asserting our positions in pending legal actions in multiple jurisdictions. See note 10 for further discussion.

NET INVESTMENT INCOME AND REALIZED INVESTMENT GAINS

During 2006, net investment income increased by 15.7 percent due to continued positive operating cash flow. On an after-tax basis, net investment income increased by 13.9 percent. Operating cash flows were $171.8 million in 2006, compared to $198.0 million in 2005, and $189.0 million in 2004. The average annual yields on our investments were as follows for 2006, 2005, and 2004:

	2006		2005		2004
Pretax yield
Taxable (on book value)	5.22	%	4.90	%	4.92	%
Tax-exempt (on book value)	4.02	%	3.98	%	4.10	%
Equities (on fair value)	2.78	%	2.80	%	3.26	%
After-tax yield
Taxable (on book value)	3.40	%	3.19	%	3.20	%
Tax-exempt (on book value)	3.81	%	3.77	%	3.88	%
Equities (on fair value)	2.39	%	2.40	%	2.79	%

The after-tax yield reflects the different tax rates applicable to each category of investment. Our taxable bonds are subject to our corporate tax rate of 35 percent, our tax-exempt municipal bonds are subject to a tax rate of 5.3 percent and our dividend income is generally subject to a tax rate of 14.2 percent. During 2006, the average after-tax yield of the fixed income portfolio increased to 3.55 percent from 3.43 percent

10

in 2005 due to an increase in taxable and tax-exempt yields on new purchases. During the year, we focused on purchasing high-quality investments, including U.S. government and agency securities, municipal bonds, mortgage-backed securities, and asset-backed securities, primarily in the 5-15 year range of the yield curve.

The fixed income portfolio increased by $24.4 million during the year. This portfolio had net realized losses of $7.3 million and a tax-adjusted total return on a mark-to-market basis of 5.3 percent. Our equity portfolio increased by $47.1 million during 2006, to $368.2 million. For the year, this portfolio had an unrealized gain of $32.1 million and realized gains of $38.6 million. The total return for the year on the equity portfolio was 21.0 percent.

Our investment results for the last five years are shown in the following table:

													Tax
													Equivalent
											Annualized		Annualized
					Net			Change in			Return		Return
	Average		Net		Realized			Unrealized			on Avg.		on Avg.
	Invested		Investment		Gains			Appreciation			Invested		Invested
(in thousands)	Assets(1)		Income(2)(3)		(Losses)(3)			(3)(4)			Assets		Assets
2002	$	896,785	$	37,640	$	(3,552	)	$	(34,091	)	0.0	%	0.7	%
2003	1,166,694		44,151		12,138			40,096			8.3	%	9.0	%
2004	1,451,539		54,087		13,365			13,200			5.6	%	6.3	%
2005	1,633,755		61,641		16,354			(35,788		)	2.6	%	3.3	%
2006	1,763,016		71,325		31,045			34,395			7.8	%	8.6	%
5-yr Avg.	$	1,382,358	$	53,769	$	13,870		$	3,562		4.9	%	5.6	%

(1) Average amounts at beginning and end of year.

(2) Investment income, net of investment expenses, including non-debt interest expense.

(3) Before income taxes.

(4) Relates to available-for-sale fixed maturity and equity securities.

We realized $31.0 million in capital gains in 2006, compared to capital gains of $16.4 million in 2005 and $13.4 million in 2004. Results for 2006 included a $16.2 million gain from the sale of our equity in Taylor, Bean & Whitaker Mortgage Corp. (TBW) as discussed in note 1 to the financial statements. Other gains resulted from routine investment management decisions regarding relative valuation, fundamental analysis, and market conditions.

We regularly evaluate the quality of our investment portfolio. When we believe that a specific security has suffered an other-than-temporary decline in value, the investment’s value is adjusted by reclassifying the decline from unrealized to realized losses. This has no impact on shareholders’ equity. There have been no losses associated with the other-than-temporary impairment of securities in 2006, 2005, or 2004. The following table is used as part of our impairment analysis and illustrates certain industry-level measurements relative to our equity portfolio as of December 31, 2006, including fair value, cost basis, and unrealized gains and losses.

												Unrealized
	Cost		12/31/06		Gross		Unrealized					Gain/
(in thousands)	Basis		Fair Value		Gains		Losses			Net		Loss%(1)
Consumer discretionary	$	12,750	$	16,663	$	4,055	$	(142	)	$	3,913	30.7	%
Consumer staples	16,331		32,616		16,293		(8		)	16,285		99.7	%
Energy	7,968		29,038		21,070		—			21,070		264.4	%
Financials	27,287		67,083		39,796		—			39,796		145.8	%
Healthcare	12,950		30,064		17,158		(44		)	17,114		132.2	%
Industrials	16,816		38,432		21,711		(95		)	21,616		128.5	%
Materials	6,515		8,757		2,382		(140		)	2,242		34.4	%
Information technology	11,705		19,885		8,278		(98		)	8,180		69.9	%
Telecommunications	7,015		15,582		8,567		—			8,567		122.1	%
Utilities	45,958		73,331		27,373		—			27,373		59.6	%
Other	36,148		36,744		596		—			596		1.6	%
Total	$	201,443	$	368,195	$	167,279	$	(527	)	$	166,752	82.8	%

(1)Calculated as the percentage of net unrealized gain (loss) to cost basis

As of December 31, 2006, we held seven common stocks that were in unrealized loss positions. The total unrealized loss on these securities was $0.5 million. All of these securities have been in an unrealized loss position for less than nine months.

The fixed income portfolio contained 412 positions at a loss as of December 31, 2006. Of these 412 securities, 248 have been in an unrealized loss position for more than 12 consecutive months and these collectively represent $10.5 million in unrealized losses. The fixed income unrealized losses can be primarily attributed to changes in interest rates from the time of purchase. We continually monitor the credit quality of our fixed income investments to gauge our ability to be repaid principal and interest. We consider price declines of securities in our other-than-temporary-impairment analysis where such price declines provide

11

evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration, as opposed to rising interest rates.

Factors that we consider in the evaluation of credit quality include:

1.Credit ratings from major rating agencies, including Moody’s and Standard & Poor’s,

2.Business and operating performance trends,

3.Management quality/turnover,

4.Industry competitive analysis, and

5.Changes in business model/strategy.

As of December 31, 2006, we held no equity or fixed income securities that individually had an unreal-ized loss greater than 12 percent. Based on our evaluation of equity securities held within specific industry sectors, as well as the duration and magnitude of unrealized losses in our equity and bond portfolios, we do not believe any securities suffered an other-than-temporary decline in value as of December 31, 2006.

The amortized cost and estimated fair value of fixed-maturity securities at December 31, 2006, by contractual maturity, are shown as follows:

	Amortized		Estimated
(in thousands)	Cost		Fair Value
Total fixed income
Due in one year or less	$	18,999	$	19,105
Due after one year through five years	317,934		318,154
Due after five years through 10 years	640,809		640,532
Due after 10 years	383,713		380,470
Total	$	1,361,455	$	1,358,261

Expected maturities may differ from contractual maturities due to call provisions on some existing securities.

INTEREST AND GENERAL CORPORATE EXPENSE

Interest on debt fell 7.5 percent as short-term obligations were paid off during the year. While debt interest was basically flat in 2005, the 2004 increase resulted from the issuance of $100 million in 10-year maturity senior notes in December 2003. Decisions regarding future short-term debt management will be based on available cash flow and the interest rate environment. General corporate expenses tend to fluctuate relative to our executive compensation plan and have increased in each of the last three years due to strong operating results. This model measures comprehensive earnings against a minimum required return on our capital. Additionally, legal fees, director fees, and travel rose since 2003.

INVESTEE EARNINGS

We maintain a 40 percent interest in Maui Jim, primarily a manufacturer of high-quality polarized sunglasses. Maui Jim’s chief executive officer owns a controlling majority of the outstanding shares of Maui Jim. In 2006 we recorded $8.8 million in earnings from this investment compared to $8.4 million in 2005 and $5.0 million in 2004. The upward trend over the last two years is the result of improved operating performance. Also included in this caption were $6.3 million, $2.5 million, and $0.5 million in earnings over the last three years from our investment in TBW. During the fourth quarter of 2004, we converted warrants to common stock in this private mortgage origination company, which increased our ownership interest to 21 percent. Prior to the conversion, earnings from this ownership were reflected in net investment income. In the fourth quarter of this year, we sold our equity in TBW for $32.5 million resulting in a pretax realized gain of $16.2 million.

INCOME TAXES

Our effective tax rates were 28.0 percent, 25.5 percent, and 27.2 percent for 2006, 2005, and 2004, respectively. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate for 2006 was higher than 2005 and 2004 due to the increase in underwriting income and net realized gains, which were taxed at 35.0 percent. Partially offsetting this increase, results for 2006 included the favorable resolution of a recent tax examination. During 2006, the Internal Revenue Service (IRS) concluded an examination of our tax years 2000 through 2004. As a result of this exam, we recorded a $3.2 million tax benefit, resulting from a change in tax estimate related to the sale of assets. In 2006 and 2005, a tax benefit was realized associated with a dividend declared and payable in 2007 and 2006, respectively, from an unconsolidated investee, Maui Jim. As required under Statement of Financial Accounting Standards (SFAS) 109, “Accounting for Income Taxes,” the gain reflects the tax benefit of applying the lower tax rate applicable to affiliated dividends (7 percent) as compared to the corporate capital gains tax rate (35 percent) on which

12

previous tax estimates were based. In addition, our pretax earnings in 2006 included $28.7 million of investment income that is wholly or partially exempt from federal income tax, compared to $28.2 million and $25.2 million in 2005 and 2004, respectively.

NET UNPAID LOSSES AND SETTLEMENT EXPENSES

The primary liability on our balance sheet relates to unpaid losses and settlement expenses, which represents our estimated liability for losses and related settlement expenses before considering offsetting reinsurance recoverable balances. This liability can be further deconstructed into two parts: (1) case reserves representing estimates of losses and settlement expenses on known claims and (2) IBNR — incurred but not reported — reserves representing estimates of losses and settlement expenses on claims that have occurred but have not yet been reported to us. Our gross liability for both case and IBNR reserves is reduced by reinsurance balances recoverable on unpaid losses and settlement expenses to calculate our net reserve balance. This net reserve balance increased from $738.7 million at December 31, 2005, to $793.1 million as of December 31, 2006. This reflects incurred loss of $256.9 million in 2006 offset by paid losses of $202.4 million, compared to incurred losses of $251.2 million offset by $180.9 million paid in 2005. As of December 31, 2006, our net IBNR reserves represented 64.3 percent of total net reserves while the remainder was for case reserves. As of December 31, 2005, IBNR net reserves represented 63.3 percent of total net reserves.

MARKET RISK DISCLOSURE

Market risk is a general term describing the potential economic loss associated with adverse changes in the fair value of financial instruments. Management of market risk is a critical component of our investment decisions and objectives. We manage our exposure to market risk by using the following tools:

1. Monitoring the fair value of all financial assets on a constant basis,

2. Changing the character of future investment purchases as needed, and

3. Maintaining a balance between existing asset and liability portfolios.

INTEREST RATE RISK

Our primary exposure to interest rate risk is with our fixed income investment portfolio.

Modified duration analysis is used to measure the sensitivity of the fixed income portfolio to changes in interest rates, providing a measure of price percentage volatility. We attempt to minimize interest rate risk by matching the duration of assets to that of liabilities.

Interest rate risk will also affect our income statement due to its impact on interest expense. We maintain a debt obligation that is long term in nature. At the end of 2005, our short-term debt was $15.5 million. As of December 31, 2006, our short-term debt obligations were zero. Our long-term debt carries a fixed interest rate. As such, our interest expense on this obligation is not subject to changes in interest rates. As this debt is not due until 2014, we will not assume risk in our ability to refinance this debt for many years.

EQUITY PRICE RISK

Equity price risk is the potential that we will incur economic loss due to the decline of common stock prices. Beta analysis is used to measure the sensitivity of our equity portfolio to changes in the value of the S&P 500 Index (an index representative of the broad equity market). Our current equity portfolio has a beta of .72 in comparison to the S&P 500. Our equity investment returns have been similar to the S&P 500 with much less volatility. This low beta statistic reflects our long-term emphasis on maintaining a conservative, value oriented, dividend-driven investment philosophy for our equity portfolio. Historically, dividend-paying common stocks have demonstrated superior down-market performance characteristics.

SENSITIVITY ANALYSIS

The tables on page 14 detail information on the market risk exposure for our financial investments as of December 31, 2006. Listed on each table is the December 31, 2006, fair value for our assets and the expected pretax reduction in fair value given the stated hypothetical events. This sensitivity analysis assumes the composition of our assets remains constant over the period being measured and also assumes interest rate changes are reflected uniformly across the yield curve. For example, our ability to

13

hold non-trading securities to maturity mitigates price fluctuation. For purposes of this disclosure, market-risk-sensitive instruments are divided into two categories: instruments held for trading purposes and those held for nontrading purposes. The examples given are not predictions of future market events, but rather illustrations of the effect such events may have on the fair value of our investment portfolio.

As of December 31, 2006, our fixed income portfolio had a fair value of $1.4 billion. The sensitivity analysis uses scenarios of interest rates increasing 100 and 200 basis points from their December 31, 2006, levels with all other variables held constant. Such scenarios would result in decreases in the fair value of the fixed income portfolio of $61.8 million and $123.9 million, respectively. Due to our use of the held-to-maturity designation for a portion of the fixed income portfolio, the balance sheet impact of these scenarios would be lower.

As of December 31, 2006, our equity portfolio had a fair value of $368.2 million. The base sensitivity analysis uses market scenarios of the S&P 500 Index declining both 10 percent and 20 percent. These scenarios would result in approximate decreases in the equity fair value of $29.9 million and $59.9 million, respectively. As we designate all common stocks as available-for-sale, these fair value declines would impact our balance sheet.

Counter to the base scenarios shown in Tables 1 and 2, Tables 3 and 4 quantify the opposite impact. Under the assumptions of falling interest rates and an increasing S&P 500 Index, the fair value of our assets will increase from their present levels by the indicated amounts.

Table 1 (in thousands)

Effect of a 100-basis-point increase in interest rates and a 10% decline in the S&P 500:

	12/31/06		Interest			Equity
	Fair Value		Rate Risk			Risk
Held for trading purposes
Fixed maturity securities	$	14,960	$	(622	)	$	—
Total trading	14,960		(622		)	—
Held for nontrading purposes
Fixed maturity securities	1,343,301		(61,132		)	—
Equity securities	368,195		—			(29,971		)
Total nontrading	$	1,711,496	(61,132		)	(29,971		)
Total trading & nontrading	$	1,726,456	$	(61,754	)	$	(29,971	)

Table 2 (in thousands)

Effect of a 200-basis-point increase in interest rates and a 20% decline in the S&P 500:

	12/31/06		Interest			Equity
	Fair Value		Rate Risk			Risk
Held for trading purposes
Fixed maturity securities	$	14,960	$	(1,216)		$	—
Total trading	14,960		(1,216		)	—
Held for nontrading purposes
Fixed maturity securities	1,343,301		(122,698		)	—
Equity securities	368,195		—			(59,942		)
Total nontrading	$	1,711,496	(122,698		)	(59,942		)
Total trading & nontrading	$	1,726,456	$	(123,914	)	$	(59,942	)

Table 3 (in thousands)

Effect of a 100-basis-point decrease in interest rates and a 10% increase in the S&P 500:

	12/31/06		Interest		Equity
	Fair Value		Rate Risk		Risk
Held for trading purposes
Fixed maturity securities	$	14,960	$	579	$	—
Total trading	14,960		579		—
Held for nontrading purposes
Fixed maturity securities	1,343,301		48,904		—
Equity securities	368,195		—		29,971
Total nontrading	$	1,711,496	48,904		29,971
Total trading & nontrading	$	1,726,456	$	49,483	$	29,971

Table 4 (in thousands)

Effect of a 200-basis-point decrease in interest rates and a 20% increase in the S&P 500:

	12/31/06		Interest		Equity
	Fair Value		Rate Risk		Risk
Held for trading purposes
Fixed maturity securities	$	14,960	$	1,103	$	—
Total trading	14,960		1,103		—
Held for nontrading purposes
Fixed maturity securities	1,343,301		95,672		—
Equity securities	368,195		—		59,942
Total nontrading	$	1,711,496	95,672		59,942
Total trading & nontrading	$	1,726,456	$	96,775	$	59,942

14

LIQUIDITY AND CAPITAL RESOURCES

OVERVIEW

We have three primary types of cash flows: (1) operating cash flows, which consist mainly of cash generated by our underwriting operations and income earned on our investment portfolio, (2) investing cash flows related to the purchase, sale, and maturity of investments, and (3) financing cash flows that impact our capital structure, such as changes in debt and shares outstanding. The following table summarizes these three cash flows over the last three years.

(in thousands)	2006			2005			2004
Operating cash flows	$	171,775		$	198,027		$	188,962
Investing cash flows	(63,325		)	(152,907		)	(177,189		)
Financing cash flows	(108,450		)	(45,120		)	(11,773		)

Our balance sheet does not reflect any cash balance because all of our funds are invested in short-term investments, primarily highly rated money market instruments.

We have entered into certain contractual obligations that require us to make recurring payments. The following table summarizes our contractual obligations as of December 31, 2006.

			Payments due by period
(in thousands)			Less than						More than
Contractual Obligations	Total		1 yr.		1-3 yrs.		3-5 yrs		5 yrs.
Loss and settlement expense	$	1,318,777	$	407,951	$	499,318	$	232,630	$	178,878
Long-term debt	100,000		—		—		—		100,000
Short-term debt	—		—		—		—		—
Capital lease	192		178		14		—		—
Operating lease	14,187		3,338		5,178		3,688		1,983
Total	$	1,433,156	$	411,467	$	504,510	$	236,318	$	280,861

Loss and settlement expense reserves represent management’s best estimate of the ultimate cost of settling reported and unreported claims and related expenses. As discussed previously, the estimation of loss and loss expense reserves is based on various complex and subjective judgments. Actual losses and settlement expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the payments due by periods are based on our historical claims payment experience. Due to the uncertainty inherent in the process of estimating the timing of such payments, there is a risk that the amounts paid in any period can be significantly different than the amounts disclosed above. Amounts disclosed above are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable on unpaid loss and settlement reserves are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not discharge us of our liability to policyholders. Amounts recoverable from reinsurers on unpaid loss and settlement reserves totaled $525.7 million at December 31, 2006.

The next largest contractual obligation relates to long-term debt outstanding. On December 12, 2003, we completed a public debt offering, issuing $100 million in senior notes maturing January 15, 2014 (a 10-year maturity), and paying interest semi-annually at the rate of 5.95 percent. The notes were issued at a discount resulting in proceeds, net of discount and commission, of $98.9 million. These notes are rated Baa2 by Moody’s and BBB+ by Standard & Poor’s. We are not party to any off-balance sheet arrangements.

Our primary objective in managing our capital is to preserve and grow shareholders’ equity and statutory surplus to improve our competitive position and allow for expansion of our insurance operations. Our insurance subsidiaries must maintain certain minimum capital levels in order to meet the requirements of the states in which we are regulated. Our insurance companies are also evaluated by rating agencies that assign financial strength ratings that measure our ability to meet our obligations to policyholders over an extended period of time.

We have historically grown our shareholders’ equity and/or policyholders’ surplus as a result of three sources of funds: (1) earnings on underwriting and investing activities, (2) appreciation in the value of our invested assets, and (3) the issuance of common stock and debt.

At December 31, 2006, we had short-term investments and other investments maturing within one year of approximately $123.2 million and investments of $440.0 million maturing within five years. We maintain revolving lines of credit with two financial institutions, each of which permits us

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to borrow up to an aggregate principal amount of $10.0 million. Under certain conditions, each of the lines may be increased up to an aggregate principal amount of $20.0 million. These facilities have three-year terms that expire on May 31, 2008. As of December 31, 2006, no amounts were outstanding on these facilities. We believe that cash generated by operations, cash generated by investments and cash available from financing activities will provide sufficient sources of liquidity to meet our anticipated needs over the next 12 to 24 months. We have generated positive operating cash flow for more than 20 consecutive years. In the most recent three years ended December 31, 2006, 2005, and 2004, our operating cash flow was $171.8 million, $198.0 million, and $189.0 million, respectively. The primary factor in our ability to generate positive operating cash flow is underwriting profitability. If we are not able to continue generating positive operating cash flow, we may have to sell investment securities, some of which might be sold at a loss.

OPERATING ACTIVITIES

The following table highlights some of the major sources and uses of cash flow from operating activities:

Sources	Uses
Premiums received	Claims
Loss payments from reinsurers	Ceded premium to reinsurers
Investment income	Commissions paid
(interest & dividends)	Operating expenses
	Interest expense
	Income taxes

Our largest source of cash is from premiums received from our customers, which we receive at the beginning of the coverage period. Our largest cash outflow is for claims that arise when a policyholder incurs an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various investment securities that earn interest and dividends — another source of cash. We use cash to pay commissions to brokers and agents, as well as to pay for ongoing operating expenses such as salaries, rent, taxes, and interest expense. We also utilize reinsurance to manage the risk that we take on our policies. We cede, or pay out, part of the premiums we receive to our reinsurers, and collect cash back when losses subject to our reinsurance coverage are paid.

The timing of our cash flows from operating activities can vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant, so their timing can influence cash flows from operating activities in any given period. We are subject to the risk of incurring significant losses on catastrophes, both natural (such as earthquakes and hurricanes) and man-made (such as terrorism). If we were to incur such losses, we would have to make significant claims payments in a relatively concentrated period of time.

INVESTING ACTIVITIES

The following table highlights some of the major sources and uses of cash flow from investing activities:

Sources	Uses
Proceeds from bonds sold, called or matured	Purchase of bonds
Proceeds from stocks sold	Purchase of stocks
Proceeds from sale of unconsolidated investee

We maintain a well-diversified investment portfolio representing policyholder funds that have not yet been paid out as claims, as well as the capital we hold for our shareholders. As of December 31, 2006, our portfolio had a carrying value of $1.8 billion. Invested assets at December 31, 2006, increased by $130.5 million, or 7.7 percent, from December 31, 2005. Contributing to this increase was the investment of cash flows from operations.

Our overall investment philosophy is designed to first protect policyholders by maintaining sufficient funds to meet corporate and policyholder obligations, then generate long-term growth in shareholders’ equity. Because our existing and projected liabilities are sufficiently funded by the fixed income portfolio, we can improve returns by investing a portion of the surplus (within limits) in an equity portfolio. As of December 31, 2006, 43.8 percent of our shareholders’ equity was invested in common stocks, as compared to 46.3 percent at December 31, 2005

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and 50.6 percent at December 31, 2004. The 2006 calculation excludes a $36.7 million investment in a bond mutual fund.

We currently classify 7.8 percent of the securities in our fixed income portfolio as held-to-maturity, meaning they are carried at amortized cost and are intended to be held until their contractual maturity. Other portions of the fixed income portfolio are classified as available-for-sale (91.1 percent) or trading (1.1 percent) and are carried at fair value. As of December 31, 2006, we maintained $1.25 billion in fixed income securities within the available-for-sale and trading classifications. The available-for-sale portfolio provides an additional source of liquidity and can be used to address potential future changes in our asset/liability structure.

Our fixed income portfolio is managed for safety, focusing on securities of the highest ratings and liquidity. Yield is of secondary importance behind the preservation of capital. The equity portfolio is weighted toward dividend-paying stocks that provide current income as well as long-term growth potential. This philosophy of portfolio diversification, management style, and asset allocation allows us to maximize overall returns within our defined risk tolerances.

Our bond portfolio comprised 74.2 percent of our total 2006 portfolio, versus 78.4 percent of the total at December 31, 2005, and 75.0 percent of the total as of December 31, 2004. As of December 31, 2006, our fixed income portfolio contained 76.9 percent AAA-rated bonds, 10.1 percent AA-rated bonds, 8.6 percent A-rated bonds, and 4.4 percent BBB-rated bonds.

In selecting the maturity of securities in which we invest, we consider the relationship between the duration of our fixed income investments and the duration of our liabilities, including the expected ultimate payout patterns of our reserves. We believe that both liquidity and interest rate risk can be minimized by such asset/liability management. As of December 31, 2006, our fixed income portfolio’s duration was 4.76 years and remained well diversified. During 2006, the total return on our bond portfolio on a tax-equivalent, mark-to-market basis was 5.25 percent.

In addition, at December 31, 2006, our equity portfolio had a value of $368.2 million, all of which is classified as available-for-sale and is also a source of liquidity. The securities within the equity portfolio remain primarily invested in large-cap issues with strong dividend performance. The strategy remains one of value investing, with security selection taking precedence over market timing. A buy-and-hold strategy is used, minimizing both transactional costs and taxes. We maintain a well-diversified group of equity securities. During 2006, the total return on our equity portfolio on a mark-to-market basis was 21.0 percent.

FINANCING ACTIVITIES

In addition to the previously discussed operating and investing activities, we also engage in financing activities to manage our capital structure. The following table highlights some of the major sources and uses of cash flow from financing activities:

Sources	Uses
Proceeds from stock offerings	Shareholder dividends
Proceeds from debt offerings	Debt repayment
Short-term borrowing	Share buy-backs
Shares issued under stock option plans

Our capital structure is comprised of equity and debt obligations. As of December 31, 2006, our capital structure consisted of $100.0 million in 10-year maturity senior notes (long-term debt), and $756.5 million of shareholders’ equity. Debt outstanding comprised 11.7 percent of total capital as of December 31, 2006.

Our 123rd consecutive dividend payment was declared in the first quarter of 2007 and will be paid on April 12, 2007, in the amount of $0.20 per share. Since the inception of cash dividends in 1976, we have increased our annual dividend every year.

Dividend payments to us from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the regulatory authority of Illinois. The maximum dividend distribution is limited by Illinois law to the greater of 10 percent of RLI Insurance Company’s policyholder surplus as of December 31 of the preceding year or its net income for the 12-month period ending December 31 of the preceding year. Therefore, the maximum dividend distribution that can be paid by RLI Insurance Company during 2007 without prior approval is $75.7 million. In 2006, a total

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of $59.5 million has been paid in dividends by RLI Insurance Company as follows: asset transfer of Maui Jim valued at $35.2 million, asset transfer of TBW valued at $13.4 million, and a cash dividend of $10.9 million.

In February 2006, we announced a $100 million common stock repurchase program. Through year end 2006, we repurchased 1,624,009 shares at an average price of $49.92 per share, which is just over $81.1 million of the program. We anticipate concluding this repurchase program in 2007.

OUTLOOK FOR 2007

Our insurance marketplace, and in particular the excess and surplus lines segment, is subject to cycles involving alternating periods of price increases (“hard markets”) and price decreases (“soft markets”). Pricing in the overall insurance marketplace has been on the decline for the past several years. We expect this trend to continue, although each of our insurance segments will likely be impacted by varying degrees. We also expect to see some organic growth in 2007 and underwriting income in all three of our insurance segments absent any major catastrophe. Specific details regarding events in our insurance segments follow.

CASUALTY

We expect the price softening seen in 2006 to continue in 2007. We will maintain our profit-focused strategy and look to broaden our production sources and product offerings as a means to holding our market position and potentially growing this segment. Rising profitability and rising levels of capital for the industry will serve to intensify competition for this segment. We look to our ability to exercise underwriting discipline and select quality risks to continue our profitability in 2007.

PROPERTY

The industry took advantage of a quiet Atlantic hurricane season to rebuild capital depleted by hurricane events in 2005. We believe property pricing will soften, but not to pre-Katrina levels. Pricing actions will be tempered by greater rating agency focus on catastrophe claims-paying ability. We expect to continue to see premium growth and favorable loss experience in this segment in 2007. Our marine business should continue to grow moderately, while we expect losses from our run-off construction book to stabilize.

SURETY

The surety segment, like our other segments, should feel the pressure of a softening marketplace. The steps we have taken over the past several years to address loss experience, coupled with a strong staffing model aided by decision support tools, point to continued profitability in 2007.

INVESTMENTS

Within our investment portfolio, we expect to continue to increase investment income as the balance of our portfolio grows from operating and investing cash flow. Interest rates for bonds with maturities of greater than five years, where a majority of our fixed income portfolio is concentrated, have remained relatively stable in the last couple of years, although they are below the historical average. If interest rates increase, we will be able to invest our cash flow into higher-yielding investments which would improve investment income. However, rising interest rates will depress the fair value of our bond portfolio which will negatively impact comprehensive earnings and book value. Twenty percent of our portfolio is invested in common stocks. We expect the dividend income on these stocks to grow and the value of this portfolio will be dictated by the performance of the general stock market, which is difficult to predict.

ACCOUNTING STANDARDS

SFAS NO. 123 (REVISED 2004), SHARE-BASED PAYMENT (SFAS 123R)

In December 2004, the Financial Accounting Standards Board (FASB) revised Statement of Financial Accounting Standards (SFAS) No. 123, “Share-Based Payment,” (SFAS 123R) which required companies to expense the estimated fair value of employee stock options and similar awards, for all options vesting, granted, or modified after the effective date of this revised statement. The accounting provisions of SFAS 123R were to become effective for interim periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission (SEC) adopted a final rule amending Rule 4-01(a) of Regulation S-X regarding the compliance date for SFAS 123R. The effect of this ruling was to

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delay the effective date of SFAS 123R to the first interim or annual reporting period of the registrant’s first fiscal year beginning on or after June 15, 2005. As a result, the accounting provisions of SFAS 123R became effective for our financial statements beginning January 1, 2006.

SFAS 123R is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and its related implementation guidance. On January 1, 2006, we adopted the provisions of SFAS 123R using the modified prospective method. SFAS 123R requires entities to recognize compensation expense for awards of equity instruments to employees based on the grant-date fair value of those awards (with limited exceptions). Prior to the adoption of SFAS 123R, we followed the intrinsic value method in accordance with APB 25 to account for our employee stock options and recognized no compensation expense for the stock option grants.

SFAS NO. 154, ACCOUNTING CHANGES AND ERROR CORRECTIONS (SFAS 154)

We adopted SFAS 154 on January 1, 2006. SFAS 154 replaces APB 20, “Accounting Changes,” and SFAS No.3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 requires retrospective application to prior periods’ financial statements for changes in accounting principle, unless determination of either the period specific effects or the cumulative effect of the change is impracticable or otherwise promulgated. We had no accounting changes or error corrections affected by the new standard.

SFAS NO. 155, ACCOUNTING FOR CERTAIN HYBRID FINANCIAL INSTRUMENTS — AN AMENDMENT OF FASB STATEMENTS NO. 133 AND 140 (SFAS 155)

In February 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments.” SFAS 155 amends FASB Statement No. 133 and FASB Statement No. 140, and improves the financial reporting of certain hybrid financial instruments by requiring more consistent accounting that eliminates exemptions and provides a means to simplify the accounting for these instruments. Specifically, SFAS 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Companies are required to adopt the provisions of SFAS 155, as applicable, beginning in fiscal year 2007. We do not believe the adoption of SFAS 155 will have a material impact on our financial position or results of operations.

FASB INTERPRETATION NO. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME TAXES, (FIN 48)

In July 2006, the FASB issued FIN 48, which clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 requires an entity to recognize the benefit of tax positions only when it is more likely than not, based on the position’s technical merits, that the position would be sustained upon examination by the respective taxing authorities. The tax benefit is measured as the largest benefit that is more than 50 percent likely of being realized upon final settlement with the respective taxing authorities. FIN 48 is effective for fiscal years beginning after December 15, 2006. FIN 48 is not expected to have a material effect on our financial position or results of operations.

SFAS NO. 157, “FAIR VALUE MEASUREMENTS” (SFAS 157)

In September 2006, the FASB issued SFAS No. 157. SFAS 157 defines fair value and establishes a framework for measuring fair value in GAAP. The pronouncement describes fair value as being based on a hypothetical transaction to sell an asset or transfer a liability at a specific measurement date, as considered from the perspective of a market participant who holds the asset or owes the liability. In addition, fair value should be viewed as a market-based measurement, not an entity-specific measurement. Therefore, fair value should be determined based on the assumptions that market participants would use in pricing an asset or liability,

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including all risks associated with that asset or liability. SFAS 157 becomes effective for fiscal years beginning after November 15, 2007. We are currently reviewing the guidance provided in this standard to determine the impact on our financial position and results of operations.

SFAS NO. 158, “EMPLOYERS’ ACCOUNTING FOR DEFINED BENEFIT PENSION AND OTHER POST RETIREMENT PLANS — AN AMENDMENT OF FASB STATEMENTS NO 87, 88, 106 AND 132(R)” (SFAS 158)

In September 2006, the FASB issued SFAS No. 158. SFAS 158 improves reporting of obligations for pensions and other post-retirement benefits by recognizing the over-funded or under-funded status of plans as an asset or liability. The pronouncement does not change how plan assets and benefit obligations are measured under SFAS 87 and SFAS 106 nor does it change the approach for measuring annual benefit cost reported in earnings. Rather, it eliminates the provisions that permit plan assets and obligations to be measured as of a date not more than three months prior to the balance sheet date, instead requiring measurement as of the reporting date. In addition, the pronouncement requires previously unrecognized items, such as actuarial gains and unrecognized prior service costs or credits to be recognized on the balance sheet as a component of other comprehensive income (loss). As discussed in note 8, our defined benefit pension plan was terminated in 2006. The implementation of SFAS 158 had no impact on our financial position or results of operations.

STATE AND FEDERAL LEGISLATION

As an insurance holding company, we, as well as our insurance company subsidiaries, are subject to regulation by the states and territories in which the insurance subsidiaries are domiciled or transact business. Holding company registration in each insurer’s state of domicile requires periodic reporting to the state regulatory authority of the financial, operational and management data of the insurers within the holding company system. All transactions within a holding company system affecting insurers must have fair and reasonable terms, and the insurer’s policyholder surplus following any transaction must be both reasonable in relation to its outstanding liabilities and adequate for its needs. Notice to regulators is required prior to the consummation of certain transactions affecting insurance company subsidiaries of the holding company system.

The insurance holding company laws also require that ordinary dividends be reported to the insurer’s domiciliary regulator prior to payment of the dividend and that extraordinary dividends may not be paid without such regulator’s prior approval. An extraordinary dividend is generally defined as a dividend that, together with all other dividends made within the past 12 months, exceeds the greater of 100 percent of the insurer’s statutory net income for the most recent calendar year, or 10 percent of its statutory policyholders’ surplus as of the preceding year end. Insurance regulators have broad powers to prevent the reduction of statutory surplus to inadequate levels, and there is no assurance that extraordinary dividend payments would be permitted.

In addition, the insurance holding company laws require advance approval by state insurance commissioners of any change in control of an insurance company that is domiciled (or, in some cases, having such substantial business that it is deemed to be commercially domiciled) in that state. “Control” is generally presumed to exist through the ownership of 10 percent or more of the voting securities of a domestic insurance company or of any company that controls a domestic insurance company. In addition, insurance laws in many states contain provisions that require prenotification to the insurance commissioners of a change in control of a non-domestic insurance company licensed in those states. Any future transactions that would constitute a change in control of our insurance company subsidiaries, including a change of control of us, would generally require the party acquiring control to obtain the prior approval by the insurance departments of the insurance company subsidiaries’ states of domicile or commercial domicile, if any, and may require pre-acquisition notification in applicable states that have adopted pre-acquisition notification provisions. Obtaining these approvals could result in material delay of, or deter, any such transaction.

Other regulations impose restrictions on the amount and type of investments our insurance company subsidiaries may have. Regulations designed to ensure financial solvency of insurers and to

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require fair and adequate treatment and service for policyholders are enforced by filing, reporting and examination requirements. Marketplace oversight is conducted by monitoring and periodically examining trade practices, approving policy forms, licensing of agents and brokers, and requiring the filing and in some cases, approval, of premiums and commission rates to ensure they are fair and equitable. Such restrictions may limit the ability of our insurance company subsidiaries to introduce new coverages or implement desired changes to current premium rates or policy forms. Financial solvency is monitored by minimum reserve and capital requirements (including risk-based capital requirements), periodic reporting procedures (annually, quarterly, or more frequently if necessary), and periodic examinations.

The quarterly and annual financial reports to the states utilize statutory accounting principles that are different from GAAP, which show the business as a going concern. The statutory accounting principles used by regulators, in keeping with the intent to assure policyholder protection, are generally based on a solvency concept.

Under state insurance laws, our insurance company subsidiaries cannot treat reinsurance ceded to an unlicensed or non-accredited reinsurer as an asset or as a deduction from its liabilities in their statutory financial statements, except to the extent that the reinsurer has provided collateral security in an approved form, such as a letter of credit. As of December 31, 2006, $1.6 million of our reinsurance recoverables were due from unlicensed or non-accredited reinsurers that had not provided us with approved collateral.

Many jurisdictions have laws and regulations that limit an insurer’s ability to withdraw from a particular market. For example, states may limit an insurer’s ability to cancel or not renew policies. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance department may disapprove a plan that may lead to marketplace disruption. Laws and regulations that limit cancellation and non-renewal and that subject program withdrawals to prior approval requirements may restrict our ability to exit unprofitable marketplaces. For example, the state of Florida passed legislation in early 2007 seeking to make residential homeowners’ insurance in Florida more accessible and affordable by imposing regulatory changes and restrictions on many aspects of the insurance market in that state. The near-term impact to us is not expected to be material since we currently write a relatively small amount of residential homeowners’ insurance in that state. However, such legislation is new, and thus its full impact, as well as the reaction of any other coastal state, is not yet certain. We will continue to carefully monitor the legislative and regulatory activity in this area.

Virtually all states require licensed insurers to participate in various forms of guaranty associations in order to bear a portion of the loss suffered by the policyholders of insurance companies that become insolvent. Depending upon state law, licensed insurers can be assessed an amount that is generally equal to between 1 percent and 2 percent of the annual premiums written for the relevant lines of insurance in that state to pay the claims of an insolvent insurer. These assessments may increase or decrease in the future, depending upon the rate of insolvencies of insurance companies. In some states, these assessments may be wholly or partially recovered through policy fees paid by insureds.

In addition to monitoring our existing regulatory obligations, we are also monitoring developments in the following areas to determine the potential effect on our business and to comply with our legal obligations.

BROKER CONTINGENT COMMISSIONS

In 2004, the New York attorney general began an investigation into insurance broker and insurance company activities connected with contingent commission arrangements. The investigation led to lawsuits, both private suits and suits by attorneys general, and prompted other attorneys general and state insurance departments to conduct further investigations. We have responded to all inquiries from state attorneys general and insurance departments, and have not been subject to any regulatory actions or paid any fees or fines as a result. We also conducted an internal investigation of our contingent commission arrangements and related underwriting practices and found no improper actions. We have also established a corporate policy regarding the proper use and

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authorization of contingent commission agreements. The National Association of Insurance Commissioners (NAIC) has created a model act on these agreements for agents and brokers, and statutes have been proposed or enacted in several states. We continue to closely monitor all legislative developments.

TERRORISM EXCLUSION REGULATORY ACTIVITY

After the events of September 11, 2001, the NAIC urged states to grant conditional approval to commercial lines endorsements that excluded coverage for acts of terrorism consistent with language developed by the Insurance Services Office, Inc (ISO). The ISO endorsement included certain coverage limitations. Many states allowed the endorsements for commercial lines, but rejected such exclusions for personal exposures.

On November 26, 2002, the federal Terrorism Risk Insurance Act of 2002 (TRIA) became law. TRIA was set to expire on December 31, 2005, but the law has been extended until December 31, 2007. The act, as extended and amended, provides for a federal backstop for terrorism losses as defined by the act and certified by the secretary of the treasury in concurrence with the secretary of state and the U.S. attorney general. Under TRIA, coverage provided for losses caused by acts of terrorism is partially reimbursed by the United States under a formula whereby the government pays 90 percent in 2006 and 85 percent in 2007 of covered terrorism losses exceeding a prescribed deductible to the insurance company providing the coverage. The deductible is calculated as 17.5 percent in 2006 and 20 percent in 2007 of gross earned premium net of a few excludable lines. Coverage under the act must be made available to policyholders, with certain specified exceptions, in commercial property and casualty policies. The immediate effect, as regards state regulation, was to nullify terrorism exclusions to the extent they exclude losses that would otherwise be covered under the act. We are in compliance with the requirements of TRIA and have made terrorism coverage available to policyholders. Given the challenges associated with attempting to assess the possibility of future acts of terror exposures and assign an appropriate price to the risk, we have taken a conservative underwriting position on most of our affected coverages. Congress is currently considering an extension of TRIA, although such action is not certain.

SARBANES-OXLEY ACT OF 2002

The Sarbanes-Oxley Act of 2002 presents a significant expansion of securities law regulation of corporate governance and compliance, accounting practices, reporting, and disclosure that affects publicly traded companies. The act, in part, sets forth requirements for certification by CEOs and CFOs of certain reports filed with the Securities and Exchange Commission (SEC), disclosures pertaining to the adoption of a code of ethics applicable to certain management personnel, and safeguards against actions to fraudulently influence, manipulate or mislead independent public or certified accountants of the issuer’s financial statements. It also provides stronger requirements for development and evaluation of internal control procedures, as well as provisions pertaining to a company’s audit committee of the board of directors. As required by the act and under the supervision from and participation of management, we annually complete an evaluation of our internal control system including all design, assessment, documentation, and testing phases. This evaluation is intended to identify any deficiencies, measure their materiality, and implement procedures, where necessary, to remediate them.

The annual certification of our CEO with respect to compliance with the New York Stock Exchange corporate governance listing standards has been submitted to the New York Stock Exchange and the annual certifications of our CEO and CFO required by the Sarbanes-Oxley Act of 2002 with respect to the our 2006 fiscal year have been filed with the SEC as an exhibit to our annual report on Form 10-K for 2006.

ASBESTOS LITIGATION REFORM

Congress has considered, but not yet enacted, asbestos litigation reform legislation. Alternatives range from a proposal requiring manufacturers and insurers to fund liabilities for asbestos exposure to provide for a remedy for all asbestos-related claims, to a proposal requiring victims to document their medical condition before suing for damages. We continue to monitor our expected exposure and do not perceive a significant risk.

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FEDERAL REGULATION OF INSURANCE

In 2006, two separate bills were introduced in Congress that would provide significant federal regulation in the insurance industry. One bill provides for an optional federal charter, and the other seeks to streamline and reduce the state regulatory burden for non-admitted/surplus lines of insurance. This proposed legislation would have a significant impact on the insurance industry, and we continue to monitor all proposals.

Also, in early 2007, bills were introduced in Congress to repeal the antitrust exemption for the insurance industry in the McCarran-Ferguson Act. We will monitor this proposed legislation, but we cannot predict if such bills will become law or the impact of such legislation on the company or the industry.

CORPORATE COMPLIANCE

We have a code of conduct, corporate governance guidelines, and compliance manual, which provide directors, officers, and employees with guidance and requirements for complying with a variety of federal and state laws and company policies. Electronic versions of these documents, as well as the following documents, are, or will be, available on our web site (www.rlicorp.com): 2006 summary annual report; 2006 financial report; 2007 proxy statement; annual report on Form 10-K for 2006; and charters of the executive resources, audit, finance and investment, strategy, and nominating/corporate governance committees of the board of directors. Printed copies of these documents will be made available upon request without charge to any shareholder.

FORWARD LOOKING STATEMENTS

Forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 appear throughout this report. These statements relate to our current expectations, beliefs, intentions, goals or strategies regarding the future and are based on certain underlying assumptions by us. These forward looking statements generally include words such as “expect,” “will,” “should,” “anticipate,” and similar expressions. Such assumptions are, in turn, based on information available and internal estimates and analyses of general economic conditions, competitive factors, conditions specific to the property and casualty insurance industry, claims development, and the impact thereof on our loss reserves, the adequacy of our reinsurance programs, developments in the securities market and the impact on our investment portfolio, regulatory changes and conditions, and other factors. Actual results could differ materially from those expressed in, or implied by, these forward looking statements. We assume no obligation to update any such statements. You should review the various risks, uncertainties, and other factors listed from time to time in our Securities and Exchange Commission filings.

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CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of the consolidated financial statements.

	December 31
(in thousands, except share data)	2006			2005
Assets
Investments:
Fixed maturities:
Available-for-sale, at fair value (amortized cost — $1,240,020 in 2006 and $1,189,408 in 2005)	$	1,234,571		$	1,181,636
Held-to-maturity, at amortized cost (fair value — $108,730 in 2006 and $138,902 in 2005)	106,310			134,451
Trading, at fair value (amortized cost — $15,125 in 2006 and $15,465 in 2005)	14,960			15,312
Equity securities available-for-sale, at fair value (cost — $201,443 in 2006 and $186,417 in 2005)	368,195			321,096
Short-term investments, at cost which approximates fair value	104,205			45,296
Total investments	1,828,241			1,697,791
Cash	—			—
Accrued investment income	18,628			16,974
Premiums and reinsurance balances receivable, net of allowances for uncollectible amounts of $21,620 in 2006 and $19,987 in 2005	126,021			126,894
Ceded unearned premiums	97,596			114,668
Reinsurance balances recoverable on unpaid losses and settlement expenses, net of allowances for uncollectible amounts of $16,806 in 2006 and $18,605 in 2005	525,671			593,209
Deferred policy acquisition costs, net	73,817			69,477
Property and equipment, at cost, net of accumulated depreciation of $38,060 in 2006 and $35,306 in 2005	20,590			20,859
Investment in unconsolidated investees	36,667			54,340
Goodwill, net of accumulated amortization of $4,700 in 2006 and 2005	26,214			26,214
Other assets	17,851			15,444
Total assets	$	2,771,296		$	2,735,870
Liabilities and shareholders’ equity
Liabilities:
Unpaid losses and settlement expenses	$	1,318,777		$	1,331,866
Unearned premiums	387,811			383,683
Reinsurance balances payable	85,046			97,526
Notes payable, short-term debt	—			15,541
Income taxes — current	8,318			4,425
Income taxes — deferred	27,069			22,717
Bonds payable, long-term debt	100,000			100,000
Other liabilities	87,755			87,171
Total liabilities	2,014,776			2,042,929
Shareholders’ equity:
Common stock ($1 par value, authorized 50,000,000 shares, issued 31,689,740 shares in 2006 and 31,344,058 shares in 2005)	31,690			31,344
Paid-in capital	187,632			181,794
Accumulated other comprehensive earnings net of tax	105,145			82,785
Retained earnings	594,147			478,043
Deferred compensation	7,744			7,735
Treasury stock, at cost (7,416,762 shares in 2006 and 5,792,753 shares in 2005)	(169,838		)	(88,760		)
Total shareholders’ equity	756,520			692,941
Total liabilities and shareholders’ equity	$	2,771,296		$	2,735,870

24

CONSOLIDATED STATEMENTS OF EARNINGS AND COMPREHENSIVE EARNINGS

The accompanying notes are an integral part of the consolidated financial statements.

	Years ended December 31
(in thousands, except per share data)	2006			2005			2004
Net premiums earned	$	530,338		$	491,307		$	511,348
Net investment income	71,325			61,641			54,087
Net realized investment gains	31,045			16,354			13,365
Consolidated revenue	632,708			569,302			578,800
Losses and settlement expenses	256,889			251,170			306,131
Policy acquisition costs	145,776			136,058			134,595
Insurance operating expenses	43,617			35,196			30,731
Interest expense on debt	6,581			7,118			6,894
General corporate expenses	8,069			6,780			5,536
Total expenses	460,932			436,322			483,887
Equity in earnings of unconsolidated investees	15,117			10,896			5,429
Earnings before income taxes	186,893			143,876			100,342
Income tax expense (benefit):
Current	59,942			40,481			32,495
Deferred	(7,688		)	(3,739		)	(5,189		)
Income tax expense	52,254			36,742			27,306
Net earnings	$	134,639		$	107,134		$	73,036
Other comprehensive earnings (loss), net of tax Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during the period	$	32,011		$	(12,594	)	$	16,871
Less: Reclassification adjustment for gains included in net earnings	(9,651		)	(10,638		)	(8,553		)
Other comprehensive earnings (loss)	22,360			(23,232		)	8,318
Comprehensive earnings	$	156,999		$	83,902		$	81,354
Earnings per share:
Basic
Net earnings per share	$	5.40		$	4.21		$	2.90
Comprehensive earnings per share	$	6.30		$	3.30		$	3.23
Diluted
Net earnings per share	$	5.27		$	4.07		$	2.80
Comprehensive earnings per share	$	6.14		$	3.19		$	3.12
Weighted average number of common shares outstanding:
Basic	24,918			25,459			25,223
Diluted	25,571			26,324			26,093

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CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of the consolidated financial statements.

	Years ended December 31
(in thousands)	2006			2005			2004
Cash flows from operating activities
Net earnings	$	134,639		$	107,13	4	$	73,036
Adjustments to reconcile net earnings to net cash provided by operating activities:
Net realized investment gains	(31,045		)	(16,354		)	(13,365		)
Depreciation	3,503			3,228			3,033
Other items, net	5,783			11,311			10,738
Change in:   Accrued investment income	(1,654		)	(1,791		)	(2,378		)
Premiums and reinsurance balances receivable (net of direct write-offs and commutations)	873			19,773			6,193
Reinsurance balances payable	(12,480		)	19,464			(14,320		)
Ceded unearned premium	17,072			(13,221		)	302
Reinsurance balances recoverable on unpaid losses	67,538			(129,029		)	(92,132		)
Deferred policy acquisition costs	(4,340		)	(2,331		)	(3,409		)
Accounts payable and accrued expenses	3,005			9,693			2,411
Unpaid losses and settlement expenses	(13,089		)	199,267			229,158
Unearned premiums	4,128			16,479			(437		)
Income taxes:  Current	6,823			(7,187		)	4,460
Deferred	(7,688		)	(3,739		)	(5,189		)
Stock option excess tax benefit	(2,930		)	—			—
Changes in investment in unconsolidated investees: Undistributed earnings	(15,117		)	(10,896		)	(5,429		)
Dividends received	16,500			—			—
Net proceeds from trading portfolio activity	254			(3,774		)	(3,710		)
Net cash provided by operating activities	$	171,775		$	198,027		$	188,962

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	Years ended December 31,
(in thousands)	2006			2005			2004
Cash flows from investing activities
Purchase of: Fixed maturities, held-to-maturity	$	—		$	(3,024	)	$	—
Fixed maturities, available-for-sale	(412,019		)	(407,658		)	(360,162		)
Equity securities, available-for-sale	(139,462		)	(73,519		)	(58,675		)
Short-term investments, net	(61,548		)	—			(2,219		)
Property and equipment	(4,590		)	(10,538		)	(4,051		)
Note receivable	(5,000		)	(6,000		)	—
Proceeds from sale of: Fixed maturities, available-for-sale	231,385			149,724			108,088
Equity securities, available-for-sale	146,635			72,374			39,638
Short-term investments, net	—			38,506			—
Property and equipment	1,356			4,787			1,298
Investment in unconsolidated investee	32,499			—			—
Proceeds from call or maturity of: Fixed maturities, held-to-maturity	28,215			25,363			24,080
Fixed maturities, available-for-sale	117,204			55,578			71,814
Note receivable	2,000			1,500			3,000
Net cash used in investing activities	$	(63,325	)	$	(152,907	)	$	(177,189	)
Cash flows from financing activities
Proceeds from issuance of short-term debt	$	35		$	214		$	366
Payment on short-term debt	(15,576		)	(31,512		)	(1,088		)
Stock option excess tax benefit	2,930			—			—
Proceeds from stock option exercises	3,254			1,437			1,059
Treasury shares purchased	(81,069		)	—			(10		)
Cash dividends paid	(18,024		)	(15,259		)	(12,100		)
Net cash used in financing activities	$	(108,450	)	$	(45,120	)	$	(11,773	)
Net decrease in cash	—			—			—
Cash at beginning of year	—			—			—
Cash at end of year	$	—		$	—		$	—

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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

The accompanying notes are an integral part of the consolidated financial statements.

								Accumulated
	Total							Other						Deferred		Treasury
(in thousands,	Shareholders’			Common		Paid-in		Comprehensive			Retained			Compen-		Stock
except per share data)	Equity			Stock		Capital		Earnings (Loss)			Earnings			sation		at Cost
Balance, January 1, 2004	$	554,134		$	30,958	$	179,684	$	97,699		$	326,808		$	6,069	$	(87,084	)
Net earnings	73,036										73,036
Other comprehensive earnings, net of tax	8,318							8,318
Treasury shares purchased (266 shares)	(10		)													(10		)
Deferred compensation under Rabbi trust plans	—													822		(822		)
Exercise of stock options	1,059			151		908
Dividends declared ($.51 per share)	(12,876		)								(12,876		)
Balance, December 31, 2004	$	623,661		$	31,109	$	180,592	$	106,017		$	386,968		$	6,891	$	(87,916	)
Net earnings	107,134										107,134
Other comprehensive loss, net of tax	(23,232		)					(23,232		)
Deferred compensation under Rabbi trust plans	—													844		(844		)
Exercise of stock options	1,437			235		1,202
Dividends declared ($.63 per share)	(16,059		)								(16,059		)
Balance, December 31, 2005	$	692,941		$	31,344	$	181,794	$	82,785		$	478,043		$	7,735	$	(88,760	)
Net earnings	$	134,639									134,639
Other comprehensive earnings, net of tax	22,360							22,360
Treasury shares purchased (1,624,009 shares)	(81,069		)													(81,069		)
Deferred compensation under Rabbi trust plans	—													9		(9		)
Stock option excess tax benefit	2,930					2,930
Exercise of stock options	3,254			346		2,908
Dividends declared ($.75 per share)	(18,535		)								(18,535		)
Balance, December 31, 2006	$	756,520		$	31,690	$	187,632	$	105,145		$	594,147		$	7,744	$	(169,838	)

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

A. Description of business: We underwrite selected property and casualty insurance coverages.

We conduct operations principally through three insurance companies. RLI Insurance Company (RLI), our principal subsidiary, writes multiple lines insurance on an admitted basis in all 50 states, the District of Columbia, and Puerto Rico. Mt. Hawley Insurance Company, a subsidiary of RLI Insurance Company, writes surplus lines insurance in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands, and Guam. RLI Indemnity Company (RIC), a subsidiary of Mt. Hawley Insurance Company, has authority to write multiple lines insurance on an admitted basis in 49 states and the District of Columbia.

B. Principles of consolidation and basis of presentation: The accompanying consolidated financial statements were prepared in conformity with GAAP (accounting principles generally accepted in the United States of America), which differ in some respects from those followed in reports to insurance regulatory authorities. The consolidated financial statements include the accounts of our holding company and our subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain reclassifications were made to the prior years’ financial statements to conform with the classifications used in 2006.

C. Investments: In compliance with Statement of Financial Accounting Standards (SFAS) 115, “Accounting for Certain Investments in Debt and Equity Securities,” we classify our investments in all debt securities and those equity securities with readily determinable fair values into one of three categories: available-for-sale, held-to-maturity, or trading.

AVAILABLE-FOR-SALE SECURITIES

Debt and equity securities not included as held-to-maturity or trading are classified as available-for-sale and reported at fair value, based upon quoted market prices. Unrealized gains and losses on these securities are excluded from net earnings but are recorded as a separate component of comprehensive earnings and shareholders’ equity, net of deferred income taxes. All of our equity securities and approximately 91 percent of debt securities are classified as available-for-sale.

HELD-TO-MATURITY SECURITIES

Debt securities that we have the positive intent and ability to hold to maturity are classified as held-to-maturity and carried at amortized cost. Except for declines that are other than temporary, changes in the fair value of these securities are not reflected in the financial statements. We have classified approximately 8 percent of our debt securities portfolio as held-to-maturity.

TRADING SECURITIES

Debt and equity securities purchased for short-term resale are classified as trading securities. These securities are reported at fair value with unrealized gains and losses included in earnings. We have classified approximately 1 percent of our debt securities portfolio as trading.

For the years ended December 31, 2006, 2005, and 2004, no securities were transferred from held-to-maturity to available-for-sale or trading.

Short-term investments are carried at cost, which approximates fair value.

Our balance sheet does not reflect any cash balance because all of our funds are invested in short-term investments, primarily highly rated money market instruments.

We continuously monitor the values of our investments in fixed maturities and equity securities. If this review suggests that a decline in fair value is other than temporary, our carrying value in the investment is reduced to its fair value through an adjustment to earnings. Realized gains and losses on disposition of investments are based on specific identification of the investments sold on the trade date.

Interest on fixed maturities and short-term investments is credited to earnings as it accrues. Premiums and discounts are amortized or accreted over the lives of the related fixed maturities. Dividends on equity securities are credited to earnings on the ex-dividend date.

D. Reinsurance: Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not relieve us of our legal liability to our policyholders.

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We continuously monitor the financial condition of our reinsurers. Our policy is to periodically charge to earnings, in the form of an allowance, an estimate of unrecoverable amounts from reinsurers.  We believe that current reserve levels for uncollectible reinsurance are sufficient to cover our exposures.

E. Unpaid losses and settlement expenses: The liability for unpaid losses and settlement expenses represents estimates of amounts needed to pay reported and unreported claims and related expenses. The estimates are based on certain actuarial and other assumptions related to the ultimate cost to settle such claims. Such assumptions are subject to occasional changes due to evolving economic, social, and political conditions. All estimates are periodically reviewed and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments are reflected in the results of operations in the period in which they are determined. Due to the inherent uncertainty in estimating reserves for losses and settlement expenses, there can be no assurance that the ultimate liability will not exceed recorded amounts. If actual liabilities do exceed recorded amounts, there will be an adverse effect. Furthermore, we may determine that recorded reserves are more than adequate to cover expected losses, as happened during 2005 and 2006, when favorable experience on casualty business led us to reduce our reserves. Based on the current assumptions used in estimating reserves, we believe that our overall reserve levels at December 31, 2006, make a reasonable provision to meet our future obligations. See note 6 for a further discussion of unpaid losses and settlement expenses.

F. Insurance revenue recognition: Insurance premiums are recognized ratably over the term of the contracts, net of ceded reinsurance. Unearned premiums are calculated on a monthly pro rata basis.

G. Policy acquisition costs: We defer commissions, premium taxes, and certain other costs that vary with and are primarily related to the acquisition of insurance contracts. Acquisition-related costs may be deemed ineligible for deferral when they are based on contingent or performance criteria beyond the basic acquisition of the insurance contract. All eligible costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premiums to be earned and anticipated losses and settlement expenses, as well as certain other costs expected to be incurred as the premiums are earned. Judgments as to the ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the premiums written. This deferral methodology applies to both gross and ceded premiums and acquisition costs.

H. Property and equipment: Property and equipment are presented at cost less accumulated depreciation and are depreciated on a straight-line basis for financial statement purposes over periods ranging from three to 10 years for equipment and up to 30 years for buildings and improvements.

I. Intangible assets: In accordance with SFAS 142, “Goodwill and Other Intangible Assets,” the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is reason to suspect that their values may have been diminished or impaired. Goodwill and indefinite-lived intangible assets, which relate to our surety segment, are listed separately on the balance sheet and totaled $26.2 million at December 31, 2006 and 2005. Impairment testing was performed during 2006, pursuant to the requirements of SFAS 142. Based upon this review, these assets are not impaired.

Intangible assets with definite lives continue to be amortized over their estimated useful lives. Definite-lived intangible assets that continue to be amortized under SFAS 142 relate to our purchase of customer-related and marketing-related intangibles. These intangibles have useful lives ranging from five to 10 years. Amortization of intangible assets was $0.4 million for 2006, compared to $0.5 million for 2005 and $1.3 million in 2004. Amortization expense in 2004 includes $0.7 million of additional expense recorded, pursuant to our review of the recoverability of the definite-lived intangible asset relating to contract surety. Definite-lived intangibles are subject to review for impairment pursuant to the requirements of SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS 144 requires, among other things, that we review our long-lived assets and certain related intangibles

30

for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. During 2004, we reviewed the recoverability of the definite-lived intangible asset relating to contract surety. In accordance with SFAS 144, this asset was tested for impairment by comparing the asset’s projected undiscounted cash flows to its carrying value. Results of these tests indicated the asset was not recoverable. We recorded $0.7 million of amortization expense. Subsequent to this adjustment, this asset had a carrying value of $0.

Amortization expense on intangible assets is expected to be $0.1 million in 2007. In 2007, these assets will be fully amortized. At December 31, 2006, net intangible assets totaled $0.1 million, net of $5.6 million of accumulated amortization, and are included in other assets. At December 31, 2005, net intangible assets totaled $0.5 million, net of $5.2 million of accumulated amortization.

J. Investment in unconsolidated investees: We maintain a 40 percent interest in the earnings of Maui Jim, Inc. (Maui Jim), primarily a manufacturer of high-quality polarized sunglasses, which is accounted for by the equity method. We also maintain a similar minority representation on their board of directors held by our chairman, president, and CFO. Maui Jim’s chief executive officer owns a controlling majority of the outstanding shares of Maui Jim, Inc. Our investment in Maui Jim was $36.7 million in 2006 and $44.3 million in 2005. In 2006, we recorded $8.8 million in investee earnings compared to $8.4 million in 2005 and $5.0 million in 2004. Maui Jim recorded net income of $22.1 million in 2006, $20.1 million in 2005 and $10.9 million in 2004. Additional summarized financial information for Maui Jim for 2006 and 2005 is outlined in the following table:

(in millions)	2006		2005
Current assets	$	77.0	$	80.8
Total assets	113.9		114.6
Current liabilities	45.7		22.7
Total liabilities	46.7		28.7
Total equity	67.2		85.9

Approximately $23.8 million of undistributed earnings from Maui Jim are included in our retained earnings as of December 31, 2006.

In January 2007, the board of directors of Maui Jim declared a dividend that will be payable in the first quarter of 2007. Our share of the cash dividend will be $5.9 million. The tax benefit associated with this dividend is discussed in note 7. We also received a dividend of $16.5 million from Maui Jim in 2006.

Prior to December 2006, we also maintained a 21 percent interest in the earnings of Taylor, Bean & Whitaker Mortgage Corp. (TBW), a private mortgage origination company which was accounted for by the equity method. In December 2006, we sold our interest in the company for $32.5 million to TBW’s chairman who owned the majority of the outstanding shares prior to the sale. We realized a $16.2 million pretax gain on the sale of equity. Our ownership commenced in October 2004 when we exercised warrants that were acquired in 1999. Our investment in TBW, prior to the sale, was $16.3 million in 2006, compared to $10.0 million in 2005 and $7.5 million in 2004. In 2006, we recorded $6.3 million in investee earnings, compared to $2.5 million in 2005.

In December 2006, we became a 17% participant in a loan syndicate which provided TBW’s majority shareholder with short-term financing. Our share of the loan totaled $5.0 million. The loan is collateralized by TBW shares and our portion contains the same market terms and conditions as those of the lead and other syndicate members. We also have a separate note receivable from TBW totaling $4.5 million at December 31, 2006, which originated in 1999 as an operating loan.

We perform impairment reviews of our investments in unconsolidated investees. Based upon these reviews, these assets were not impaired.

K. Income taxes: We file a consolidated income tax return. Income taxes are accounted for using the asset and liability method under which deferred income taxes are recognized for the tax consequences of ‘‘temporary differences’’ by applying enacted statutory tax rates applicable to future years to differences between the  financial statement carrying amounts and the tax bases of existing assets and liabilities, operating losses, and tax credit carry forwards. The effect on deferred taxes for a change in tax rates is recognized in income in the period that includes the enactment date.

L. Earnings per share: Pursuant to disclosure requirements contained in SFAS 128, “Earnings per Share,” the following represents a reconciliation of the numerator and denominator of the basic and diluted

31

earnings per share (EPS) computations contained in the financial statements.

(in thousands,
except per share data)	Income		Shares	Per Share
	(Numerator)		(Denominator)	Amount
For the year ended December 31, 2006
Basic EPS
Income available to common shareholders	$	134,639	24,918	$	5.40
Stock options	—		653
Diluted EPS
Income available to common shareholders and assumed conversions	$	134,639	25,571	$	5.27
For the year ended December 31, 2005
Basic EPS
Income available to common shareholders	$	107,134	25,459	$	4.21
Stock options	—		865
Diluted EPS
Income available to common shareholders and assumed conversions	$	107,134	26,324	$	4.07
For the year ended December 31, 2004
Basic EPS
Income available to common shareholders	$	73,036	25,223	$	2.90
Stock options	—		870
Diluted EPS
Income available to common shareholders and assumed conversions	$	73,036	26,093	2.80

M. Comprehensive earnings: The difference between our net earnings and our comprehensive earnings is that comprehensive earnings include unrealized gains/losses net of tax, whereas net earnings does not include such amounts, and such amounts are instead directly credited or charged against shareholders’ equity. In reporting the components of comprehensive earnings on a net basis in the income statement, we have used a 35 percent tax rate. Other comprehensive income (loss), as shown, is net of tax expense (benefit) of $12.0 million, $(12.5) million, and $4.5 million, respectively, for 2006, 2005, and 2004.

N. Fair value disclosures: The following methods were used to estimate the fair value of each class of financial instruments for which it was practicable to estimate that value. Fixed maturities and equity securities are valued using quoted market prices, if available. If a quoted market price is not available, fair value is estimated using independent pricing services or quoted market prices of similar securities. Fair value disclosures for investments are included in note 2. Due to the relatively short-term nature of cash, short-term investments, accounts receivable, accounts payable, and short-term debt, their carrying amounts are reasonable estimates of fair value.

O. Stock based compensation: In December 2004, the Financial Accounting Standards Board (FASB) revised Statement of Financial Accounting Standards (SFAS) No. 123, “Share-Based Payment,” (SFAS 123R) which required companies to expense the estimated fair value of employee stock options and similar awards, for all options vesting, granted, or modified after the effective date of this revised statement. The accounting provisions of SFAS 123R were to become effective for interim periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission (SEC) adopted a final rule amending Rule 4-01(a) of Regulation S-X regarding the compliance date for SFAS 123R. The effect of this ruling was to delay the effective date of SFAS 123R to the first interim or annual reporting period of the registrant’s first fiscal year beginning on or after June 15, 2005. As a result, the accounting provisions of SFAS 123R became effective for our financial statements beginning January 1, 2006.

SFAS 123R is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and its related implementation guidance. On January 1, 2006, we adopted the provisions of SFAS 123R using the modified prospective method. SFAS 123R requires entities to recognize compensation expense for awards of equity instruments to employees based on the grant-date fair value of those awards. Prior to the adoption of SFAS 123R, we followed the intrinsic value method in accordance with APB 25 to account for our employee stock options and recognized no compensation expense for the stock option grants.

On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. SFAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The alternative transition method includes

32

simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of employee share-based compensation awards that are outstanding upon adoption of SFAS 123(R). We have elected to adopt the alternative transition method provided in this FASB Staff Position for calculating the tax effects of share-based compensation pursuant to SFAS 123(R).

See note 8 for further discussion and related disclosures regarding stock options.

P. Risks and uncertainties: Certain risks and uncertainties are inherent to our day-to-day operations and to the process of preparing our financial statements. The more significant risks and uncertainties, as well as our methods for mitigating, quantifying and minimizing such, are presented below and throughout the notes to the consolidated financial statements.

CATASTROPHE EXPOSURES

Our insurance coverages include exposure to catastrophic events. Our major catastrophe exposure is to losses caused by earthquakes, primarily in the state of California. Our second largest catastrophe exposure is to losses caused by hurricanes to commercial properties throughout the Gulf and East Coasts, as well as to homes we insure in Hawaii. Using computer-assisted modeling techniques, we monitor and manage our exposure to catastrophic events. Additionally, we further limit our risk to such catastrophes through the purchase of reinsurance. In 2006, our property underwriting was supported by $450 million in traditional catastrophe reinsurance protection, subject to certain retentions by us. At January 1, 2007, we increased our reinsured limit of catastrophe coverage for earthquake exposures by $50 million, thereby bringing our total reinsurance protection to $500 million, subject to certain retentions by us. We actively restructure our catastrophe program in order to maximize limits and minimize costs.

ENVIRONMENTAL EXPOSURES

We are subject to environmental claims and exposures through our commercial umbrella, general liability, and discontinued assumed reinsurance lines of business. Although exposure to environmental claims exists in these lines of business, we have sought to mitigate or control the extent of this exposure through the following methods: 1) our policies include pollution exclusions that have been continually updated to further strengthen the exclusions, 2) our policies primarily cover moderate hazard risks, and 3) we began writing this business after the insurance industry became aware of the potential pollution liability exposure.

We have made loss and settlement expense payments on environmental liability claims and have loss and settlement expense reserves for others. We include this historical environmental loss experience with the remaining loss experience in the applicable line of business to project ultimate incurred losses and settlement expenses as well as related incurred but not reported (IBNR) loss and settlement expense reserves.

Although historical experience on environmental claims may not accurately reflect future environmental exposures, we have used this experience to record loss and settlement expense reserves in the exposed lines of business. See further discussion of environmental exposures in note 6.

REINSURANCE

Reinsurance does not discharge us from our primary liability to policyholders, and to the extent that a reinsurer is unable to meet its obligations, we would be liable. We continuously monitor the financial condition of prospective and existing reinsurers. As a result, we currently purchase reinsurance from a limited number of financially strong reinsurers. We provide a reserve for reinsurance balances deemed uncollectible. See further discussion of reinsurance exposures in note 5.

FINANCIAL STATEMENTS

In preparing the consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. See note 10 for a discussion of a significant policy-related contingency. Actual results could differ from those estimates.

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The most significant of these amounts is the liability for unpaid losses and settlement expenses. We continually update our estimates as additional data becomes available and adjusts the financial statements as deemed necessary. Other estimates such as investment valuation, the collectibility of reinsurance balances, recoverability of deferred tax assets, and deferred policy acquisition costs are regularly monitored, evaluated, and adjusted. Although recorded estimates are supported by actuarial computations and other supportive data, the estimates are ultimately based on our expectations of future events.

EXTERNAL FACTORS

Our insurance subsidiaries are highly regulated by the states in which they are incorporated and by the states in which they do business. Such regulations, among other things, limit the amount of dividends, impose restrictions on the amount and types of investments and regulate rates insurers may charge for various coverages. We are also subject to insolvency and guarantee fund assessments for various programs designed to ensure policyholder indemnification. We generally accrue an assessment during the period in which it becomes probable that a liability has been incurred from an insolvency and the amount of the related assessment can be reasonably estimated.

The National Association of Insurance Commissioners (NAIC) has developed Property-Casualty Risk-Based Capital (RBC) standards that relate an insurer’s reported statutory surplus to the risks inherent in its overall operations. The RBC formula uses the statutory annual statement to calculate the minimum indicated capital level to support asset (investment and credit) risk and underwriting (loss reserves, premiums written, and unearned premium) risk. The NAIC model law calls for various levels of regulatory action based on the magnitude of an indicated RBC capital deficiency, if any. We regularly monitor our subsidiaries’ internal capital requirements and the NAIC’s RBC developments. As of December 31, 2006, we have determined that our capital levels are well in excess of the minimum capital requirements for all RBC action levels and that our capital levels are sufficient to support the level of risk inherent in our operations.

In addition, ratings are a critical factor in establishing the competitive position of insurance companies. Our insurance companies are rated by A.M. Best, Standard & Poor’s, and Moody’s. Their ratings reflect their opinions of an insurance company’s and an insurance holding company’s financial strength, operating performance, strategic position, and ability to meet its obligations to policyholders.

2.INVESTMENTS

A summary of net investment income is as follows:

Net Investment Income (in thousands)	2006			2005			2004
Interest on fixed maturities	$	64,486		$	56,427		$	49,657
Dividends on equity securities	10,402			9,466			8,919
Appreciation in private equity warrants	—			—			110
Interest on short-term investments	2,125			1,316			621
Gross investment income	77,013			67,209			59,307
Less investment expenses	(5,688		)	(5,568		)	(5,220		)
Net investment income	$	71,325		$	61,641		$	54,087

Pretax net realized investment gains (losses) and net changes in unrealized gains (losses) on investments for the years ended December 31 are summarized as follows:

Realized/unrealized gains
(in thousands)	2006			2005			2004
Net realized investment gains (losses)
Fixed maturities
Available-for-sale	$	(7,351	)	$	573		$	335
Held-to-maturity	92			18			126
Trading	(53		)	(32		)	(154		)
Equity securities	38,578			15,887			12,824
Other	(221		)	(92		)	234
	31,045			16,354			13,365
Net changes in unrealized gains (losses) on investments
Fixed maturities
Available-for-sale	2,323			(24,070		)	(1,725		)
Held-to-maturity	(2,030		)	(5,055		)	(4,841		)
Equity securities	32,072			(11,718		)	14,925
	32,365			(40,843		)	8,359
Net realized investment gains and changes in unrealized gains (losses) on investments	$	63,410		$	(24,489	)	$	21,724

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Following is a summary of the disposition of fixed maturities and equities for the years ended December 31, with separate presentations for sales and calls/maturities:

								Net
	Proceeds		Gross Realized					Realized
(in thousands)	From Sales		Gains		Losses			Gain(Loss)
Sales
2006 — Available-for-sale	$	231,385	$	666	$	(8,076	)	$	(7,410	)
Trading	4,950		17		(70		)	(53		)
Equities	179,134		41,097		(2,519		)	38,578
2005 — Available-for-sale	$	149,724	$	2,629	$	(2,319	)	$	310
Trading	1,359		4		(34		)	(30		)
Equities	72,374		18,791		(2,904		)	15,887
2004 — Available-for-sale	$	108,088	$	300	$	(252	)	$	48
Trading	2,645		126		(3		)	123
Equities	39,638		13,677		(853		)	12,824
Calls/Maturities
2006 — Available-for-sale	$	117,204	$	59	$	—		$	59
Held-to-maturity	28,215		92		—			92
Trading	1,083		—		—			—
2005 — Available-for-sale	$	55,578	$	263	$	—		$	263
Held-to-maturity	25,363		19		(1		)	18
Trading	942		—		(2		)	(2		)
2004 — Available-for-sale	$	71,814	$	303	$	(16	)	$	287
Held-to-maturity	24,080		126		—			126
Trading	524		—		—			—

The following is a schedule of amortized costs and estimated fair values of investments in fixed maturities and equity securities as of December 31, 2006 and 2005:

	Amortized		Estimated		Gross Unrealized
(in thousands)	Cost		Fair Value		Gains		Losses
2006
Available-for-sale
U.S. government	$	8,792	$	8,541	$	12	$	(263	)
U.S. agencies	465,629		461,831		588		(4,386		)
Mtge/ABS/CMO*	109,538		109,272		824		(1,090		)
Corporate	237,905		235,291		1,645		(4,259		)
States, political subdivisions & revenues	418,156		419,636		3,338		(1,858		)
Fixed maturities	1,240,020		1,234,571		6,407		(11,856		)
Equity securities	201,443		368,195		167,279		(527		)
Total available-for-sale	$	1,441,463	$	1,602,766	$	173,686	$	(12,383	)
Held-to-maturity
U.S. government	$	6,291	$	6,309	$	21	$	(3	)
U.S. agencies	18,850		19,415		625		(60		)
States, political subdivisions & revenues	81,169		83,006		1,837		—
Total held-to-maturity	$	106,310	$	108,730	$	2,483	$	(63	)
Trading
U.S. government	$	2,438	$	2,399	$	2	$	(41	)
U.S. agencies	4,679		4,630		5		(54		)
Mtge/ABS/CMO*	3,015		2,979		3		(39		)
Corporate	4,893		4,848		18		(63		)
States, political subdivisions & revenues	100		104		4		—
Total trading	15,125		14,960		32		(197		)
Total	$	1,562,898	$	1,726,456	$	176,201	$	(12,643	)

35

	Amortized		Estimated		Gross Unrealized
(in thousands)	Cost		Fair Value		Gains		Losses
2005
Available-for-sale
U.S. government	$	9,492	$	9,324	$	31	$	(199	)
U.S. agencies	440,237		435,561		596		(5,272		)
Mtge/ABS/CMO*	107,638		106,298		446		(1,786		)
Corporate	210,748		208,760		2,634		(4,622		)
States, political subdivisions & revenues	421,293		421,693		3,414		(3,014		)
Fixed maturities	1,189,408		1,181,636		7,121		(14,893		)
Equity securities	186,417		321,096		135,493		(814		)
Total available-for-sale	$	1,375,825	$	1,502,732	$	142,614	$	(15,707	)
Held-to-maturity
U.S. government	$	10,104	$	10,224	$	120	$	—
U.S. agencies	23,770		24,800		1,078		(48		)
States, political subdivisions & revenues	100,577		103,878		3,301		—
Total held-to-maturity	$	134,451	$	138,902	$	4,499	$	(48	)
Trading
U.S. government	$	3,523	$	3,481	$	10	$	(52	)
U.S. agencies	3,370		3,345		24		(49		)
Mtge/ABS/CMO*	3,441		3,391		—		(50		)
Corporate	5,031		4,989		17		(59		)
States, political subdivisions & revenues	100		106		6		—
Total trading	15,465		15,312		57		(210		)
Total	$	1,525,741	$	1,656,946	$	147,170	$	(15,965	)

*Mortgage-backed, asset-backed & collateralized mortgage obligations

The amortized cost and estimated fair value of fixed-maturity securities at December 31, 2006, by contractual maturity, are shown as follows:

	Amortized		Estimated
(in thousands)	Cost		Fair Value
Available-for-sale
Due in one year or less	$	3,662	$	3,664
Due after one year through five years	251,561		250,469
Due after five years through 10 years	605,338		604,189
Due after 10 years	379,459		376,249
	$	1,240,020	$	1,234,571
Held-to-maturity
Due in one year or less	$	15,337	$	15,441
Due after one year through five years	61,207		62,566
Due after five years through 10 years	29,766		30,723
Due after 10 years	—		—
	$	106,310	$	108,730
Trading
Due in one year or less	$	—	$	—
Due after one year through five years	5,166		5,119
Due after five years through 10 years	5,705		5,620
Due after 10 years	4,254		4,221
	$	15,125	$	14,960
Total fixed-income
Due in one year or less	$	18,999	$	19,105
Due after one year through five years	317,934		318,154
Due after five years through 10 years	640,809		640,532
Due after 10 years	383,713		380,470
	$	1,361,455	$	1,358,261

Expected maturities may differ from contractual maturities due to call provisions on some existing securities and prepayment features on mortgage-backed, asset-backed, and collateralized mortgage obligations. At December 31, 2006, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $161.3 million. At December 31, 2005, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $126.9 million.

The following tables are also used as part of our impairment analysis and illustrate the total value of securities that were in an unrealized loss position as of December 31, 2006 and December 31, 2005, respectively. These tables segregate the securities based on type, noting the fair value, cost (or amortized cost), and unrealized loss on each category of

36

investment as well as in total. The tables further classify the securities based on the length of time they have been in an unrealized loss position.

Investment Positions with Unrealized Losses Segmented by Type and
Period of Continuous Unrealized Loss at December 31, 2006

(in thousands)	0-12 Mos.			>12 Mos.			Total
U.S. Government
Fair value	$	1,850		$	8,994		$	10,844
Cost or amortized cost	1,856			9,296			11,152
Unrealized loss	(6		)	(302		)	(308		)
U.S. Agency
Fair value	$	113,858		$	147,103		$	260,961
Cost or amortized cost	114,245			148,987			263,232
Unrealized loss	(387		)	(1,884		)	(2,271		)
Mtge/ABS/CMO*
Fair value	$	69,800		$	129,598		$	199,398
Cost or amortized cost	70,108			132,874			202,982
Unrealized loss	(308		)	(3,276		)	(3,584		)
Corporate debt securities
Fair value	$	59,079		$	86,074		$	145,153
Cost or amortized cost	59,629			89,620			149,249
Unrealized loss	(550		)	(3,546		)	(4,096		)
States, political subdivisions, revenues & debt securities
Fair value	$	117,351		$	99,216		$	216,567
Cost or amortized cost	117,765			100,659			218,424
Unrealized loss	(414		)	(1,443		)	(1,857		)
Subtotal, debt securities
Fair value	$	361,938		$	470,985		$	832,923
Cost or amortized cost	363,603			481,436			845,039
Unrealized loss	(1,665		)	(10,451		)	(12,116		)
Common stock
Fair value	$	12,519		$	—		$	12,519
Cost or amortized cost	13,046			—			13,046
Unrealized loss	(527		)	—			(527		)
Total
Fair value	$	374,457		$	470,985		$	845,442
Cost or amortized cost	376,649			481,436			858,085
Unrealized loss	(2,192		)	(10,451		)	(12,643		)

*Mortgage-backed, asset-backed & collateralized mortgage obligations

Investment Positions with Unrealized Losses Segmented by Type and
Period of Continuous Unrealized Loss at December 31, 2005

(in thousands)	0-12 Mos.			>12 Mos.			Total
U.S. Government
Fair value	$	10,062		$	—		$	10,062
Cost or amortized cost	10,313			—			10,313
Unrealized loss	(251		)	—			(251		)
U.S. Agency
Fair value	$	338,930		$	35,118		$	374,048
Cost or amortized cost	343,141			36,278			379,419
Unrealized loss	(4,211		)	(1,160		)	(5,371		)
Mtge/ABS/CMO*
Fair value	$	84,283		$	2,852		$	87,135
Cost or amortized cost	86,104			2,866			88,970
Unrealized loss	(1,821		)	(14		)	(1,835		)
Corporate debt securities
Fair value	$	103,121		$	42,269		$	145,390
Cost or amortized cost	105,798			44,271			150,069
Unrealized loss	(2,677		)	(2,002		)	(4,679		)
States, political subdivisions, revenues & debt securities
Fair value	$	210,089		$	17,904		$	227,993
Cost or amortized cost	212,673			18,335			231,008
Unrealized loss	(2,584		)	(431		)	(3,015		)
Subtotal, debt securities
Fair value	$	746,485		$	98,143		$	844,628
Cost or amortized cost	758,029			101,750			859,779
Unrealized loss	(11,544		)	(3,607		)	(15,151		)
Common stock
Fair value	$	13,019		$	—		$	13,019
Cost or amortized cost	13,833			—			13,833
Unrealized loss	(814		)	—			(814		)

Total
Fair value	$	759,504		$	98,143		$	857,647
Cost or amortized cost	771,862			101,750			873,612
Unrealized loss	(12,358		)	(3,607		)	(15,965		)

*Mortgage-backed, asset-backed & collateralized mortgage obligations

As of December 31, 2006, we held seven common stocks that were in unrealized loss positions. The total unrealized loss on these securities was $0.5 million. All of these securities have been in an unrealized loss position for less than nine months. The fixed income portfolio contained 412 securities at a loss as of December 31, 2006. Of these 412 securities, 248 have been in an unrealized loss position for more

37

than 12 consecutive months and these collectively represent $10.5 million in unrealized losses. The fixed income unrealized losses can primarily be attributed to an increase in intermediate and long-term interest rates since the purchase of many of these fixed income securities. We continually monitor the credit quality of our fixed income investments to gauge our ability to be repaid principal and interest. We consider price declines of securities in our other-than-temporary impairment analysis where such price declines provide evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration, as opposed to rising interest rates.

Factors that we consider in the evaluation of credit quality include:

1.     Credit ratings from major rating agencies, including Moody’s and Standard & Poor’s,

2.     Business and operating performance trends,

3.     Management quality/turnover,

4.     Industry competitive analysis, and

5.     Changes in business model/strategy.

As of December 31, 2006, we held no equity or fixed income securities that individually had an unrealized loss greater than 12 percent. Based on our evaluation of equity securities held within specific industry sectors, as well as the duration and magnitude of unrealized losses in our equity and bond portfolios, we do not believe any securities suffered an other-than-temporary decline in value as of December 31, 2006.

At December 31, 2006, we were party to a securities lending program whereby fixed-income securities are loaned to third parties, primarily major brokerage firms. At December 31, 2006, fixed maturities with a fair value of $46.8 million were loaned. Agreements with custodian banks facilitating such lending generally require 102 percent of the value of the loaned securities to be separately maintained as collateral for each loan. Pursuant to SFAS 140, an invested asset and a corresponding liability have been recognized for the cash collateral amount. To further minimize the credit risks related to this lending program, we monitor the financial condition of other parties to these agreements.

As required by law, certain fixed maturities and short-term investments amounting to $18.8 million at December 31, 2006, were on deposit with either regulatory authorities or banks. Additionally, we have certain fixed maturities held in trust amounting to $15.0 million at December 31, 2006. These funds cover net premiums, losses, and expenses related to a property and casualty insurance program.

3.POLICY ACQUISITION COSTS

Policy acquisition costs deferred and amortized to income for the years ended December 31 are summarized as follows:

(in thousands)	2006			2005			2004
Deferred policy acquisition costs, beginning of year	$	69,477		$	67,146		$	63,737
Deferred:
Direct commissions	126,270			120,996			120,323
Premium taxes	6,483			7,572			8,460
Other direct underwriting expenses	54,946			50,312			43,154
Ceding commissions	(41,520		)	(44,126		)	(36,881		)
Net deferred	146,179			134,754			135,056
Amortized	141,839			132,423			131,647
Deferred policy acquisition costs, end of year	$	73,817		$	69,477		$	67,146
Policy acquisition costs:
Amortized to expense	141,839			132,423			131,647
Period costs:
Ceding commission – contingent	(3,049		)	(5,698		)	(5,368		)
Other	6,986			9,333			8,316
Total policy acquisition costs	$	145,776		$	136,058		$	134,595

4.DEBT

As of December 31, 2006, outstanding debt balances totaled $100.0 million, consisting only of long-term senior notes. These notes are rated Baa2 by Moody’s and BBB+ by Standard & Poor’s.

On December 12, 2003, we completed a public debt offering, issuing $100.0 million in senior notes maturing January 15, 2014, and paying interest semi-annually at the rate of 5.95 percent. The notes were issued at a discount resulting in proceeds, net of discount and commission, of $98.9 million. The amount of the discount is being charged to income over the life of the debt on an effective-yield basis. Of the proceeds, capital contributions were made in 2003 and 2004 to our insurance subsidiaries to increase their statutory surplus in the amounts of $50.0 million and $15.0 million, respectively. The

38

balance of the proceeds was used by the holding company to fund investment and operating activities.

We paid off all short-term debt previously held through reverse repurchase transactions at the insurance subsidiaries, leaving us with no short-term debt as of December 31, 2006, compared to December 31, 2005, short-term debt balances of $15.5 million. The pool of securities underlying the reverse repurchase transactions consists of U.S. government and agency securities. With no outstanding reverse repurchase transactions at December 31, 2006, there was no carrying value of securities associated with such transactions, compared with a December 31, 2005, carrying value of $15.2 million. The use and repayment of such agreements remains an investment decision, based on whether the allocation of available cash flow to purchase debt securities generates a greater amount of investment income than would be paid in interest expense.

We maintain revolving lines of credit with two financial institutions, each of which permits us to borrow up to an aggregate principal amount of $10.0 million. Under certain conditions, each of the lines may be increased up to an aggregate principal amount of $20.0 million. These facilities have three-year terms that expire on May 31, 2008. As of December 31, 2006, no amounts were outstanding on these facilities.

We incurred interest expense on debt at the following average interest rates for 2006, 2005, and 2004:

	2006		2005		2004
Line of credit	—		—		—
Reverse repurchase agreements	4.97	%	3.00	%	1.62	%
Total short-term debt	5.34	%	3.17	%	1.79	%
Senior notes	6.02	%	6.02	%	6.02	%
Total debt	5.95	%	5.27	%	4.66	%

Interest paid on outstanding debt for 2006, 2005, and 2004 amounted to $6.6 million, $7.2 million, and $4.0 million respectively.

5.REINSURANCE

In the ordinary course of business, the insurance subsidiaries assume and cede premiums with other insurance companies. A large portion of the reinsurance is put into effect under contracts known as treaties and, in some instances, by negotiation on each individual risk (known as facultative reinsurance). In addition, there are quota share, excess of loss and catastrophe reinsurance contracts that protect against losses over stipulated amounts arising from any one occurrence or event. The arrangements allow us to pursue greater diversification of business and serve to limit the maximum net loss on catastrophes and large risks.

Through the purchase of reinsurance, we generally limit our net loss on any individual risk to a maximum of $2.0 million, although retentions can range from $0.5 million to $7.0 million. Additionally, through extensive use of computer-assisted modeling techniques, we monitor the concentration of risks exposed to catastrophic events.

Premiums written and earned along with losses and settlement expenses incurred for the years ended December 31 are summarized as follows:

(in thousands)	2006			2005			2004
Written
Direct	$	794,093		$	748,852		$	745,227
Reinsurance assumed	4,920			7,160			7,361
Reinsurance ceded	(247,477		)	(261,447		)	(241,376		)
Net	$	551,536		$	494,565		$	511,212
Earned
Direct	$	788,904		$	731,483		$	744,596
Reinsurance assumed	5,982			7,629			8,305
Reinsurance ceded	(264,548		)	(247,805		)	(241,553		)
Net	$	530,338		$	491,307		$	511,348
Losses and settlement expenses incurred
Direct	$	381,661		$	506,434		$	486,978
Reinsurance assumed	8,956			7,277			4,273
Reinsurance ceded	(133,728		)	(262,541		)	(185,120		)
Net	$	256,889		$	251,170		$	306,131

At December 31, 2006, we had prepaid reinsurance premiums and reinsurance recoverables on paid and unpaid losses and settlement expenses totaling $586.4 million. More than 94 percent of our reinsurance recoverables are due from companies rated “A-” or better by A.M. Best and S&P rating services.

The following table displays net reinsurance balances recoverable, including collateral, from our top ten reinsurers, as of December 31, 2006. All other reinsurance balances recoverable, when considered

39

by individual reinsurer, are less than 2 percent of shareholders’ equity.

Reinsurer	Amounts		A.M Best	S&P
(amounts in thousands)	Recoverable		Rating	Rating
Munich Re America	$	136,069	A, Excellent	A-, Good
General Rein Corp	55,704		A++, Superior	AAA, Superior
Swiss Reinsurance	44,693		A+, Superior	AA-, Excellent
Berkley Insurance Company	36,397		A, Excellent	A+, Good
Lloyds of London	32,525		A, Excellent	A, Good
Endurance Reinsurance Corp.	30,275		A-, Excellent	A, Good
Toa-Re	30,014		A, Excellent	A+, Excellent
Employers Reinsurance Corp.	25,473		A+, Superior	AA-, Good
Everest Reinsurance	24,870		A+, Superior	AA-, Excellent
Liberty Mutual Insurance	20,780		A, Excellent	A, Good

6.HISTORICAL LOSS AND LAE DEVELOPMENT

The table which follows is a reconciliation of our unpaid losses and settlement expenses (LAE) for the years 2006, 2005, and 2004.

(in thousands)	2006			2005			2004
Unpaid losses and LAE at beginning of year:
Gross	$	1,331,866		$	1,132,599		$	903,441
Ceded	(593,209		)	(464,180		)	(372,048		)
Net	$	738,657		$	668,419		$	531,393
Increase (decrease) in incurred losses and LAE:
Current accident year	300,292			313,643			316,948
Prior accident years	(43,403		)	(62,473		)	(10,817		)
Total incurred	$	256,889		$	251,170		$	306,131
Loss and LAE payments for claims incurred:
Current accident year	(47,994		)	(43,062		)	(39,206		)
Prior accident year	(154,446		)	(137,870		)	(129,899		)
Total paid	(202,440		)	$	(180,932	)	$	(169,105	)
Net unpaid losses and LAE at end of year	$	793,106		738,657			668,419
Unpaid losses and LAE at end of year:
Gross	1,318,777			1,331,866			1,132,599
Ceded	(525,671		)	(593,209		)	(464,180		)
Net	$	793,106		$	738,657		$	668,419

The deviations from our initial reserve estimates appeared as changes in our ultimate loss estimates as we updated those estimates through our reserve analysis process. The recognition of the changes in initial reserve estimates occurred over time as claims were reported, initial case reserves were established, initial reserves were reviewed in light of additional information, and ultimate payments were made on the collective set of claims incurred as of that evaluation date. The new information on the ultimate settlement value of claims is therefore continually updated and revised as this process takes place until all claims in a defined set of claims are settled. As a relatively small insurer, our experience will ordinarily exhibit fluctuations from period to period. While we attempt to identify and react to systematic changes in the loss environment, we also must consider the volume of experience directly available to us, and interpret any particular period’s indications with a realistic technical understanding of the reliability of those observations.

The table below summarizes our prior accident years’ loss reserve development by segment for 2006, 2005, and 2004:

(Favorable)/Unfavorable reserve development by segment
(in thousands)	2006			2005			2004
Casualty	$	(40,030	)	$	(57,505	)	$	(11,813	)
Property	(1,784		)	(7,581		)	(5,137		)
Surety	(1,589		)	2,613			6,133
Total	$	(43,403	)	$	(62,473	)	$	(10,817	)

A discussion of significant components of reserve development for the three most recent calendar years follows:

2006. During 2006, we continued to experience favorable loss development and a reduction in its prior years’ loss reserve estimates. Pricing increased substantially and policy terms and conditions became more favorable for most of our products during the 2001-2004 policy years. Many of the improvements in market conditions were difficult to quantify at the time of the original estimate. Our significant growth in premium and exposures made precise quantification of these changes even more challenging. In 2006, losses continued to emerge on the prior accident years much more favorably than the company expected when making its original estimates. We

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experienced favorable development of $43.4 in aggregate on prior years’ estimates.

Of this decrease to prior years’ loss reserve estimates, approximately $40.0 million occurred in the casualty segment. The development is primarily from our general liability, executive products liability, and Texas employer’s indemnity products. In our general liability product we experienced $25.4 million of favorable development. Most of this development came from the 2004 and 2005 accident years. As part of our normal reserving process, we reviewed the expected loss ratios used in several of its reserving methods. This review confirmed the favorable emergence from 2002-2005 accident years. As a result of this study, the expected loss ratios were reduced for 2004-2006 with the most significant change occurring to the 2005 accident year. Approximately $15.4 million of the favorable general liability development can be attributed to this update in expected loss ratios. The remaining portion of the decrease in prior year’s loss reserve estimate was the result of the continued favorable loss emergence and the natural progression of shifting more weight to our incurred and paid development methods as accident years get older. In our executive products liability business, we experienced $7.4 million of favorable development. Most of this change can be attributed to accident years 2001, 2003, and 2004. The estimates improved as a result of lower than expected loss severity in those accident years.  For our Texas employer’s indemnity product, we experienced $5.7 million of favorable development.  We experienced significantly less loss emergence than expected for accident years prior to 2003 and benefited from favorable settlements on several claims in accident years 2001-2003.

Overall, our property and surety segments experienced relatively small changes in prior years’ estimates of reserves. However, we experienced $4.2 million of favorable development from 2004 and 2005 hurricane estimates. We also saw $7.2 million of unfavorable development on our construction product that is in runoff. Most of this development came from accident years 2002-2005. The construction emergence pattern revealed itself to be longer than originally anticipated and has not behaved consistent with reporting patterns expected from a property segment. We do not anticipate any further deterioration in our estimates.

2005. During 2005, we experienced an aggregate of $62.5 million of favorable development. Of this total, approximately $57.5 million of this reserve development occurred in the casualty segment. It was primarily from accident years 2002, 2003, and 2004 for our general liability, specialty programs, and transportation products. Pricing and policy terms and conditions rapidly became more favorable for most of our products beginning in 2002. Many of the improvements in market conditions were difficult to quantify at the time of our original estimate. Our significant growth in premium and exposures over this same time period made precise quantification of these changes more challenging because of the resulting mix changes, new exposures underwritten for the first time, and uncertainty in whether the new exposures would have similar emergence patterns as those reflected in our historical data. We appropriately reflected these significant risks in our 2002-2004 initial carried reserves for this business. During 2005, we regularly observed emergence of losses lower than expected for these accident years as the anticipated risks failed to materialize. This resulted in a re-evaluation and corresponding reduction in expected loss ratios used in the loss reserving analysis for these products. The lower than expected emergence, lower expected loss ratios, and the natural progression of increased weighting on the incurred and paid development actuarial methods caused the reserve estimate to decrease. In response to the reduction in reserve estimates, we released $36.8 million, $11.6 million, and $6.3 million of IBNR loss and LAE reserves to general liability, specialty programs, and transportation, respectively. The release for these products was consistent with our loss reserving processes. These releases comprise a majority of the favorable development within our casualty segment.

The property segment also experienced $7.6 million of favorable development. A portion of this positive development is due to the claims department reassessing and decreasing the estimated ultimate level of loss payments for the 2004 hurricanes. Overall, the surety segment experienced $2.6 million in adverse development. Reserve additions on

41

surety products for the 2002 accident year exceeded favorable experience on surety products for accident years prior to 2002.

2004. During 2004, we experienced an aggregate of $10.8 million of favorable development. Of this total, approximately $5.1 million of favorable development occurred in the property segment. Approximately half of the favorable development within our property segment was due to a favorable settlement of an outstanding claim from the Northridge, California earthquake of 1994. The remainder relates primarily to favorable development on losses that occurred during 2003.

In 2004 the cumulative experience attributable to many of our casualty products for mature accident years was materially lower than the IBNR reserves originally booked. Due to the low emergence of loss and LAE, we released $9.7 million of IBNR reserves during the fourth quarter of 2004, which accounted for the majority of the favorable development within our casualty segment. While we had been experiencing robust price improvements in this segment for several years, we also produced significant new business with new exposures. Our reserving evaluation process requires adequate time periods to elapse to assess the impact of such changes in marketplace conditions on our book of casualty business.

The surety segment experienced $6.1 million in adverse development. A portion of this development comes from contract bond products, where we increased IBNR reserves on bonds primarily written before 2003. Additionally, we experienced adverse development on reserves for other surety products, primarily related to the 2002 accident year.

ENVIRONMENTAL, ASBESTOS, AND MASS TORT EXPOSURES

We are subject to environmental site cleanup, asbestos removal, and mass tort claims and exposures through our commercial umbrella, general liability, and discontinued assumed reinsurance lines of business. The majority of the exposure is in the excess layers of our commercial umbrella and assumed reinsurance books of business.

The following table represents inception-to-date paid and unpaid environmental claims data (including incurred but not reported losses) as of December 31, 2006, 2005, and 2004:

(in thousands)	2006			2005			2004
Loss and LAE payments
Gross	$	53,323		$	46,685		$	44,360
Ceded	(29,853		)	(26,888		)	(25,590		)
Net	$	23,470		$	19,797		$	18,770
Unpaid losses and LAE at end of year
Gross	$	48,541		$	47,391		$	43,716
Ceded	(25,720		)	(30,950		)	(28,998		)
Net	$	22,821		$	16,441		$	14,718

Our environmental, asbestos, and mass tort exposure is limited, relative to that of other insurers, as a result of entering the affected liability lines after the insurance industry had already recognized environmental and asbestos exposure as a problem and adopted appropriate coverage exclusions. During 2006, we reviewed our reserves for these exposures relative to industry benchmarks and re-evaluated its emergence patterns. As a result, net reserves for these exposures were increased $6.4 million. Other significant activity during 2006 was payment for the settlement of a large claim associated with a Superfund site. The claim arose out of commercial umbrella business written in the early 1980s. Gross payments of $4.0 million and net payments of $2.1 million for this claim caused the majority of the 2006 increase, reflected in the table above. This claim had no effect on 2006 incurred losses, however, because an adequate case reserve estimate had been established for it in 2004.

While our environmental exposure is limited, the ultimate liability for this exposure is difficult to assess because of the extensive and complicated litigation involved in the settlement of claims and evolving legislation on such issues as joint and several liability, retroactive liability, and standards of cleanup. Additionally, we participate primarily in the excess layers of coverage, where accurate estimates of ultimate loss are more difficult to derive than for primary coverage.

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7.INCOME TAXES

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are summarized as follows:

(in thousands)	2006			2005
Deferred tax assets:
Tax discounting of claim reserves	$	38,294		$	35,591
Unearned premium offset	20,315			18,831
Other	7,937			5,843
	66,546			60,265
Less valuation allowance	—			—
Total deferred tax assets	$	66,546		$	60,265
Deferred tax liabilities:
Net unrealized appreciation of securities	$	57,017		$	44,856
Deferred policy acquisition costs	25,837			24,318
Book/tax depreciation	2,289			2,217
Undistributed earnings of unconsolidated investee	8,043			11,108
Other	429			483
Total deferred tax liabilities	93,615			82,982
Net deferred tax liability	$	(27,069	)	$	(22,717	)

We believe that our deferred tax assets will be fully realized through deductions against future taxable income.

Income tax expense attributable to income from operations for the years ended December 31, 2006, 2005, and 2004, differed from the amounts computed by applying the U.S. federal tax rate of 35 percent to pretax income from continuing operations as demonstrated in the following table:

(in thousands)	2006			2005			2004
Provision for income taxes at the statutory federal tax rates	$	65,413		$	50,357		$	35,120
Increase (reduction) in taxes resulting from:
Dividends received deduction	(1,858		)	(1,705		)	(1,637		)
ESOP dividends paid deduction	(469		)	(439		)	(370		)
Tax-exempt interest income	(5,885		)	(5,980		)	(5,175		)
Resolution of tax contingency	(3,171		)	—			—
Goodwill	—			—			291
Other items, net	(1,776		)	(5,491		)	(923		)
Total	$	52,254		$	36,742		$	27,306

Our net earnings include equity in earnings of unconsolidated investees. These investees (Maui Jim and TBW) do not have a pattern of paying dividends. As a result, we record a deferred tax liability on these earnings at the corporate capital gains rate of 35 percent. In January 2007, the board of directors of Maui Jim declared a dividend that will be payable in the first quarter of 2007. Our share of the cash dividend will be $5.9 million. As required by SFAS 109, “Accounting for Income Taxes,” in 2006 we recognized a $1.7 million tax benefit from applying the lower tax rate applicable to affiliated dividends as compared to the corporate capital gains rate on which the deferred tax liabilities were based. This benefit is included in the other items, net caption in the previous table. A dividend was also paid in 2006 by Maui Jim in the amount of $16.5 million and a $4.6 million tax benefit was recorded in 2005 from applying the lower tax rates. Although a dividend has been received for two straight years, we do not anticipate the payment of dividends to continue. On December 28, 2006, we sold our equity investment in TBW. This resulted in a realized capital gain of $16.2 million with a corresponding current tax expense of $5.7 million and the current recognition of tax expense of $5.5 million from the previously deferred tax expense on undistributed earnings of this unconsolidated investee. Additionally, results for 2006 include a favorable resolution of a recent tax examination. During the second quarter of 2006, the Internal Revenue Service (IRS) concluded an examination of our tax years 2000 through 2004. As a result of this exam, we recorded a $3.2 million tax benefit, resulting from a change in tax estimate related to the sale of assets. Although the IRS is not currently examining any of our income tax returns, tax years 2005 and 2006 remain open and are subject to examination.

We have recorded our deferred tax assets and liabilities using the statutory federal tax rate of 35 percent. We believe it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax asset. In addition, we believe when these deferred items reverse in future years, our taxable income will be taxed at an effective rate of 35 percent.

Net federal and state income taxes paid in 2006, 2005, and 2004 amounted to $53.1 million, $47.7 million, and $27.8 million, respectively.

During the fourth quarter of 2005, we repatriated a $4.0 million dividend from our foreign subsidiary, RLI

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Insurance, Ltd., which qualified for the special 85% dividends received deduction passed in The American Jobs Creation Act of 2004. This allowed a $1.3 million deferred tax liability to be reversed because the dividend fully repatriated all foreign earnings. The tax benefit associated with the repatriation is included in the other items, net caption in the previous table.

8.EMPLOYEE BENEFITS

PENSION PLAN

Through 2006, we maintained a noncontributory defined benefit pension plan covering employees meeting age and service requirements. The plan provided a benefit based on a participant’s service and the highest five consecutive years’ average compensation out of the last 10 years. During 2006, 2005, and 2004, we made tax-deductible contributions totaling $1.8 million, $1.8 million, and $0.5 million, respectively, to adequately meet the funding requirements of the plan.

We have made various amendments to the plan in order to comply with certain Internal Revenue Code changes.

Additionally, on December 31, 2003, our pension plan was amended to freeze benefit service as of March 1, 2004. As a result, we expensed the entire unrecognized prior service cost as of December 31, 2003. The plan was also closed to new participants after December 31, 2003.

However, effective December 31, 2005, the plan was further amended such that all participants’ benefits were frozen and future pay would not alter a participant’s accrued benefit. In 2005, we also shortened the amortization period of the plan’s unrecognized gain/loss, to fully amortize it over the next two years.

The plan was terminated in 2006. All participants either elected and were paid lump sum amounts or had an insurance contract for their benefit purchased on their behalf during 2006. At the close of 2006, $561,186 remains in the trust, of which $559,618 was due to pension checks not cashed, and the remaining $1,568 is the net assets remaining in the trust.

The financial status of the plan for each of the two years ended December 31 is illustrated in the following table:

(in thousands)	2006			2005
Change in benefit obligation
Benefit obligation at January 1	$	11,365		$	13,781
Service cost	—			—
Interest cost	583			757
Net actuarial loss/(gain)	1,538			1,669
Benefits paid	(14,420		)	(1,457		)
Curtailment cost(1)	—			(3,385		)
Settlement cost(2)	934			—
Benefit obligation at December 31	—			$	11,365
Change in plan assets
Fair value of plan assets at January 1	$	11,514		$	10,729
Actual return on plan assets	1,099			417
Employer contributions	1,809			1,825
Benefits paid	(14,420		)	(1,457		)
Fair value of plan assets at December 31	$	2		$	11,514

(1)At December 31, 2005 all future plan benefits were frozen which results in a curtailment.

(2)In December 2006 all plan benefits were paid which resulted in a settlement.

The components of benefit cost for each of the three years ended December 31 is illustrated in the following table:

(in thousands)	2006			2005			2004
Service cost	$	—		$	—		$	—
Interest cost	583			757			717
Expected (return) on assets	(481		)	(460		)	(698		)
Amortization of prior service cost	—			—			—
Amortization of losses/(gains)	1,603			1,760			732
Amortization of transitional obligation/(asset)	—			—			(7		)
Net periodic benefit cost	$	1,705		$	2,057		$	744
FAS 88 events(1) (2)	934			399			—
Total pension cost/(income) for year	$	2,639		$	2,456		$	744

(1)The pension plan had benefit payments in excess of the sum of service cost and interest cost. This resulted in a recognition of settlement expense in 2005.

(2)In December 2006 all plan benefits were paid which resulted in a settlement.

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The reconciliation of (accrued)/prepaid benefit cost for each of the two years ended December 31 is illustrated in the following table:

Reconciliation of (accrued)/prepaid benefit cost (in thousands)	2006			2005
(Accrued)/prepaid benefit cost (before adjustment) at beginning of year	$	832		$	1,463
Net periodic benefit (cost)/income for fiscal year	(1,705		)	(2,057		)
Cost of SFAS 88 events	(934		)	(399		)
Employer contributions	1,809			1,825
Benefits paid directly by company	—			—
Other adjustment	—			—
Amount recognized in accumulated other comprehensive income	—			—
Net balance sheet (liability)/asset at end of year	$	2		$	832

The funded status of the plan for each of the two years ended December 31 is illustrated below:

Development of funded status
(in thousands)	2006		2005
Actuarial value of benefit obligations measurement date	12/31/2006		12/31/2005
Accumulated benefit obligation	$	—	$	11,365
Projected benefit obligation/accumulated postretirement benefit obligation	—		11,365
Funded Status
Projected benefit obligation/accumulated postretirement benefit obligation	—		11,365
Plan assets at fair value	2		11,514
Employer contribution after measurement date, before year end	—		—
Directly paid benefits after measurement date, before year end	—		—
Net balance sheet (liability)/asset	$	2	$	148

Information for plans with PBO/APBO less than plan assets (in thousands)	2006		2005
Projected benefit obligation/accumulated postretirement benefit obligation	—		$	11,365
Accumulated benefit obligation/accumulated postretirement benefit obligation	—		$	11,365
Fair value of plan assets	$	2	$	11,514

The change in net actuarial loss/(gain) for each of the two years ended December 31 is illustrated below:

Change in net actuarial loss/gain
(in thousands)	2006			2005
Net actuarial loss/(gain) at end of prior year	$	684		$	4,515
Amortization credit/(cost) for year	$	(1,603	)	(1,760		)
Liability loss/(gain)	1,538			1,669
Asset loss/(gain)	(619		)	44
Recognition of curtailment (gain)/loss	—			(3,385		)
Recognition of settlement (gain)/loss	—			(399		)
Other adjustments	—			—
Net actuarial loss/(gain) at year end	$	—		$	684

The change in amortization expected to be recognized for each of the two years ended December 31 is illustrated below:

Amortizations expected to be recognized during next fiscal year (in thousands)	2006		2005
Amortization of net transition obligation/(asset)	$	—	$	—
Amortization of prior service cost/(credit)	$	—	$	—
Amortization of net losses/(gains)	$	—	$	(1,760	)

Actuarial assumptions, plan assets, contribution and benefit payment information, and additional information of the plan for each of the two plan years ended December 31 is illustrated below.

Actuarial assumptions	2006		2005
Weighted-average assumptions used to determine benefit obligations at year end
Discount rate	N/A		4.75	%
Rate of compensation increase	N/A		N/A
Social Security increase	N/A		N/A
Pension increases for participants in-payment status	N/A		N/A
Weighted-average assumptions used to determine net periodic benefit cost for year
Discount rate	4.75	%	5.75	%
Expected long-term return on plan assets	4.75	%	4.75	%
Rate of compensation increase	N/A		N/A
Social Security increase	N/A		N/A
Pension increases for participants in-payment status	N/A		N/A

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Plan assets	2006		2005
Allocation of assets at year end
Equity securities	0.00	%	87.00	%
Debt securities	0.00	%	0.00	%
Real estate	0.00	%	0.00	%
Other	100.00	%	13.00	%
Total	100.00	%	100.00	%

Company contributions (in thousands)	2006		2005
Company contributions for the year ending:
December 31, 2005	0		$	1,825
December 31, 2006	$	1,809	N/A
December 31, 2007 (estimated)	N/A		N/A
Actual benefit payments for the year ending:
December 31, 2005	0		$	1,457
December 31, 2006	$	14,420	0

Additional information
Balance sheet entries under prior rules
(in thousands)	2006		2005
Statement of financial position prior to deferred tax adjustments:
(Accrued)/prepaid as of end of year	$	2	N/A
Additional minimum liability	—		N/A
Intangible asset	—		N/A
Accumulated other comprehensive income using prior rules	—		N/A
Accumulated other comprehensive income using new rules	—		N/A

In September 2006, the FASB published SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” This statement requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. This statement also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. As previously stated, the plan was terminated in 2006. As a result, the implementation of SFAS 158 had no impact on our financial statements.

EMPLOYEE STOCK OWNERSHIP, 401K AND BONUS AND INCENTIVE PLANS

We maintain an Employee Stock Ownership Plan (ESOP), 401k, and bonus and incentive plans covering executives, managers, and associates. At the board’s discretion, funding of these plans is primarily dependent upon reaching predetermined levels of operating return on equity and Market Value Potential (MVP). While some management incentive plans may be affected somewhat by other performance factors, the larger influence of corporate performance ensures that the interests of our executives, managers, and associates correspond with those of our shareholders.

In January 2004, we made certain changes to our employee benefit plans. We froze our pension plan, modified our ESOP plan, and began offering a 401k plan. The 401k plan has eligibility rules similar to those in place for our ESOP, allows voluntary contributions by employees, and permits ESOP diversification transfers for employees meeting certain age and service requirements. We provide a basic 401k contribution of 3 percent of eligible compensation. Participants are 100 percent vested in both voluntary and basic contributions. Additionally, an annual discretionary profit-sharing contribution may be made to the ESOP and 401k, subject to the achievement of certain overall financial goals. For plan years prior to 2007, profit-sharing contributions were subject to a five-year cliff vest. Beginning in 2007, contributions will vest after three years of service.

Our ESOP and 401k cover substantially all employees meeting eligibility requirements. ESOP and 401k contributions are determined annually by our board of directors and are expensed in the year earned. ESOP and 401k-related expenses were $7.9 million, $7.7 million, and $6.4 million, respectively, for 2006, 2005, and 2004.

During 2006, the ESOP purchased 94,430 shares of RLI stock on the open market at an average price of $54.19 ($5.1 million) relating to 2005’s contribution. Shares held by the ESOP as of December 31, 2006, totaled 1,716,446, and are treated as outstanding in computing our earnings per share. During 2005, the ESOP purchased 95,762 shares on the open market at an average price of $44.55 ($4.3 million) relating to 2004’s contribution. During 2004, the ESOP purchased 131,700 shares on the open market at

46

an average price of $40.57 ($5.3 million) relating to 2003’s contribution.

A portion of both MVP and operating earnings is shared by executives, managers, and associates provided certain thresholds are met. MVP, in particular, requires that we generate a return in excess of our cost of capital before the payment of such bonuses. Annual expenses for these bonus plans totaled $15.1 million, $9.2 million, and $6.8 million for 2006, 2005, and 2004, respectively.

DEFERRED COMPENSATION

We maintain Rabbi Trusts for deferred compensation plans for directors, key employees, and executive officers through which our shares are purchased. The Emerging Issues Task Force consensus on Issue 97-14 governs the accounting for Rabbi Trusts. This issue prescribed an accounting treatment whereby the employer stock in the plan is classified and accounted for as equity, in a manner consistent with the accounting for treasury stock. The deferred compensation obligation is classified as an equity instrument.

The expense associated with funding these plans is recognized through salary, bonus, and ESOP expenses for key employees and executive officers. The expense recognized from the directors’ deferred plan was $0.4 million, $0.3 million, and $0.4 million in 2006, 2005, and 2004, respectively.

In 2006, the trusts purchased 13,913 shares of our common stock on the open market at an average price of $51.61 ($0.7 million). In 2005, the trusts purchased 23,744 shares of common stock on the open market at an average price of $44.83 ($1.1 million). In 2004, the trusts purchased 20,421 shares of common stock on the open market at an average price of $39.05 ($0.8 million). At December 31, 2006, the trusts’ assets were valued at $24.4 million.

STOCK OPTION AND STOCK PLANS

During 1995, we adopted and the shareholders approved a tax-favored incentive stock option plan (the incentive plan). During 1997, the shareholders approved the Outside Directors’ Stock Option Plan (the directors’ plan). Normal vesting for options granted was pro rata over five years under the incentive plan and pro rata over three years under the directors’ plan with a 10-year life for both plans. The plans provided for grants of up to 3,125,000 shares under the incentive plan and 500,000 shares under the directors’ plan. Through May 5, 2005, we had granted 2,640,188 options under these plans.

During 2005, our shareholders approved the RLI Corp. Omnibus Stock Plan (omnibus plan). In conjunction with the adoption of this plan, effective May 5, 2005, options will no longer be granted under the two other option plans previously in existence. The purpose of the omnibus plan is to promote the interests of our shareholders by providing our key personnel an opportunity to acquire a proprietary interest in the company and reward them for achieving a high level of corporate performance and to encourage our continued success and growth. Awards under the omnibus plan may be in the form of restricted stock, stock options (both incentive and nonqualified), stock appreciation rights, performance units, as well as other stock based awards. Eligibility under the omnibus plan is limited to our employees or employees of any affiliate and to individuals or entities who are not employees but who provide services to us or an affiliate, including services provided in the capacity of consultant, advisor or director. The granting of awards is solely at the discretion of the executive resources committee and the nominating/corporate governance committee of our board of directors. The total number of shares of common stock available for distribution under the omnibus plan may not exceed 1,500,000 shares (subject to adjustment for changes in our capitalization). In 2005, we granted 233,500 stock options under this plan. In 2006, we granted 206,300 stock options under this plan.

Under the omnibus plan, we grant to officers, directors, and other employees stock options for shares with an exercise price equal to the fair value of the shares at the date of grant. Options generally vest and become exercisable ratably over a five-year period and have a 10-year life. The related compensation expense is recognized over the requisite service period. In most instances, the requisite service period and vesting period will be the same. For participants who are retirement eligible, defined by the plan as those individuals whose age and years of service equals 75, the requisite service period is deemed to be met and options are immediately expensed on the date of grant. For participants who will become retirement eligible during the vesting period, the

47

requisite service period over which expense is recognized is the period between the grant date and the attainment of retirement eligibility. Shares issued upon option exercise are newly issued shares.

During 2005, our board of directors adopted resolutions authorizing the accelerated vesting of existing unvested stock options, including directors’ stock options. These resolutions were effective May 5, 2005, for all options issued prior to this date and December 30, 2005, for options issued in 2005 subsequent to May 5, 2005. Acceleration was applicable to substantially all unvested options and contains certain share transfer restrictions. These modifications, which occurred prior to the effective date of SFAS 123R, effectively removed these options from expense consideration under SFAS 123R. Under APB 25, compensation expense recorded for accelerated vesting was measured by applying two criteria: (1) the difference between the market price and the option exercise price on the date of acceleration and (2) the number of options that would have been forfeited as unexercisable (unvested) had acceleration not occurred. Using the guidance set forth in APB 25 and related interpretations, we recorded $0.8 million of pre-tax compensation expense during 2005. This expense represented our best estimate of the total expense associated with acceleration.

The following tables summarize option activity in 2006, 2005, and 2004:

					Weighted
			Weighted		Average	Aggregate
	Number of		Average		Remaining	Intrinsic
	Options		Exercise		Contractual	Value
	Outstanding		Price		Life	(in 000’s)
Outstanding options at January 1, 2006	1,931,627		$	26.53
Options granted	206,300		$	50.31
Options exercised	(459,828	)	$	18.98		$	15,997
Options cancelled/ forfeited	(46,080	)	$	39.48
Outstanding options at December 31, 2006	1,632,019		$	31.30	5.75	$	41,015
Exercisable options at December 31, 2006	1,429,219		$	28.59	5.23	$	39,770

					Weighted
			Weighted		Average	Aggregate
	Number of		Average		Remaining	Intrinsic
	Options		Exercise		Contractual	Value
	Outstanding		Price		Life	(in 000’s)
Outstanding options at January 1, 2005	2,058,632		$	22.78
Options granted	238,300		$	44.64
Options exercised	(340,099	)	$	15.83		$	10,068
Options cancelled/ forfeited	(25,206	)	$	35.98
Outstanding options at December 31, 2005	1,931,627		$	26.53	5.05	$	45,085
Exercisable options at December 31, 2005	1,924,787		$	26.50	5.04	$	44,991

					Weighted
			Weighted		Average	Aggregate
	Number of		Average		Remaining	Intrinsic
	Options		Exercise		Contractual	Value
	Outstanding		Price		Life	(in 000’s)
Outstanding options at January 1, 2004	1,953,848		$	19.95
Options granted	313,240		$	35.62
Options exercised	(200,656	)	$	15.02		$	4,664
Options cancelled/ forfeited	(7,800	)	$	27.74
Outstanding options at December 31, 2004	2,058,632		$	22.78	5.16	$	38,680
Exercisable options at December 31, 2004	1,219,412		$	17.84	3.86	$	28,931

The majority of our options are granted annually at the board meeting in May. In 2006, 206,300 options were granted with an average exercise price of $50.31 and an average fair value of $13.95. Of these grants, 171,900 were granted at the board meeting in May with a calculated fair value of $13.97. We recognized $0.8 million of expense during 2006 related to 2006 grants. Since options granted in 2006 have been non-qualified, we recorded a tax benefit of $0.3 million related to this compensation expense. Total unrecognized compensation expense relating to these grants was $1.9 million, which will be recognized over the remainder of the five-year vesting period. There were no options that vested during 2006.

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The fair value of options were estimated using a Black-Scholes based option pricing model with the following grant-date assumptions and weighted average fair values:

	2006			2005			2004
Weighted-average fair value of grants	$	13.95		$	13.08		$	10.62
Risk-free interest rates	4.99		%	3.97		%	4.55		%
Dividend yield	1.51		%	1.52		%	1.79		%
Expected volatility	22.35		%	22.93		%	21.46		%
Expected option life	6.31 years			8.0 years			9.0 years

The risk-free rate is determined based on U.S. treasury yields that most closely approximate each options expected life. The dividend yield is calculated based on the average annualized dividends paid during the most recent five-year period. The expected volatility is an implied volatility. For 2006, this volatility is calculated by computing the weighted average of the most recent one-year volatility, the most recent 6.31-year (equal to the expected life) volatility and the median of the 6.31-year rolling volatilities of RLI stock. For 2006, the expected option life is determined based on historical exercise behavior and the assumption that all outstanding options will be exercised at the midpoint of the current date and remaining contractual term, adjusted for the demographics of the current year’s grant. In prior years, the expected life was determined using historical exercise patterns.

As discussed previously, prior to the adoption of SFAS 123R, we followed the intrinsic value method in accordance with APB 25 to account for employee stock options and accordingly recognized no compensation expense for the stock option grants. In accordance with SFAS 123R, we adopted the provisions of the statement on January 1, 2006 using the modified prospective approach. Under this method, prior periods are not restated. Had compensation cost for share-based plans been determined consistent with SFAS 123R, our net earnings and earnings per share for the years ended December 31, 2005 and 2004 would have been reduced to the pro forma amounts that follow:

(in thousands, except per share data)	2005			2004
Net earnings, as reported	$	107,134		$	73,036
Add:    Stock-based employee compensation expense included in reported earnings, net of related tax effects	553			—
Deduct:   Total stock-based employee compensation expense determined under fair-value-based methods for all awards, net of related tax effects	(4,592		)	(1,941		)
Pro forma net earnings	$	103,095		$	71,095
Earnings per share:
Basic – as reported	$	4.21		$	2.90
Basic – pro forma	$	4.05		$	2.82
Diluted – as reported	$	4.07		$	2.80
Diluted – pro forma	$	3.92		$	2.72

Pro forma disclosures for 2006 are not presented because the amounts are recognized in the statement of earnings.

During 2004, the shareholders approved the NonEmployee Directors’ Stock Plan (stock plan). An aggregate of 200,000 shares of common stock is reserved under the stock plan. The stock plan is designed to provide compensation to each nonemployee director in the form of a stock grant at the time of such director’s election or appointment to the board of directors, and future stock grants based on continued service as a director. In conjunc-tion with the shareholders’ approval of the omnibus plan in May 2005, no further awards will be issued under the stock plan. Awards to outside directors will be made under the omnibus plan.

Shares granted to outside directors were 7,267 in 2006 and 5,642 in 2005. Shares were granted at an average share price of $51.72 in 2006 and $45.75 in 2005. In 2006, 3,452 of the shares granted were issued under the directors’ deferred plan. We recognized $0.4 million of expense, relating to these grants.

POST-RETIREMENT BENEFITS OTHER THAN PENSION

In 2002, we began offering certain eligible employees post-employment medical coverage. Under our plan, employees who retire at age 55 or older with 20 or more years of company service may continue medical coverage under our health plan. Former employees who elect continuation of coverage pay the

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full COBRA (Consolidated Omnibus Budget Reconciliation Act of 1985) rate and coverage terminates upon reaching age 65. We expect a relatively small number of employees will become eligible for this benefit. The COBRA rate established for participating employees covers the cost of providing this coverage.

9.STATUTORY INFORMATION AND DIVIDEND RESTRICTIONS

Our insurance subsidiaries maintain their accounts in conformity with accounting practices prescribed or permitted by state insurance regulatory authorities that vary in certain respects from GAAP. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of statutory nonadmitted assets, and the inclusion of net unrealized holding gains or losses in shareholders’ equity relating to fixed maturities.

Year-end statutory surplus includes $44.0 million of RLI Corp. stock (cost basis of $63.1 million) held by Mt. Hawley Insurance Company. The Securities Valuation Office provides specific guidance for valuing this investment, which is eliminated in our consolidated financial statements.

In December 2003, we closed a public debt offering of $100.0 million, generating $98.9 million in net proceeds. Of these proceeds, $50.0 million was contributed to the insurance subsidiaries to bolster statutory surplus. In March 2004, an additional $15.0 million of these proceeds was contributed to the insurance subsidiaries.

The following table includes selected information for our insurance subsidiaries as filed with insurance regulatory authorities:

(in thousands)
Year ended December 31,	2006		2005		2004
Consolidated net income, statutory basis	$	136,135	$	95,776	$	62,189
Consolidated surplus, statutory basis	$	746,905	$	690,547	$	605,967

Dividend payments to us from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the regulatory authorities of Illinois. The maximum dividend distribution is limited by Illinois law to the greater of 10 percent of RLI policyholder surplus as of December 31 of the preceding year or the net income of RLI for the 12-month period ending December 31 of the preceding year. RLI’s stand-alone net income for 2006 was $75.7 million. Therefore, the maximum dividend distribution that can be paid by RLI during 2007 without prior approval is $75.7 million — RLI’s 2006 net income. Dividends paid in the form of asset transfers are applied to the dividend limitation at the estimated fair value of the asset as of the dividend date. In 2006, a total of $59.5 million was paid in dividends by RLI Insurance as follows: asset transfer of Maui Jim valued at $35.2 million, asset transfer of TBW valued at $13.4 million, and a cash dividend of $10.9 million. This left $16.2 million in unused dividend capacity for 2006. The total amount paid in 2005 was $13.0 million.

10.COMMITMENTS AND CONTINGENT LIABILITIES

The following is a description of a complex set of litigation wherein we are both a plaintiff and a defendant. While it is impossible to ascertain the ultimate outcome of this matter at this time, we believe, based upon facts known to date, that our position is meritorious. Our opinion is that the final resolution of these matters will not have a material adverse effect on our financial statements taken as a whole.

We are the plaintiff in an action captioned RLI Insurance Co. v. Commercial Money Center, which was filed in U.S. District Court, Southern District of California (San Diego) on February 1, 2002. Other defendants in that action are Commercial Servicing Corporation (“CSC”), Sterling Wayne Pirtle, Anita Pirtle, Americana Bank & Trust, Atlantic Coast Federal Bank, Lakeland Bank and Sky Bank. We filed a similar complaint against the Bank of Waukegan in San Diego, California Superior Court. Americana Bank & Trust, Atlantic Coast Federal Bank, Lakeland Bank, Sky Bank and Bank of Waukegan are referred to here as the “investor banks.” The litigation arises out of the equipment and vehicle leasing program of Commercial Money Center (“CMC”). CMC originated leases, procured bonds pertaining to the performance of obligations of each lessee under each lease, and then formed “pools” of such leases that it marketed to banks and other institutional investors. We sued for rescission and/or exoneration of the bonds we

50

issued to CMC and sale and servicing agreements we entered into with CMC and the investor banks, which had invested in CMC’s equipment leasing program. We contend we were fraudulently induced to issue the bonds and enter into the agreements by CMC, who misrepresented and concealed the true nature of its program and the underlying leases originated by CMC (for which bonds were procured). We also sued for declaratory relief to determine our rights and obligations, if any, under the instruments. Each investor bank disputes our claims for relief. CMC is currently in Chapter 7 bankruptcy proceedings.

Between the dates of April 4 and April 18, 2002, each investor bank subsequently filed a complaint against us in various state courts, which we removed to U.S. District Courts. Each investor bank sued us on certain bonds we issued to CMC as well as a sale and servicing agreement between the investor bank, CMC and us. Each investor bank sued for breach of contract, bad faith and other extra-contractual theories. We have answered and deny each investor bank’s claim to entitlement to relief. The investor banks claim entitlement to aggregate payment of approximately $53 million under either the surety bonds or the sale and servicing agreements, plus unknown extra-contractual damages, attorney’s fees and interest. On October 25, 2002, the judicial panel for multi-district litigation (“MDL Panel”) transferred 23 actions pending in five federal districts involving numerous investor banks, five insurance companies and CMC to the Federal District Court for the Northern District of Ohio for consolidated pre-trial proceedings, assigning the litigation to the Honorable Kathleen O’Malley.

In the third quarter of 2005, RLI reached a confidential settlement agreement with Lakeland Bank. This settlement ends our litigation with Lakeland, but does not resolve our pending litigation with the four other investor banks. The settlement with Lakeland relates to surety bonds representing approximately 17 percent of the amount to which the five investor banks had claimed entitlement. The settlement did not have a material adverse effect on our financial statements taken as a whole. In addition, in August 2005, the Federal District Court denied outright the investor banks’ motion for judgment on the pleadings as to RLI and subsequently ordered all remaining cases to mandatory mediation. Mediations held in January 2006 between RLI and each of the four remaining investor banks did not resolve the claims of those investor banks. In September 2006, the Court issued a case management order governing expert witness discovery and future motion practice.  While we cannot predict the ultimate outcome of the pending litigation between RLI and the remaining four investor banks at this time, RLI continues to believe it has meritorious defenses with respect to each of the banks making claims against it and will continue to vigorously assert those defenses in the pending litigation.

Our financial statements contain an accrual for defense costs relating to this matter, included in unpaid losses and settlement expenses, as well as an accrual to cover rescission of collected premium related to the program. In our opinion, final resolution of this matter will not have a material adverse effect on our financial condition, results of operations or cash flows. However, litigation is subject to inherent uncertainties, and if there were an outcome unfavorable to us, there exists the possibility of a material adverse impact on our financial condition, results of operation or cash flows in the period in which the outcome occurred.

In addition, we are party to numerous claims and losses that arise in the normal course of our business. Many of such claims or losses involve claims under policies that we underwrite as an insurer. We believe that the resolution of these claims and losses will not have a material adverse effect on our financial condition, results of operations or cash flows.

We have capital lease obligations for leased computers and operating lease obligations for regional office facilities. These leases expire in various years through 2013. Expense associated with these leases totaled $3.4 million in 2006, $2.7 million in 2005 and $2.0 million in 2004. Minimum future rental payments under noncancellable leases are as follows:

(in thousands)
2007	$	3,516
2008	2,737
2009	2,455
2010	2,149
2011	1,539
2012-2013	1,983
Total minimum future rental payments	$	14,379

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11.INDUSTRY SEGMENT INFORMATION

The following table summarizes our segment data as specified by SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” As prescribed by the pronouncement, reporting is based on the internal structure and reporting of information as it is used by management.

The segments of our insurance operations include property, casualty, and surety. The property segment is comprised of insurance coverages providing physical damage coverage for commercial and personal risks. These risks are exposed to a variety of perils including earthquakes, fires, and hurricanes. Losses are developed in a relatively short period of time.

The casualty segment includes liability coverages where loss and related settlement expenses must be estimated, as the ultimate disposition of claims may take several years to fully develop. Policy coverage is more significantly impacted by evolving legislation and court decisions.

The surety segment offers a selection of small and medium-size commercial coverages related to the statutory requirement for bonds on construction and energy-related projects. The results of this segment are generally characterized by relatively low loss ratios. Expense ratios tend to be higher due to the high volume of transactions at lower premium levels.

Net investment income is the by-product of the interest and dividend income streams from our investments in fixed-income and equity securities. Interest and general corporate expenses include the cost of debt and other director and shareholder relations costs incurred for the benefit of the corporation, but not attributable to the operations of our insurance segments. Investee earnings represent our share in Maui Jim and TBW earnings. We own approximately 40 percent of Maui Jim, which operates in the sunglass and optical goods industries, and, up until the sale in December, 2006, 21 percent of TBW, a mortgage origination company; both companies are private.

The following table provides financial data used by management. The net earnings of each segment are before taxes, and include revenues (if applicable), direct product or segment costs (such as commissions, claims costs, etc.), as well as allocated support costs from various overhead departments. While depreciation and amortization charges have been included in these measures via our expense allocation system, the related assets are not allocated for management use and, therefore, are not included in this schedule.

(in thousands)	Revenues						Depreciation and Amortization
	2006		2005		2004		2006		2005		2004
Casualty	$	348,217	$	358,893	$	365,617	$	2,086	$	1,901	$	1,671
Property	122,581		80,528		98,043		963		993		1,063
Surety	59,540		51,886		47,688		501		450		1,263
Segment totals before income taxes	$	530,338	$	491,307	$	511,348	$	3,550	$	3,344	$	3,997
Net investment income	71,325		61,641		54,087
Net realized gains	31,045		16,354		13,365
Total	$	632,708	$	569,302	$	578,800

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(in thousands)	Net Earnings (Losses)
	2006			2005			2004
Casualty	$	68,393		$	72,024		$	19,560
Property	4,988			(8,342		)	20,400
Surety	10,675			5,201			(69		)
Net Underwriting Income	$	84,056		$	68,883		$	39,891
Net investment income	71,325			61,641			54,087
Realized gains	31,045			16,354			13,365
General corporate expense and interest on debt	(14,650		)	(13,898		)	(12,430		)
Equity in earnings of unconsolidated investees	15,117			10,896			5,429
Total earnings before income taxes	$	186,893		$	143,876		$	100,342
Income taxes	52,254			36,742			27,306
Total	$	134,639		$	107,134		$	73,036

The following table further summarizes revenues by major product type within each segment:

(in thousands)	2006		2005		2004
Casualty
General liability	$	180,037	$	180,267	$	174,954
Commercial and personal umbrella	64,730		59,847		53,478
Executive coverages	13,040		9,807		13,074
Specialty program business	25,507		38,289		47,072
Commercial transportation	48,285		51,707		55,994
Other	16,618		18,976		21,045
Total	$	348,217	$	358,893	$	365,617
Property
Commercial property	$	91,507	$	66,410	$	69.169
Construction	4,493		2,521		21,633
Marine	16,785		3,286		—
Other property	9,796		8,311		7,241
Total	$	122,581	$	80,528	$	98,043
Surety	$	59,540	$	51,886	$	47,688
Grand total	$	530,338	$	491,307	$	511,348

12. UNAUDITED INTERIM FINANCIAL INFORMATION

Selected quarterly information is as follows:

(in thousands, except per share data)	First		Second		Third		Fourth		Year
2006
Net premiums earned	$	127,387	$	125,867	$	138,245	$	138,839	$	530,338
Net investment income	16,708		17,556		18,316		18,745		71,325
Net realized investment gains	4,442		1,489		2,822		22,292		31,045
Earnings before income taxes	36,263		27,506		43,562		79,562		186,893
Net earnings	25,656		22,922		30,378		55,683		134,639
Basic earnings per share(1)	$	1.00	$	0.91	$	1.24	$	2.29	$	5.40
Diluted earnings per share(1)	$	0.97	$	0.89	$	1.21	$	2.23	$	5.27
2005
Net premiums earned	$	124,040	$	123,674	$	126,129	$	117,464	$	491,307
Net investment income	14,612		14,666		15,855		16,508		61,641
Net realized investment gains	2,984		4,389		7,194		1,787		16,354
Earnings before income taxes	41,540		49,609		35,680		17,047		143,876
Net earnings	29,307		34,395		25,327		18,105		107,134
Basic earnings per share(1)	$	1.15	$	1.35	$	0.99	$	0.71	$	4.21
Diluted earnings per share(1)	$	1.12	$	1.31	$	0.96	$	0.68	$	4.07

(1)Since the weighted-average shares for the quarters are calculated independently of the weighted-average shares for the year, quarterly earnings per share may not total to annual earnings per share.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders RLI Corp.:

We have audited management’s assessment, included in the accompanying Report on Controls and Procedures, that RLI Corp. and Subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company, and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2006 and 2005, and the related consolidated statements of earnings and comprehensive earnings, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated February 28, 2007 expressed an unqualified opinion on those consolidated financial statements.

Chicago, Illinois

February 28, 2007

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders RLI Corp.:

We have audited the accompanying consolidated balance sheets of RLI Corp. and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of earnings and comprehensive earnings, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

Chicago, Illinois

February 28, 2007

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STATEMENT OF FINANCIAL REPORTING RESPONSIBILITY

The management of RLI Corp. and Subsidiaries is responsible for the preparation and for the integrity and objectivity of the accompanying financial statements and other financial information in this report. The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and include amounts that are based on management’s estimates and judgments.

Management has established and maintains internal control throughout its operations that is designed to provide assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use, and the execution and recording of transactions in accordance with management’s authorization. Internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are updated by management as necessary. Management considers the recommendations of its internal auditor and independent public accounting firm concerning the Company’s internal control and takes the necessary actions that are cost effective in the circumstances to respond appropriately to the recommendations presented.

The accompanying financial statements have been audited by KPMG LLP (KPMG), an independent registered public accounting firm selected by the audit committee and approved by the shareholders. Management has made available to KPMG all of the Company’s financial records and related data, including minutes of directors’ meetings. Furthermore, management believes that all representations made to KPMG during its audit were valid and appropriate.

The audit committee is comprised of four independent directors and is charged with general supervision of the audits, examinations and inspections of the books and accounts of RLI Corp. and Subsidiaries. The independent registered public accounting firm and the internal auditor have ready access to the audit committee.

Jonathan E. Michael

President, CEO

Joseph E. Dondanville, CPA

Senior Vice President, CFO

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REPORT ON CONTROLS AND PROCEDURES

CONCLUSION REGARDING THE EFFECTIVENESS OF DISCLOSURE CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act). Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control — Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2006.

Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by KPMG, an independent registered public accounting firm, as stated in their report which is included herein.

Jonathan E. Michael

President, CEO

Joseph E. Dondanville, CPA

Senior Vice President, CFO

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GLOSSARY

ADMITTED COMPANY

An insurer domiciled in one state licensed to do business in one or more other states.

COMBINED RATIO (GAAP)

A common measurement of underwriting profit (less than 100) or loss (more than 100). The sum of the expense and the loss ratios.

COMBINED RATIO (STATUTORY)

The same as a GAAP combined ratio, except in calculating the expense ratio, the denominator used is net premiums written instead of net premiums earned.

COMPREHENSIVE EARNINGS

The sum of net after-tax earnings and net after-tax unrealized gains (losses) on investments.

COMMERCIAL GENERAL LIABILITY INSURANCE

Liability coverage for all premises and operations, other than personal, for non-excluded general liability hazards.

CONSOLIDATED REVENUE

Net premiums earned plus net investment income and realized gains (losses).

DIFFERENCE IN CONDITIONS (DIC) INSURANCE

Coverage for loss normally excluded in standard commercial or personal property policies, particularly flood and earthquake.

EXCESS INSURANCE

A policy or bond covering against certain hazards, only in excess of a stated amount.

EXPENSE RATIO

The percentage of the premium used to pay all the costs of acquiring, writing and servicing business.

FIRE INSURANCE

Property insurance on which the predominant peril is fire, but generally includes wind and other lines.

GAAP

Generally accepted accounting principles.

HARD/FIRM MARKET

When the insurance industry has limited capacity available to handle the amount of business written, creating a seller’s market, driving insurance prices upward.

INLAND MARINE INSURANCE

Property coverage for perils arising from transportation of goods or covering types of property that are mobile, and other hazards.

LOSS RATIO

The percentage of premium used to pay for losses incurred.

MARKET CAP

Short for market capitalization. The value of a company as determined by the market. Multiply the share price by the number of outstanding shares. Can change daily.

MARKET VALUE POTENTIAL (MVP)

An RLI incentive plan covering all employees that requires we first generate a return in excess of our cost of capital, aligning our interests with those of shareholders.

PROFESSIONAL LIABILITY INSURANCE

Insures against claims for damages due to professional misconduct or lack of ordinary care in the performance of a service.

REINSURER/REINSURANCE

A company that accepts part or all of the risk of loss covered by another insurer. Insurance for insurers.

RESERVES

Funds set aside by an insurer for meeting estimated obligations when due. Periodically readjusted.

SOFT MARKET

When the insurance industry has excess capacity to handle the amount of business written, creating a buyer’s market, lowering insurance prices overall.

STANDARD LINES VS. SPECIALTY LINES

Those insurance coverages or target market segments that are commonly insured through large, admitted insurers using standard forms and pricing are in contrast to unique insurance coverages or selected market niches that are served by only a single insurer or a select group of insurers, often with unique coverage forms and pricing approach.

SURETY BOND

Provides for compensation if specific acts are not performed within a stated period.

SURPLUS LINES COMPANY

In most states, an insurer not licensed to do business in that state, but which may sell insurance in the state if admitted insurers decline to write a risk.

TRANSPORTATION INSURANCE

Coverage for transporting people or goods by land. For RLI, this involves motor vehicle transportation and focuses on automobile liability and physical damage, with incidental public liability, umbrella and excess liability, and motor truck cargo insurance.

UNREALIZED GAINS (LOSSES)

The result of an increase (decrease) in fair value of an asset which is not recognized in the traditional statement of income. The difference between an asset’s fair and book values.

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INVESTOR INFORMATION

ANNUAL MEETING

The annual meeting of shareholders will be held at 2 p.m., CDT, on May 3, 2007, at our offices at 9025 N. Lindbergh Drive, Peoria, Ill.

TRADING AND DIVIDEND INFORMATION

	Stock Price						Dividends
2006	High		Low		Close		Declared
1st Quarter	$	57.35	$	50.65	$	57.30	$	.17
2nd Quarter	57.25		45.85		48.18		.19
3rd Quarter	51.62		45.16		50.79		.19
4th Quarter	57.41		49.75		56.42		.20

	Stock Price						Dividends
2005	High		Low		Close		Declared
1st Quarter	$	44.99	$	40.28	$	41.45	$	.14
2nd Quarter	46.80		40.73		44.60		.16
3rd Quarter	48.75		44.79		46.26		.16
4th Quarter	55.68		44.00		49.87		.17

RLI common stock trades on the New York Stock Exchange under the symbol RLI. RLI has paid and increased dividends for 31 consecutive years.

STOCK OWNERSHIP

December 31, 2006	Shares	%
Insiders	2,004,667	8.2
ESOP	1,713,298	7.1
Institutions & other public	20,555,013	84.7
Total outstanding	24,272,978	100.0

SHAREHOLDER INQUIRIES

Shareholders of record with requests concerning individual account balances, stock certificates, dividends, stock transfers, tax information or address corrections should contact the transfer agent and registrar:

Wells Fargo Shareholder Services

P.O. Box 64854

St. Paul, MN 55164-0854

Phone: (800) 468-9716 or (651) 450-4064

Fax: (651) 450-4033

Email: stocktransfer@wellsfargo.com

DIVIDEND REINVESTMENT PLANS

If you wish to sign up for an automatic dividend reinvestment and stock purchase plan or to have your dividends deposited directly into your checking, savings or money market accounts, send your request to the transfer agent and registrar.

REQUESTS FOR ADDITIONAL INFORMATION

Electronic versions of the following documents are, or will be made, available on our website: 2006 summary annual report; 2006 financial report; 2007 proxy statement; annual report on form 10-K; code of conduct, corporate governance guidelines; and charters of the executive resources, audit, finance and investment, strategy, and nominating/corporate governance committees. Printed copies of these documents are available without charge to any shareholder. To be placed on a mailing list to receive shareholder materials, contact our corporate headquarters.

COMPANY FINANCIAL STRENGTH RATINGS

A.M. Best:	A+ (Superior)	RLI Group
Standard & Poor’s:	A+ (Strong)	RLI Insurance
		Company
	A+ (Strong)	Mt. Hawley
		Insurance
		Company
Moody’s:	A2 (Good)	RLI Insurance
		Company
	A2 (Good)	Mt. Hawley
		Insurance
		Company
	A2 (Good)	RLI Indemnity
		Company

CONTACTING RLI

For investor relations requests and management’s perspective on specific issues, contact John Robison, treasurer, at (309) 693-5846 or at john_robison@rlicorp.com.

Turn to the back cover for corporate headquarters contact information.

Find comprehensive investor information at www.rlicorp.com.

59

SELECTED FINANCIAL DATA

The following is selected financial data of RLI Corp. and Subsidiaries for the 11 years ended December 31, 2006.

(amounts in thousands, except per share data)	2006			2005		2004		2003		2002
OPERATING RESULTS
Gross premiums written (1)	$	799,013		756,012		752,588		742,477		707,453
Consolidated revenue	$	632,708		569,302		578,800		519,886		382,153
Net earnings	$	134,639		107,134		73,036		71,291		35,852
Comprehensive earnings(2)	$	156,999		83,902		81,354		97,693		13,673
Net cash provided from operating activities	$	171,775		198,027		188,962		191,019		161,971
FINANCIAL CONDITION
Total investments	$	1,828,241		1,697,791		1,569,718		1,333,360		1,000,027
Total assets	$	2,771,296		2,735,870		2,468,775		2,134,364		1,719,327
Unpaid losses and settlement expenses	$	1,318,777		1,331,866		1,132,599		903,441		732,838
Total debt	$	100,000		115,541		146,839		147,560	(7)	54,356
Total shareholders’ equity	$	756,520		692,941		623,661		554,134		456,555	(5)
Statutory surplus(3)	$	746,905		690,547		605,967	(7)	546,586	(7)	401,269	(5)
SHARE INFORMATION(3)
Net earnings per share:
Basic	$	5.40		4.21		2.90		2.84		1.80
Diluted	$	5.27		4.07		2.80		2.76		1.75
Comprehensive earnings per share:(2)
Basic	$	6.30		3.30		3.23		3.89		0.69
Diluted	$	6.14		3.19		3.12		3.78		0.67
Cash dividends declared per share	$	0.75		0.63		0.51		0.40		0.35
Book value per share	$	31.17		27.12		24.64		22.02		18.50	(5)
Closing stock price	$	56.42		49.87		41.57		37.46		27.90
Stock split										200	%
Weighted average shares outstanding:(5)(6)
Basic	24,918			25,459		25,223		25,120		19,937
Diluted	25,571			26,324		26,093		25,846		20,512
Common shares outstanding	24,273			25,551		25,316		25,165		24,681
OTHER NON-GAAP FINANCIAL INFORMATION(1)
Net premiums written to statutory surplus(3)	74		%	72	%	84	%	87	%	103	%
GAAP combined ratio	84.1			86.0		92.2		92.0		95.6
Statutory combined ratio(3)	84.0			86.7		93.8		93.1		92.4

60

(amounts in thousands, except per share data)	2001		2000		1999		1998		1997		1996
OPERATING RESULTS
Gross premiums written (1)	511,985		437,867		339,575		291,073		278,843		276,801
Consolidated revenue	309,354		263,496		225,756		168,114		169,424		155,354
Net earnings	31,047		28,693		31,451		28,239		30,171		25,696
Comprehensive earnings(2)	11,373		42,042		20,880		51,758		66,415		41,970
Net cash provided from operating activities	77,874		53,118		58,361		23,578		35,022		48,947
FINANCIAL CONDITION
Total investments	793,542		756,111		691,244		677,294		603,857		537,946
Total assets	1,390,970		1,281,323		1,170,363		1,012,685		911,741		845,474
Unpaid losses and settlement expenses	604,505		539,750		520,494		415,523		404,263		405,801
Total debt	77,239		78,763		78,397		39,644		24,900		46,000
Total shareholders’ equity	335,432		326,654		293,069		293,959		266,552		200,039
Statutory surplus(3)	289,997		309,945		286,247		314,484		265,526		207,787
SHARE INFORMATION(3)
Net earnings per share:
Basic	1.58		1.46		1.55		1.34		1.45		1.30
Diluted	1.55		1.44		1.54		1.33		1.33		1.14
Comprehensive earnings per share:(2)
Basic	0.58		2.14		1.03		2.46		3.19		2.13
Diluted	0.57		2.11		1.02		2.43		2.88		1.81
Cash dividends declared per share	0.32		0.30		0.28		0.26		0.24		0.22
Book value per share	16.92		16.66		14.84		14.22		12.35		10.23
Closing stock price	22.50		22.35		17.00		16.63		19.93		13.35
Stock split							125	%
Weighted average shares outstanding:(5)(6)
Basic	19,630		19,634		20,248		21,028		20,804		19,742
Diluted	20,004		19,891		20,444		21,276		23,428		24,210
Common shares outstanding	19,826		19,608		19,746		20,670		21,586		19,554
OTHER NON-GAAP FINANCIAL INFORMATION(1)
Net premiums written to statutory surplus(3)	109	%	84	%	79	%	46	%	54	%	64	%
GAAP combined ratio	97.2		94.8		91.2		88.2		86.8		87.4
Statutory combined ratio(3)	95.8		95.8		90.1		88.4		90.4		89.1

(1)See page 2 for information regarding non-GAAP financial measures.

(2)See note 1.M to the consolidated financial statements.

(3)Ratios and surplus information are presented on a statutory basis. As discussed further in the MD&A and note 9, statutory accounting principles differ from GAAP and are generally based on a solvency concept. Reporting of statutory surplus is a required disclosure under GAAP.

(4)On October 15, 2002, our stock split on a 2-for-1 basis. All share and per share data has been retro-actively stated to reflect this split.

(5)On December 26, 2002, we closed an underwritten public offering of 4.8 million shares of common stock. This offering generated $115.1 million in net proceeds. Of this, $80.0 million was contributed to the insurance subsidiaries. Remaining funds were used to pay down lines of credit.

(6)In July 1993, we issued $46.0 million of convertible debentures. In July 1997, these securities were called for redemption. This conversion created an additional 4.4 million new shares of RLI common stock.

(7)On December 12, 2003, we successfully completed a public debt offering, issuing $100.0 million in Senior Notes maturing January 15, 2014. This offering generated proceeds, net of discount and commission, of $98.9 million. Of the proceeds, capital contributions were made in 2003 and 2004 to our insurance subsidiaries to increase their statutory surplus in the amounts of $50.0 million and $15.0 million, respectively. Remaining funds were retained at the holding company.

61

2,004,667

1,713,298

20,555,013

24,272,978

632,708

134,640

157,000

171,775

1,828,241

2,771,296

1,318,777

100,000

756,520

746,905

1,697,791

1,569,718

1,333,360

1,000,027

2,735,870

2,468,775

2,134,364

1,719,327

1,331,866

1,132,599

903,441

732,838

115,541

146,839

147,560

54,356

2,004,667

1,713,298

20,555,013

24,272,978

632,708

134,640

157,000

171,775

1,828,241

2,771,296

1,318,777

100,000

756,520

746,905

1,697,791

1,569,718

1,333,360

1,000,027

2,735,870

2,468,775

2,134,364

1,719,327

1,331,866

1,132,599

903,441

732,838

115,541

146,839

147,560

54,356

9025 N. Lindbergh Drive., Peoria, IL 61615-1499
309-692-1000  |  800-331-4929  |  309-692-1068 F
www.rlicorp.com

©2007 RLI Corp.
MHP03077.5M

EX-21.1

Exhibit 21.1

Subsidiaries of the Registrant

The following companies are subsidiaries of the Registrant as of December 31, 2006.

	Jurisdiction of	Percentage
Name	Incorporation	Ownership
RLI Insurance Company	Illinois	100	%
Mt. Hawley Insurance Company	Illinois	100	%
RLI Indemnity Company	Illinois	100	%
RLI Aviation, Inc.	Illinois	100	%
RLI Underwriting Services, Inc.	Illinois	100	%
RLI Insurance Ltd.	Bermuda	100	%
RLI Insurance Agency Ltd.	Canada	100	%
Underwriters Indemnity General Agency, Inc.	Texas	100	%
Safe Fleet Insurance Services, Inc.	California	100	%

53

EX-23.1

Exhibit 23.1

Consent of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

RLI Corp.:

We consent to the incorporation by reference in the registration statements on Form S-8 (Nos. 333-01637, 333-28625, 333-117714 and 333-125354) of RLI Corp. of our reports dated February 28, 2007, with respect to the consolidated balance sheets of RLI Corp. and Subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of earnings and comprehensive earnings, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006, and all related financial statement schedules, management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2006 and the effectiveness of internal control over financial reporting as of December 31, 2006, which reports are incorporated by reference in, or appear in, the December 31, 2006 annual report on Form 10-K of RLI Corp.

/s/ KPMG LLP                     

Chicago, Illinois

February 28, 2007

54

EX-31.1

Exhibit 31.1

CERTIFICATION

Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Jonathan E. Michael, certify that:

I have reviewed this annual report on Form 10-K of RLI Corp.

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e))and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date:	February 28, 2007
		/s/ Jonathan E. Michael
		Jonathan E. Michael
		President & CEO

55

EX-31.2

Exhibit 31.2

CERTIFICATION

Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Joseph E. Dondanville, certify that:

I have reviewed this annual report on Form 10-K of RLI Corp.

Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e))and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date:	February 28, 2007
		/s/ Joseph E. Dondanville
		Joseph E. Dondanville
		Senior VP, Chief Financial Officer

56

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of RLI Corp. (the “Company”) on Form 10-K for the period ending December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Jonathan E. Michael, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

(1)  The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, and

(2)  The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Jonathan E. Michael

Jonathan E. Michael

President & CEO

February 28, 2007

57

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of RLI Corp. (the “Company”) on Form 10-K for the period ending December 31, 2006 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Joseph E. Dondanville, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

(1)  The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934, and

(2)  The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ Joseph E. Dondanville

Joseph E. Dondanville

Senior VP, Chief Financial Officer

February 28, 2007

58