EX-13 6 a09-1317_1ex13.htm EX-13

Exhibit 13

 

THE ROAD TO DIFFERENT

2008 RLI CORP. FINANCIAL ANNUAL REPORT

 


 

TABLE OF CONTENTS

 

01 / Management’s Discussion and Analysis

 

28 / Consolidated Balance Sheets

 

29 / Consolidated Statements of Earnings and Comprehensive Earnings

 

30 / Consolidated Statements of Cash Flows

 

32 / Consolidated Statements Shareholders’ Equity

 

33 / Notes to Consolidated Financial Statements

 

57 / Letters of Responsibility

 

61 / Glossary

 

62 / Selected Financial Data

 

64 / Investor Information

 

 


 

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 difference in conditions coverages 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 in all marketplaces, and we have achieved this for 13 consecutive years, averaging an 88.5 combined ratio over that period of time. This foundation 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 equity securities. Our equity portfolio consists of a core stock portfolio weighted toward dividend-paying stocks, as well as preferred stock, exchange traded funds (ETFs), and mutual funds. Private equity investments, primarily our minority ownership in Maui Jim, Inc. (Maui Jim), have also enhanced overall returns. We have a diversified investment portfolio and balance our investment credit risk and related underwriting risks to minimize total potential exposure to any one security. Despite fluctuations of realized and unrealized gains and losses in the equity portfolio, our investment in equity securities 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 underwriting segments.

 

The casualty portion of our business consists largely of general liability, personal umbrella, transportation, executive products, commercial umbrella, multi-peril program business, 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, facultative reinsurance, 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 on the West Coast. 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 exposure to a catastrophic event by limiting the total policy limits written in a particular region, 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. We offer miscellaneous bonds, including license and permit, notary, and court bonds. We also offer fidelity and crime coverage for commercial insureds and select financial institutions. Often, our surety coverages 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

 

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project. Generally, losses occur due to adverse economic 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 several years, meaning that the marketplace became more competitive and prices were 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 (generally accepted accounting principles in the United states of America) 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 one measure of 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 operating segment information. The nearest comparable GAAP measure is earnings before income taxes which, in addition to underwriting income, includes net investment income, net realized gains/losses on investments, 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 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.

 

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

 

CRITICAL ACCOUNTING POLICIES

 

LOSSES AND SETTLEMENT EXPENSES

 

Overview

 

Loss and loss adjustment expense (LAE) 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.

 

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 LAE 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 event 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 may 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 LAE reserves — case-specific reserves and 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 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 LAE 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.

 

LAE represents the cost involved in adjusting and administering losses from policies we issued. The LAE reserves are frequently separated into two components: allocated and unallocated. Allocated loss adjustment expense (ALAE) reserves represent an estimate of claims

 

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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 various members of the management team including the chief executive officer, chief operating officer, chief financial officer, chief actuary, general counsel 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, 2008, 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 ALAE 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 12 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.

 

We do not reserve for natural or man-made catastrophes until an event has occurred. shortly after such occurrence, we review insured locations exposed to the event, model loss estimates of the event based on our own exposures, and industry loss estimates of the event, and we consider our knowledge of frequency and severity from early claim reports to determine an appropriate reserve for the catastrophe. These reserves are reviewed frequently based on loss reports and appropriate changes to our estimates are made to reflect any new information as it arises.

 

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 mix and price change and loss cost inflation. The initial loss and ALAE ratios also reflect some provision for 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,

·                  a new business or one experiencing significant growth and/or high 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 risks listed 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, loss trends, price changes, and prevailing risk factors. The LRC 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 LAE 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

 

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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 LAE 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 LAE 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 emerges. 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 our 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 various qualified experts may differ materially from each other. We consider this uncertainty by examining our historic reserve accuracy and through an internal peer review process.

 

Given the substantial impact of the reserve estimates on our financial statements, we subject the reserving process to significant diagnostic testing and reasonability checks. We have incorporated data validity checks and balances into our front-end processes. Data anomalies are researched and explained to reach a comfort level with the data and results. 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 LAE estimation analysis, the results are discussed with the 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. Quarterly, we also consider the actual loss emergence as compared to the expected loss emergence derived from the last full loss and LAE analyses. A review of the resulting 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 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.

 

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One reason for the 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 that which 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 above the amount 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 refine them by adopting industry best practices where appropriate. A detailed, ground-up analysis of the actuarial estimation risks associated with each of our products and segments, including an assessment of industry information, is performed annually.

 

Loss reserve estimates are subject to a high degree of variability due to the inherent uncertainty of ultimate settlement values. Periodic adjustments to these estimates will likely occur as the actual loss emergence reveals itself over time. We believe our loss reserving processes reflect industry best practices and our methodologies result in a reasonable provision for reserves as of December 31, 2008.

 

INVESTMENT VALUATION AND OTHER-THAN-TEMPORARY IMPAIRMENT

 

Throughout each year, we and our investment managers buy and sell securities to achieve investment objectives in accordance with investment policies established and monitored by our board of directors and executive officers.

 

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 income and equity securities using both quantitative and qualitative criteria to determine impairment losses for other-than-temporary declines in the fair value of the investments. The following are the factors for determining if a security is other-than-temporarily impaired:

 

·                  The length of time and the extent to which the fair value has been less than cost;

·                  The probability of significant adverse changes to the cash flows on a fixed income investment;

·                  The occurrence of a discrete credit event resulting in the issuer defaulting on a material obligation or the issuer is seeking protection from creditors under the bankruptcy laws, or the issuer is proposing a voluntary reorganization which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than par value of their claims; or

·                  The probability that we will not receive all contractual or estimated cash flows in the form of principal and interest.

 

Quantitative criteria considered during this process include, but are not limited to: the degree and duration of 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 and, for fixed maturities, whether the issuer is in compliance with terms and covenants of the security. Qualitative criteria include the credit quality, current economic conditions, the anticipated speed of cost recovery, the financial health of and specific prospects for the issuer, as well as our intent and ability to hold the security to maturity or until forecasted recovery. In addition, we consider price declines of securities in our other-than-temporary impairment analysis where such price declines provide evidence of

 

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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:

 

·                  changes in technology that may impair the earnings potential of the investment,

·                  the discontinuance of a segment of the business that may affect the future earnings potential,

·                  reduction or elimination of dividends,

·                  specific concerns related to the issuer’s industry or geographic area of operation,

·                  significant or recurring operating losses, poor cash flows, and/or deteriorating liquidity ratios, and

·                  downgrade in credit quality by a major rating agency.

 

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. significant changes in these factors could result in a charge to net earnings for impairment losses. Impairment losses result in a reduction of the underlying investment’s cost basis.

 

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. As part of our monitoring efforts, we review their annual financial statements, securities and Exchange Commission filings, A.M. Best and s&P rating developments, and insurance industry developments that may impact the financial condition of our reinsurers. In addition, we subject our reinsurance recoverables to detailed recoverable tests, including one based on average default by s&P rating. Based upon our review and testing, our policy is to charge to earnings, in the form of an allowance, an estimate of unrecoverable amounts from reinsurers. This allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover.

 

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.

 

DEFERRED TAXES

 

We record net deferred tax assets to the extent temporary differences representing future deductible items exceed future taxable items. A significant amount of our deferred tax assets relate to expected future tax deductions arising from claim reserves and future tax deductions related to changes in our investments’ unrealized gain or loss positions.

 

Since there is no absolute assurance that these assets will be ultimately realized, management reviews our deferred tax positions to determine if it is more likely than not that the assets will be realized. Periodic reviews include, among other things, the nature and amount of the taxable income and expense items, the expected timing of when assets will be used or liabilities will be required to be reported and the reliability of historical profitability of businesses expected to provide future earnings. Furthermore, management considers tax-planning strategies it can use to increase the likelihood that the tax assets will be realized. If after conducting the periodic review, management determines that the realization of the tax asset does not meet the “more-likely-than-not” criteria, an offsetting valuation allowance is recorded, thereby reducing net earnings and the deferred tax asset in that period. In addition, management must make estimates of the tax rates expected to apply in the periods in which future taxable items are realized. such estimates include determinations and judgments as to the expected manner in which certain temporary differences, including deferred amounts related to our equity method investment, will be recovered and thereby the applicable tax rates. These estimates are subject to change based on the circumstances.

 

On January 1, 2007, we adopted the provisions of FIN 48, “Accounting for Uncertainty in Income Taxes,” 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.” As it relates to uncertainties in income taxes, our unrecognized tax benefits, including interest and penalty accruals, are not

 

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considered material to the consolidated financial statements and have not changed significantly upon the adoption of FIN 48. Also, no tax uncertainties are expected to result in significant increases or decreases to unrecognized tax benefits within the next 12-month period. Penalties and interest related to income tax uncertainties, should they occur, would be included in tax expense.

 

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

 

RESULTS OF OPERATIONS

 

Consolidated revenue, as displayed in the table that follows, totaled $561.0 million for 2008, compared to $652.3 million in 2007 and $632.7 million in 2006.

 

CONSOLIDATED REVENUE

 

 

 

Year ended December 31,

 

(in thousands)

 

2008

 

2007

 

2006

 

Net premiums earned

 

$

528,764

 

$

544,478

 

$

530,338

 

Net investment income

 

78,986

 

78,901

 

71,325

 

Net realized investment gains (losses)

 

(46,738

)

28,966

 

31,045

 

Total consolidated revenue

 

$

561,012

 

$

652,345

 

$

632,708

 

 

Revenue declined in 2008 as premiums earned from insurance operations were down and the financial market turmoil resulted in realized losses on investment securities. Net premiums earned declined 3 percent in 2008, returning to a level similar to 2006. Casualty premium continued to decline due to overall rate softening and served to more than offset the increased premium writings our property and surety segments posted in the last three years and the subsequent earning of this premium as revenue. Despite a declining interest rate environment, investment income was flat compared to 2007, after posting a 10 percent increase in 2007. The result for 2007 was influenced by higher investment yields and an increased asset base over 2006. During 2008, we recorded $46.7 million in net realized investment losses, primarily from other-than-temporarily impaired securities. Impairment charges were recorded on a high-yield municipal bond fund and securities in the financial sector, as the credit crisis and financial turmoil negatively impacted fixed income and equity values in the latter half of 2008. In 2007 and 2006, net realized gains contributed significantly to revenue. Results in 2007 included gains associated with the sale of certain equity securities deemed to have reached their full potential. Funds received were used to further diversify the investment portfolio. Realized gains in 2006 were largely due to the sale of the equity in one of our investee holdings.

 

NET EARNINGS (in thousands)

 

2008

 

2007

 

2006

 

Underwriting income

 

$

83,063

 

$

155,765

 

$

84,056

 

Net investment income

 

78,986

 

78,901

 

71,325

 

Net realized investment gains (losses)

 

(46,738

)

28,966

 

31,045

 

Debt interest

 

(6,704

)

(6,997

)

(6,581

)

Corporate expenses

 

(6,853

)

(9,474

)

(8,069

)

Investee earnings

 

4,844

 

7,315

 

15,117

 

Pretax earnings

 

$

106,598

 

$

254,476

 

$

186,893

 

Income tax

 

(27,922

)

(78,609

)

(52,254

)

Net earnings

 

$

78,676

 

$

175,867

 

$

134,639

 

 

Net earnings declined in 2008 after two consecutive years of record earnings. The result for 2008 included $24.0 million in hurricane losses and was negatively impacted by net realized investment losses. As discussed previously, in 2008, we recorded $46.7 million in net realized investment losses, primarily from other-than-temporarily impaired securities.

 

Underwriting income remained positive at $83.1 million, compared to $155.8 million in 2007 and $84.1 million in 2006. For each of these periods, the results were the product of disciplined underwriting in the current accident year, coupled with favorable development on prior accident years’ reserves. In a soft market, as we have seen in the past several years, disciplined underwriting can result in a reduction in premium revenue. This discipline, however, can differentiate us from the broader market by ensuring more adequate pricing of both new and renewal business and serves to slow the pace of deterioration in underwriting results. Included in underwriting income for each of the last three years were the effects of favorable development on prior years’ loss reserves. The more significant of these developments occurred in our casualty and surety segments, where loss trends have remained favorable. In 2008, we experienced $55.7 million in favorable development on prior accident years’ casualty and surety reserves, compared to favorable development for these segments of $98.5 million in 2007 and $41.6 million in 2006. Further discussion of reserve development can be found in note 6 to the financial statements.

 

Bonuses earned by executives, managers and associates are predominately influenced by corporate performance (operating earnings and return on capital). Bonus and profit sharing-related expenses attributable to the aforementioned favorable reserve developments totaled $6.0 million, $9.9 million, and $3.5 million, respectively, for 2008, 2007 and 2006. These performance-related expenses affected policy acquisition, insurance operating and general corporate expenses. Partially offsetting the 2008 increase were reductions in bonus and profit-sharing earned due to hurricane losses and lower returns on capital. Hurricane losses resulted in a $2.8 million reduction in bonus-related expenses. Realized and unrealized losses on investment

 

8


 

securities reduced our return on capital and resulted in reductions to and/or elimination of other bonus and profit-sharing expenses in 2008. In addition, we focused efforts on reducing non-acquisition/non-production expenses in 2008, which served to further reduce other insurance expenses.

 

Over the past several years, we have invested in our capacity to produce premium. We have expanded our geographic footprint of existing products by adding underwriters and entering new markets, and we have hired teams of underwriters to start new products. As a result, our policy acquisition costs, which include the expenses associated with this expansion, increased in 2008 and 2007. We believe this investment has positioned us well to capitalize on future market opportunities.

 

Investee earnings declined in 2008 and 2007. Investee results for 2008 were impacted by foreign exchange losses and the economic slowdown experienced during the last half of the year. The decline in 2007 was due in large part to the fourth quarter 2006 sale of the equity in one of our investee holdings.

 

Comprehensive loss for 2008 was $1.9 million compared to comprehensive earnings of $166.4 million in 2007 and $157.0 million in 2006. Results for 2008 were negatively impacted by unrealized losses on equity and fixed income securities.

 

RLI INSURANCE GROUP

 

In general, we have experienced continued softening in the marketplace over the last several years. As reflected in the table below, premium writings were down in 2008 and 2007. Increased competition and capacity in the marketplace have resulted in rate declines in our casualty and property segments. Our largest growth contributor in 2006, general liability, experienced a rate decline of 12 percent in 2008, following a similar rate decline in 2007. While rates have declined, this product continued to produce underwriting income. On the property side, in addition to a decline in rates, targeted reductions in our catastrophe exposure resulted in reduced writings in 2008 and 2007, as we continued to manage our exposure to catastrophic events. In 2008 and 2007, we posted moderate growth in our surety segment as we added underwriters and expanded geographically.

 

Our underwriting income and combined ratios are displayed in the tables below. solid underwriting results for the casualty and surety segments were magnified by favorable development on prior accident years’ loss reserves in each of the last three years. The property segment was impacted by hurricane losses in 2008, while 2007 and 2006 benefited from light hurricane seasons. Excluding hurricanes, loss frequency and severity declined in 2008 and 2007, particularly with respect to the discontinued construction program and reduction in habitational fire exposures, both of which negatively impacted results for 2006. The following table and narrative provide a more detailed look at individual segment performance over the last three years.

 

GROSS PREMIUMS WRITTEN

 

(in thousands)

 

2008

 

2007

 

2006

 

Casualty

 

$

403,337

 

$

462,591

 

$

506,887

 

Property

 

200,794

 

206,041

 

225,610

 

Surety

 

77,038

 

70,702

 

66,516

 

Total

 

$

681,169

 

$

739,334

 

$

799,013

 

 

UNDERWRITING INCOME

 

(in thousands)

 

2008

 

2007

 

2006

 

Casualty

 

$

46,507

 

$

101,863

 

$

68,393

 

Property

 

15,813

 

30,569

 

4,988

 

Surety

 

20,743

 

23,333

 

10,675

 

Total

 

$

83,063

 

$

155,765

 

$

84,056

 

 

COMBINED RATIO

 

 

 

2008

 

2007

 

2006

 

Casualty

 

85.2

 

70.3

 

80.4

 

Property

 

89.3

 

77.9

 

95.9

 

Surety

 

69.7

 

62.8

 

82.1

 

Total

 

84.2

 

71.4

 

84.1

 

 

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

 

(in thousands)

 

2008

 

2007

 

2006

 

CASUALTY

 

 

 

 

 

 

 

General liability

 

$

140,891

 

$

167,876

 

$

180,037

 

Commercial and personal umbrella

 

65,091

 

66,281

 

64,730

 

Commercial transportation

 

46,710

 

49,119

 

48,285

 

Specialty program business

 

31,425

 

29,362

 

25,507

 

Executive products

 

13,846

 

12,029

 

13,040

 

Other

 

15,518

 

18,735

 

16,618

 

Total

 

$

313,481

 

$

343,402

 

$

348,217

 

 

 

 

 

 

 

 

 

PROPERTY

 

 

 

 

 

 

 

Commercial property

 

$

85,271

 

$

92,634

 

$

91,507

 

Marine

 

48,166

 

32,868

 

16,785

 

Other property

 

13,426

 

12,865

 

14,289

 

Total

 

$

146,863

 

$

138,367

 

$

122,581

 

 

 

 

 

 

 

 

 

SURETY

 

$

68,420

 

$

62,709

 

$

59,540

 

Grand total

 

$

528,764

 

$

544,478

 

$

530,338

 

 

9


 

Casualty

 

Casualty gross premiums written of $403.3 million were down 13 percent in 2008 following a decline of 9 percent in 2007 and 2 percent decline in 2006. Personal umbrella, executive products, and specialty program business experienced modest premium growth, while all other lines were down by varying degrees as marketplace conditions for this segment continued to soften. General liability, our largest product in this segment, experienced a rate decline of 12 percent in 2008, following rate declines of 12 percent in 2007 and 8 percent in 2006. General liability posted gross premiums written of $140.0 million, down 21 percent from 2007 and 28 percent from 2006. While rates have deteriorated, this coverage continued to sustain a good margin and profitable results. Transportation and commercial umbrella also sustained declines in gross premiums written in 2008, down 15 percent each, due to continued rate and exposure declines. Our personal umbrella coverage posted a 3 percent increase in gross premiums written in 2008, after posting a 5 percent increase in 2007. Executive products posted a 4 percent increase in gross premiums written in 2008, as the marketplace for this product improved during the last quarter of the year. Increased submission activity and opportunities to write new business resulted in increased production in the last quarter of the year. specialty program business posted a 1 percent increase in gross premiums as new production sources and product offerings served to offset declines in existing programs that were scaled back. Despite competitive pressures in the casualty segment, we remained disciplined in writing only those accounts which we believe will provide adequate returns. The soft marketplace is likely to continue to challenge our ability to grow premium in this segment in 2009.

 

Underwriting income for the casualty segment was $46.5 million in 2008, compared to $101.9 million in 2007 and $68.4 million in 2006. These results translated into combined ratios of 85.2, 70.3 and 80.4, respectively for 2008, 2007, and 2006. Favorable development on prior accident years’ loss reserves totaled $50.6 million, $87.4 million, and $40.0 million, respectively, for 2008, 2007, and 2006. This favorable emergence was concentrated in accident years 2002-2006, with the more recent years representing a larger portion of the release. 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, resulting in the release of reserves. The 2007 result was further impacted by a detailed analysis of recent favorable loss trends and reserve risk factors. This review resulted in certain refinements to our reserving methodologies. This and the increased stability in our business in more recent years diminished the needed level of carried reserves above the actuarial point estimate. Over half of the favorable prior years’ loss development recorded in 2007 was the result of this detailed assessment and resulting reductions to our booked reserves.

 

From an insurance standpoint, the casualty segment has exposure to the financial crisis and subprime market issues through our executive products’ (directors and officers) coverages. As financial institutions have not been a segment of focus for our executive products’ coverages, we believe our exposure to the financial crisis is limited. In addition, we believe our exposure to subprime is also minimal.

 

Property

 

Gross premiums written in the property segment declined 3 percent in 2008 after posting a decline of 9 percent in 2007 and an increase of 28 percent in 2006. The decline in 2008 and 2007 was reflective of the softening marketplace for commercial property, impacted by two years (2006 and 2007) of benign hurricane activity. While the market experienced hurricane losses in 2008, we have not seen a significant increase in rates as capacity remains available. softening rates for coastal wind-exposed risks, combined with increased competition for non-catastrophe exposed accounts, resulted in a reduction in premium writings in 2008 and 2007. In addition, targeted reductions in our catastrophe exposure to earthquake reduced property writings. Earthquake coverage premiums have dropped in each of the last three years as we focused on reducing our exposure. While still providing an adequate return, wind rates softened toward the end of 2006 and have remained soft through 2008. On a positive note, our marine division that was launched in 2005 posted gross writings of $61.4 million in 2008, compared to $45.3 million in 2007 and $28.7 million in 2006. In addition, facultative reinsurance added $4.8 million during 2008 in gross premiums written in its first full year of production.

 

Net premiums earned for the property segment advanced for each of the last three years. Net premiums earned for 2008 benefited from decreased catastrophe reinsurance costs and a reduction in facultative reinsurance purchased. We have increased our retention in select areas. The marine division, a growth product over the last three years, represented a larger percentage of segment premiums and has increased retentions. Increased retention results in a higher level of risk of loss. Net premiums earned in 2007 and 2006 advanced as the significant growth in premium writings in commercial fire and marine during each of the preceding years was earned as revenue.

 

Underwriting income was $15.8 million in 2008, compared to income of $30.6 million in 2007 and $5.0 million in 2006. Results for 2008 include $22.8 million in losses associated with Hurricanes Gustav and Ike, which more than offset the improved loss performance of non-wind

 

10


 

commercial fire accounts. Results for 2007 benefited from a benign hurricane season, a decline in losses from tornadoes and hail storms, as well as lower frequency and severity of commercial fire losses. Additionally, unlike 2006, the segment’s results for 2008 and 2007 were not adversely affected by losses on discontinued construction coverages. In fact, results for 2008 include favorable development on prior years’ construction reserves as losses developed better than anticipated. For 2006, although we experienced a light hurricane season, other catastrophe losses such as tornadoes and hailstorms, along with increased severity of commercial fire losses, served to hamper the segment’s income. Favorable loss reserve development from prior years’ hurricane reserves contributed $4.2 million to income in 2006. However, additional charges were incurred from the run-off of the previously exited construction coverage, which amounted to $13.7 million in 2006.

 

Surety

 

Surety gross premiums written increased in each of the last three years, as all coverages in this segment produced increases in 2008. Net premiums earned followed suit, improving by 9 percent in 2008, 6 percent in 2007 and 15 percent in 2006. Investment in capacity, through underwriter additions and geographic expansion, fueled premium growth in mature coverages. In addition, we established a new fidelity division in late 2008 focusing on fidelity and crime coverage for commercial insureds and select financial institutions. While these investments resulted in increased acquisition costs, loss ratios remained low resulting in positive underwriting income.

 

Underwriting income totaled $20.7 million in 2008, compared to $23.3 million in 2007 and $10.7 million in 2006. After doubling for two consecutive years, underwriting income declined modestly in 2008, but represented excellent results for this segment. Premium growth was achieved while maintaining underwriting discipline. Positive results on the current accident year were amplified by favorable development on prior accident years. In 2008, favorable development on prior accident years’ loss reserves totaled $5.1 million, compared to $11.1 million in 2007 and $1.6 million in 2006. The majority of development in 2008 was from the 2007 accident year, as loss trends continued to be favorable. For 2007, the majority of the favorable development was the result of our actuary’s risk reassessment and reflection of significantly lower reserve risk, following continued favorable loss trends and further progress on the Commercial Money Center litigation.

 

As discussed more fully in note 10, we have been in litigation regarding certain commercial surety bond claims arising out of a specific bond program (the Commercial Money Center or “CMC” litigation). During 2008, we reached confidential settlements with the two remaining banks. With these two settlements, we have now reached settlements with each of the five investor banks that had claimed entitlement under the surety bonds issued. We were adequately reserved for these settlements. See note 10 for further discussion.

 

The surety segment is another area that can have exposure to the financial crisis and subprime market issues. The financial turmoil resulted in a slight increase in claim frequency on miscellaneous and energy bonds during the last quarter of the year. As for subprime market issues, we write only a few mortgage broker bonds and believe this exposure to be minimal. In addition, we do not have significant exposure from a surety standpoint to the home building industry.

 

NET INVESTMENT INCOME AND REALIZED INVESTMENT GAINS

 

During 2008, net investment income was flat. The average annual yields on our investments were as follows for 2008, 2007, and 2006:

 

 

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

PRETAX YIELD

 

 

 

 

 

 

 

Taxable (on book value)

 

5.58

%

5.46

%

5.22

%

Tax-exempt (on book value)

 

3.99

%

4.07

%

4.02

%

Equities (on fair value)

 

3.81

%

3.03

%

2.78

%

 

 

 

 

 

 

 

 

AFTER-TAX YIELD

 

 

 

 

 

 

 

Taxable (on book value)

 

3.63

%

3.55

%

3.40

%

Tax-exempt (on book value)

 

3.78

%

3.85

%

3.81

%

Equities (on fair value)

 

3.27

%

2.60

%

2.39

%

 

The after-tax yield reflects the different tax rates applicable to each category of investment. Our taxable fixed income securities are subject to our corporate tax rate of 35 percent, our tax-exempt municipal securities 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 2008, the average after-tax yield on the fixed income portfolio remained at 3.7 percent, the same yield as 2007. During the year, we focused on purchasing high-quality fixed income investments, primarily in the 5-15 year range of the yield curve.

 

The fixed income portfolio decreased by $98.3 million during the year. This portfolio had net realized losses of $8.2 million and a tax-adjusted total return on a mark-to-market basis of 2.5 percent. Our equity portfolio decreased by $106.9 million during 2008, to $286.8 million. As of December 31, 2008, our equity portfolio had net unrealized gains of $35.5 million. The total return for the year on the equity portfolio was -31.1 percent.

 

11


 

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

 

(in thousands)

 

Average
Invested
Assets(1)

 

Net
Investment
Income(2)(3)

 

Net
Realized
Gains
(Losses)(3)

 

Change in
Unrealized
Appreciation
(3)(4)

 

Annualized
return
on Avg.
Invested
Assets

 

Tax
Equivalent
Annualized
Return
on Avg.
Invested
Assets

 

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

%

2007

 

1,834,009

 

78,901

 

28,966

 

(14,650

)

5.1

%

5.9

%

2008

 

1,749,303

 

78,986

 

(46,738

)

(123,607

)

-5.2

%

-4.5

%

5-yr Avg.

 

$

1,686,324

 

$

68,988

 

$

8,598

 

$

(25,290

)

3.2

%

3.9

%

 

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

 

(2) Investment income, net of investment expenses.

 

(3) Before income taxes.

 

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

 

We realized $46.7 million in net investment losses in 2008. Included in this number is $38.7 million in net realized losses in the equity portfolio, $8.2 million in net realized losses in the fixed income portfolio, and other realized gains of $0.2 million. In 2007, we realized $29.0 million in net investment gains. We realized $29.9 million in net realized gains in the equity portfolio, $1.0 million in net realized losses in the fixed income portfolio, and other realized gains of $0.1 million. In 2006, we realized net investment gains of $31.0 million. Included in this number are net realized gains of $22.4 million in the equity portfolio, net realized losses of $7.3 million in the fixed income portfolio, and other realized gains of $16.0 million. Included in other gains for 2006 was 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.

 

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. During 2008, we recognized other-than-temporary impairment losses of $76.2 million. This total includes $64.2 million in equity and $12.0 million in fixed income securities. The majority of the losses came during the third and fourth quarters as the markets were impacted by the slowing economy and global financial crisis. The majority of our other-than-temporary impairment losses were related to securities in the financial sector and a high-yield municipal bond mutual fund. The impaired securities were negatively impacted by the overall financial crisis and lack of liquidity in the credit markets. There were no losses associated with the other-than-temporary impairment of securities in 2007 or 2006.

 

The following table is used as part of our impairment analysis and illustrates the total value of securities that were in an unrealized loss position as of December 31, 2008. This table segregates the securities based on type, noting the fair value, cost (or amortized cost), and unrealized loss on each category of investment as well as in total. The table further classifies the securities based on the length of time they have been in an unrealized loss position.

 

(in thousands)

 

0-12 Mos.

 

>12 Mos.

 

Total

 

 

 

 

 

 

 

 

 

U.S. Government

 

 

 

 

 

 

 

fair value

 

$

—

 

$

—

 

$

—

 

Cost or amortized cost

 

—

 

—

 

—

 

Unrealized loss

 

—

 

—

 

—

 

 

 

 

 

 

 

 

 

U.S. Agency

 

 

 

 

 

 

 

fair value

 

$

34,955

 

$

—

 

$

34,955

 

Cost or amortized cost

 

35,379

 

—

 

35,379

 

Unrealized loss

 

(424

)

—

 

(424

)

 

 

 

 

 

 

 

 

Mtge/ABS/CMO*

 

 

 

 

 

 

 

fair value

 

$

38,551

 

$

16,721

 

$

55,272

 

Cost or amortized cost

 

41,769

 

19,495

 

61,264

 

Unrealized loss

 

(3,218

)

(2,774

)

(5,992

)

 

 

 

 

 

 

 

 

Corporate

 

 

 

 

 

 

 

fair value

 

$

135,865

 

$

32,737

 

$

168,602

 

Cost or amortized cost

 

149,935

 

38,707

 

188,642

 

Unrealized loss

 

(14,070

)

(5,970

)

(20,040

)

 

 

 

 

 

 

 

 

States, political subdivisions and revenues

 

 

 

 

 

 

 

fair value

 

$

133,515

 

$

13,250

 

$

146,765

 

Cost or amortized cost

 

137,660

 

13,970

 

151,630

 

Unrealized loss

 

(4,145

)

(720

)

(4,865

)

 

 

 

 

 

 

 

 

Subtotal, debt securities

 

 

 

 

 

 

 

fair value

 

$

342,886

 

$

62,708

 

$

405,594

 

Cost or amortized cost

 

364,743

 

72,172

 

436,915

 

Unrealized loss

 

(21,857

)

(9,464

)

(31,321

)

 

 

 

 

 

 

 

 

Common stock

 

 

 

 

 

 

 

fair value

 

$

83,406

 

$

11,912

 

$

95,318

 

Cost or amortized cost

 

106,540

 

16,076

 

122,616

 

Unrealized loss

 

(23,134

)

(4,164

)

(27,298

)

 

 

 

 

 

 

 

 

Preferred stock

 

 

 

 

 

 

 

fair value

 

$

2,613

 

$

—

 

$

2,613

 

Cost or amortized cost

 

2,871

 

—

 

2,871

 

Unrealized loss

 

(258

)

—

 

(258

)

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

fair value

 

$

428,905

 

$

74,620

 

$

503,525

 

Cost or amortized cost

 

474,154

 

88,248

 

562,402

 

Unrealized loss

 

(45,249

)

(13,628

)

(58,877

)

 

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

 

12


 

The following table is also used as part of our impairment analysis and illustrates certain industry-level measurements relative to our equity portfolio as of December 31, 2008, including fair value, cost basis, and unrealized gains and losses.

 

 

 

Cost

 

12/31/08

 

Net Unrealized

 

 

 

Unrealized
Gain/

 

(in thousands)

 

Basis

 

Fair Value

 

Gains

 

Losses

 

Net

 

Loss%(1)

 

Common stock:

 

 

 

 

 

 

 

 

 

 

 

 

 

Consumer discretionary

 

$

18,265

 

$

14,700

 

$

102

 

$

(3,667

)

$

(3,565

)

-19.5

%

Consumer staples

 

11,492

 

22,113

 

10,621

 

—

 

10,621

 

92.4

%

Energy

 

11,171

 

22,181

 

11,792

 

(782

)

11,010

 

98.6

%

Financials

 

17,549

 

20,406

 

4,134

 

(1,277

)

2,857

 

16.3

%

Healthcare

 

10,395

 

18,439

 

9,073

 

(1,029

)

8,044

 

77.4

%

Industrials

 

15,560

 

19,249

 

5,121

 

(1,432

)

3,689

 

23.7

%

Information technology

 

13,005

 

14,807

 

4,333

 

(2,531

)

1,802

 

13.9

%

Materials

 

4,329

 

3,284

 

—

 

(1,045

)

(1,045

)

-24.1

%

REITs

 

4,771

 

4,833

 

86

 

(24

)

62

 

1.3

%

Telecommunications

 

4,408

 

8,950

 

4,542

 

—

 

4,542

 

103.0

%

Utilities

 

41,980

 

52,495

 

12,581

 

(2,066

)

10,515

 

25.0

%

ETFs

 

53,556

 

40,111

 

—

 

(13,445

)

(13,445

)

-25.1

%

High-yield muni fund

 

33,341

 

33,341

 

—

 

—

 

—

 

—

 

Preferred stock

 

11,461

 

11,881

 

678

 

(258

)

420

 

3.7

%

Total

 

$

251,283

 

$

286,790

 

$

63,063

 

$

(27,556

)

$

35,507

 

14.1

%

 

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

 

As of December 31, 2008, we held 37 securities in our equity portfolio that were in unrealized loss positions. The total unrealized loss on these securities was $27.6 million. In considering both the significance and duration of the unrealized loss positions, we have no equity securities in an unrealized loss of greater than 20 percent for more than six months.

 

The fixed income portfolio contained 229 positions at an unrealized loss as of December 31, 2008. Of these 229 securities, 33 have been in an unrealized loss position for more than 12 consecutive months and these collectively represent $9.5 million in unrealized losses. The fixed income unrealized losses can be primarily attributed to spreads widening in the corporate, municipal and mortgage backed security markets. We have the ability and intent to hold these securities to maturity. In addition, we continually monitor the credit quality of our fixed income investments to assess if it is probable that we will receive our contractual or estimated cash flows in the form of 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:

 

·                  changes in technology that may impair the earnings potential of the investment,

·                  the discontinuance of a segment of the business that may affect the future earnings potential,

·                  reduction or elimination of dividends,

·                  specific concerns related to the issuer’s industry or geographic area of operation,

·                  significant or recurring operating losses, poor cash flows, and/or deteriorating liquidity ratios, and

·                  downgrade in credit quality by a major rating agency.

 

Based on our analysis, we’ve concluded that the remaining securities are not other-than-temporarily impaired.

 

INVESTMENTS

 

We maintain a diversified investment portfolio which has had an 80 percent fixed income and 20 percent equity target over the last five years. As of December 31, 2008, the portfolio had a fair value of $1.7 billion, down from $1.8 billion at the end of 2007. The decline in the value of the investment portfolio was the result of the severe downturn in the global financial markets and economy. Our continuing focus is to manage our risks and to position the portfolio to take advantage of market opportunities while minimizing declines in the portfolio.

 

As of December 31, 2008, our investment portfolio had the following asset allocation breakdown:

 

PORTFOLIO ALLOCATION

 

(in thousands)
Asset Class

 

Cost or
Amortized
Cost

 

Fair
Value

 

Unrealized
Gain/(Loss)

 

% of Total
Fair Value

 

Quality

 

Agencies

 

$

294,897

 

$

298,093

 

$

3,196

 

18.0

%

AAA

 

Corporates

 

290,492

 

272,886

 

(17,606

)

16.4

%

A

 

Mortgage-backed

 

217,778

 

216,196

 

(1,582

)

13.0

%

AAA

 

Asset-backed

 

21,594

 

21,206

 

(388

)

1.3

%

AAA

 

Treasuries

 

12,662

 

13,396

 

734

 

0.8

%

AAA

 

Munis

 

449,356

 

453,879

 

4,523

 

27.3

%

AA

 

Total fixed income

 

$

1,286,779

 

$

1,275,656

 

$

(11,123

)

76.8

%

AA

 

Equities

 

$

206,481

 

$

241,568

 

$

35,087

 

14.6

%

 

 

High-yield muni fund

 

33,341

 

33,341

 

—

 

2.0

%

 

 

Total equity

 

$

239,822

 

$

274,909

 

$

35,087

 

16.6

%

 

 

Preferred stock

 

$

11,461

 

$

11,881

 

$

420

 

0.7

%

 

 

Short-term investments

 

$

97,982

 

$

97,982

 

—

 

5.9

%

 

 

Total portfolio

 

$

1,636,044

 

$

1,660,428

 

$

24,384

 

100.0

%

 

 

 

Quality in the above table and in all subsequent tables is an average of each bond’s credit rating, adjusted for its relative weighting in the portfolio.

 

13


 

Our fixed income portfolio comprised 77 percent of our total 2008 portfolio, versus 75 percent of the total at December 31, 2007, and 74 percent of the total as of December 31, 2006. As of December 31, 2008, the carrying value of our fixed income portfolio consisted of 48 percent AAA-rated securities, 23 percent AA-rated securities, 22 percent A-rated securities, and 7 percent BBB-rated or lower securities.

 

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, 2008, our fixed income portfolio’s duration was 4.4 years and remained diversified. During 2008, the total return on our bond portfolio on a tax-equivalent, mark-to-market basis was 2.5 percent.

 

In addition, at December 31, 2008, our equity portfolio had a value of $286.8 million, all of which is classified as available-for-sale and is also a source of liquidity. We maintain a diversified group of equity securities. The securities within the equity portfolio remain primarily invested in large-cap issues with strong dividend performance. In addition, we have investments in real estate investment trusts, exchange traded funds, preferred stocks, and a high-yield municipal bond fund. 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. During 2008, the total return on our equity portfolio on a mark-to-market basis was -31.1 percent, compared to the s&P return of -37.0 percent.

 

Our investment portfolio does not have any direct exposure to credit default swaps or derivatives. As of December 31, 2008, $15.4 million of our bond portfolio was part of a securities lending program. We have suspended the securities lending program and expect to be out of the program by the end of next year.

 

14


 

FIXED INCOME PORTFOLIO

 

As of December 31, 2008, our fixed income portfolio had the following rating distributions:

 

FAIR VALUE

 

(in thousands)

 

AAA

 

AA

 

A

 

BBB

 

BB or
Below

 

Fair Value

 

Bonds:

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate - financial

 

$

1,542

 

$

5,118

 

$

58,927

 

$

12,803

 

$

6

 

$

78,396

 

All other corporate

 

1,595

 

1,755

 

120,795

 

48,755

 

2,959

 

175,859

 

Financials - private placements

 

—

 

—

 

1,619

 

7,894

 

—

 

9,513

 

All other corporates - private placements

 

—

 

—

 

7,578

 

1,540

 

—

 

9,118

 

U.S. govt. agency (GSE)

 

311,224

 

265

 

—

 

—

 

—

 

311,489

 

Tax-Exempt municipal securities

 

57,026

 

290,284

 

85,429

 

21,140

 

—

 

453,879

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Structured:

 

 

 

 

 

 

 

 

 

 

 

 

 

GSE - RMBS

 

$

170,537

 

$

2,024

 

—

 

—

 

—

 

$

172,561

 

Non-GSE RMBS - prime

 

—

 

—

 

—

 

—

 

—

 

—

 

Non-GSE RMBS - Alt A

 

—

 

—

 

—

 

—

 

—

 

—

 

Non-GSE RMBS - subprime

 

—

 

—

 

—

 

—

 

—

 

—

 

ABS - home equity

 

2,529

 

—

 

—

 

—

 

—

 

2,529

 

ABS - credit cards

 

339

 

—

 

—

 

—

 

—

 

339

 

ABS - auto loans

 

3,646

 

—

 

—

 

153

 

—

 

3,799

 

All other ABS

 

14,539

 

—

 

—

 

—

 

—

 

14,539

 

CMBS

 

43,635

 

—

 

—

 

—

 

—

 

43,635

 

CDOs/CLOs

 

—

 

—

 

—

 

—

 

—

 

—

 

 

 

$

606,612

 

$

299,446

 

$

274,348

 

$

92,285

 

$

2,965

 

$

1,275,656

 

 

Our fixed income portfolio remained diversified with investments in treasury, government sponsored agency, corporate, municipal, mortgage backed, and asset backed securities. All fixed income securities in the investment portfolio continue to pay the expected coupon payments under the contractual terms of the securities and we believe it is probable that we will receive all contractual or estimated cash flows based on our analysis of previously disclosed factors.

 

We have two securities that are rated BB or below. The first security, a Lehman Bros. corporate bond, has a fair value of $5,700 and is held in our trading portfolio. We are currently not receiving any interest payments for this security. The second security, a Wrigley Co. corporate bond, has a fair value of $3.0 million and is currently not rated. The Wrigley Co. was purchased by a private company, Mars, Inc., in 2008. We believe it is probable that we will receive all contractual payments from this security.

 

Mortgage-Backed, Commercial Mortgage-Backed, and Asset-Backed Securities

 

Our mortgage-backed securities (MBs) portfolio is comprised of residential MBs investments. As of December 31, 2008, MBs investments totaled $172.6 million (14 percent) of the fixed income portfolio compared to $205.7 million (15 percent) as of December 31, 2007.

 

We believe MBs investments add diversification, liquidity, credit quality and additional yield to our portfolio. Our objective for the MBs portfolio is to provide reasonable cash flow stability and increased yield. This sector experienced unusually high volatility given the concerns over housing prices and general economic conditions. The MBs portfolio includes collateralized mortgage obligations (CMOs) and mortgage-backed pass-through securities. A mortgage pass-through is a security consisting of a pool of residential mortgage loans. All payments of principal and interest are passed through to investors each month. A CMO is a mortgage-backed security with a fixed maturity. This can eliminate the risks associated with prepayment because each security is divided into maturity classes that are paid off in order. Our MBs portfolio does not include interest-only securities, principal-only securities or other MBs investments which may exhibit extreme market volatility.

 

Prepayment/extension risk is an inherent risk of holding MBss. However, the degree of prepayment/extension risk varies by the type of MBs held. We reduce our portfolio’s exposure to prepayment/extension by including less volatile types of MBss. As of December 31, 2008, $0.6 million of the MBs portfolio was invested in planned amortization class CMOs (PACs) compared to $32.2 million (16 percent) as of December 31, 2007. PACs are securities whose cash flows are designed to remain constant in a variety of mortgage prepayment environments. Most of the portfolio’s non-PAC MBss possess varying degrees of cash flow structure and prepayment/extension risk. The MBs portfolio contained 78 percent of pure pass-throughs as of December 31, 2008, compared to 81 percent as of December 31, 2007. As of December 31, 2008, virtually all of the securities in our MBs portfolio were rated AAA. In addition, these securities were mortgage-backed securities issued by

 

15


 

the Governmental National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC). Government sponsored Enterprises (GsEs), such as GNMA, FNMA and FHLMC, facilitate liquidity in the mortgage market by purchasing conforming mortgages from lenders, securitizing them and selling them into the secondary market. This market was further strengthened in the fourth quarter as a result of several federal Treasury policies including buying mortgages in the open market.

 

The following table summarizes the distribution by investment type of our MBs portfolio as of the dates indicated:

 

MBS

 

(in thousands)

 

Rating

 

Amortized
Cost

 

Fair Value

 

% of Total

 

 

 

 

 

 

 

 

 

 

 

2008

 

 

 

 

 

 

 

 

 

Planned amortization class

 

AAA

 

$

62

 

$

62

 

0

%

Sequential

 

AAA

 

37,846

 

38,538

 

22

%

Pass-throughs

 

AAA

 

130,343

 

133,962

 

78

%

Total

 

 

 

$

168,251

 

$

172,562

 

100

%

 

 

 

 

 

 

 

 

 

 

2007

 

 

 

 

 

 

 

 

 

Planned amortization class

 

AAA

 

$

32,481

 

$

32,180

 

16

%

Sequential

 

AAA

 

5,964

 

5,987

 

3

%

Pass-throughs

 

AAA

 

166,463

 

167,520

 

81

%

Total

 

 

 

$

204,908

 

$

205,687

 

100

%

 

An asset-backed security (ABs) is a type of debt security that is based on pools of assets or collateralized by the cash flows from a specific pool of underlying assets. These asset pools can include items such as credit card payments, auto loans and mortgages. The majority of our ABs portfolio is comprised of rate reduction utility bonds. As of December 31, 2008, ABs/CMBs (commercial mortgage-backed securities) investments were $64.8 million (5 percent) of the fixed income portfolio, compared to $97.7 million (7 percent) as of December 31, 2007. CMBs made up $43.6 million (67 percent) of the ABs/CMBs portfolio compared to $61.5 million (63 percent) at December 31, 2007. The entire CMBs portfolio was rated AAA as of December 31, 2008.

 

We believe that ABs/CMBs investments add diversification and additional yield to our portfolio. Like the MBs portfolio, the objective for the ABs/CMBs portfolio is to provide reasonable cash flow stability and attractive yield. Our ABs/CMBs portfolio does not include interest- only securities, principal-only securities or other ABs/CMBs investments which may exhibit extreme market volatility.

 

The following table summarizes the distribution by investment type of our ABs/CMBs portfolio as of the dates indicated:

 

ABS/CMBS

 

(in thousands)

 

Rating

 

Amortized
Cost

 

Fair Value

 

% of Total

 

 

 

 

 

 

 

 

 

 

 

2008

 

 

 

 

 

 

 

 

 

CMBS

 

AAA

 

$

49,527

 

$

43,635

 

67

%

Home equity

 

AAA

 

2,702

 

2,529

 

4

%

Auto

 

AAA

 

3,903

 

3,799

 

6

%

Equipment

 

AAA

 

1,768

 

1,774

 

3

%

Franchise

 

AAA

 

—

 

—

 

—

 

Utility

 

AAA

 

12,860

 

12,765

 

19

%

Credit card

 

AAA

 

361

 

339

 

1

%

Total

 

 

 

$

71,121

 

$

64,841

 

100

%

 

 

 

 

 

 

 

 

 

 

2007

 

 

 

 

 

 

 

 

 

CMBS

 

AAA

 

$

61,333

 

$

61,493

 

63

%

Home equity

 

AAA

 

9,716

 

9,629

 

10

%

Auto

 

AAA

 

5,000

 

5,024

 

5

%

Equipment

 

AAA

 

3,460

 

3,486

 

4

%

Franchise

 

AAA

 

3,000

 

2,960

 

3

%

Utility

 

AAA

 

14,350

 

14,664

 

15

%

Credit card

 

AAA

 

409

 

408

 

0

%

Total

 

AAA

 

$

97,268

 

$

97,664

 

100

%

 

When making investments in MBs/ABs/CMBs, we evaluate the quality of the underlying collateral, the structure of the transaction (which dictates how losses in the underlying collateral will be distributed) and prepayment risks.

 

Recent market activity has put pressure on many collateralized securities. In general, as credit becomes more difficult to obtain, interest rate spreads on collateralized securities widen. As stated previously, the vast majority of our MBs/ABs/CMBs portfolio is rated AAA.

 

The following table summarizes the distribution by collateral classification and rating of our subprime securities as of December 31, 2008 and 2007:

 

SUBPRIME

 

(in thousands)

 

Rating

 

Amortized
Cost

 

Fair Value

 

% of Total

 

2008

 

 

 

 

 

 

 

 

 

Home equity

 

AAA

 

$

2,702

 

$

2,529

 

100

%

Total

 

 

 

$

2,702

 

$

2,529

 

100

%

 

 

 

 

 

 

 

 

 

 

2007

 

 

 

 

 

 

 

 

 

Home equity

 

AAA

 

$

9,716

 

$

9,629

 

100

%

Total

 

 

 

$

9,716

 

$

9,629

 

100

%

 

16


 

We define subprime mortgages as loans which include one or more of the following: a weak credit score (FICO score of less than 640), high debt-to-income ratio, high loan-to-value ratio or undocumented income. We have reviewed our subprime investment exposure and believe our risk is minimal. We review our portfolio in three main areas to assess our subprime investment exposure — fixed income securities, common stocks and preferred stocks. Our exposure to subprime is through direct investments in subprime backed mortgage products and is less than $3 million. Of this amount, all securities are rated AAA and have been paying as agreed. All of these are fixed rate, exclude interest rate resets, were issued prior to 2005, and are not currently on watch from any major rating agency.

 

Municipal Fixed Income Securities

 

We have a significant allocation to municipal fixed income securities. As of December 31, 2008, municipal bonds totaled $453.9 million (36 percent) of our fixed income portfolio as compared to $473.7 million (34 percent) as of December 31, 2007.

 

We believe municipal fixed income securities provide diversification, high credit quality and additional yield to our portfolio. Our objective for the municipal fixed income portfolio is to provide reasonable cash flow stability and increased after tax yield.

 

Our municipal fixed income portfolio is comprised of general obligation (GO) and revenue securities. The revenue sources include sectors such as sewer and water, public improvement, school, transportation, colleges and universities, water and sewer.

 

As of December 31, 2008, approximately 55 percent of the municipal fixed income securities in the investment portfolio were GO and the remaining 45 percent were revenue fixed income. seventy-six percent of our municipal fixed income securities were rated AA or better, while 95 percent were rated A or better. Our municipal fixed income portfolio has very high credit quality.

 

The amortized cost and fair value of fixed income securities at December 31, 2008, by contractual maturity, are shown as follows:

 

(in thousands)

 

amortized Cost

 

fair Value

 

Total fixed income

 

 

 

 

 

Due in one year or less

 

$

28,430

 

$

28,725

 

Due after one year through five years

 

280,630

 

284,994

 

Due after five years through 10 years

 

447,920

 

439,101

 

Due after 10 years

 

529,799

 

522,836

 

Total

 

$

1,286,779

 

$

1,275,656

 

 

Corporate Debt Securities

 

As of December 31, 2008, our corporate debt portfolio totaled $272.9 million (21 percent) of the fixed income portfolio compared to $232.1 million (17 percent) as of December 31, 2007. The corporate debt portfolio has an overall quality rating of single A, diversified amongst 102 issuers across 18 industries.

 

The following table illustrates our corporate debt exposure to the financial and non-financial sectors as of December 31, 2008, including fair value, cost basis, and unrealized gains and losses:

 

(in thousands)

 

amortized
Cost

 

fair Value

 

Gross
Unrealized
Gains

 

Gross
Unrealized
losses

 

Bonds:

 

 

 

 

 

 

 

 

 

Corporate – financial

 

$

84,267

 

$

78,396

 

$

110

 

$

(5,981

)

all other corporate

 

183,509

 

175,859

 

2,600

 

(10,250

)

financials – private placements

 

12,026

 

9,513

 

—

 

(2,513

)

all other corporate – private placements

 

10,690

 

9,118

 

—

 

(1,572

)

 

 

$

290,492

 

$

272,886

 

$

2,710

 

$

(20,316

)

 

Corporate debt securities experienced large interest rate spread widening in 2008 as this market was directly impacted by the declining housing market, credit crisis and slowing economy. We believe corporate debt investments add diversification and additional yield to our portfolio. With our high quality, diversified portfolio, the corporate debt investments will continue to be a significant part of our investment program and we believe it is probable that the securities in our portfolio will continue to receive contractual payments in the form of principal and interest.

 

EQUITY SECURITIES

 

As of December 31, 2008, our equity portfolio totaled $286.8 million (17 percent) of the investment portfolio compared to $393.7 million (21 percent) as of December 31, 2007. The securities within the equity portfolio remain primarily invested in large-cap issues with a focus on dividend income. In addition, we have investments in real estate investment trusts, exchange traded funds, preferred stocks, and a high-yield municipal bond fund. In 2008, we recorded impairment losses of $64.2 million on our equity securities. The impairments were the result of our belief that the securities were not likely to recover in a reasonable period of time.

 

17


 

The following table illustrates the distribution by sector of our equity portfolio as of December 31, 2008, including fair value, cost basis, and unrealized gains and losses:

 

(in thousands)

 

Cost
Basis

 

12/31/2008
Fair Value

 

% of Total
Fair Value

 

Net
Unrealized
Gain/Loss

 

Common stock:

 

 

 

 

 

 

 

 

 

Consumer discretionary

 

$

18,265

 

$

14,700

 

5.1

%

$

(3,565

)

Consumer staples

 

11,492

 

22,113

 

7.7

%

10,621

 

Energy

 

11,171

 

22,181

 

7.7

%

11,010

 

Financials

 

17,549

 

20,406

 

7.1

%

2,857

 

Healthcare

 

10,395

 

18,439

 

6.4

%

8,044

 

Industrials

 

15,560

 

19,249

 

6.7

%

3,689

 

Information technology

 

13,005

 

14,807

 

5.2

%

1,802

 

Materials

 

4,329

 

3,284

 

1.2

%

(1,045

)

REITs

 

4,771

 

4,833

 

1.7

%

62

 

Telecommunications

 

4,408

 

8,950

 

3.1

%

4,542

 

Utilities

 

41,980

 

52,495

 

18.3

%

10,515

 

ETFs

 

53,556

 

40,111

 

14.0

%

(13,445

)

High-yield muni fund

 

33,341

 

33,341

 

11.6

%

—

 

Preferred stock

 

11,461

 

11,881

 

4.2

%

420

 

Total

 

$

251,283

 

$

286,790

 

100.0

%

$

35,507

 

 

Common Stocks

 

As of December 31, 2008, our common stock portfolio totaled $201.5 million (70 percent) of the equity portfolio compared to $322.7 million (82 percent) as of December 31, 2007. The decline in value of our common stock portfolio in 2008 was primarily due to an investment decision to reduce our common stock exposure as well as a negative return in the asset class.

 

Our common stock portfolio consists largely of large cap, value oriented, dividend paying securities. We employ a long-term, buy-and-hold strategy that has provided superior returns over the last 10 years. While we anticipate continued volatility, we believe an equity allocation provides certain diversification and return benefits over the long term. The strategy provides above-market dividend yields with less volatility than the market. The beta of our equity portfolio is 0.7.

 

Exchange Traded Fund Securities (ETFs)

 

ETFs are portfolios of stocks, bonds or, in some cases, other investments that trade on a stock exchange much the same as a regular stock.

 

All of our ETF holdings are stock portfolios that track to major indices. We believe this ETF strategy is a low cost, efficient vehicle enabling us to effectively participate in certain sectors of the market.

 

In 2008, we added two exchange traded funds to our equity portfolio. As of December 31, 2008, our ETF investment totaled $40.1 million (14 percent) of the equity portfolio compared to $2.6 million (1 percent) as of December 31, 2007. The ETF investments add diversification, liquidity and increased return potential to our portfolio. In 2008, our ETFs outperformed the overall market but still contributed to the negative performance of the equity portfolio. We believe that ETF securities will be an important part of our investment program going forward. Our current ETFs contain large-cap securities that match our overall equity investment philosophy of providing superior dividend yields with less volatility than the market. These ETFs track various indices and have returns for 2008 consistent with the benchmark indices they follow.

 

High-Yield Municipal Bond Fund

 

As of December 31, 2008, our investment in the high-yield municipal bond fund totaled $33.3 million (12 percent) of the equity portfolio compared to $34.3 million (9 percent) as of December 31, 2007. While this mutual fund is comprised of fixed income securities, as a mutual fund we treat it as an equity. In 2008, we recorded impairment losses of $18.6 million on the high-yield municipal bond fund due to our belief that the fund is unlikely to completely recover in value in a reasonable period of time and related changes in our intent to hold this security until recovery.

 

The holdings are comprised of lower quality investment grade and below investment grade tax-exempt securities. sectors include healthcare, airports, tobacco, and infrastructure securities among others. The fund continues to make dividend payments and default rates of the bonds held in the fund remain below 1%. This market has been hurt by the flight to quality and overall liquidity in the municipal bond markets.

 

Preferred Stocks

 

As of December 31, 2008, our investment in preferred stock securities totaled $11.9 million (4 percent) of the equity portfolio compared to $34.2 million (9 percent) as of December 31, 2007. Preferred stocks are primarily issued by companies in the financial sector and were negatively affected by this year’s credit crisis.

 

In 2008, we recorded other-than-temporary impairment losses of $26.4 million in our preferred stock portfolio based on our analysis of factors previously disclosed. In addition, we had related changes in our intent to hold these securities until recovery.

 

INTEREsT AND GENERAL CORPORATE EXPENsE

 

Interest on debt declined in 2008 as we paid off our short-term debt. We incur short-term debt primarily through the use of reverse repurchase transactions. 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

 

18


 

expense. In 2007, we had expanded our use of this debt as yield spreads had widened. We paid off the reverse repurchase debt in 2008 as the credit markets experienced increased volatility. Decisions regarding future short-term debt management will be based on available cash flow and the interest rate environment.

 

In 2008, 2007, and 2006, we incurred $6.0 million in interest on our long-term debt each year. Our long-term debt consists of $100.0 million in senior notes that mature on January 15, 2014, and pay interest semi-annually at the rate of 5.95 percent.

 

General corporate expenses tend to fluctuate relative to our executive compensation plan. Our compensation model measures comprehensive earnings against a minimum required return on our capital. Bonuses are earned as we generate earnings in excess of this required return. In 2008, the actual return was below the required return resulting in no bonus earned on the current year and reductions to bonuses accrued but unpaid on prior years. In 2007 and 2006, we had generated earnings significantly above the required return, resulting in increased bonuses accrued.

 

INVESTEE EARNINGS

 

We maintain a 40 percent equity interest in Maui Jim, Inc. (Maui Jim), 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 2008, we recorded $4.8 million in earnings from this investment compared to $7.3 million in 2007 and $8.8 million in 2006. While sunglass sales advanced 7 percent in 2008 and 15 percent in 2007, costs associated with expansion efforts, foreign exchange losses, and the global economy affected earnings. In 2008, Maui Jim recorded over $5 million in foreign exchange loss and was negatively affected by the global economic slowdown. In 2007 and 2006, Maui Jim had recorded foreign exchange gains of $0.5 million and $1.9 million, respectively. In 2007, Maui Jim invested heavily in new sales and distribution offices (nationally and internationally), a new state-of-the-art Rx lab for prescription sunglasses, as well as new display programs and duty free and corporate gift channels across the world. In addition, the company recorded higher-than-normal expense associated with the discontinuance of some slow-moving styles and the replacement of temples on a specific product line.

 

In 2006, investee earnings included $6.3 million from our investment in TBW. In the fourth quarter of 2006, 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 26.2 percent, 30.9 percent, and 28.0 percent for 2008, 2007, and 2006, respectively. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate for 2008 was lower than 2007 and 2006 due to the decrease in underwriting income and the recognition of realized investment losses, which were taxed at 35.0 percent.

 

Our net earnings also include equity in earnings of an unconsolidated investee, Maui Jim. This investee does 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%. In recent periods, a tax benefit was realized associated with a dividend declared and subsequently received from Maui Jim. As required under statement of Financial Accounting Standards (SFAS) 109, “Accounting for Income Taxes,” the tax benefit results from applying the lower tax rate applicable to affiliated dividends (7 percent) as compared to the corporate capital gains tax rate (35 percent) on which previous tax estimates were based.

 

In addition, our pretax earnings in 2008 included $30.3 million of investment income that is partially exempt from federal income tax, compared to $29.8 million and $28.7 million in 2007 and 2006, respectively. Partially offsetting tax expense in 2007 was a $2.4 million tax benefit recorded in the third quarter to reflect the benefit expected to be realized upon the future payment of certain accrued compensation. Results for 2006 include the favorable resolution of a tax examination. During 2006, the Internal Revenue Service 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.

 

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 balances recoverable. The largest asset on our balance sheet, outside of investments, is the reinsurance balances recoverable on unpaid losses and settlement expenses, which serves to offset this liability.

 

The 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 to $809.0 million at December 31, 2008, from $774.9 million as of December 31, 2007. This reflects incurred losses of $247.2 million in

 

19


 

2008 offset by paid losses of $213.1 million, compared to incurred losses of $190.9 million offset by $209.0 million paid in 2007. The overall increase in our net loss and loss adjustment expense reserves between 2008 and 2007 was due to higher loss and loss adjustment expense ratios for the current accident year reflecting soft market conditions and a net loss from 2008 hurricanes of $24.0 million which is still largely unpaid. In 2008, favorable loss development of $62.3 million from prior years offset a portion of these increases.

 

Both the gross reserves (liability) and the reinsurance balances recoverable (asset) were reduced by the favorable reserve development. Total gross and ceded loss and loss adjustment expense reserves dropped to $1,159.3 million and $350.3 million, respectively, at December 31, 2008, from $1,192.2 million and $417.3 million, respectively, at December 31, 2007.

 

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:

 

·          monitoring the fair value of all financial assets on a constant basis,

·          changing the character of future investment purchases as needed, and

·          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. As of December 31, 2008, we had no short-term debt obligations. At the end of 2007, our short-term debt was $28.0 million. We also maintain a debt obligation that is long-term in nature. 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 0.7 in comparison to the S&P 500. Our equity investment returns have been superior to the S&P 500 with less volatility. This low beta statistic reflects our long-term emphasis on maintaining a value oriented, dividend-driven investment philosophy for our equity portfolio.

 

SENSITIVITY ANALYSIS

 

The tables that follow detail information on the market risk exposure for our financial investments as of December 31, 2008. Listed on each table is the December 31, 2008, 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 hold non-trading securities to maturity mitigates price fluctuation risks. For purposes of this disclosure, market-risk-sensitive instruments are divided into two categories: instruments held for trading purposes and those held for non-trading 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, 2008, our fixed income portfolio had a fair value of $1.3 billion. The sensitivity analysis uses scenarios of interest rates increasing 100 and 200 basis points from their December 31, 2008, levels with all other variables held constant. Such scenarios would result in decreases in the fair value of the fixed income portfolio of $41.1 million and $88.4 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, 2008, our equity portfolio had a fair value of $286.8 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 $22.7 million and $45.4 million, respectively. As we designate all equities 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.

 

20


 

TABLE 1

 

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

 

(in thousands)

 

12/31/08
Fair Value

 

Interest
Rate Risk

 

Equity
Risk

 

Held for trading purposes

 

 

 

 

 

 

 

Fixed income securities

 

$

 10,020

 

$

 (282

)

$

 —

 

Total trading

 

10,020

 

(282

)

—

 

 

 

 

 

 

 

 

 

Held for nontrading purposes

 

 

 

 

 

 

 

Fixed income securities

 

1,265,636

 

(40,836

)

—

 

Equity securities

 

286,790

 

—

 

 (22,715

)

Total nontrading

 

1,552,426

 

(40,836

)

(22,715

)

Total trading & nontrading

 

$

1,562,446

 

$

(41,118

)

$

(22,715

)

 

TABLE 2

 

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

 

(in thousands)

 

12/31/08
Fair Value

 

Interest
Rate Risk

 

Equity
Risk

 

Held for trading purposes

 

 

 

 

 

 

 

Fixed income securities

 

$

 10,020

 

$

 (648

)

$

 —

 

Total trading

 

10,020

 

(648

)

—

 

 

 

 

 

 

 

 

 

Held for nontrading purposes

 

 

 

 

 

 

 

Fixed income securities

 

1,265,636

 

(87,747

)

—

 

Equity securities

 

286,790

 

—

 

(45,429

)

Total nontrading

 

1,552,426

 

(87,747

)

(45,429

)

Total trading & nontrading

 

$

1,562,446

 

$

(88,395

)

$

(45,429

)

 

TABLE 3

 

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

 

(in thousands)

 

12/31/08
Fair Value

 

Interest
Rate Risk

 

Equity
Risk

 

Held for trading purposes

 

 

 

 

 

 

 

Fixed income securities

 

$

 10,020

 

$

 340

 

$

 —

 

Total trading

 

10,020

 

340

 

—

 

 

 

 

 

 

 

 

 

Held for nontrading purposes

 

 

 

 

 

 

 

Fixed income securities

 

1,265,636

 

37,591

 

—

 

Equity securities

 

286,790

 

—

 

22,715

 

Total nontrading

 

1,552,426

 

37,591

 

22,715

 

Total trading & nontrading

 

$

1,562,446

 

$

 37,931

 

$

 22,715

 

 

TABLE 4

 

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

 

(in thousands)

 

12/31/08
Fair Value

 

Interest
Rate Risk

 

Equity
Risk

 

Held for trading purposes

 

 

 

 

 

 

 

Fixed income securities

 

$

 10,020

 

$

 763

 

$

 —

 

Total trading

 

10,020

 

763

 

—

 

 

 

 

 

 

 

 

 

Held for nontrading purposes

 

 

 

 

 

 

 

Fixed income securities

 

1,265,636

 

78,206

 

—

 

Equity securities

 

286,790

 

—

 

45,429

 

Total nontrading

 

1,552,426

 

78,206

 

45,429

 

Total trading & nontrading

 

$

1,562,446

 

$

 78,969

 

$

 45,429

 

 

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)

 

2008

 

2007

 

2006

 

Operating cash flows

 

$

161,334

 

$

127,023

 

$

171,775

 

Investing cash flows (uses)

 

(69,474

)

(6,718

)

(63,325

)

Financing cash flows (uses)

 

(91,860

)

(120,305

)

(108,450

)

 

We have posted strong operating cash flow in each of the last three years. Over the last ten years, our operating cash flow has averaged $138.9 million per year. variations in operating cash flow between periods are largely driven by premium volume, claim payments, reinsurance and taxes. In addition, fluctuations in insurance operating expenses impact operating cash flow. The reduction in premium volume experienced in 2008 and 2007 was partially offset by a decline in paid losses, relative to the level experienced in 2006. Loss payments were higher in 2006 as prior year hurricane claims were settled. In 2007, a higher level of pre-tax earnings resulted in significantly higher tax payments than were experienced in either 2008 or 2006. In each of the last three years, the majority of the operating cash flow generated was used in financing activities, funding the share repurchase program. During the last half of 2008, the share repurchase program was suspended and operating cash flow was allocated to investing activities.

 

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.

21


 

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, 2008.

 

CONTRACTUAL OBLIGATIONS

 

 

 

 

 

Payments due by period

 

 

 

 

 

Less than

 

 

 

More than

 

(in thousands)

 

Total

 

1 yr.

 

1-3 yrs.

 

3-5 yrs

 

5 yrs.

 

Loss and settlement expense

 

$

1,159,311

 

$

329,581

 

$

443,185

 

$

186,972

 

$

199,573

 

Long-term debt

 

132,725

 

5,950

 

11,900

 

11,900

 

102,975

 

Operating leases

 

12,948

 

3,676

 

5,901

 

3,275

 

96

 

Total

 

$

1,304,984

 

$

339,207

 

$

460,986

 

$

202,147

 

$

302,644

 

 

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 $350.3 million at December 31, 2008.

 

The next largest contractual obligation relates to long-term debt outstanding. On December 12, 2003, we completed a public debt offering of $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 S&P. 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, 2008, we had short-term investments and other investments maturing within one year of approximately $126.2 million and investments of $409.8 million maturing within five years. We maintain a revolving line of credit with JP Morgan, which permits us to borrow up to an aggregate principal amount of $25.0 million. Under certain conditions, the line may be increased up to an aggregate principal amount of $50.0 million. The facility has a three- year term that expires on May 31, 2011. As of December 31, 2008, no amounts were outstanding on the revolving line of credit. 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, 2008, 2007, and 2006, our operating cash flow was $161.3 million, $127.0 million, and $171.8 million, respectively. The primary factor in our ability to generate positive operating cash flow is underwriting profitability.

 

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 (interest & dividends)

 

Commissions paid

 

 

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, for most policies. 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.

 

22


 

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

 

 

Purchase of stocks

Proceeds from stocks sold

 

 

Proceeds from sale of unconsolidated investee

 

 

 

We maintain a 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, 2008, our portfolio had a carrying value of $1.7 billion. Invested assets at December 31, 2008, decreased by $180.9 million, or 10 percent, from December 31, 2007.

 

Our overall investment philosophy is designed to first protect policyholders by maintaining sufficient funds to meet corporate and policyholder obligations, then generate longterm 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, 2008, 41 percent of our shareholders’ equity was invested in equities, as compared to 51 percent at December 31, 2007, and 49 percent at December 31, 2006.

 

We currently classify 3 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 (96 percent) or trading (1 percent) and are carried at fair value. As of December 31, 2008, we maintained $1.2 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.

 

The fixed income portfolio is structured to meet policyholder obligations and optimize the generation of after-tax investment income and total return objectives.

 

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, 2008, our capital structure consisted of $100.0 million in 10-year maturity senior notes (long-term debt) and $708.2 million of shareholders’ equity. Debt outstanding comprised 12 percent of total capital as of December 31, 2008.

 

Our 131st consecutive dividend payment was declared in the first quarter of 2009 and will be paid on April 15, 2009, in the amount of $0.26 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 authorities of Illinois. The maximum dividend distribution in a rolling 12-month period is limited by Illinois law to the greater of 10 percent of RLI Insurance Company (RLI Ins.) policyholder surplus as of December 31 of the preceding year or the net income of RLI Ins. For the 12-month period ending December 31 of the preceding year. Therefore, the maximum dividend distribution that can be paid by RLI Ins. during 2009 without prior approval is $67.8 million which represents 10 percent of policyholder surplus at December 31, 2008. The 12-month rolling dividend limitation in 2008, based on the above criteria, was $126.2 million. In 2008, total cash dividends of $70.0 million were paid by RLI Ins. These dividends were paid to provide additional capital to RLI Corp. and used for the share repurchase plan, shareholder dividends, interest on senior notes, and general corporate expenses.

 

For the year, we repurchased 917,200 shares at an average cost of $52.23 per share ($47.9 million). We have $37.8 million of remaining capacity from the $200 million stock repurchase program approved in 2007. In light of market volatility in the second half of 2008, the repurchase program was suspended in the third quarter of 2008 and will remain suspended until conditions warrant its reactivation.

 

23


 

OUTLOOK FOR 2009

 

The 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”). It is expected that deteriorating industry results, the “financial meltdown” of 2008 and the economic recession that intensified in late 2008 will begin to have a moderating impact on the soft market that has been in existence for the past several years.

 

We expect to see premium growth in selected products in 2009 and underwriting income overall, absent any major catastrophe. Specific details regarding events in our insurance segments follow.

 

CASUALTY

 

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 in this segment. We do expect to see soft market pricing beginning to moderate as the year unfolds.

 

Continued rate declines will make it increasingly difficult to post underwriting profits. However, we look to our ability to continue to exercise underwriting discipline, and select quality risks to outperform the marketplace in 2009.

 

PROPERTY

 

We believe property pricing will start to flatten in the year ahead. We expect our marine business to grow moderately due to new product offerings and an increased focus on writing inland marine coverages. In addition, the recently launched facultative reinsurance product will be additive to premium in 2009. We expect the segment to produce underwriting income in 2009 absent any major catastrophes.

 

SURETY

 

The surety segment, like our other segments, is expected to feel the pressure of the stressed economic situation. In 2008, we expanded our geographic footprint and added fidelity coverages. We expect premium growth to continue in 2009. Our experienced underwriting staff coupled with our effective use of technology point to continued profitability in 2009.

 

INVESTMENTS

 

We anticipate further volatility in the capital markets in 2009. The underlying factors that drove equity prices higher including earnings growth, ease of credit, leverage, etc., are under pressure going into 2009. Because of this, we have allowed our equity allocations to drift below our 20 percent target. We would expect our allocation to remain below our target unless market conditions improve.

 

The low interest rate environment will put pressure on our investment income as cash flow is invested at lower yields.

 

Given the economic conditions of a recession, we believe maintaining a high quality, liquid portfolio in this environment is prudent.

 

PROSPECTIVE ACCOUNTING STANDARDS

 

There are several prospective accounting standards that we have not implemented either because the standard has not been finalized or the implementation date has not yet occurred. For a discussion of these prospective standards, see note 1 to the financial statements.

 

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 under Illinois law 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.

 

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

 

24


 

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.

 

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 in a timely manner.

 

In addition, state-level changes to the insurance regulatory environment are frequent, including changes caused by legislation, regulations by the state insurance regulators, and court rulings. For example, the Florida supreme Court issued a case ruling in 2008 with the effect that surplus lines insurance in Florida is subject to the same regulation as admitted insurance in Florida, excluding rate regulation and certain other areas. Although not stated expressly in the ruling, it implies that surplus lines policy forms must be filed and approved by the Florida Office of Insurance Regulation (FOIR). In response, the FOIR has publicly stated that it disagrees with the ruling and its foundations and that the FOIR does not now nor has it ever required surplus lines insurers to comply with such form filing requirements. In early 2009, a bill was introduced in the Florida legislature to clarify the regulatory status of surplus lines insurance in Florida and provide that policy forms need not be filed and approved by the FOIR. Although the status of this situation is uncertain and at this stage we cannot predict if such legislation will become law or how this matter ultimately will be resolved, we believe it will not result in material negative consequences for us.

 

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 a small percentage 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, 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 a material delay of, or deter, any such transaction.

 

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.

 

TROUBLED ASSET RELIEF PROGRAM

 

In 2008, in response to market and banking turmoil, the federal government implemented the Troubled Asset Relief Program (TARP), which is a federal program of the Department of Treasury designed to strengthen U.S. financial institutions through purchasing or insuring troubled assets and equity. The TARP program contains restrictions and controls on participating entities, and may be amended in the future to contain additional restrictions in areas such as executive compensation. To the extent an insurance company participates in TARP, it will be subject to all applicable restrictive and control provision. We do not currently participate in TARP and do not anticipate electing to participate in the future.

 

TERRORISM INSURANCE

 

After the events of september 11, 2001, the National Association of Insurance Commissioners (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

 

25


 

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 extended through December 31, 2007 and reauthorized through December 31, 2014. 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 foreign or domestic terrorism is partially reimbursed by the United States under a formula whereby the government pays 85 percent of covered terrorism losses exceeding a prescribed deductible to the insurance company providing the coverage. The deductible is 20 percent of gross earned premium net of a few excludable lines and the federal coverage is limited to $100 billion. 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 applicable 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.

 

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 our 2008 fiscal year have been filed with the SEC as an exhibit to our annual report on Form 10-K for 2008.

 

FEDERAL REGULATION OF INSURANCE

 

The U.S. insurance industry is not currently subject to any significant amount of federal regulation, and instead is regulated principally at the state level. However, federal insurance legislation of various types is periodically proposed in Congress, and in 2007 several bills were introduced in Congress that would impact and regulate various aspects of the insurance industry. These proposed laws covered many areas, including amending and extending the current TRIA law, optional federal charter, streamlining state regulation of nonadmitted insurance, expanding the national flood insurance program, creating a national catastrophe insurance program, and ending the antitrust exemption for insurance companies. However, only the extension and amendment of the TRIA law was enacted. In 2008, such proposals were limited, but we expect that the federal government’s reaction to the economic and financial market turmoil will include some type of federal oversight of the insurance industry, including possibly establishing a federal insurance charter and a federal Office of Insurance Information. We cannot predict whether one or more of the other proposed bills will again be proposed or enacted or whether any significant federal involvement in insurance regulation will be implemented in 2009 or later, or the impact of any such laws or regulation on our company. We will continue to monitor all significant federal insurance legislation.

 

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): 2008 summary annual report; 2008 financial report; 2009 proxy statement; annual report on Form 10-K for 2008; and charters of the executive resources, audit, finance and investment, strategy, and nominating/corporate governance committees of our board of directors. Printed copies of these documents will be made available upon request without charge to any shareholder.

 

26


 

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.

 

27


 

CONSOLIDATED BALANCE SHEETS

 

 

 

December 31

 

in thousands, except per share data

 

2008

 

2007

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Investments:

 

 

 

 

 

Fixed income:

 

 

 

 

 

Available-for-sale, at fair value (amortized cost – $1,236,676 in 2008 and $1,274,734 in 2007)

 

$

1,224,215

 

$

1,283,305

 

Held-to-maturity, at amortized cost (fair value – $41,421 in 2008 and $75,673 in 2007)

 

39,821

 

73,648

 

Trading, at fair value (amortized cost – $10,282 in 2008 and $15,350 in 2007)

 

10,020

 

15,413

 

Equity securities available-for-sale, at fair value (cost – $251,283 in 2008 and $255,598 in 2007)

 

286,790

 

393,680

 

Short-term investments, at cost which approximates fair value

 

97,982

 

73,731

 

Total investments

 

1,658,828

 

1,839,777

 

 

 

 

 

 

 

Cash

 

—

 

—

 

Accrued investment income

 

17,226

 

18,296

 

Premiums and reinsurance balances receivable, net of allowances for uncollectible amounts of $14,740 in 2008 and $13,336 in 2007

 

92,149

 

105,937

 

Ceded unearned premiums

 

65,977

 

71,021

 

Reinsurance balances recoverable on unpaid losses and settlement expenses, net of allowances for uncollectible amounts of $15,803 in 2008 and $18,877 in 2007

 

350,284

 

417,250

 

Deferred policy acquisition costs, net

 

78,520

 

78,882

 

Property and equipment, at cost, net of accumulated depreciation of $43,218 in 2008 and $40,509 in 2007

 

21,565

 

20,050

 

Income taxes – deferred

 

24,141

 

—

 

Investment in unconsolidated investees

 

38,697

 

38,162

 

Goodwill

 

26,214

 

26,214

 

Other assets

 

45,800

 

10,934

 

Total assets

 

$

2,419,401

 

$

2,626,523

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

Liabilities:

 

 

 

 

 

Unpaid losses and settlement expenses

 

$

1,159,311

 

$

1,192,178

 

Unearned premiums

 

335,170

 

355,522

 

Reinsurance balances payable

 

30,224

 

38,273

 

Notes payable, short-term debt

 

—

 

27,975

 

Income taxes – deferred

 

—

 

25,042

 

Bonds payable, long-term debt

 

100,000

 

100,000

 

Accrued expenses

 

32,894

 

39,303

 

Other liabilities

 

53,648

 

73,808

 

Total liabilities

 

$

1,711,247

 

$

1,852,101

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

Common stock ($1 par value, authorized 50,000,000 shares, issued 32,106,085 shares in 2008 and 31,869,596 shares in 2007)

 

32,106

 

31,870

 

Paid-in capital

 

196,989

 

192,446

 

Accumulated other comprehensive earnings, net of tax

 

15,130

 

95,701

 

Retained earnings

 

807,195

 

749,767

 

Deferred compensation

 

8,312

 

7,980

 

Treasury stock, at cost (10,631,656 shares in 2008 and 9,714,456 shares in 2007)

 

(351,578

)

(303,342

)

Total shareholders’ equity

 

$

708,154

 

$

774,422

 

Total liabilities and shareholders’ equity

 

$

2,419,401

 

$

2,626,523

 

 

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

 

28


 

CONSOLIDATED STATEMENTS OF EARNINGS AND COMPREHENSIVE EARNINGS

 

 

 

Years Ended December 31

 

in thousands, except per share data

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Net premiums earned

 

$

 528,764

 

$

544,478

 

$

530,338

 

Net investment income

 

78,986

 

78,901

 

71,325

 

Net realized investment gains (losses)

 

(46,738

)

28,966

 

31,045

 

Consolidated revenue

 

561,012

 

652,345

 

632,708

 

Losses and settlement expenses

 

247,174

 

190,868

 

256,889

 

Policy acquisition costs

 

163,320

 

155,610

 

145,776

 

Insurance operating expenses

 

35,207

 

42,235

 

43,617

 

Interest expense on debt

 

6,704

 

6,997

 

6,581

 

General corporate expenses

 

6,853

 

9,474

 

8,069

 

Total expenses

 

459,258

 

405,184

 

460,932

 

Equity in earnings of unconsolidated investees

 

4,844

 

7,315

 

15,117

 

Earnings before income taxes

 

106,598

 

254,476

 

186,893

 

Income tax expense (benefit):

 

 

 

 

 

 

 

Current

 

33,721

 

75,551

 

59,942

 

Deferred

 

(5,799

)

3,058

 

(7,688

)

Income tax expense

 

27,922

 

78,609

 

52,254

 

Net earnings

 

$

78,676

 

$

175,867

 

$

134,639

 

 

 

 

 

 

 

 

 

Other comprehensive earnings (loss), net of tax

 

 

 

 

 

 

 

Unrealized gains (losses) on securities:

 

 

 

 

 

 

 

Unrealized holding gains (losses) arising during the period

 

$

(111,152

)

$

9,339

 

$

 32,011

 

Less: Reclassification adjustment for losses (gains) included in net earnings

 

30,581

 

(18,783

)

(9,651

)

Other comprehensive earnings (loss)

 

(80,571

)

(9,444

)

22,360

 

Comprehensive earnings (loss)

 

$

(1,895

)

$

166,423

 

$

156,999

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

Basic – Net earnings per share

 

$

 3.65

 

$

7.46

 

$

5.40

 

Comprehensive earnings (loss) per share

 

$

(0.09

)

$

7.06

 

$

6.30

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

Diluted – Net earnings per share

 

$

 3.60

 

$

7.30

 

$

5.27

 

Comprehensive earnings (loss) per share

 

$

(0.09

)

$

6.91

 

$

6.14

 

 

 

 

 

 

 

 

 

Weighted average number of common shares outstanding:

 

 

 

 

 

 

 

Basic

 

21,540

 

23,574

 

24,918

 

Diluted

 

21,848

 

24,085

 

25,571

 

 

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

 

29


 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

 

Years ended December 31,

 

(in thousands)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Cash flows from operating activities

 

 

 

 

 

 

 

Net earnings

 

$

 78,676

 

$

 175,867

 

$

 134,639

 

Adjustments to reconcile net earnings to net cash provided by operating activities:

 

 

 

 

 

 

 

Net realized investment losses (gains)

 

46,738

 

(28,966

)

(31,045

)

Depreciation

 

3,596

 

3,567

 

3,503

 

Other items, net

 

17,287

 

10,137

 

5,783

 

Change in:

Accrued investment income

 

1,070

 

332

 

(1,654

)

 

Premiums and reinsurance balances receivable  (net of direct write-offs and commutations)

 

13,788

 

20,084

 

873

 

 

Reinsurance balances payable

 

(8,049

)

(16,702

)

(12,480

)

 

Ceded unearned premium

 

5,044

 

26,575

 

17,072

 

 

Reinsurance balances recoverable on unpaid losses

 

66,966

 

108,421

 

67,538

 

 

Deferred policy acquisition costs

 

362

 

(5,065

)

(4,340

)

 

Accounts payable and accrued expenses

 

(6,409

)

4,613

 

3,005

 

 

Unpaid losses and settlement expenses

 

(32,867

)

(126,599

)

(13,089

)

 

Unearned premiums

 

(20,352

)

(32,289

)

4,128

 

Income taxes:

Current

 

2,163

 

(12,250

)

6,823

 

 

Deferred

 

(5,799

)

3,058

 

(7,688

)

Stock option excess tax benefit

 

(4,929

)

(2,042

)

(2,930

)

 

 

 

 

 

 

 

 

Changes in investment in unconsolidated investees:

Undistributed earnings

 

(4,844

)

(7,315

)

(15,117

)

 

Dividends received

 

3,960

 

5,940

 

16,500

 

Net (cash used in) proceeds from trading portfolio activity

 

4,933

 

(343

)

254

 

Net cash provided by operating activities

 

$

161,334

 

$

 127,023

 

$

 171,775

 

 

30


 

 

 

Years ended December 31,

 

(in thousands)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Cash flows from Investing activities

 

 

 

 

 

 

 

Purchase of:

Fixed income, held-to-maturity

 

$

—

 

$

—

 

$

—

 

 

Fixed income, available-for-sale

 

(445,778

)

(339,334

)

(412,019

)

 

Equity securities, available-for-sale

 

(123,415

)

(101,332

)

(139,462

)

 

Short-term investments, net

 

(88,838

)

—

 

(61,548

)

 

Property and equipment

 

(6,002

)

(4,456

)

(4,590

)

 

Note receivable

 

—

 

—

 

(5,000

)

Proceeds from sale of:

Fixed income, held-to-maturity

 

5,230

 

—

 

—

 

 

Fixed income, available-for-sale

 

143,074

 

99,360

 

231,385

 

 

Equity securities, available-for-sale

 

89,032

 

77,040

 

146,635

 

 

Short-term investments, net

 

—

 

18,926

 

—

 

 

Property and equipment

 

891

 

1,429

 

1,356

 

 

Investment in unconsolidated investee

 

—

 

—

 

32,499

 

Proceeds from call or maturity of:

Fixed income, held-to-maturity

 

28,870

 

32,722

 

28,215

 

 

Fixed income, available-for-sale

 

327,462

 

199,427

 

117,204

 

 

Note receivable

 

—

 

9,500

 

2,000

 

Net cash used in investing activities

 

$

 (69,474

)

$

(6,718

)

$

 (63,325

)

 

 

 

 

 

 

 

 

Cash flows from financing activities

 

 

 

 

 

 

 

Proceeds from issuance of short term debt

 

$

 54,017

 

$

80,619

 

$

35

 

Payment on short-term debt

 

(81,992

)

(52,644

)

(15,576

)

Stock option excess tax benefit

 

4,929

 

2,042

 

2,930

 

Proceeds from stock option exercises

 

(150

)

2,952

 

3,254

 

Treasury shares purchased

 

(47,904

)

(133,268

)

(81,069

)

Cash dividends paid

 

(20,760

)

(20,006

)

(18,024

)

Net cash used in financing activities

 

$

(91,860

)

$

(120,305

)

$

(108,450

)

Net decrease in cash

 

—

 

—

 

—

 

Cash at beginning of year

 

—

 

—

 

—

 

Cash at end of year

 

$

—

 

$

—

 

$

—

 

 

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

 

31


 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

 

(in thousands,
except per share data)

 

Common
Shares

 

Total
Shareholders’
Equity

 

Common
Stock

 

Paid-in
Capital

 

Accumulated
Other
Comprehensive
Earnings (loss)

 

Retained
Earnings

 

Deferred
Compensation

 

Treasury
Stock at
Cost

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, January 1, 2006

 

25,551,305

 

$

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

)

(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

 

345,682

 

3,254

 

346

 

2,908

 

 

 

 

 

 

 

 

 

Dividends declared ($.75 per share)

 

 

 

(18,535

)

 

 

 

 

 

 

(18,535

)

 

 

 

 

Balance, December 31, 2006

 

24,272,978

 

$

756,520

 

$

31,690

 

$

187,632

 

$

105,145

 

$

594,147

 

$

7,744

 

$

(169,838

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net earnings

 

 

 

$

175,867

 

 

 

 

 

 

 

175,867

 

 

 

 

 

Other comprehensive loss, net of tax

 

 

 

(9,444

)

 

 

 

 

(9,444

)

 

 

 

 

 

 

Treasury shares purchased

 

(2,297,694

)

(133,268

)

 

 

 

 

 

 

 

 

 

 

(133,268

)

Deferred compensation under Rabbi trust plans

 

 

 

—

 

 

 

 

 

 

 

 

 

236

 

(236

)

Stock option excess tax benefit

 

 

 

2,042

 

 

 

2,042

 

 

 

 

 

 

 

 

 

Exercise of stock options

 

179,856

 

2,952

 

180

 

2,772

 

 

 

 

 

 

 

 

 

Dividends declared ($.87 per share)

 

 

 

(20,247

)

 

 

 

 

 

 

(20,247

)

 

 

 

 

Balance, December 31, 2007

 

22,155,140

 

$

774,422

 

$

31,870

 

$

192,446

 

$

95,701

 

$

749,767

 

$

7,980

 

$

(303,342

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net earnings

 

 

 

$

78,676

 

 

 

 

 

 

 

78,676

 

 

 

 

 

Other comprehensive loss, net of tax

 

 

 

(80,571

)

 

 

 

 

(80,571

)

 

 

 

 

 

 

Treasury shares purchased

 

(917,200

)

(47,904

)

 

 

 

 

 

 

 

 

 

 

(47,904

)

Deferred compensation under Rabbi trust plans

 

 

 

—

 

 

 

 

 

 

 

 

 

332

 

(332

)

Stock option excess tax benefit

 

 

 

4,929

 

 

 

4,929

 

 

 

 

 

 

 

 

 

Exercise of stock options

 

236,489

 

(150

)

236

 

(386

)

 

 

 

 

 

 

 

 

Dividends declared ($.99 per share)

 

 

 

(21,248

)

 

 

 

 

 

 

(21,248

)

 

 

 

 

Balance, December 31, 2008

 

21,474,429

 

$

708,154

 

$

32,106

 

$

196,989

 

$

15,130

 

$

807,195

 

$

8,312

 

$

(351,578

)

 

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

 

32


 

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 Ins.), 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 Ins., 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 (generally accepted accounting principles 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.

 

C. ADOPTED ACCOUNTING STANDARDS

 

SFAS NO. 157, Fair Value Measurements (SFAS 157)

 

On January 1, 2008, we partially adopted statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements.” As allowed under Financial Accounting Standards Board (FASB) Staff Position (FSP) FAS 157-2, we have elected not to fully adopt SFAS 157 at this time and have deferred adoption for certain nonfinancial assets and liabilities. SFAS 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and provides a hierarchical disclosure framework for assets and liabilities measured at fair value. 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 (an exit price), 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, including all risks associated with that asset or liability, such as credit or liquidity risk. SFAS 157 became effective for fiscal years beginning after November 15, 2007. The partial adoption of SFAS 157 had no impact on our financial position or results of operations.

 

FSP FAS 157-2, Effective Date of FASB Statement No. 157

 

FASB Staff Position (FSP) FAS 157-2 delays the effective date of FAS 157, Fair Value Measurements, to fiscal years beginning after November 15, 2008 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. The delay is intended to allow the Board and constituents additional time to consider the effect of various implementation issues that have arisen, or that may arise, from the application of FAS 157. Partial deferral of FAS 157 would apply to our goodwill.

 

FSP FAS 157-3, Determining the Fair Value of a Financial Asset when the Market for that Asset is not Active

 

FSP FAS 157-3 became effective on October 10, 2008 and clarifies the application of FASB Statement No. 157, “Fair Value Measurements,” in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. In situations in which there is little, if any, market activity for an asset at the measurement date, the fair value measurement objective remains the same, that is, the price that would be received by the holder of the financial asset in an orderly transaction that is not a forced liquidation or distressed sale. Determining the fair value of a financial asset in an illiquid market depends on the facts and circumstances and may require the use of significant judgments for certain Level 2 and all Level 3 financial assets where market activity is not readily available. As of December 31, 2008, we did not have any Level 3 financial assets which would require the use of significant judgments in the determination of fair value.

 

SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159)

 

On January 1, 2008, we adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” The Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is expected to expand the use of fair value measurement, which is consistent with the board’s long-term measurement objectives for accounting for financial instruments. SFAS 159 became effective for fiscal years beginning after November 15, 2007. We elected not to

 

33


 

implement the fair value option with respect to any existing assets or liabilities; therefore, the adoption of SFAS 159 had no impact on our financial position or results of operations.

 

D. PROSPECTIVE ACCOUNTING STANDARDS

 

SFAS No. 141(R), “Business Combinations” (SFAS 141(R))

 

In December 2007, the FASB issued SFAS 141(R), “Business Combinations,” which replaces SFAS 141, “Business Combinations.” Assets and liabilities that arose from business combinations which occurred prior to the adoption of SFAS 141(R) are not adjusted upon the adoption of SFAS 141(R). Among other things, SFAS 141(R) broadens the scope of SFAS 141 to include all transactions where an acquirer obtains control of one or more other businesses. SFAS 141(R) retains the guidance to recognize intangible assets separately from goodwill and requires, with limited exceptions, that all assets acquired and liabilities assumed, including certain contractual contingencies, be measured at their acquisition date fair values. SFAS 141(R) requires most acquisition and restructuring—related costs to be expensed as incurred. Step acquisitions, once control is acquired, are to be recorded at the full amounts of the fair values of the identifiable assets, liabilities and the non-controlling interest in the acquiree. SFAS 141(R) also replaces the reduction of asset values and recognition of negative goodwill with a requirement to recognize a gain in earnings. The provisions of SFAS 141(R) are effective for fiscal years beginning after December 15, 2008. Early adoption is not permitted. We will apply the provisions of SFAS No. 141(R) as applicable when effective.

 

FSP No. 142-3, “Determination of the Useful Life of Intangible Assets” (FSP 142-3)

 

In April 2008, the FASB issued FSP 142-3, “Determination of the Useful Life of Intangible Assets.” FSP 142-3 amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under FASB 142, “Goodwill and Other Intangible Assets.” The intent of FSP 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141(R) and other generally accepted accounting principles. This new guidance applies prospectively to intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. FSP 142-3 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. Early adoption is prohibited. We do not expect the implementation of FSP 142-3 to have a significant impact on our financial position or results of operations.

 

FSP No. 140-4 and FIN 46(R)-8, “Disclosure by public Entities (Enterprises) About Transfers of Financial Assets and interests in Variable Interest Entities” (FSP 140-4 and FIN 46(R)-8)

 

In December 2008, the FASB issued FSP 140-4 and FIN 46R-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in variable Interest Entities.” FSP 140-4 and FIN 46R-8 require additional disclosures about transfers of financial assets and involvement with variable interest entities. The requirements apply to transferors, sponsors, servicers, primary beneficiaries and holders of significant variable interests in a variable interest entity or qualifying special purpose entity. Disclosures required by FSP 140-4 and FIN 46R-8 are effective in the first quarter of fiscal 2009. Because FSP 140-4 and FIN 46R-8 only require additional disclosures, the adoption will not impact our financial position or results of operations.

 

E. 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 and equity securities 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. Our equity securities consist of a core stock portfolio weighted toward dividend-paying stocks, as well as preferred stock, real estate investment trusts (REITs), exchange traded funds (ETFs), and mutual funds. 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 94 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 3 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. In 2008,

 

34


 

we inadvertently sold three fixed income positions ($5.2 million) designated as held-to-maturity. From a custodial perspective, these securities were held with our available-for-sale portfolio. These transactions generated a realized gain of $0.2 million. To mitigate the likelihood of this event reoccurring, we opened new custodial accounts to segregate our held-to-maturity investments from our available-for-sale investments.

 

For the years ended December 31, 2008, 2007, and 2006, no securities were transferred from held-to-maturity to available-for-sale or trading.

 

We regularly evaluate our fixed income and equity securities using both quantitative and qualitative criteria to determine impairment losses for other-than-temporary declines in the fair value of the investments. The following are the factors for determining if a security is other-than-temporarily impaired:

 

·                  The length of time and the extent to which the fair value has been less than cost;

·                  The probability of significant adverse changes to the cash flows on a fixed income investment;

·                  The occurrence of a discrete credit event resulting in the issuer defaulting on a material obligation or the issuer is seeking protection from creditors under the bankruptcy laws, or the issuer is proposing a voluntary reorganization which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than par value of their claims; or

·                  The probability that we will not receive all contractual or estimated cash flows in the form of principal and interest.

 

Quantitative criteria considered during this process include, but are not limited to: the degree and duration of 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 and, for fixed maturities, whether the issuer is in compliance with terms and covenants of the security. Qualitative criteria include the credit quality, current economic conditions, the anticipated speed of cost recovery, the financial health of and specific prospects for the issuer, as well as our intent and ability to hold the security to maturity or until forecasted recovery. In addition, 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. see note 2 for further discussion of other-than-temporary impairment.

 

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. Realized gains and losses on disposition of investments are based on specific identification of the investments sold on the trade date.

 

F. CASH: Cash consists of cash in banks, generally in operating accounts. On a daily basis, our cash accounts are swept into short-term investments, principally money market instruments. As a result, our balance sheet does not reflect any cash balance.

 

G. SHORT-TERM INVESTMENTS: We classify money market funds and securities lending collateral as short-term investments. Whereas our strategy is to be fully invested at all times, short-term investments in excess of demand deposit balances are considered a component of investment activities, and thus are classified as investments in our consolidated balance sheets. Short-term investments are carried at cost, which approximates fair value. These funds generally have original maturities of less than 90 days and, therefore, bear minimal risk. We have not experienced losses on these instruments.

 

H. 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.

 

We continuously monitor the financial condition of our reinsurers. As part of our monitoring efforts, we review their annual financial statements and Securities and Exchange Commission filings. We also review insurance industry developments that may impact the financial condition of our reinsurers. We analyze the credit risk associated with our reinsurance balances recoverable by monitoring the A.M. Best and Standard & Poor’s (S&P) ratings of our reinsurers. In addition, we subject our reinsurance recoverables to detailed recoverable tests, including one based on average default by S&P rating. Based upon our review and testing, our policy is to charge to earnings, in the form of an allowance, an estimate of unrecoverable amounts from reinsurers. This allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover.

 

I. 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

 

35


 

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.

 

J. 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.

 

K. INVESTMENT IN UNCONSOLIDATED INVESTEES: We maintain a 40 percent interest in the earnings of Maui Jim, Inc. (Maui Jim), 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 $38.7 million in 2008 and $38.2 million in 2007. In 2008, we recorded $4.8 million in investee earnings compared to $7.3 million in 2007 and $8.8 million in 2006. Maui Jim recorded net income of $11.6 million in 2008, $18.0 million in 2007 and $22.1 million in 2006. Additional summarized financial information for Maui Jim for 2008 and 2007 is outlined in the following table:

 

(in millions)

 

2008

 

2007

 

Total assets

 

$

141.3

 

$

150.3

 

Total liabilities

 

68.4

 

79.0

 

Total equity

 

72.9

 

71.3

 

 

Approximately $26.0 million of undistributed earnings from Maui Jim are included in our retained earnings as of December 31, 2008. In 2008, we received a dividend of $4.0 million from Maui Jim.

 

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 investment in TBW, prior to the sale, was $16.3 million in 2006. In 2006, we recorded $6.3 million in investee earnings.

 

In December 2006, we became a 17 percent 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 was collateralized by TBW shares and our portion contained the same market terms and conditions as those of the lead and other syndicate members. We also had a separate note receivable from TBW totaling $4.5 million at December 31, 2006, which originated in 1999 as an operating loan. In 2007, we received payment in full for both the loan and note receivable from TBW.

 

We perform an impairment review of our investment in our unconsolidated investee which considers current valuation and operating results. Based upon the most recent review, this asset was not impaired.

 

L. 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 earlier when there is reason to suspect that their values may have been diminished or impaired. Goodwill, which relates to our surety segment, is listed separately on the balance sheet and totaled $26.2 million at December 31, 2008 and 2007. Goodwill impairment testing was performed during 2008, pursuant to the requirements of SFAS 142. Based upon this review, this asset was not impaired.

 

Intangible assets with definite lives continue to be amortized over their estimated useful lives. Definite-lived intangible assets that were amortized under SFAS 142 during the periods presented relate to our purchase of customer-related and marketing-related intangibles. These intangibles had useful lives ranging from five to 10 years. Amortization of intangible assets was $0.1 million for 2007 compared to $0.4 million for 2006. There was no amortization expense in 2008 as these assets were fully amortized in 2007.

 

At December 31, 2006, net intangible assets totaled $0.1 million, net of $5.6 million of accumulated amortization, and were included in other assets.

 

M. 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

 

36


 

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 2004 through 2008, when favorable experience primarily 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, 2008, make a reasonable provision to meet our future obligations. see note 6 for a further discussion of unpaid losses and settlement expenses.

 

N. 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.

 

O. 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. Deferred tax assets are reduced by a valuation allowance if it is more-likely-than-not all or some of the deferred tax assets will not be realized.

 

On January 1, 2007, we adopted the provisions of FIN 48, “Accounting for Uncertainty in Income Taxes,” 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.” The adoption of FIN 48 did not have an impact on our financial position or results of operations as we have taken no significant tax positions which would require accrual or disclosure under the new guidance. Penalties and interest are included in tax expense. Although the IRS is not currently examining any of our income tax returns, tax years 2005 through 2008 remain open and are subject to examination.

 

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

 

(in thousands,
except per share data)

 

Income
(Numerator)

 

Shares
(Denominator)

 

Per Share
Amount

 

 

 

 

 

 

 

 

 

For the year ended December 31, 2008

 

 

 

 

 

 

 

Basic EPS

 

 

 

 

 

 

 

Income available to common shareholders

 

$

78,676

 

21,540

 

$

3.65

 

Stock options

 

—

 

308

 

 

 

 

 

 

 

 

 

 

 

Diluted EPS

 

 

 

 

 

 

 

Income available to common shareholders and assumed conversions

 

$

78,676

 

21,848

 

$

3.60

 

 

 

 

 

 

 

 

 

For the year ended December 31, 2007

 

 

 

 

 

 

 

Basic EPS

 

 

 

 

 

 

 

Income available to common shareholders

 

$

175,867

 

23,574

 

$

7.46

 

Stock options

 

—

 

511

 

 

 

 

 

 

 

 

 

 

 

Diluted EPS

 

 

 

 

 

 

 

Income available to common shareholders and assumed conversions

 

$

175,867

 

24,085

 

$

7.30

 

 

 

 

 

 

 

 

 

(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

 

 

Q. COMPREHENSIVE EARNINGS: The difference between our net earnings and our comprehensive earnings is that comprehensive earnings include unrealized gains/losses on our available-for-sale investment securities 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 in the consolidated statements of earnings and comprehensive earnings, is net of tax expense (benefit) of $(43.3) million, $(5.1) million and $12.0 million, respectively, for 2008, 2007, and 2006.

 

R. FAIR VALUE DISCLOSURES: The following was considered in the estimation of fair value for each class of financial instruments for which it was practicable to estimate that value. We utilize Interactive Data Corporation (IDC) to

 

37


 

obtain quoted market prices for our investment securities. We continue to classify our equities as level 1 securities with “an active market.” All bonds are classified as level 2. Because these securities do not always have quoted market prices, other transactional data (prices of similar securities, prices of securities from the same issuer, spreads by issuer, sector, etc.) is used to arrive at the current market price. All but five of our 856 positions were priced through IDC at December 31, 2008. Two of the five positions that were not automatically priced used Bloomberg as the secondary pricing source, while the other three were priced by our custodian, JP Morgan. The total fair value of these five securities was less than $13 million.

 

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. The fair value of our long-term debt is discussed further in note 4.

 

S. STOCK-BASED COMPENSATION: We account for stock-based compensation pursuant to statement of Financial Accounting Standards (SFAS) No. 123, “Share-Based Payment,” (SFAS 123R) which requires companies to expense the estimated fair value of employee stock options and similar awards. SFAS 123R requires entities to measure compensation cost for awards of equity instruments to employees based on the grant-date fair value of those awards and recognize compensation expense over the service period that the awards are expected to vest.

 

We calculate the tax effects of share-based compensation pursuant to SFAS 123(R) and under the alternative transition method provided in Financial Accounting standards Board (“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 included simplified methods to determine the impact on the additional paid-in capital pool (“APIC pool”) and consolidated statements of cash flows of the tax effects of employee share-based compensation awards that were outstanding upon adoption of SFAS 123(R).

 

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

 

T. 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 attempt to mitigate, quantify, and minimize such risks, 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 on the West Coast. 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 monitor these exposures by quantifying our exposed policy limits in each region and by using computer-assisted modeling techniques. Additionally, we further limit our risk to such catastrophes through the purchase of reinsurance. In 2008, our property underwriting was supported by $375 million in excess of a $25 million first dollar retention in traditional catastrophe reinsurance protection, subject to certain retentions by us. The limit decreased to $350 million at July 1, 2008. At January 1, 2009, we renewed our $350 million reinsured limit, subject to certain retentions by us. We actively manage our catastrophe program to keep our net retention in line with risk tolerances and to optimize the risk/return trade off.

 

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 number of financially strong reinsurers. We provide an allowance for reinsurance balances deemed uncollectible. See further discussion of reinsurance exposures in note 5.

 

38


 

Investment Risk

 

Our investment portfolio is subject to market, credit, and interest rate risks. The equity portfolio will fluctuate with movements in the overall stock market. While the equity portfolio has been constructed to have lower downside risk than the market, the portfolio is sensitive to movements in the market. The bond portfolio is affected by interest rate changes and credit spreads. We mitigate our interest rate and credit risks by constructing a well-diversified portfolio with high-quality securities.

 

The prolonged downturn of the global financial markets and economy resulted in significant declines and lack of liquidity in the financial markets. While we maintain a high quality portfolio, it was not immune to the negative swings in the markets. The deterioration was not limited in its scope, as most segments of the financial markets were impacted. As such, this resulted in our total portfolio having a negative return of 4.4 percent for the year. Continued downturns in the financial markets could have a negative effect on our portfolio. However, we manage this risk through asset allocation and security selection.

 

Liquidity Risk

 

Liquidity is essential to our business and a key component of our concept of asset-liability matching. Our liquidity may be impaired by an inability to collect premium receivable or reinsurance recoverable balances timely, an inability to sell assets or redeem our investments, an inability to access funds from our insurance subsidiaries, unforeseen outflows of cash or large claim payments, or an inability to access debt or equity capital markets. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects third parties or us, or even by the perception among market particpants that we, or other market particpants, are experiencing greater liquidity risk. To date, the ongoing liquidity crisis and the loss of confidence in financial institutions has not increased our cost of funding and has not limited our access to some of our traditional sources of liquidity.

 

Our credit ratings are important to our liquidity. A reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs, or limit our access to the capital markets.

 

Financial Statements

 

The preparation of the accompanying consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. The most significant of these amounts is the liability for unpaid losses and settlement expenses. Other estimates include investment valuation, the collectibility of reinsurance balances, recoverability of deferred tax assets, and deferred policy acquisition costs. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets and volatile equity markets have combined to increase the uncertainty inherent in such estimates and assumptions. Although recorded estimates are supported by actuarial computations and other supportive data, the estimates are ultimately based on our expectations of future events. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.

 

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, 2008, 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.

 

39


 

In addition, ratings are a critical factor in establishing the competitive position of insurance companies. Our insurance companies are rated by A.M. Best, S&P, 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)

 

2008

 

2007

 

2006

 

Interest on fixed income securities

 

$

68,290

 

$

69,481

 

$

64,486

 

Dividends on equity securities

 

13,863

 

12,252

 

10,402

 

Interest on short-term investments

 

1,484

 

2,716

 

2,125

 

Gross investment income

 

83,637

 

84,449

 

77,013

 

Less investment expenses

 

(4,651

)

(5,548

)

(5,688

)

Net investment income

 

$

78,986

 

$

78,901

 

$

71,325

 

 

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)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Net realized Investment gains (losses)

 

 

 

 

 

 

 

Fixed income

 

 

 

 

 

 

 

Available-for-sale

 

$

(8,350

)

$

(966

)

$

(7,351

)

Held-to-maturity

 

270

 

89

 

92

 

Trading

 

(123

)

(103

)

(53

)

Equity securities

 

(38,698

)

29,863

 

22,374

 

Other

 

163

 

83

 

15,983

 

 

 

(46,738

)

28,966

 

31,045

 

 

 

 

 

 

 

 

 

Net changes in unrealized gains (losses) on investments

 

 

 

 

 

 

 

Fixed income

 

 

 

 

 

 

 

Available-for-sale

 

(21,032

)

14,020

 

2,323

 

Held-to-maturity

 

(425

)

(395

)

(2,030

)

Equity securities

 

(102,575

)

(28,669

)

32,072

 

 

 

(124,032

)

(15,044

)

32,365

 

 

 

 

 

 

 

 

 

Net realized investment gains (losses) and changes in unrealized gains (losses) on investments

 

$

(170,770

)

$

13,922

 

$

63,410

 

 

During 2008, we recorded $46.7 million in net realized losses and the portfolio experienced unrealized losses of $124.0 million. For 2008, the net realized investment losses and changes in unrealized gains (losses) on investments totaled $170.8 million. The majority of our net realized losses and change in unrealized gains were in our equity portfolio. The equity portfolio was impacted by the negative return in the stock market, exposure to the financial sector with preferred stocks, and a flight to quality in the municipal bond market which negatively impacted our high-yield municipal bond mutual fund.

 

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:

 

 

 

Proceeds

 

Gross Realized

 

Net
Realized

 

(in thousands)

 

From Sales

 

Gains

 

Losses

 

Gain (Loss)

 

 

 

 

 

 

 

 

 

 

 

SALES

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2008 —

 

 

 

 

 

 

 

 

 

Available-for-sale

 

$

143,074

 

$

4,269

 

$

(3,759

)

$

510

 

Held-to-maturity

 

5,230

 

179

 

—

 

179

 

Trading

 

10,885

 

241

 

(312

)

(71

)

Equities

 

89,032

 

25,959

 

(30,806

)

(4,847

)

 

 

 

 

 

 

 

 

 

 

2007 —

 

 

 

 

 

 

 

 

 

Available-for-sale

 

$

99,360

 

$

452

 

$

(1,435

)

$

(983

)

Trading

 

6,619

 

25

 

(128

)

(103

)

Equities

 

77,040

 

32,347

 

(2,484

)

29,863

 

 

 

 

 

 

 

 

 

 

 

2006 —

 

 

 

 

 

 

 

 

 

Available-for-sale

 

$

231,385

 

$

666

 

$

(8,076

)

$

(7,410

)

Trading

 

4,950

 

17

 

(70

)

(53

)

Equities

 

146,635

 

41,097

 

(2,519

)

22,374

 

 

 

 

 

 

 

 

 

 

 

CALLS/MATURITIES

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2008 —

 

 

 

 

 

 

 

 

 

Available-for-sale

 

$

327,462

 

$

137

 

$

—

 

$

137

 

Held-to-maturity

 

28,870

 

92

 

(1

)

91

 

Trading

 

1,561

 

1

 

—

 

1

 

 

 

 

 

 

 

 

 

 

 

2007 —

 

 

 

 

 

 

 

 

 

Available-for-sale

 

$

199,427

 

$

38

 

$

(21

)

$

17

 

Held-to-maturity

 

32,722

 

89

 

—

 

89

 

Trading

 

1,309

 

—

 

—

 

—

 

 

 

 

 

 

 

 

 

 

 

2006 —

 

 

 

 

 

 

 

 

 

Available-for-sale

 

$

117,204

 

$

59

 

$

—

 

$

59

 

Held-to-maturity

 

28,215

 

92

 

—

 

92

 

Trading

 

1,083

 

—

 

—

 

—

 

 

FAIR VALUE MEASUREMENTS

 

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

 

Effective January 1, 2008, we determined the fair values of certain financial instruments based on the fair value hierarchy established in SFAS 157. SFAS 157 requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.

 

Level 1: Quoted price (unadjusted) in active markets for identical assets.

 

40


 

Level 2: Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the instrument.

 

Level 3: Inputs to the valuation methodology are unobservable for the asset or liability.

 

SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

 

To measure fair value, we obtain quoted market prices for our investment securities. If a quoted market price is not available, we use quoted market prices of similar securities.

 

Assets measured at fair value on a recurring basis as of December 31, 2008, are summarized below:

 

(in thousands)

 

Quoted
in Active
Markets for
Identical
Assets
(Level 1)

 

Significant
Other
Observable
Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Total
Total

 

Trading securities

 

$

—

 

$

10,020

 

—

 

$

10,020

 

Available-for-sale securities

 

286,790

 

1,224,215

 

—

 

1,511,005

 

Total

 

$

286,790

 

$

1,234,235

 

—

 

$

1,521,025

 

 

As noted in the above table, we did not have any assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of December 31, 2008.

 

Assets and Liabilities Recorded at Fair Value on a Non-recurring Basis

 

As allowed under FSP FAS 157-2, Effective Date of FASB Statement No. 157, as of January 1, 2008, we have elected not to fully adopt SFAS 157 and have deferred adoption for certain nonfinancial assets and liabilities. On our balance sheet, this deferral would apply to goodwill.

 

In addition, the following is a schedule of amortized costs and estimated fair values of investments in fixed income and equity securities as of December 31, 2008 and 2007:

 

 

 

Amortized

 

 

 

Gross Unrealized

 

(in thousands)

 

Cost

 

Fair Value

 

Gains

 

Losses

 

 

 

 

 

 

 

 

 

 

 

2008

 

 

 

 

 

 

 

 

 

AVAILABLE-FOR-SALE

 

 

 

 

 

 

 

 

 

U.S. government

 

$

6,596

 

$

7,065

 

$

469

 

$

—

 

U.S. agencies

 

285,937

 

288,177

 

2,664

 

(424

)

Mtge/ABS/CMO*

 

233,275

 

231,522

 

4,239

 

(5,992

)

Corporate

 

287,557

 

270,164

 

2,647

 

(20,040

)

States, political subdivisions & revenues

 

423,311

 

427,287

 

8,841

 

(4,865

)

Fixed maturities

 

1,236,676

 

1,224,215

 

18,860

 

(31,321

)

Equity securities

 

251,283

 

286,790

 

63,063

 

(27,556

)

Total available-for-sale

 

$

1,487,959

 

$

1,511,005

 

$

81,923

 

$

(58,877

)

 

 

 

 

 

 

 

 

 

 

HELD-TO-MATURITY

 

 

 

 

 

 

 

 

 

U.S. government

 

$

4,916

 

$

5,019

 

$

103

 

$

—

 

U.S. agencies

 

8,960

 

9,916

 

956

 

—

 

States, political subdivisions & revenues

 

25,945

 

26,486

 

541

 

—

 

Total held-to-maturity

 

$

39,821

 

$

41,421

 

$

1,600

 

$

—

 

 

 

 

 

 

 

 

 

 

 

TRADING**

 

 

 

 

 

 

 

 

 

U.S. government

 

$

1,150

 

$

1,312

 

—

 

—

 

U.S. agencies

 

—

 

—

 

—

 

—

 

Mtge/ABS/CMO*

 

6,097

 

5,881

 

—

 

—

 

Corporate

 

2,935

 

2,722

 

—

 

—

 

States, political subdivisions & revenues

 

100

 

105

 

—

 

—

 

Total trading

 

$

10,282

 

$

10,020

 

—

 

—

 

Total

 

$

1,538,062

 

$

1,562,446

 

$

83,523

 

$

(58,877

)

 

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

**Trading securities are carried at fair value with unrealized gains (losses) included in earnings.

 

41


 

 

 

Amortized 

 

 

 

Gross Unrealized

 

(in thousands)

 

Cost

 

Fair Value

 

Gains

 

Losses

 

 

 

 

 

 

 

 

 

 

 

2007

 

 

 

 

 

 

 

 

 

AVAILABLE-FOR-SALE

 

 

 

 

 

 

 

 

 

U.S. government

 

$

6,656

 

$

6,788

 

$

132

 

$

—

 

U.S. agencies

 

335,873

 

339,171

 

3,298

 

—

 

Mtge/ABS/CMO*

 

294,125

 

295,274

 

2,741

 

(1,592

)

Corporate

 

229,587

 

228,183

 

2,299

 

(3,703

)

States, political subdivisions & revenues

 

408,493

 

413,889

 

5,784

 

(388

)

Fixed maturities

 

1,274,734

 

1,283,305

 

14,254

 

(5,683

)

Equity securities

 

255,598

 

393,680

 

150,937

 

(12,855

)

Total available-for-sale

 

$

1,530,332

 

$

1,676,985

 

$

165,191

 

$

(18,538

)

 

 

 

 

 

 

 

 

 

 

HELD-TO-MATURITY

 

 

 

 

 

 

 

 

 

U.S. government

 

$

6,250

 

$

6,382

 

$

132

 

$

—

 

U.S. agencies

 

8,912

 

9,630

 

718

 

—

 

States, political subdivisions & revenues

 

58,486

 

59,661

 

1,175

 

—

 

Total held-to-maturity

 

$

73,648

 

$

75,673

 

$

2,025

 

$

—

 

 

 

 

 

 

 

 

 

 

 

TRADING**

 

 

 

 

 

 

 

 

 

U.S. government

 

$

2,150

 

$

2,221

 

—

 

—

 

U.S. agencies

 

1,066

 

1,087

 

—

 

—

 

Mtge/ABS/CMO*

 

8,051

 

8,077

 

—

 

—

 

Corporate

 

3,983

 

3,921

 

—

 

—

 

States, political subdivisions & revenues

 

100

 

107

 

—

 

—

 

Total trading

 

$

15,350

 

$

15,413

 

—

 

—

 

Total

 

$

1,619,330

 

$

1,768,071

 

$

167,216

 

$

(18,538

)

 

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

**Trading securities are carried at fair value with unrealized gains (losses) included in earnings.

 

MBS/ABS/CMO

 

The unrealized losses in our MBs/ABs/CMO portfolio are primarily contained in the commercial mortgage-backed securities. These securities were negatively affected in the second half of the year by the overall decline in the real estate market and the lack of liquidity in the credit markets. The securities remain AAA rated and we believe it is probable that we will receive all contractual or estimated cash flows in the form of principal and interest. We have the ability and intent to hold these investments until recovery

in value, which may be maturity, and thus do not consider these investments to be other-than-temporarily impaired at December 31, 2008.

 

Corporate Bonds

 

The unrealized losses in the corporate bond portfolio were caused by a general rise in interest rate spreads in 2008. The interest rate spread widening was primarily caused by the financial crisis and slowing economy. The corporate bond portfolio has an overall rating of A and we believe it is probable that we will receive all contractual payments in the form of principal and interest. In addition, we have the ability and intent to hold these investments until a recovery in value, which may be maturity. We do not consider these investments to be other-than-temporarily impaired at December 31, 2008.

 

Equity Securities

 

Our equity portfolio consists of common stock, REITs, preferred stocks, exchange traded funds and a high-yield municipal bond fund. The majority of our net unrealized losses are contained within the three exchange traded funds in the portfolio. We began diversifying our equity portfolio towards the end of 2007 with exchange traded funds. The exchange traded funds track various indices and have returns for 2008 consistent with the equity benchmark indices they follow. Given the short amount of time we owned these securities, the ETFs’ position relative to the benchmarks they track, and forecasted recovery periods, we do not consider the exchange traded funds to be other-than-temporarily impaired at December 31, 2008.

 

42


 

The amortized cost and estimated fair value of fixed income securities at December 31, 2008, by contractual maturity, are shown as follows:

 

(in thousands)

 

Amortized Cost

 

Fair Value

 

 

 

 

 

 

 

AVAILABLE-FOR-SALE

 

 

 

 

 

Due in one year or less

 

$

16,317

 

$

16,465

 

Due after one year through five years

 

253,210

 

256,334

 

Due after five years through 10 years

 

442,644

 

433,793

 

Due after 10 years

 

524,505

 

517,623

 

 

 

$

1,236,676

 

$

1,224,215

 

 

 

 

 

 

 

HELD-TO-MATURITY

 

 

 

 

 

Due in one year or less

 

$

12,113

 

$

12,260

 

Due after one year through five years

 

25,320

 

26,627

 

Due after five years through 10 years

 

2,388

 

2,534

 

Due after 10 years

 

—

 

—

 

 

 

$

39,821

 

$

41,421

 

 

 

 

 

 

 

TRADING

 

 

 

 

 

Due in one year or less

 

$

—

 

$

—

 

Due after one year through five years

 

2,100

 

2,033

 

Due after five years through 10 years

 

2,888

 

2,774

 

Due after 10 years

 

5,294

 

5,213

 

 

 

$

10,282

 

$

10,020

 

 

 

 

 

 

 

TOTAL FIXED INCOME

 

 

 

 

 

Due in one year or less

 

$

28,430

 

$

28,725

 

Due after one year through five years

 

280,630

 

284,994

 

Due after five years through 10 years

 

447,920

 

439,101

 

Due after 10 years

 

529,799

 

522,836

 

 

 

$

1,286,779

 

$

1,275,656

 

 

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, 2008, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $23.0 million. At December 31, 2007, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $146.7 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, 2008, and December 31, 2007, respectively. These tables segregate the securities based on type, noting the fair value, cost (or amortized cost), and unrealized loss on each category of 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.

 

DECEMBER 31, 2008

 

(in thousands)

 

0-12 Mos.

 

>12 Mos.

 

Total

 

 

 

 

 

 

 

 

 

U.S. Government

 

 

 

 

 

 

 

Fair value

 

$

—

 

$

—

 

$

—

 

Cost or amortized cost

 

—

 

—

 

—

 

Unrealized loss

 

—

 

—

 

—

 

U.S. Agency

 

 

 

 

 

 

 

Fair value

 

$

34,955

 

$

—

 

$

34,955

 

Cost or amortized cost

 

35,379

 

—

 

35,379

 

Unrealized loss

 

(424

)

—

 

(424

)

Mtge/ABS/CMO*

 

 

 

 

 

 

 

Fair value

 

$

38,551

 

$

16,721

 

$

55,272

 

Cost or amortized cost

 

41,769

 

19,495

 

61,264

 

Unrealized loss

 

(3,218

)

(2,774

)

(5,992

)

Corporate

 

 

 

 

 

 

 

Fair value

 

$

135,865

 

$

32,737

 

$

168,602

 

Cost or amortized cost

 

149,935

 

38,707

 

188,642

 

Unrealized loss

 

(14,070

)

(5,970

)

(20,040

)

States, political subdivisions and revenues

 

 

 

 

 

 

 

Fair value

 

$

133,515

 

$

13,250

 

$

146,765

 

Cost or amortized cost

 

137,660

 

13,970

 

151,630

 

Unrealized loss

 

(4,145

)

(720

)

(4,865

)

Subtotal, debt securities

 

 

 

 

 

 

 

Fair value

 

$

342,886

 

$

62,708

 

$

405,594

 

Cost or amortized cost

 

364,743

 

72,172

 

436,915

 

Unrealized loss

 

(21,857

)

(9,464

)

(31,321

)

Common stock

 

 

 

 

 

 

 

Fair value

 

$

83,406

 

$

11,912

 

$

95,318

 

Cost or amortized cost

 

106,540

 

16,076

 

122,616

 

Unrealized loss

 

(23,134

)

(4,164

)

(27,298

)

Preferred stock

 

 

 

 

 

 

 

Fair value

 

$

2,613

 

$

—

 

$

2,613

 

Cost or amortized cost

 

2,871

 

—

 

2,871

 

Unrealized loss

 

(258

)

—

 

(258

)

Total

 

 

 

 

 

 

 

Fair value

 

$

428,905

 

$

74,620

 

$

503,525

 

Cost or amortized cost

 

474,154

 

88,248

 

562,402

 

Unrealized loss

 

(45,249

)

(13,628

)

(58,877

)

 

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

 

43


DECEMBER 31, 2007

 

(in thousands)

 

0-12 Mos.

 

>12 Mos.

 

Total

 

U.S. Government

 

 

 

 

 

 

 

Fair value

 

$

—

 

$

—

 

$

—

 

Cost or amortized cost

 

—

 

—

 

—

 

Unrealized loss

 

—

 

—

 

—

 

U.S. Agency

 

 

 

 

 

 

 

Fair value

 

$

—

 

$

70

 

$

70

 

Cost or amortized cost

 

—

 

70

 

70

 

Unrealized loss

 

—

 

—

 

—

 

Mtge/ABS/CMO*

 

 

 

 

 

 

 

Fair value

 

$

7,892

 

$

87,746

 

$

95,638

 

Cost or amortized cost

 

8,000

 

89,230

 

97,230

 

Unrealized loss

 

(108

)

(1,484

)

(1,592

)

Corporate

 

 

 

 

 

 

 

Fair value

 

$

53,846

 

$

65,185

 

$

119,031

 

Cost or amortized cost

 

55,229

 

67,505

 

122,734

 

Unrealized loss

 

(1,383

)

(2,320

)

(3,703

)

States, political subdivisions and revenues

 

 

 

 

 

 

 

Fair value

 

$

42,218

 

$

46,604

 

$

88,822

 

Cost or amortized cost

 

42,472

 

46,738

 

89,210

 

Unrealized loss

 

(254

)

(134

)

(388

)

Subtotal, debt securities

 

 

 

 

 

 

 

Fair value

 

$

103,956

 

$

199,605

 

$

303,561

 

Cost or amortized cost

 

105,701

 

203,543

 

309,244

 

Unrealized loss

 

(1,745

)

(3,938

)

(5,683

)

Common stock

 

 

 

 

 

 

 

Fair value

 

$

56,808

 

$

—

 

$

56,808

 

Cost or amortized cost

 

64,604

 

—

 

64,604

 

Unrealized loss

 

(7,796

)

—

 

(7,796

)

Preferred stock

 

 

 

 

 

 

 

Fair value

 

$

29,436

 

$

—

 

$

29,436

 

Cost or amortized cost

 

34,495

 

—

 

34,495

 

Unrealized loss

 

(5,059

)

—

 

(5,059

)

Total

 

 

 

 

 

 

 

Fair value

 

$

190,200

 

$

199,605

 

$

389,805

 

Cost or amortized cost

 

204,800

 

203,543

 

408,343

 

Unrealized loss

 

(14,600

)

(3,938

)

(18,538

)

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

 

As of December 31, 2008, we held 37 common and preferred stocks that were in unrealized loss positions. The total unrealized loss on these securities was $27.6 million. In considering both the significance and duration of the unrealized loss positions, we have no equity securities in an unrealized loss position of greater than 20 percent for more than six months. The fixed income portfolio contained 229 securities at a loss as of December 31, 2008. Of these 229 securities, 33 have been in an unrealized loss position for more than 12 consecutive months and these collectively represent $9.5 million in unrealized losses. The fixed income unrealized losses can be primarily attributed to spreads widening in the corporate, municipal and mortgage backed security markets. We have the ability and intent to hold these securities to maturity. In addition, we continually monitor the credit quality of our fixed income investments to access if it is probable that we will receive our contractual or estimated cash flows in the form of 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:

 

·                  changes in technology that may impair the earnings potential of the investment,

·                  the discontinuance of a segment of the business that may affect the future earnings potential,

·                  reduction or elimination of dividends,

·                  specific concerns related to the issuer’s industry or geographic area of operation,

·                  significant or recurring operating losses, poor cash flows, and/or deteriorating liquidity ratios, and

·                  downgrade in credit quality by a major rating agency.

 

Based on our analysis, we’ve concluded that the securities in an unrealized loss position are not other-than temporarily impaired.

 

During 2008, we recognized impairment losses of $76.2 million. This total includes $64.2 million in equity and $12.0 million in fixed income declines. Of the total charge, $39.7 million came during the fourth quarter as the overall market continued its downward trend. The majority of our other-than-temporary impairment is related to securities in the financial sector and a high-yield municipal bond mutual fund. The impaired securities were negatively impacted by the overall financial crisis and lack of liquidity in the credit markets. There were no losses associated with the other-than-temporary impairment of securities in 2007 or 2006.

 

At December 31, 2008, we were party to a securities lending program whereby fixed income securities are loaned to third parties, primarily major brokerage firms. At December 31, 2008, fixed maturities with a fair value of $15.4 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.

 

44


 

As required by law, certain fixed maturities and short-term investments amounting to $18.3 million at December 31, 2008, were on deposit with either regulatory authorities or banks. Additionally, we have certain fixed maturities held in trust amounting to $10.0 million at December 31, 2008. 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)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Deferred policy acquisition costs, beginning of year

 

$

78,882

 

$

73,817

 

$

69,477

 

 

 

 

 

 

 

 

 

Deferred:

 

 

 

 

 

 

 

Direct commissions

 

110,985

 

119,344

 

126,270

 

Premium taxes

 

7,663

 

6,902

 

6,483

 

Other direct underwriting expenses

 

65,270

 

60,695

 

54,946

 

Ceding commissions

 

(27,438

)

(31,454

)

(41,520

)

Net deferred

 

156,480

 

155,487

 

146,179

 

Amortized

 

156,842

 

150,422

 

141,839

 

Deferred policy acquisition costs, end of year

 

$

78,520

 

$

78,882

 

$

73,817

 

Policy acquisition costs: Amortized to expense

 

156,842

 

150,422

 

141,839

 

Period costs: Ceding commission – contingent

 

(2,683

)

(3,334

)

(3,049

)

Other

 

9,161

 

8,522

 

6,986

 

Total policy acquisition costs

 

$

163,320

 

$

155,610

 

$

145,776

 

 

4.  DEBT

 

As of December 31, 2008, outstanding debt balances totaled $100.0 million, all of which was our long-term senior notes. The senior notes are rated Baa2 by Moody’s and BBB+ by S&P.

 

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 totaling $65.0 million were made to our insurance subsidiaries to increase their statutory surplus. The balance of the proceeds was used by the holding company to fund investment and operating activities. The estimated fair value for the senior note is $88.5 million. The fair value of our long-term debt is estimated based on the limited observable prices that reflect thinly traded securities.

 

As of December 31, 2008, we had no short-term debt outstanding as compared to $28.0 million outstanding under reverse repurchase agreements at December 31, 2007. 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 that would be paid in interest expense.

 

We maintain a revolving line of credit with JP Morgan which permits us to borrow up to an aggregate principal amount of $25.0 million. Under certain conditions, the line may be increased up to an aggregate principal amount of $50.0 million. This facility has a three-year term that expires on May 31, 2011. As of December 31, 2008, no amounts were outstanding on this facility.

 

We incurred interest expense on debt at the following average interest rates for 2008, 2007, and 2006:

 

 

 

2008

 

2007

 

2006

 

Line of credit

 

—

 

—

 

—

 

Reverse repurchase agreements

 

3.42

%

5.15

%

4.97

%

Total short-term debt

 

3.42

%

5.15

%

4.97

%

Senior notes

 

6.02

%

6.02

%

6.02

%

Total debt

 

5.60

%

5.88

%

5.95

%

 

Interest paid on outstanding debt for 2008, 2007, and 2006 amounted to $6.7 million, $7.0 million, and $6.6 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 several types of treaties including: 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 quantification of exposed policy limits in each region and the extensive use of computer-assisted modeling techniques, we monitor the concentration of risks exposed to catastrophic events.

 

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 $7.5 million.

 

45


 

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

 

(in thousands)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

WRITTEN

 

 

 

 

 

 

 

Direct

 

$

673,226

 

$

734,287

 

$

794,093

 

Reinsurance assumed

 

7,943

 

5,047

 

4,920

 

Reinsurance ceded

 

(167,713

)

(200,571

)

(247,477

)

Net

 

$

513,456

 

$

538,763

 

$

551,536

 

 

 

 

 

 

 

 

 

EARNED

 

 

 

 

 

 

 

Direct

 

$

695,824

 

$

765,894

 

$

788,904

 

Reinsurance assumed

 

5,218

 

5,729

 

5,982

 

Reinsurance ceded

 

(172,278

)

(227,145

)

(264,548

)

Net

 

$

528,764

 

$

544,478

 

$

530,338

 

 

 

 

 

 

 

 

 

LOSSES AND SETTLEMENT EXPENSES INCURRED

 

 

 

 

 

 

 

Direct

 

$

234,121

 

$

180,140

 

$

381,661

 

Reinsurance assumed

 

7,399

 

7,746

 

8,956

 

Reinsurance ceded

 

5,654

 

2,982

 

(133,728

)

Net

 

$

247,174

 

$

190,868

 

$

256,889

 

 

Direct, ceded, and net losses and settlement expenses incurred, as displayed in the table above, were lower in 2007 and 2008 relative to 2006 due to favorable development on prior accident years’ reserves. While we have experienced favorable development in all three years, there was a significant impact to direct, ceded, and net reserves during 2007. This was the direct result of several refinements in our loss reserve methodologies that culminated in significant favorable development on prior years’ reserves. This is further outlined in note 6. Many of our longer-tailed products make extensive use of reinsurance. As a result, the favorable emergence we have seen on an overall basis has had an even more significant impact on our estimates of ceded reserves. This factor influenced the calendar year ceded incurred losses shown in the table for both 2007 and 2008.

 

At December 31, 2008, we had prepaid reinsurance premiums on paid and unpaid losses and settlement expenses totaling $376.4 million. More than 91 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 10 reinsurers, as of December 31, 2008. All other reinsurance balances recoverable, when considered by individual reinsurer, are less than 2 percent of shareholders’ equity.

 

REINSURER

 

 

 

Amounts

 

A.M Best

 

S&P

 

(in thousands)

 

Recoverable

 

Rating

 

Rating

 

 

 

 

 

 

 

 

 

 

Munich Re America

 

$

59,716

 

A+, Superior

 

AA-, Very Strong

 

Swiss Re /Westport Ins. Corp.

 

41,660

 

A+, Superior

 

A+, Strong

 

Endurance Re

 

40,632

 

A, Excellent

 

A, Strong

 

Axis Re

 

32,743

 

A, Excellent

 

A, Strong

 

General Cologne Re

 

31,839

 

A++, Superior

 

AAA, Extremely Strong

 

Berkley Insurance Co.

 

28,202

 

A+, Superior

 

A+, Strong

 

Toa-Re

 

17,916

 

A, Excellent

 

A+, Strong

 

Lloyds of London

 

15,184

 

A, Excellent

 

A+, Strong

 

Ace Property & Casualty

 

15,078

 

A+, Superior

 

A+, Strong

 

Transatlantic Re

 

14,892

 

A, Excellent

 

AA-, Very Strong

 

 

6.  HISTORICAL LOSS AND LAE DEVELOPMENT

 

The table which follows is a reconciliation of our unpaid losses and settlement expenses (LAE) for the years 2008, 2007, and 2006.

 

(in thousands)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Unpaid losses and LAE at beginning of year:

 

 

 

 

 

 

 

Gross

 

$

1,192,178

 

$

1,318,777

 

$

1,331,866

 

Ceded

 

(417,250

)

(525,671

)

(593,209

)

Net

 

$

774,928

 

$

793,106

 

$

738,657

 

 

 

 

 

 

 

 

 

Increase (decrease) in incurred losses and LAE:

 

 

 

 

 

 

 

Current accident year

 

$

309,512

 

$

296,047

 

$

300,292

 

Prior accident years

 

(62,338

)

(105,179

)

(43,403

)

Total incurred

 

$

247,174

 

$

190,868

 

$

256,889

 

 

 

 

 

 

 

 

 

Loss and LAE payments for claims incurred:

 

 

 

 

 

 

 

Current accident year

 

$

(51,599

)

$

(46,598

)

$

(47,994

)

Prior accident year

 

(161,476

)

(162,448

)

(154,446

)

Total paid

 

$

(213,075

)

$

(209,046

)

$

(202,440

)

 

 

 

 

 

 

 

 

Net unpaid losses and LAE at end of year

 

$

809,027

 

$

774,928

 

$

793,106

 

Unpaid losses and LAE at end of year:

 

 

 

 

 

 

 

Gross

 

1,159,311

 

1,192,178

 

1,318,777

 

Ceded

 

(350,284

)

(417,250

)

(525,671

)

Net

 

$

809,027

 

$

774,928

 

$

793,106

 

 

46


 

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 2008, 2007, and 2006:

 

(FAVORABLE)/UNFAVORABLE RESERVE DEVELOPMENT BY SEGMENT

 

(in thousands)

 

2008

 

2007

 

2006

 

Casualty

 

$

(50,562

)

$

(87,397

)

$

(40,030

)

Property

 

(6,646

)

(6,690

)

(1,784

)

Surety

 

(5,130

)

(11,092

)

(1,589

)

Total

 

$

(62,338

)

$

(105,179

)

$

(43,403

)

 

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

 

2008. During 2008, we experienced favorable loss emergence from prior years’ reserve estimates across all of our segments. For our casualty segment, we experienced $50.6 million of favorable development, predominantly from the accident years of 2002-2006. In retrospect, the expected loss ratios initially used to set booked reserves for these accident years have proven to be conservative, which has resulted in loss emergence significantly lower than expected. This is particularly true for our general liability, personal umbrella, and commercial umbrella products, which experienced favorable loss development of $33.1 million, $12.7 million, and $11.8 million, respectively. The construction class was the largest contributor to the favorable emergence in the general liability product. In addition, our program business experienced $9.3 million of unfavorable prior years’ loss development during the year, mostly isolated in accident years 2004-2007. Our experience in the liquor liability class has been particularly adverse. In the past, we relied on external loss development patterns that have not proven predictive of actual emergence. As a result, this class is being re-underwritten and we implemented a more stringent reserving approach in 2008.

 

Our property segment realized $6.6 million of favorable loss development in 2008. Most of this emergence was in accident years 2005-2007. The construction and fire products were the drivers of the favorable emergence, recording $4.4 million and $4.2 million, respectively. The construction business has been in run-off for three years and recent experience has been much better than expected, with a significant reduction in both frequency and severity of claims. Only a handful of contracts remain open and we have observed little new activity from this product line. Our fire product saw significant favorable emergence from the 2007 accident year, as our year-end 2007 reserves have developed more favorably than originally estimated.

 

Our surety segment experienced $5.1 million of favorable emergence. Almost all of the favorable emergence is from the 2007 accident year. very little observed loss severity in the commercial surety product resulted in $1.7 million of favorable emergence. Continued improvement in our contract surety loss ratio resulting from past re-underwriting of the business led to $2.5 million of favorable loss reserve development.

 

2007. We periodically review our loss reserve estimates and underlying actuarial reserving methodologies in order to assess their accuracy and suitability, and to benchmark our reserving practices against industry best practices. A detailed assessment of recent trends and reserve risk factors was undertaken in 2007. As part of our reviews, we performed a more detailed, ground-up analysis of the actuarial estimation risks associated with each of our products and segments, including an assessment of industry information.

 

Our analyses also revealed that our quarterly actuarial reserve estimates over recent historical periods had shown a downward trend as a result of a moderating loss trend environment, improvements in policy terms and conditions and a favorable underlying exposure mix that occurred during the hard market period from 2001 through 2004.

 

Based on this review, we made certain refinements to our reserving methodologies to include a more detailed consideration of the impact of risk factors on total recorded reserves through increased internal dialogue among the claim, underwriting, risk management and actuarial departments, greater transparency of the actuarial process and results, and improved reserving diagnostics. Overall, these enhancements and improved information provide better and faster feedback to management regarding loss development resulting in greater overall confidence in the actuarial estimates. This and the increased stability in our business in the last few years diminished the needed level

 

47


 

of carried reserves above the actuarial point estimate. We believe that these reserve methodology enhancements improved the overall accuracy of our best estimate of loss and LAE reserves. Over half of the favorable prior years’ loss development was the result of this detailed assessment and resulting changes in our booked reserves.

 

Our casualty segment was most impacted by prior years’ loss development realizing a total of $87.4 million of favorable emergence. All casualty products were impacted by the enhanced risk assessment previously mentioned. Our general liability, transportation, personal umbrella, and professional liability products realized favorable development of $42.5 million, $19.6 million, $10.5 million, and $8.1 million, respectively. This favorable emergence was concentrated in accident years 2004-2006. As a result of significant favorable loss development observed over the past several years for our general liability product, we reassessed the expected loss ratios used in our actuarial analysis and subsequently lowered them for the construction classes. For our transportation and personal umbrella products, we reassessed and subsequently lowered the loss development factors in our analysis, reflecting our observation that the emergence patterns were more favorable than previously anticipated. Finally, our professional liability products realized actual loss emergence much more favorably than expected.

 

The property segment realized $6.7 million of favorable prior years’ development. The favorable emergence was realized across almost all of our property products, predominantly in accident years 2005 and 2006. We also executed a favorable reinsurance commutation impacting accident years prior to 2000.

 

The surety segment realized $11.1 million of favorable prior years’ development. Almost all of the development was the result of the risk reassessment and reflection of significantly lower reserve risk after achieving settlement with the larger banks involved in the CMC litigation (see note 10 for more details).

 

2006. During 2006, we continued to experience favorable loss development and a reduction in 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 we expected when making our original estimates. We experienced favorable development of $43.4 million 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 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 our 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 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 significant deterioration in our estimates.

 

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 casualty reinsurance lines of business. The majority of the exposure is in the excess layers of our commercial umbrella and assumed reinsurance books of business.

 

48


 

The following table represents inception-to-date paid and unpaid environmental, asbestos, and mass tort claims data (including incurred but not reported losses) as of December 31, 2008, 2007, and 2006:

 

(in thousands)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

LOSS AND LAE PAYMENTS

 

 

 

 

 

 

 

Gross

 

$

70,210

 

$

56,060

 

$

53,323

 

Ceded

 

(39,143

)

(30,607

)

(29,853

)

Net

 

$

31,067

 

$

25,453

 

$

23,470

 

 

 

 

 

 

 

 

 

UNPAID LOSSES AND LAE AT END OF YEAR

 

 

 

 

 

 

 

Gross

 

$

65,583

 

$

67,891

 

$

48,541

 

Ceded

 

(20,407

)

(29,198

)

(25,720

)

Net

 

$

45,176

 

$

38,693

 

$

22,821

 

 

Our environmental, asbestos, and mass tort exposure is limited, relative to 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 2008, payment activity was more than we experienced in 2007, which was not surprising, given the increased amount of case reserve activity during 2007. However, we did not observe a corresponding decrease in case reserves, as gross case reserves decreased by only $4.8 million while net case reserves increased by about $0.5 million. Much of the reported adverse development can be tied to a small number of claims. Two related asbestos claims from our assumed reinsurance book accounted for $2.7 million in gross emergence and $2.1 million in net emergence with large payments being made. A mass tort claim from accident year 2005 against an insured hotel involving carbon monoxide discharge accounted for another $1.6 million direct and $1.0 million net. In light of these developments and a few additional reported claims, we decided to strengthen our IBNR position.

 

During 2007, while payment activity was less than we experienced in 2006, we experienced an unusual amount of case reserve activity. About two-thirds of the increase in net reserves was from case reserve adjustments. A $4.8 million case reserve increase was posted due to a reversal of a previous court decision for a claim involving pollution during the late 1980s. In addition, an insurance company we reinsured in the early 1980s and that went into liquidation in 1986, reported a number of claims in 2007. The largest of these involves asbestos. Because of this situation, we posted total net case reserves of $2.9 million. Also, a $2.2 million reserve adjustment was made on a 1983 asbestos related claim because the coverage layers below our excess policy had been exhausted. In addition to these case reserve increases, we made a minor adjustment in our emergence pattern assumptions that resulted in an increase in our total reserve position relative to industry benchmarks.

 

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.

 

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)

 

2008

 

2007

 

 

 

 

 

 

 

Deferred tax assets:

 

 

 

 

 

Tax discounting of claim reserves

 

$

32,728

 

$

35,800

 

Unearned premium offset

 

18,843

 

19,915

 

Net unrealized depreciation of securities

 

4,912

 

—

 

Other

 

6,999

 

10,203

 

Deferred tax assets before allowance

 

63,482

 

65,918

 

Less valuation allowance

 

—

 

—

 

Total deferred tax assets

 

$

63,482

 

$

65,918

 

 

 

 

 

 

 

Deferred tax liabilities:

 

 

 

 

 

Net unrealized appreciation of securities

 

$

—

 

$

51,757

 

Deferred policy acquisition costs

 

27,482

 

27,609

 

Book/tax depreciation

 

1,823

 

1,635

 

Undistributed earnings of unconsolidated investee

 

9,773

 

9,700

 

Other

 

263

 

259

 

Total deferred tax liabilities

 

39,341

 

90,960

 

Net deferred tax asset (liability)

 

$

24,141

 

$

(25,042

)

 

49


 

Income tax expense attributable to income from operations for the years ended December 31, 2008, 2007, and 2006, 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)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Provision for income taxes at the statutory federal tax rates

 

$

37,309

 

$

89,067

 

$

65,413

 

Increase (reduction) in taxes resulting from:

 

 

 

 

 

 

 

Dividends received deduction

 

(1,830

)

(1,815

)

(1,858

)

ESOP dividends paid deduction

 

(508

)

(471

)

(469

)

Tax-exempt interest income

 

(6,418

)

(6,276

)

(5,885

)

Non-recurring tax benefit

 

—

 

(2,356

)

(3,171

)

Other items, net

 

(631

)

460

 

(1,776

)

Total

 

$

27,922

 

$

78,609

 

$

52,254

 

 

Our effective tax rates were 26.2 percent, 30.9 percent, and 28.0 percent for 2008, 2007, and 2006, respectively. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate for 2008 was lower than 2007 and 2006 due to the decrease in underwriting income and net realized losses, which were taxed at 35.0 percent. In addition, changes in items that are non-taxable, such as tax-exempt interest income, impact the effective tax rate. Partially offsetting tax expense in 2007 was a $2.4 million tax benefit recorded in the third quarter to reflect the benefit expected to be realized upon the future payment of certain accrued compensation. Results for 2006 include the favorable resolution of a 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.

 

Our net earnings include equity in earnings of unconsolidated investees. These investees do not have a policy or 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 the third quarter of 2008, we received a $4.0 million dividend from Maui Jim. As required by SFAS 109, “Accounting for Income Taxes,” we recognized a $1.1 million tax benefit in 2008 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. In the first quarter of 2007, we received a cash dividend of $5.9 million and recognized a $1.7 million tax benefit in 2006 from applying the lower tax rate. 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 three straight years, we do not anticipate the payment of dividends to continue and expect to recover our investment through means other than receipt of dividends. 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.

 

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 all deferred tax assets will be recovered given the carry back availability as well as the results of future operations, which 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 2008, 2007, and 2006 amounted to $31.6 million, $87.8 million, and $53.1 million, respectively.

 

8.  EMPLOYEE BENEFITS

 

PENSION PLAN

 

During 2003 through 2006, our board and management took a series of steps to freeze and terminate our defined benefit pension plan. The plan termination was finalized in 2006. All plan distributions were made in late 2006.

 

In 2006, we paid $14.4 million in benefits and had no remaining benefit obligation at December 31, 2006. We incurred $2.6 million in pension expense in 2006. No expenses were incurred in 2007 or 2008.

 

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. Because the plan termination was finalized in 2006, the implementation of SFAS 158 had no impact on our financial statements.

 

50


 

EMPLOYEE STOCK OWNERSHIP, 401(K) AND BONUS AND INCENTIVE PLANS

 

We maintain an Employee Stock Ownership Plan (ESOP), 401(k), 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). MVP is a compensation model that measures comprehensive earnings against a minimum required return on our capital. Bonuses are earned as we generate earnings in excess of this required return. 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.

 

Our 401(k) plan allows voluntary contributions by employees and permits ESOP diversification transfers for employees meeting certain age or service requirements. We provide a basic 401(k) 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 401(k), 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. For plan year 2007 and later, contributions vest after three years of service.

 

Our ESOP and 401(k) cover all employees meeting eligibility requirements. ESOP and 401(k) profit-sharing contributions are determined annually by our board of directors and are expensed in the year earned. ESOP and 401(k)-related expenses (basic and profit-sharing) were $8.8 million, $9.8 million and $7.9 million, respectively, for 2008, 2007, and 2006.

 

During 2008, the ESOP purchased 118,902 shares of RLI stock on the open market at an average price of $53.85 ($6.4 million) relating to the contribution for plan year 2007. Shares held by the ESOP as of December 31, 2008, totaled 1,476,635 and are treated as outstanding in computing our earnings per share. During 2007, the ESOP purchased 90,561 shares of RLI stock on the open market at an average price of $57.92 ($5.2 million) relating to the contribution for plan year 2006. 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 the contribution for plan year 2005.

 

Annual bonuses are awarded to executives, managers, and associates through our incentive plans, provided certain financial and operational goals are met. Annual expenses for these incentive plans totaled $4.6 million, $15.8 million and $15.1 million for 2008, 2007, and 2006, 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 prescribes 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 and bonus expenses for key employees and executive officers. The expense recognized from the directors’ deferred plan was $0.5 million, $0.5 million and $0.4 million in 2008, 2007, and 2006, respectively.

 

In 2008, the trusts purchased 18,496 shares of common stock on the open market at an average price of $51.62 ($1.0 million). In 2007, the trusts purchased 13,013 shares of our common stock on the open market at an average price of $56.76 ($0.7 million). 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). At December 31, 2008, the trusts’ assets were valued at $22.9 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 our interests and those 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

 

51


 

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 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). Since 2005, we have granted 948,100 stock options under this plan, including 267,000 in 2008.

 

Under the omnibus plan, we grant stock options for shares with an exercise price equal to the fair market value of the shares at the date of grant. Options generally vest and become exercisable ratably over a five-year period and have a ten-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 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.

 

Shares issued may be less than the number of shares actually exercised, as our plan allows participants to swap shares to cover the option exercise price and taxes due upon option exercise. Shares swapped are valued at the closing stock price on the date of option exercise. In these instances, the actual number of shares issued will be less than the options exercised and can result in a decrease to shareholders’ equity. Specifically, when options are exercised with significant intrinsic value (i.e. market value in excess of exercise price) and the exercise is facilitated via a stock swap, amounts withheld for taxes result in a decrease in shareholders’ equity. During 2008, the aggregate intrinsic value of options exercised was $16.6 million. A majority of these options were exercised via stock swaps with taxes withheld at the statutory minimum rate. As shown in the Consolidated Statements of Shareholders’ Equity, the exercise of options in 2008 resulted in a decrease to paid-in-capital, as the taxes withheld pursuant to swaps exceeded amounts paid in for options that were exercised using cash.

 

The following tables summarize option activity in 2008, 2007, and 2006:

 

 

 

Number of
Options
Outstanding

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Life

 

Aggregate
Intrinsic
Value
(in 000’s)

 

Outstanding options at January 1, 2008

 

1,605,252

 

$ 

36.34

 

 

 

 

 

Options granted

 

267,000

 

$ 

51.03

 

 

 

 

 

Options exercised

 

(439,404

)

$

22.37

 

 

 

$

16,616

 

Options cancelled/forfeited

 

(3,720

)

$

50.04

 

 

 

 

 

Outstanding options at December 31, 2008

 

1,429,128

 

$

43.35

 

6.46

 

$

23,999

 

Exercisable options at December 31, 2008

 

853,367

 

$

37.12

 

5.07

 

$

19,645

 

 

 

 

Number of
Options
Outstanding

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Life

 

Aggregate
Intrinsic
Value
(in 000’s)

 

Outstanding options at January 1, 2007

 

1,632,019

 

$

31.30

 

 

 

 

 

Options granted

 

241,300

 

$

56.15

 

 

 

 

 

Options exercised

 

(261,527

)

$

22.76

 

 

 

$

9,255

 

Options cancelled/forfeited

 

(6,540

)

$

49.83

 

 

 

 

 

Outstanding options at December 31, 2007

 

1,605,252

 

$

36.34

 

5.84

 

$

32,822

 

Exercisable options at December 31, 2007

 

1,206,951

 

$

30.57

 

4.81

 

$

31,642

 

 

 

 

Number of
Options
Outstanding

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Life

 

Aggregate
Intrinsic
Value
(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

 

 

The majority of our options are granted annually at the board meeting in May. In 2008, 267,000 options were granted with an average exercise price of $51.03 and an average fair value of $13.01. Of these grants, 218,000 were granted at the board meeting in May with a calculated fair value of $12.38. We recognized $2.6 million of expense during 2008 related to options vesting. Since options

 

52


 

granted under our plan are non-qualified, we recorded a tax benefit of $0.9 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $4.3 million, which will be recognized over the remainder of the vesting period.

 

In 2007, 241,300 options were granted with an average exercise price of $56.15 and an average fair value of $15.15. Of these grants, 202,600 were granted at the board meeting in May with a calculated fair value of $15.11. We recognized $1.8 million of expense during 2007 related to options vesting. Since options granted under our plan are non-qualified, we recorded a tax benefit of $0.6 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $3.5 million, which will be recognized over the remainder of the vesting period.

 

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 2006 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 were non-qualified, we recorded a tax benefit of $0.3 million in 2006 related to this compensation expense. Total unrecognized compensation expense in 2006 relating to these grants was $1.9 million, which will be recognized over the remainder of the five-year vesting period.

 

The fair value of options were estimated using a BlackScholes based option pricing model with the following grant-date assumptions and weighted average fair values:

 

 

 

2008

 

2007

 

2006

 

Weighted-average fair value of grants

 

$

13.01

 

$

15.15

 

$

13.95

 

Risk-free interest rates

 

3.29

%

4.56

%

4.99

%

Dividend yield

 

1.53

%

1.47

%

1.51

%

Expected volatility

 

24.01

%

21.78

%

22.35

%

Expected option life

 

6.40 years

 

6.95 years

 

6.31 years

 

 

The risk-free rate is determined based on U.S. treasury yields that most closely approximate each option’s 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 calculated by computing the weighted average of the most recent one-year volatility, the most recent volatility based on expected life and the median of the rolling volatilities based on the expected life of RLI stock. 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.

 

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 conjunction 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.

 

Total shares granted to outside directors under the omnibus plan were 4,700 in 2008, 2,949 in 2007 and 7,267 in 2006. Shares were granted at an average share price of $53.83 in 2008, $57.51 in 2007 and $51.72 in 2006. In 2006, 3,452 of the shares granted were issued under the directors’ deferred plan. We recognized $0.3 million of expense relating to grants in 2008, compared to $0.2 million in 2007 and $0.4 million in 2006.

 

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 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 has historically covered 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 presented in the table below includes $31.3 million of RLI stock (cost basis of $64.6 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.

 

53


 

The following table includes selected information for our insurance subsidiaries for the year ending and as of December 31:

 

(in thousands)

 

2008

 

2007

 

2006

 

Consolidated net income, statutory basis

 

$

74,478

 

$

177,307

 

$

136,135

 

Consolidated surplus, statutory basis

 

$

678,041

 

$

752,004

 

$

746,905

 

 

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 in a rolling 12-month period is limited by Illinois law to the greater of 10 percent of RLI Ins. policyholder surplus as of December 31 of the preceding year or the net income of the Company for the 12-month period ending December 31 of the preceding year. Stand-alone net income for RLI Ins. was $26.7 million for 2008. Therefore, the maximum dividend distribution that can be paid by RLI Ins. during 2009 without prior approval is $67.8 million which represents 10 percent of RLI Ins.’s policyholder surplus at December 31, 2008. The 12-month rolling limitation for 2008, based on the above criteria, was $126.2 million. In 2008, a total cash dividend of $70.0 million was paid by RLI Ins. These dividends were paid to provide additional capital to RLI Corp. and used for the share repurchase plan, shareholder dividends, interest on senior notes, and general corporate expenses. In 2007, a total cash dividend of $149.7 million was paid by RLI Ins. after obtaining permission for special dividends from the Illinois Department of Insurance.

 

10.  COMMITMENTS AND CONTINGENT LIABILITIES

 

We are the plaintiff and a defendant 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 denied each investor bank’s claim to entitlement to relief. The investor banks claimed 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 pretrial proceedings, assigning the litigation to the Honorable Kathleen O’Malley.

 

In the third quarter of 2005, we reached a confidential settlement agreement with Lakeland Bank. This settlement ended our litigation with Lakeland, but did not resolve our pending litigation with the four other investor banks. The settlement with Lakeland related 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 and subsequently ordered all remaining cases to mandatory mediation. Mediations held in January 2006 between us 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. In the second quarter of 2007, we reached a confidential settlement agreement with Sky Bank. In the third quarter of 2007, we reached a confidential settlement agreement with Ameriana Bank. These settlements ended our litigation with Sky Bank and Ameriana Bank but did not resolve our pending litigation with the remaining two investor banks (Bank of Waukegan and Atlantic Coast Federal, whose initial bond penal sum

 

54


 

claims total approximately $9.3 million). The settlements with Sky Bank and Ameriana Bank related to surety bonds representing approximately 66 percent of the amount to which the five investor banks had claimed entitlement. In the first quarter of 2008, we reached a confidential settlement agreement with the Bank of Waukegan. In the fourth quarter of 2008, we reached a confidential settlement agreement with Atlantic Coast Federal Bank. The settlements with Bank of Waukegan and Atlantic Coast Federal related to surety bonds representing approximately 17 percent of the amount to which the five investor banks had claimed entitlement. With these latter two settlements, we have now reached settlements with each of the five investor banks that had claimed entitlement under the surety bonds issued by RLI.

 

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 are also involved in various other legal proceedings and litigation unrelated to our insurance business that arise in the ordinary course of business operations. Management believes that any liabilities that may arise as a result of these legal matters will not have a material adverse effect on our financial condition or operating results.

 

We have capital lease obligations for leased computers and operating lease obligations for regional office facilities. These leases expire in various years through 2014. Expense associated with these leases totaled $3.9 million in 2008, $3.7 million in 2007 and $3.4 million in 2006. Minimum future rental payments under noncancellable leases are as follows:

 

(in thousands)

 

 

 

2009

 

$

3,676

 

2010

 

3,257

 

2011

 

2,644

 

2012

 

2,336

 

2013

 

939

 

2014

 

96

 

Total minimum future rental payments

 

$

12,948

 

 

11.  OPERATING 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 casualty, property, and surety. The casualty segment includes liability coverages where loss and related settlement expenses are subject to greater estimation, 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 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 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 and higher commissions.

 

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 earnings and, through 2006, 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 privately held.

 

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.

 

REVENUES

 

(in thousands)

 

2008

 

2007

 

2006

 

Casualty

 

$

313,481

 

$

343,402

 

$

348,217

 

Property

 

146,863

 

138,367

 

122,581

 

Surety

 

68,420

 

62,709

 

59,540

 

Segment totals before income taxes

 

$

528,764

 

$

544,478

 

$

530,338

 

Net investment income

 

78,986

 

78,901

 

71,325

 

Net realized gains (losses)

 

(46,738

)

28,966

 

31,045

 

Total

 

$

561,012

 

$

652,345

 

$

632,708

 

 

55


 

DEPRECIATION AND AMORTIZATION

 

(in thousands)

 

2008

 

2007

 

2006

 

Casualty

 

$

1,648

 

$

1,825

 

$

2,086

 

Property

 

872

 

891

 

963

 

Surety

 

604

 

588

 

501

 

Segment totals before income taxes

 

$

3,124

 

$

3,304

 

$

3,550

 

 

NET EARNINGS (LOSSES)

 

(in thousands)

 

2008

 

2007

 

2006

 

Casualty

 

$

46,507

 

$

101,863

 

$

68,393

 

Property

 

15,813

 

30,569

 

4,988

 

Surety

 

20,743

 

23,333

 

10,675

 

Net Underwriting Income

 

$

83,063

 

$

155,765

 

$

84,056

 

 

 

 

 

 

 

 

 

Net investment income

 

78,986

 

78,901

 

71,325

 

Realized gains (losses)

 

(46,738

)

28,966

 

31,045

 

General corporate expense and interest on debt

 

(13,557

)

(16,471

)

(14,650

)

Equity in earnings of unconsolidated investees

 

4,844

 

7,315

 

15,117

 

Total earnings before income taxes

 

$

106,598

 

$

254,476

 

$

186,893

 

Income taxes

 

27,922

 

78,609

 

52,254

 

Total

 

$

78,676

 

$

175,867

 

$

134,639

 

 

The following table further summarizes revenues by major product type within each segment:

 

(in thousands)

 

2008

 

2007

 

2006

 

 

 

 

 

 

 

 

 

CASUALTY

 

 

 

 

 

 

 

General liability

 

$

140,891

 

$

167,876

 

$

180,037

 

Commercial and personal umbrella

 

65,091

 

66,281

 

64,730

 

Commercial transportation

 

46,710

 

49,119

 

48,285

 

Specialty program business

 

31,425

 

29,362

 

25,507

 

Executive products

 

13,846

 

12,029

 

13,040

 

Other

 

15,518

 

18,735

 

16,618

 

Total

 

$

313,481

 

$

343,402

 

$

348,217

 

 

 

 

 

 

 

 

 

PROPERTY

 

 

 

 

 

 

 

Commercial property

 

$

85,271

 

$

92,634

 

$

91,507

 

Marine

 

48,166

 

32,868

 

16,785

 

Other property

 

13,426

 

12,865

 

14,289

 

Total

 

$

146,863

 

$

138,367

 

$

122,581

 

 

 

 

 

 

 

 

 

SURETY

 

$

68,420

 

$

62,709

 

$

59,540

 

Grand total

 

$

528,764

 

$

544,478

 

$

530,338

 

 

12.  UNAUDITED INTERIM FINANCIAL INFORMATION

 

Selected quarterly information is as follows:

 

(in thousands, except per share data)

 

First

 

Second

 

Third

 

Fourth

 

Year

 

 

 

 

 

 

 

 

 

 

 

 

 

2008

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned

 

$

135,965

 

$

132,295

 

$

130,850

 

$

129,654

 

$

528,764

 

Net investment income

 

19,258

 

19,605

 

19,844

 

20,279

 

78,986

 

Net realized investment gains (losses)

 

3,741

 

8,075

 

(24,212

)

(34,342

)

(46,738

)

Earnings before income taxes

 

35,961

 

57,121

 

7,696

 

5,820

 

106,598

 

Net earnings

 

25,459

 

38,650

 

8,586

 

5,981

 

78,676

 

Basic earnings per share(1)

 

$

1.16

 

$

1.80

 

$

0.40

 

$

0.28

 

$

3.65

 

Diluted earnings per share(1)

 

$

1.14

 

$

1.77

 

$

0.40

 

$

0.28

 

$

3.60

 

 

 

 

 

 

 

 

 

 

 

 

 

2007

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned

 

$

137,977

 

$

137,488

 

$

134,111

 

$

134,902

 

$

544,478

 

Net investment income

 

18,990

 

19,077

 

20,433

 

20,401

 

78,901

 

Net realized investment gains

 

4,625

 

14,967

 

3,822

 

5,552

 

28,966

 

Earnings before income taxes

 

47,138

 

73,847

 

87,355

 

46,136

 

254,476

 

Net earnings

 

32,517

 

49,853

 

61,539

 

31,958

 

175,867

 

Basic earnings per share(1)

 

$

1.35

 

$

2.09

 

$

2.61

 

$

1.41

 

$

7.46

 

Diluted earnings per share(1)

 

$

1.32

 

$

2.04

 

$

2.56

 

$

1.38

 

$

7.30

 

 

(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.

 

56


 

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, 2008 and 2007, and the related consolidated statements of earnings and comprehensive earnings, cash flows, and shareholders’ equity for each of the years in the three-year period ended December 31, 2008. 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, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2008, 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 Company’s internal control over financial reporting as of December 31, 2008, 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 25, 2009, expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

 

 

Chicago, Illinois

 

February 25, 2009

 

 

57


 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders
RLI Corp.:

 

We have audited RLI Corp. and Subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2008, 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, included in the accompanying Report on Controls and Procedures. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included 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, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, 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, 2008 and 2007, and the related consolidated statements of earnings and comprehensive earnings, cash flows, and shareholders’ equity for each of the years in the three-year period ended December 31, 2008, and our report dated February 25, 2009, expressed an unqualified opinion on those consolidated financial statements.

 

 

Chicago, Illinois

 

February 25, 2009

 

 

58


 

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 registered 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

 

 

59


 

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, 2008.

 

Our internal control over financial reporting as of December 31, 2008 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

 

60


 

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, which are based on premiums earned.

 

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

Sort 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.

 

61


 

SELECTED FINANCIAL DATA

 

The following is selected financial data of RLI Corp. and Subsidiaries for the 11 years ended December 31, 2008.

 

(amounts in thousands, except per share data)

 

2008

 

2007

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

 

 

OPERATING RESULTS

 

 

 

 

 

 

 

 

 

 

 

Gross premiums written(1)

 

$

681,169

 

739,334

 

799,013

 

756,012

 

752,588

 

Consolidated revenue

 

$

561,012

 

652,345

 

632,708

 

569,302

 

578,800

 

Net earnings

 

$

78,676

 

175,867

 

134,639

 

107,134

 

73,036

 

Comprehensive earnings (loss)(2)

 

$

(1,895

)

166,423

 

156,999

 

83,902

 

81,354

 

Net cash provided from operating activities

 

$

161,334

 

127,023

 

171,775

 

198,027

 

188,962

 

 

 

 

 

 

 

 

 

 

 

 

 

FINANCIAL CONDITION

 

 

 

 

 

 

 

 

 

 

 

Total investments

 

$

1,658,828

 

1,839,777

 

1,828,241

 

1,697,791

 

1,569,718

 

Total assets

 

$

2,419,401

 

2,626,523

 

2,771,296

 

2,735,870

 

2,468,775

 

Unpaid losses and settlement expenses

 

$

1,159,311

 

1,192,178

 

1,318,777

 

1,331,866

 

1,132,599

 

Total debt

 

$

100,000

 

127,975

 

100,000

 

115,541

 

146,839

 

Total shareholders’ equity

 

$

708,154

 

774,422

 

756,520

 

692,941

 

623,661

 

Statutory surplus(3)

 

$

678,141

 

752,004

 

746,905

 

690,547

 

605,967

(6)

 

 

 

 

 

 

 

 

 

 

 

 

SHARE INFORMATION

 

 

 

 

 

 

 

 

 

 

 

Net earnings per share:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

3.65

 

7.46

 

5.40

 

4.21

 

2.90

 

Diluted

 

$

3.60

 

7.30

 

5.27

 

4.07

 

2.80

 

Comprehensive earnings (loss) per share:(2)

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.09

)

7.06

 

6.30

 

3.30

 

3.23

 

Diluted

 

$

(0.09

)

6.91

 

6.14

 

3.19

 

3.12

 

Cash dividends declared per share

 

$

0.99

 

0.87

 

0.75

 

0.63

 

0.51

 

Book value per share

 

$

32.98

 

34.95

 

31.17

 

27.12

 

24.64

 

Closing stock price

 

$

61.16

 

56.79

 

56.42

 

49.87

 

41.57

 

Stock split

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:(4)(7)

 

 

 

 

 

 

 

 

 

 

 

Basic

 

21,540

 

23,574

 

24,918

 

25,459

 

25,223

 

Diluted

 

21,848

 

24,085

 

25,571

 

26,324

 

26,093

 

Common shares outstanding

 

21,474

 

22,155

 

24,273

 

25,551

 

25,316

 

 

 

 

 

 

 

 

 

 

 

 

 

OTHER NON-GAAP FINANCIAL INFORMATION(1)

 

 

 

 

 

 

 

 

 

 

 

Net premiums written to statutory surplus(3)

 

76

%

72

%

74

%

72

%

84

%

GAAP combined ratio(5)

 

84.2

 

71.4

 

84.1

 

86.0

 

92.2

 

Statutory combined ratio(3) (5)

 

85.7

 

73.3

 

84.0

 

86.7

 

93.8

 

 

62


 

(amounts in thousands, except per share data)

 

2003

 

2002

 

2001

 

2000

 

1999

 

1998

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

OPERATING RESULTS

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross premiums written (1)

 

$

742,477

 

707,453

 

511,985

 

437,867

 

339,575

 

291,073

 

Consolidated revenue

 

$

519,886

 

382,153

 

309,354

 

263,496

 

225,756

 

168,114

 

Net earnings

 

$

71,291

 

35,852

 

31,047

 

28,693

 

31,451

 

28,239

 

Comprehensive earnings (loss)(2)

 

$

97,693

 

13,673

 

11,373

 

42,042

 

20,880

 

51,758

 

Net cash provided from operating activities

 

$

191,019

 

161,971

 

77,874

 

53,118

 

58,361

 

23,578

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

FINANCIAL CONDITION

 

 

 

 

 

 

 

 

 

 

 

 

 

Total investments

 

$

1,333,360

 

1,000,027

 

793,542

 

756,111

 

691,244

 

677,294

 

Total assets

 

$

2,134,364

 

1,719,327

 

1,390,970

 

1,281,323

 

1,170,363

 

1,012,685

 

Unpaid losses and settlement expenses

 

$

903,441

 

732,838

 

604,505

 

539,750

 

520,494

 

415,523

 

Total debt

 

$

147,560

(6)

54,356

 

77,239

 

78,763

 

78,397

 

39,644

 

Total shareholders’ equity

 

$

554,134

 

456,555

(4)

335,432

 

326,654

 

293,069

 

293,959

 

Statutory surplus(3)

 

$

546,586

(6)

401,269

(4)

289,997

 

309,945

 

286,247

 

314,484

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

SHARE INFORMATION

 

 

 

 

 

 

 

 

 

 

 

 

 

Net earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

2.84

 

1.80

 

1.58

 

1.46

 

1.55

 

1.34

 

Diluted

 

$

2.76

 

1.75

 

1.55

 

1.44

 

1.54

 

1.33

 

Comprehensive earnings (loss) per share:(2)

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

3.89

 

0.69

 

0.58

 

2.14

 

1.03

 

2.46

 

Diluted

 

$

3.78

 

0.67

 

0.57

 

2.11

 

1.02

 

2.43

 

Cash dividends declared per share

 

$

0.40

 

0.35

 

0.32

 

0.30

 

0.28

 

0.26

 

Book value per share

 

$

22.02

 

18.50

(4)

16.92

 

16.66

 

14.84

 

14.22

 

Closing stock price

 

$

37.46

 

27.90

 

22.50

 

22.35

 

17.00

 

16.63

 

Stock split

 

 

 

200

%(7)

 

 

 

 

 

 

125

%

Weighted average shares outstanding:(4)(7)

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

25,120

 

19,937

 

19,630

 

19,634

 

20,248

 

21,028

 

Diluted

 

25,846

 

20,512

 

20,004

 

19,891

 

20,444

 

21,276

 

Common shares outstanding

 

25,165

 

24,681

 

19,826

 

19,608

 

19,746

 

20,670

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

OTHER NON-GAAP FINANCIAL INFORMATION(1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums written to statutory surplus(3)

 

87

%

103

%

109

%

84

%

79

%

46

%

GAAP combined ratio(5)

 

92.0

 

95.6

 

97.2

 

94.8

 

91.2

 

88.2

 

Statutory combined ratio(3) (5)

 

93.1

 

92.4

 

95.8

 

95.8

 

90.1

 

88.4

 

(1)

 

See page 2-3 for information regarding non-GAAP financial measures.

 

 

 

(2)

 

See note 1.Q 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 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.

 

 

 

(5)

 

The GAAP and statutory combined ratios are impacted by favorable development on prior accident years’ loss reserves. See note 6 for further discussion.

 

 

 

(6)

 

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.

 

 

 

(7)

 

On October 15, 2002, our stock split on a 2-for-1 basis. All share and per share data has been retroactively stated to reflect this split.

 

63


 

INVESTOR INFORMATION

 

ANNUAL MEETING

 

The annual meeting of shareholders will be held at 2 p.m., CDT, on May 7, 2009, at our offices at 9025 N. Lindbergh Drive, Peoria, Ill.

 

TRADING AND DIVIDEND INFORMATION

 

 

 

Closing Stock Price

 

Dividends

 

2008

 

High

 

Low

 

Ending

 

Declared

 

1st Quarter

 

$

56.68

 

$

48.48

 

$

49.57

 

$

.23

 

2nd Quarter

 

54.03

 

46.93

 

49.47

 

.25

 

3rd Quarter

 

66.61

 

44.64

 

62.09

 

.25

 

4th Quarter

 

62.38

 

46.71

 

61.16

 

.26

 

 

 

 

Closing Stock Price

 

Dividends

 

2007

 

High

 

Low

 

Ending

 

Declared

 

1st Quarter

 

$

58.38

 

$

51.00

 

$

54.93

 

$

.20

 

2nd Quarter

 

58.11

 

54.79

 

55.95

 

.22

 

3rd Quarter

 

60.82

 

55.82

 

56.72

 

.22

 

4th Quarter

 

60.60

 

55.13

 

56.79

 

.23

 

 

RLI common stock trades on the New York Stock Exchange under the symbol RLI. RLI has paid and increased dividends for 33 consecutive years.

 

STOCK OWNERSHIP

 

December 31, 2008

 

Shares

 

%

 

Insiders

 

2,255,824

 

10.5

 

ESOP

 

1,476,635

 

6.9

 

Institutions & other public

 

17,741,970

 

82.6

 

Total outstanding

 

21,474,429

 

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: 2008 summary annual report; 2008 financial report; 2009 proxy statement; 2008 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 of our board. 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.

 

64


 

DIFFERENT WORKS

 

 

9025 N. Lindbergh Drive, Peoria, IL 61615-1431  T 309-692-1000, 800-331-4929  F 309-693-1068
www.rlicorp.com  ©RLI Corp. 2009  RLI-2.5M-309

 

65