MANAGEMENT'S DISCUSSION & ANALYSIS
Overview
RLI Corp. (the Company) is a holding company that underwrites selected
property and casualty insurance through its major subsidiaries collectively
known as RLI Insurance Group (the Group). The Group has accounted for
approximately 86% of consolidated revenue over the last two years by
providing property and casualty coverages primarily for commercial risks. As
a niche insurer, the Group offers products targeted to the needs of those
insureds generally overlooked by traditional insurance markets.
The property and casualty insurance business is cyclical and influenced by
many factors, including price competition, economic conditions, natural
disasters, interest rates, state regulations, court decisions, and changes in
the law. One of the unique and challenging features of the property and
casualty insurance business is that products must be priced before costs are
fully known, because premiums are charged before claims are incurred.
Property insurance results are subject to the variability introduced by
natural and man-made disasters such as earthquakes, fires and hurricanes. The
Company's major catastrophe exposure is to losses caused by earthquakes,
since approximately 52% of the Company's 1999 total property premiums were
written in California. The Company limits its net aggregate exposure to a
catastrophic event by purchasing reinsurance and through extensive use of
computer-assisted modeling techniques. These techniques provide estimates of
the concentration of risks exposed to catastrophic events. Utilizing this
approach, the Company attempts to limit its net aggregate exposure to a
single catastrophic event to less than 10% of total shareholders' equity.
The casualty portion of the Company's business consists largely of commercial
and personal umbrella, general liability, and commercial auto coverages. In
addition, the Group provides directors & officers liability, employers'
indemnity, and in-home business owners coverage. The casualty book of
business is subject to the risk of accurately estimating losses and related
loss reserves since the ultimate settlement of a casualty claim may take
several years to fully develop. The casualty line 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.
The surety segment of RLI specializes in writing small- and medium-sized
commercial and contract surety products, as well as those for the energy,
petrochemical and refining industries. The commercial surety products usually
involve a statutory requirement for bonds. This industry has historically
maintained a relatively low loss ratio. Losses may fluctuate, however, due to
adverse economic conditions that may affect the financial viability of an
insured.
The contract surety market guarantees the construction work of a commercial
contractor for a specific project. As such, this line has historically
produced marginally higher loss ratios than the commercial surety line.
Generally, losses occur due to adverse economic conditions, inclement weather
conditions, or the deterioration of a contractor's financial condition.
The consolidated financial statements and related notes found on pages 26-48,
and the "Forward Looking Statements" on page 4, should be read in conjunction
with the following discussion.
Significant Developments
In January 1999, RLI Insurance Company acquired Underwriters Indemnity
Holdings, Inc. (UIH), located in Houston, Texas. UIH specializes in the
marketing and underwriting of surety products for energy, petrochemical and
refining exposures.
RLI paid $40.7 million in cash in exchange for all outstanding shares of UIH.
Included in the transaction are both of UIH's insurance operating
subsidiaries, Underwriters Indemnity Company of Texas and Planet Indemnity
Company of Illinois. The transaction was financed through short-term
borrowings and has been accounted for under the purchase method of
accounting. More detailed discussions of these operations follow in the
segment highlights as well as the notes to financial statements.
Year ended December 31, 1999, compared to year ended December 31, 1998
Consolidated gross sales totaled $370.1 million, a 16.8% increase from 1998.
This increase was largely driven by increased gross premium writings of $48.5
million, 16.7% more than in the prior year. Consolidated revenue for 1999 was
$225.8 million, up 34.3% from the previous year. This increase was fueled by
increased writings and the implementation of a combined casualty reinsurance
arrangement, which resulted in larger net retentions of premium.
Year Ended December 31,
Gross sales (in thousands) 1999 1998 1997
Gross premiums written $339,575 $291,073 $278,843
Net investment income 26,015 23,937 24,558
Realized investment gains 4,467 1,853 2,982
Total gross sales $370,057 $316,863 $306,383
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Net after-tax earnings for the Company were $31.5 million ($3.08 per diluted
share) in 1999, compared to $28.2 million ($2.65 per share) in 1998.
Pretax earnings (in thousands) 1999 1998 Increase
Insurance Group $17,135 $16,789 $ 346
Net investment income 26,015 23,937 2,078
Net realized investment gains 4,467 1,853 2,614
Equity in investee earnings 1,613 1,337 276
Comprehensive earnings fell to $20.9 million in 1999 compared to $51.8
million last year, reflecting the impact of the -1.0% total return on the
equity portfolio. Significantly below its average return of more than 17%
since 1982, the equity portfolio's return was diminished by the effect of
rising interest rates on its financial and utility sectors as well as a
general underperformance by value stocks. Despite this aberration, the
Company remains committed to its investment strategy, which management
believes will maximize value for shareholders in the future as it has done
historically, according to the following chart:
Diluted earnings per share Net Comprehensive
1995 0.81 2.77
1996 2.28 3.62
1997 2.66 5.76
1998 2.65 4.87
1999 3.08 2.04
Total $11.48 $19.06
As this chart indicates, comprehensive earnings per share for the last five
years exceeded reported net earnings by 66.0% on a diluted basis.
RLI Insurance Group
Gross written premiums in 1999 were $339.6 million, compared to $291.1
million in 1998. While all three insurance segments' premiums increased
nicely, the casualty segment led the way with writings of $35.2 million, or
23.7% over 1998. The Group's pretax underwriting earnings for 1999 were $17.1
million, a 2.1% increase from the $16.8 million reported in 1998. This growth
was related to the higher volume of business despite a slightly higher GAAP
combined ratio (91.2 compared to 88.2 last year).
The Company's property segment improved gross written premiums by 9.8%,
reaching $124.8 million in 1999, compared to $113.6 million in 1998. This
growth was fueled by fire premiums, which increased 33.8%, as well as added
production from new product lines. These increases offset the 7.7% decline in
difference in conditions premiums from the prior year. The property segment
contributed most of the Group's pretax profits, generating $17.1 million in
1999, compared to $19.8 million in 1998. The pressure on profitability came
as a result of an increase in fire business, which has an inherently higher
loss ratio than difference in conditions business. Still, this segment
achieved an enviable GAAP combined ratio of 66.8, up slightly from 62.2 in
the prior year.
Casualty gross written premiums improved 23.7% from 1998, finishing at $183.9
million. This increase was the result of advances in virtually every casualty
product line, led by the transportation line at $12.6 million and
commercial/personal umbrella at $12.0 million. The GAAP combined ratio for
the casualty segment was 101.9, compared to 103.2 in 1998. The new combined
casualty reinsurance contract, implemented at the start of the year, resulted
in an assumption of less exposure per risk. It also increased the retention
of premiums and eliminated reinsurance commissions associated with this
business. The combined ratio improvement complements management's belief that
loss reserves for this segment will be adequate and investment income derived
from reserved funds will provide significant future earnings potential.
The surety segment gross written premiums increased to $30.9 million, a 7.4%
improvement over 1998. This was the direct impact of the Underwriters
Indemnity acquisition, which contributed $7.3 million in gross written
premiums, and helped to offset writings lost from the Company's
disassociation with a particular contract surety producer late in 1998. The
segment's combined ratio came in at 90.5, compared to 103.9 in 1998. The
prior year included a charge of $2.6 million related to unfavorable loss
development from the same discontinued contract surety book. The
Underwriter's Indemnity book contributed to underwriting profits with a
combined ratio below 90, despite some start-up costs associated with the
transition.
Investment Income
Net dividend and interest income increased by 8.7% during 1999 due to
increased cash flow allocated to investments and the acquisition of
Underwriters Indemnity Holdings. On an after-tax basis, investment income
increased by 9.1%. The Company realized $4.5 million in capital gains in
1999, compared to $1.9 million in 1998. Operating cash flows were $58.4
million in 1999. Most cash flows in excess of current needs were used to fund
the stock repurchase program and purchase fixed income securities, which
continue to be comprised primarily of high-grade, tax-exempt, U.S. government
and agency issues. Equity purchases continue to be in large-cap, value
investments with attractive dividend yields.
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Pretax yield 1999 1998 1997
Taxable (on book value) 6.57% 6.58% 6.91%
Tax-exempt (on book value) 4.78% 4.95% 5.00%
Equities (on market value) 2.43% 2.49% 2.96%
After-tax yield
Taxable (on book value) 4.27% 4.27% 4.49%
Tax-exempt (on book value) 4.53% 4.69% 4.74%
Equities (on market value) 2.07% 2.14% 2.54%
Although overall yields in the fixed income markets increased during 1999,
the yields on the portfolio's taxable side were relatively unchanged from
last year. Tax-exempt yields actually fell due to increased call activity on
certain higher-yielding issues early in the year. As the year progressed,
fixed income purchases were being made in both the taxable and tax-exempt
sectors, depending upon the available yields at the time of purchase.
The Company's investment results for the last five years are shown in the
following table:
(in thousands)
Tax Equivalent
Change in Annualized Annualized
Unrealized Return on Return on
Average Appreciation/ Average Average
Invested Investment Realized Depreciation Invested Invested
Year Assets(1) Income(2)(3) Gains(Losses)(3) (3)(4) Assets Assets
1995 $442,717 $22,029 $ 457 $36,037 13.2% 14.1%
1996 504,773 23,681 1,017 25,033 9.9% 10.7%
1997 570,901 24,558 2,982 55,760 14.6% 15.5%
1998 640,576 23,937 1,853 36,183 9.7% 10.6%
1999 684,269 26,015 4,467 (16,263) 2.1% 3.0%
5-yr. avg. $568,647 $24,044 $2,155 $27,350 9.4% 10.3%
(1) Average of amounts at beginning and end of year.
(2) Investment income, net of investment expenses, including non-debt
interest expense.
(3) Before income taxes.
(4) Relates to available-for-sale fixed maturity and equity securities.
Interest and General Corporate Expense
Interest expense on debt was $4.1 million in 1999, up from $2.3 million in
1998. This increase was the result of the Company's financing associated with
the Underwriters Indemnity acquisition. General corporate expenses fell to
$2.1 million compared to $3.9 million in 1998 due to executive compensation
that was not earned under the Market Value Potential program.
Income Taxes
The Company's effective tax rates for 1999 and 1998 were 26.9% and 25.1%,
respectively. Effective rates are dependent upon components of pretax
earnings and the related tax effects. Much of the rate increase was due to
the amortization of goodwill associated with the UIH acquisition, which is
not deductible for federal income tax purposes. The Company's pretax earnings
included $15.7 million of investment income in 1999 that is wholly or
partially exempt from federal income tax, compared to $14.3 million in 1998.
Investee Earnings
The Company maintains a 44% interest in the earnings of Maui Jim, Inc.,
primarily a manufacturer of high-quality polarized sunglasses. In 1999, the
Company recorded $1.6 million in earnings compared to $1.3 million in 1998.
Sales for Maui Jim grew 35% in 1999 on the strength of increased
international sunglass marketing efforts. Profit margins declined slightly in
1999 as the cost of goods sold was unfavorably impacted by the dollar's
performance against the yen.
Market Risk Disclosure
Market risk is a general term describing the potential economic loss
associated with adverse changes in the fair market value of financial
instruments. Management of market risk is a critical component of the
Company's investment decisions and objectives. The Company manages its
exposure to market risk by using the following tools:
1. Continually monitoring the fair market value of all financial assets;
2. Changing the character of future investment purchases as needed, and;
3. Maintaining a balance between existing asset and liability portfolios.
The Company's primary risk exposures are to changes in interest rates and
equity prices, as it had no derivative or foreign exchange risk as of
December 31, 1999.
Interest Rate Risk
The Company's primary exposure to interest rate risk is with its fixed income
investment portfolio and outstanding short-term debt instruments.
Modified duration analysis is used to measure the sensitivity of the fixed
income portfolio to changes in interest rates, providing a measure of price
volatility. The Company attempts to minimize
18
interest rate risk by matching the duration of its assets to that of its
liabilities. The Company limits the financial statement impact of changes in
interest rates by designating a majority of the fixed income holdings as
held-to-maturity. As of December 31, 1999, the Company had classified 86% of
its fixed income portfolio as held-to-maturity. The balance of the Company's
fixed income portfolio is classified as either available-for-sale or trading
(see note 2).
Interest rate risk could also affect the Company's income statement due to
its impact on interest expense. The Company's debt obligations are short-term
in nature, with no long-term debt outstanding as of December 31, 1999. As a
result, the Company assumes interest rate risk in its ability to refinance
these short-term debt obligations. Any rise in interest rates will cause
interest expense to increase, assuming debt is maintained at current levels.
Equity Price Risk
Equity price risk is the potential that the Company will incur economic loss
due to a decline in common stock prices. Beta analysis is used to measure the
sensitivity of the Company's equity portfolio to changes in the value of the
S&P 500 index (an index representative of the broad equity market). As
measured from December 31, 1981, to December 31, 1999, the Company's equity
portfolio has a beta of approximately 0.67 in comparison to the S&P 500. This
low beta statistic reflects the Company's long-term emphasis on maintaining a
conservative, value-oriented, dividend-driven investment philosophy for its
equity portfolio. Historically, dividend-paying common stocks have
demonstrated superior down-market performance characteristics.
Additional risk management techniques include:
1. Restricting individual security weightings to no more than 3% of the equity
portfolio's market value, and
2. Reducing exposure to sector risk by limiting the market value to be
invested in any one industry sector to 25% of the equity portfolio.
Equity securities are classified as available-for-sale, with unrealized gains
and losses excluded from net earnings, but recorded as a component of
comprehensive earnings and shareholders' equity, net of deferred income taxes.
Sensitivity Analysis
The following tables detail information on the market risk exposure for the
Company's financial instruments as of December 31, 1999. Listed on each table
is year-end market value for the Company's assets and the expected reduction
in market value, given the stated hypothetical events. This sensitivity
analysis assumes that the composition of the Company's assets remains
constant over the period being measured and that interest rate changes are
reflected uniformly across the yield curve. The analysis does not consider
any action the Company would undertake in response to changes in market
conditions. For purposes of this disclosure, securities are divided into two
categories: those held for trading purposes and those held for nontrading
purposes. The examples given are not predictions of future market events, but
rather illustrations of the effect such events may have on the market value
of the Company's investment portfolio.
As of December 31, 1999, the Company's fixed income portfolio had a market
value of $338.5 million. This sensitivity analysis uses scenarios of interest
rates increasing 100 and 200 basis points from their December 31, 1999,
levels, with all other variables held constant. Such scenarios would result
in decreases in the market value of the fixed income portfolio of $14.2
million and $27.8 million, respectively. Due to the Company's use of the
held-to-maturity designation for a majority of the fixed income portfolio,
the balance sheet impact of these scenarios would be much lower. The income
statement would be affected only by holdings designated as trading.
As of December 31, 1999, the Company's equity portfolio had a market value of
$284.6 million. This base sensitivity analysis uses market scenarios of the
S&P 500 index declining 10 percent and 20 percent. These scenarios would
result in approximate decreases in the market value of the equity portfolio
of $19.1 million and $38.1 million, respectively. As the Company designates
all common stocks as available-for-sale, these market value declines would
impact the Company's 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 market value of the Company's assets
will increase from their present levels by the indicated amounts.
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Table 1 (in thousands)
Effect of a 100 basis point increase in interest rates and a 10% decline in the
S&P 500:
12/31/99 Interest Rate Equity
Market Value Risk Risk
Held for trading purposes
Fixed maturity securities $ 7,651 $ (259) --
Total trading 7,651 (259) --
Held for nontrading purposes
Fixed income securities 330,882 (13,957) --
Equity securities 284,639 -- (19,071)
Total nontrading 615,521 (13,957) (19,071)
Total trading & nontrading $623,172 $(14,216) $(19,071)
Table 2 (in thousands)
Effect of a 200 basis point increase in interest rates and a 20% decline in
the S&P 500:
12/31/99 Interest Rate Equity
Market Value Risk Risk
Held for trading purposes
Fixed maturity securities $ 7,651 $ (504) --
Total trading 7,651 (504) --
Held for nontrading purposes
Fixed maturity securities 330,882 (27,268) --
Equity securities 284,639 -- (38,142)
Total nontrading 615,521 (27,268) (38,142)
Total trading & nontrading $ 623,172 $(27,772) $(38,142)
Table 3 (in thousands)
Effect of a 100 basis point decrease in interest rates and a 10% increase in the
S&P 500:
12/31/99 Interest Rate Equity
Market Value Risk Risk
Held for trading purposes
Fixed maturity securities $ 7,651 $ 270 --
Total trading 7,651 270 --
Held for nontrading purposes
Fixed maturity securities 330,882 13,472 --
Equity securities 284,639 -- 19,071
Total nontrading 615,521 13,472 19,071
Total trading & nontrading $623,172 $13,742 $19,071
Table 4 (in thousands)
Effect of a 200 basis point decrease in interest rates and a 20% increase in the
S&P 500:
12/31/99 Interest Rate Equity
Market Value Risk Risk
Held for trading purposes
Fixed maturity securities $ 7,651 $ 530 --
Total trading 7,651 530 --
Held for nontrading purposes
Fixed maturity securities 330,882 26,217 --
Equity securities 284,639 -- 38,142
Total nontrading 615,521 26,217 38,142
Total trading & nontrading $623,172 $26,747 $38,142
The income statement will also be affected by interest expense. As of
December 31, 1999, the Company had $78.4 million in short-term debt
obligations. Assuming this debt level remains constant, a hypothetical
100-basis-point increase in interest rates would increase the Company's
annual pretax interest expense by $0.8 million and a 200-basis-point increase
would increase annual pretax interest expense by $1.6 million. Conversely,
falling interest rates would result in equivalent reductions in interest
expense. These numbers are not included in the previous tables.
Outlook for 2000
In 2000, the Company will continue to pursue profitable opportunities for
top-line growth. While some markets show signs of hardening, there is a
continued pursuit of growth through such avenues as the addition of
underwriting talent in certain product lines, strategic alliances with
producers on existing products, or through acquisition. The materiality or
viability of future ventures or products is not known at this time. Specific
details regarding events in the Group's various business segments follow.
Property
The Company expects some leveling of difference in conditions premiums in
2000 despite a continued soft market. The focus on exposure management will
remain as innovative reinsurance arrangements are continually evaluated and
developed.
The Company's fire book of business should continue to grow as new
initiatives related to international and construction lines were begun in the
fall of 1999. Management intends to significantly focus on the development of
these lines.
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Casualty
Several initiatives launched over the last two years, coupled with market
firming in select lines, continue to generate substantial revenue. Management
is confident that these initiatives involving product lines such as
commercial umbrella, general liability, executive products, and commercial
auto will produce satisfactory growth results into the near future.
Management's priority in this segment will be the development of the program
product line and the continued expansion of e-commerce.
Surety
Gross written premium increases are anticipated as the Company's contract
surety business is expanded into new geographic areas. A new branch office in
New York, established in mid-1999, is expected to drive this expansion in
2000. Additionally, cross-selling opportunities between the existing
miscellaneous and contract lines with the acquired energy-related operation
will also help to increase writings.
Capital Management
In July 1997, the Company implemented a 1.8 million (2.25 million, adjusted
for the June 1998 5-for-4 stock split) share common stock repurchase program.
In 1999, the Company repurchased 546,476 shares at a total cost of $18.2
million. Including 1998 and 1997, 1,895,879 shares were purchased at a total
cost of $66.5 million. Approximately 354,000 shares remain authorized for
repurchase at year-end 1999. It is anticipated that the program will continue
as market conditions and the Company's capital requirements warrant.
The repurchase program has been funded by the use of the Company's operating
cash flow, line of credit facility, and reverse repurchase agreements. It is
anticipated that future repurchases will be funded in a similar fashion.
Depending upon the Company's capital needs and prevailing market conditions,
the Company may issue a longer-term debt instrument and repay the outstanding
short-term debt.
In the fourth quarter of 1999, RLI declared a cash dividend to be paid in
January 2000 of $0.14 per share, representing the 94th consecutive dividend
payment for the Company. Since the inception of cash dividends in 1976, the
Company has increased the annual dividend every year. In its annual "Handbook
of Dividend Achievers," Moody's ranks RLI 189th out of 10,000 U.S. public
companies in dividend growth over the last decade. No changes in the
Company's dividend policy are anticipated in 2000.
Year ended December 31, 1998, compared to year ended December 31, 1997
Consolidated gross sales totaled $316.9 million, a 3.4% increase from 1997.
Consolidated revenue for 1998 was $168.1 million, down 0.8% from the previous
year. Revenue was relatively flat due to a decrease in net realized
investment gains of 37.9% as well as a 2.5% decline in net investment income.
Year Ended December 31,
Gross sales (in thousands) 1998 1997
Gross premiums written $291,073 $278,843
Net investment income 23,937 24,558
Realized investment gains 1,853 2,982
Total gross sales $316,863 $306,383
Net after-tax earnings for the Company were $28.2 million ($2.65 per diluted
share) in 1998, compared to $30.2 million ($2.66 per share) in 1997.
Pretax earnings (in thousands) 1998 1997
Insurance Group $ 16,789 $ 18,751
Net investment income 23,937 24,558
Net realized investment gains 1,853 2,982
Equity in investee earnings 1,337 951
RLI Insurance Group
Gross written premiums in 1998 were $291.1 million, compared to $278.8
million in 1997. This modest increase reflected the Company's firm commitment
to sound underwriting practices during an ongoing period of difficult pricing
and market conditions in certain lines. The Group's pretax underwriting
earnings for 1998 were $16.8 million, a 10.5% decrease from the $18.8 million
reported in 1997. This decline can be attributed to losses from Hurricane
Georges of $1.1 million and reserve strengthening of $2.6 million on the
surety line, both third quarter events.
The Company's property segment gross written premiums were lower in 1998, at
$113.6 million, compared to $139.5 million in 1997. Nonrecurring premiums
associated with the acquisition of the Hawaii residential insurance business
in March of 1997 accounted for $10.7 million of this decline. While fire
premiums were flat, difference in conditions premiums were down 19.1% from
1997. This decrease can be attributed to rate reductions on these lines of
business while the Company continues to focus on controlling its total
exposure to catastrophe risks.
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The property segment contributed the largest share of the Group's pretax
profits, generating $19.8 million in 1998, compared to $21.4 million in 1997.
These results were reflected in the property segment GAAP combined ratio of
62.1 for 1998, compared to 65.5 in 1997. Despite the drop in the combined
ratio, Group profits decreased slightly due to $1.1 million in Hurricane
Georges losses as well as a decline in revenue associated with Hawaii
residential insurance.
Casualty gross written premiums improved 31.0% from 1997, reaching $148.7
million in 1998. This overall increase was the result of gains in the
following products: commercial umbrella -- $19.3 million; transportation --
$16.1 million; and general liability -- $3.6 million. The GAAP combined ratio
for the casualty segment was 103.2, compared to 104.6 in 1997. This resulted
from premium increases in the more profitable lines. Despite the lower ratio
in 1998, management believes that loss reserves for this segment will be
adequate and the investment income derived from reserved funds will provide
significant future earnings potential.
The surety segment continued a trend of solid growth as gross written
premiums increased to $28.8 million, which was an 11.5% improvement over
1997. The segment's combined ratio of 103.9 included a charge of $2.6 million
related to unfavorable loss development from one specific contract surety
producer. This particular book of business constituted only 8% of the total
surety book. Excluding this adjustment, the combined ratio for the year would
have fallen to 89.7, compared to 95.4 in 1997. Contributing to this decline
was an improved expense ratio, which dropped to 67.7 in 1998, from 73.8 in
1997. Increased premium volumes paid back earlier infrastructure investments.
Investment Income
Net dividend and interest income decreased by 2.5% during 1998. Despite the
growth in invested assets during the year, a focus on investing new cash flow
in tax-exempt securities, as well as the general downturn in interest rates,
caused the decline. On an after-tax basis, investment income actually
increased slightly (0.3%). The Company realized $1.9 million in capital gains
in 1998, compared to $3.0 million in 1997. Operating cash flows were $23.6
million in 1998. All cash flows in excess of current needs were used to fund
the stock repurchase program and purchase both fixed income and equity
securities.
Overall yields continued to decline during 1998, reflecting the general trend
in the fixed income markets. At year end, the yields on the tax-exempt side
were relatively unchanged from last year, while taxable yields fell rather
significantly. As a result, the after-tax spread between these securities has
widened, making the tax-exempt selections increasingly more attractive. Given
the Company's tax position, the majority of fixed income purchases were made
in this sector.
Interest and General Corporate Expense
Interest expense on debt was $2.3 million in 1998, up from $1.5 million in
1997. This increase was largely the result of the Company's increased use of
short-term borrowings to finance the stock repurchase program. General
corporate expenses decreased 6.2% in 1998 as a result of lower executive
compensation costs relating to the Market Value Potential program.
Income Taxes
The Company's effective tax rates for 1998 and 1997 were 25.1% and 27.3%,
respectively. Effective rates are dependent upon components of pretax
earnings and the related tax effects. The Company's pretax earnings included
$14.3 million of investment income in 1998 that is wholly or partially exempt
from federal income tax, compared to $12.5 million in 1997.
Investee Earnings
The Company maintains a 44% interest in the earnings of Maui Jim, Inc.,
primarily a manufacturer of high-quality polarized sunglasses. In 1998, the
Company recorded $1.3 million in earnings compared to $951,000 in 1997. Sales
for Maui Jim grew 50% in 1998 on the strength of increased sunglass marketing
efforts in several international territories. Profit margins also improved in
1998 as the cost of goods sold was favorably impacted by the dollar's
performance against the yen.
Accounting Standards
In June 1998, the FASB issued Statement No. 133, "Accounting for Derivative
Instruments and Hedging Activities" (Statement 133). Statement 133 addresses
the accounting for and disclosure of derivative instruments, including
certain derivative instruments embedded in other contracts, and hedging
activities. This Statement standardizes the accounting for derivative
instruments by requiring that an entity recognize those items as assets or
liabilities in the statement of financial position and measure them at fair
value. This Statement, as amended by FASB Statement No. 137, is effective for
all fiscal quarters of fiscal years beginning after June 15, 2000. Although
the Company does not currently invest in derivative instruments, this
recently issued Statement is under evaluation.
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Legislation
State Regulation
As an insurance holding company, RLI Corp., as well as its insurance
subsidiaries, are subject to regulation by the states in which the insurance
subsidiaries are domiciled or transact business. Holding company registration
in each insurer's state of domicile requires reporting to the state
regulatory authority the financial, operational and management data of the
insurers within the holding company system. All transactions within a holding
company system affecting insurers must be fair, 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 subsidiaries of the holding company system.
Other regulations limit the amount of dividends and other distributions the
subsidiaries can pay without prior approval of the insurance department in
the states in which they are physically and/or commercially domiciled, and
impose restrictions on the amount and type of investments they 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. Market oversight is conducted
by monitoring trade practices, approving policy forms, licensing of agents
and brokers, and requiring fair and equitable premiums and commission rates.
Financial solvency is monitored by minimum reserve and 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 accounting
principles which are different from the generally accepted accounting
principles that 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 liquidation concept.
The National Association of Insurance Commissioners (NAIC) has recently
developed a codified version of these statutory accounting principles, and
its deployment in the near future will foster more consistency among the
states for accounting guidelines and reporting.
State regulatory authorities have relatively broad discretion with respect to
granting, renewing and revoking brokers' and agents' licenses to transact
business in the state. The manner of operating in particular states may vary
according to the licensing requirements of the particular state, which may,
among other things, require a firm to operate in the state through a
corporation. In a few states, licenses are issued only to individual
residents.
Commercial Lines Deregulation -- The NAIC and several state legislatures have
taken up the issue of commercial lines deregulation in an attempt to
streamline specific areas of insurance regulation. A growing contingent in
the regulatory community has acknowledged that some regulatory procedures and
practices may be cumbersome and inappropriate for commercial buyers of
insurance. Specifically, the large, sophisticated, multi-state or
multinational businesses that employ their own teams of risk managers to
evaluate, reduce and finance their loss exposures are less likely to need the
form and rate protections that regulators provide consumers and small to
medium business endeavors. And, while these large businesses may receive some
benefit from the state financial regulation of licensed insurers, it has long
been acknowledged that they do not need the protections addressed by the
barriers to the surplus lines market and other nontraditional markets.
Indisputably, deregulation of the licensed market will have an impact on the
surplus lines insurance carriers, which have been free from form and rate
requirements.
Use of Credit Reports in Underwriting -- Gains in access to electronic
commerce, and the means to gather information more rapidly, have spurred
regulators to take a second look at the use of consumer credit reports in
underwriting and rate making. In some states, regulators charged with
protecting insurance consumers from unfair trade practices are concerned that
some consumers' risks may be underwritten based solely on their credit
standing, and have sought to strengthen their laws and regulations to address
this. This trend comes on the heels of Congress' retooling of the Fair Credit
Reporting Act in 1997, which specifically addresses this issue, and permits
the use of consumer credit reports in underwriting. The issue of federal
preemption of state action in this arena has not been judicially addressed.
Federal Regulation
Although the federal government generally does not directly regulate the
insurance business, federal initiatives often have an impact on the business
in a variety of ways. Current and proposed federal measures which may
significantly affect the insurance business include federal preemption of
state auto liability laws, tax reform measures, product liability and
electronic commerce. The Company is also monitoring the following federal
proposals:
Natural Disaster Act -- Recent natural disasters including Atlantic Coast
hurricanes, continue to fuel concern regarding the best way to provide
affordable insurance coverage for such events. Congress has yet to pass
legislation, but proposals to set up a system for federal relief to the
industry continue to be discussed. Two Initiatives, "The Natural Disaster
Protection and Insurance Act of 1997" (S.1361), and "The Homeowners Insurance
Availability Act
23
of 1997" (H.R. 21), focus on excess federal reinsurance. In 1999, both the
House and Senate introduced versions of the "Policyholder Disaster Protection
Act," which would permit insurers to build tax deferred catastrophe reserves.
The Company will continue to monitor the progress of this issue.
Financial Services Modernization -- The Gramm-Leach-Bliley Act was signed
into law by President Clinton on November 12, 1999. The principal focus of
the Act is to facilitate affiliations among banks, securities firms and
insurance companies. The Act amends the Federal Bank Holding Company Act by
creating a new category of bank holding company known as a "financial holding
company" to engage in activities that are "financial in nature," such as
securities and insurance. The Act repealed the Glass-Steagall Act, which
prohibited a Federal Reserve System member bank from being affiliated with a
securities firm; repealed the Garn-St. Germain Act, which prohibited a bank
holding company and its subsidiaries from selling or underwriting insurance;
and repealed the Federal Bank Holding Company Act provisions that prohibited
a director, officer or employee of a securities firm from serving as a
director, officer or employee of a bank.
Liquidity and Capital Resources
Historically, the primary sources of the Company's liquidity have been funds
generated from insurance premiums (operating activities) and investment
income and maturing investments (investment activities). In addition, the
Company has occasionally received funds from financing activities, such as
short-term borrowings, the sale of Company treasury stock to its Employee
Stock Ownership Plan, and the issuance of common stock or convertible
debentures.
The Company maintains a $30.0 million revolving line of credit with one
financial institution. The facility has a three-year term that expires on
December 31, 2001. At December 31, 1999, the Company had $19.6 million in
outstanding debt from this facility. Additionally, the Company was party to
five reverse repurchase transactions totaling $58.8 million. Management
believes that cash generated from operations, investments, and cash available
from financing activities will provide sufficient liquidity to meet the
Company's anticipated needs over the next 12 to 24 months.
In 1996, the Company entered into an innovative catastrophe reinsurance and
loss financing program with Zurich Reinsurance NA (Zurich Re). The program,
called Catastrophe Equity Puts (CatEPutsSM), augments the Company's
traditional reinsurance by integrating its loss financing needs with a
pre-negotiated sale of securities linked to exchange-traded shares. For a
more detailed description of CatEPuts, see note 5.
During 1999, the Company generated net operating cash flow of $58.4 million,
which was added to the Company's investment portfolio and used to repurchase
shares of the Company's stock. Financing activities included the borrowing of
$42.8 million in reverse repurchase agreements that were used, in part, to
finance the January acquisition of Underwriters Indemnity Holdings.
The Company's fixed-income portfolio continues to be biased toward U.S.
government and agency securities due to their high liquidity and almost
risk-free nature. As part of its investment strategy, the Company attempts to
avoid exposure to default risk by holding, almost exclusively, securities
ranked in the top two grades of investment quality by Standard & Poor's and
Moody's (i.e., AAA or AA). Virtually all of the Company's fixed-income
portfolio consists of securities rated A or better, with 98% rated AA or
better. Most of the Company's fixed-income portfolio is noncallable.
The Company follows a program of matching assets to anticipated liabilities
to ensure its ability to hold securities until maturity. Anticipated
liabilities are factored against ultimate payout patterns and the resulting
payout streams are funded with the purchase of fixed-income securities of
like maturity. Management believes that both liquidity and interest rate risk
can be minimized by such asset/liability matching.
The Company currently classifies approximately 86% of the securities in its
fixed-income portfolio as held-to-maturity, meaning they are carried at
amortized cost and are intended to be held until their contractual maturity.
Smaller portions of the fixed-income portfolio are classified as
available-for-sale (12%) or trading (2%) and are carried at fair market
value. As of December 31, 1999, the Company maintained $48.3 million in
fixed-income securities within the available-for-sale and trading
classifications. Although it is likely that the majority of these securities
will be held by the Company to maturity, they provide an additional source of
liquidity and can be used to address potential future changes in the
Company's asset/liability structure.
The Company's equity portfolio decreased by $11.9 million during 1999, to
$284.6 million. The Company had net sales during the year of $2.8 million of
equities, with a pretax portfolio depreciation of $15.3 million. Capital
gains of $4.9 million on this portfolio were realized during the year. The
securities within the equity portfolio remain invested in large-cap issues
with strong dividend performance. The strategy remains one of value
investing, with security selection taking precedence over market timing. A
buy-and-hold strategy is used, minimizing both transactional costs and taxes.
The National Association of Insurance Commissioners (NAIC) continues its work
on developing a model investment law.
24
This law would regulate insurance company investments. The Company's current
investment portfolio appears to be in compliance with the proposed model
investment law. Management does not feel the proposed model law will affect
its current strategies.
Other Matters
The Year 2000 (Y2K) issue is a result of computerized systems, including both
hardware and software systems, using a two-digit format, as opposed to four
digits, to indicate the year in the date field. Such computer systems may be
unable to interpret dates beyond the year 1999, which could cause a system
failure or other computer errors, leading to disruptions in operations.
RLI had identified three major areas determined to be critical for successful
Y2K compliance: (1) accounting and premium processing systems, (2) terms and
conditions of existing insurance contracts, and (3) third-party
relationships. The Company has successfully addressed software and hardware
system issues associated with Y2K through a five-phase program that began in
August of 1997 and was completed in January of 2000.
RLI's offices were closed for the New Year's holiday beginning Friday,
December 31, 1999, through Sunday, January 2, 2000. During this time, the
Company secured systems and data networks through data backups, controlled
shutdowns and verification of system applications and data following Y2K
rollover. A number of activities were undertaken to minimize the potential
impact of Y2K issues on RLI's ability to provide quality service to its
customers, business partners, state regulators and employees.
The computer systems environment was returned to operation on Saturday
morning January 1, 2000. Preliminary testing of operating systems, networks,
communications and primary applications was without problems or issues. On
Sunday, January 2, 2000, effort was dedicated to user and development testing
of applications on the Local Area Networks, P390 and AS/400 systems.
Additionally, RLI branch employees provided support to each remote office to
bring networks and related equipment online and conducted network and
application testing.
The Company controlled and monitored the entry of information into mission
critical systems on January 3 and 4, 2000. This period was used to verify
input, calculations and output of data into financial and processing systems.
To date, RLI has not experienced production issues related to Y2K in any of
the primary or supporting computer systems. RLI continued to monitor data and
system reports through the first quarter for irregularities that may be
caused by Year 2000.
Since 1997, the Company incurred approximately $1.5 million of direct expense
to complete changes and modifications to the business environment for Y2K
compliance. The effort required approximately 30,000 hours of technical staff
effort and changes to systems representing 13.5 million lines of code. Actual
Y2K expenses have been within acceptable ranges of those originally
forecasted. Variations from the original budgets were due to network and
personal computer equipment found to be non-Y2K compliant during mid-1999.
The Company expects to incur a limited amount of additional operational
expense for the remainder of 2000 to monitor and support final Y2K efforts.
Various state insurance departments continue to request and inquire on the
status of the Company's Y2K efforts. The Company received a favorable Y2K
report from the State of Illinois Department of Insurance in September of
1999.
The types of insurance that may be the subject of claims arising from Y2K
losses include property, directors & officers liability, miscellaneous
professional liability, and other casualty. Although uncertainty exists with
respect to legal interpretations of Y2K liability, it is anticipated that if
Y2K claims are received, the majority will stem from director & officers and
miscellaneous professional liability policies, in terms of both frequency and
severity. The Company formulated a Y2K questionnaire to be completed at the
time of initial policy application and renewal. Each application is
individually underwritten, and responses on the Y2K questionnaire are a
component of the underwriter's determination whether to offer coverage and if
so, to what extent. A Y2K exclusion has been drafted and is available for
underwriters' use if needed.
Additionally, a Y2K team of underwriters and claims personnel have been
assembled to prepare for the proper handling of Y2K claims. All claims are
handled on an individual basis in accordance with policy terms and
conditions. The Company has developed an insurance coverage position
statement that is sent to inquiries requesting information regarding policy
provisions.
The Company's executive management has placed emphasis on monitoring
potential issues associated with Y2K and as of this date the Company has not
experienced related problems.
A comprehensive Year 2000 Disclosure is clearly posted on the Company's
Internet site (www.rlicorp.com) and updated on a regular basis to provide
status information for insureds, producers, shareholders and prospective
investors. In addition, regular reports will continue to be prepared for SEC
reporting, insurance regulators, internal management and the board of
directors pertaining to Y2K efforts.
25
Consolidated Balance Sheets
RLI Corp. and Subsidiaries
December 31,
(in thousands, except share data) 1999 1998
Assets
Investments:
Fixed maturities:
Held-to-maturity, at amortized cost
(fair value -- $290,219 in 1999 and $294,544 in 1998) $ 294,199 $ 283,992
Trading, at fair value
(amortized cost -- $7,887 in 1999 and $8,157 in 1998) 7,651 8,348
Available-for-sale, at fair value
(amortized cost -- $41,277 in 1999 and $36,185 in 1998) 40,663 36,516
Equity securities available-for-sale, at fair value
(cost -- $130,808 in 1999 and $127,367 in 1998) 284,639 296,521
Short-term investments, at cost which approximates fair value 64,092 51,917
---------- ----------
Total investments 691,244 677,294
---------- ----------
Cash -- --
Accrued investment income 6,999 6,457
Premiums and reinsurance balances receivable, net of allowances for
insolvent reinsurers of $9,825 in 1999 and $6,669 in 1998 65,477 46,667
Ceded unearned premiums 48,676 59,780
Reinsurance balances recoverable on unpaid losses and settlement
expenses, net of allowances for insolvent reinsurers of
$2,092 in 1999 and $3,096 in 1998 245,580 168,261
Federal income tax receivable 2,062 --
Deferred policy acquisition costs, net 34,358 22,510
Property and equipment, at cost, net of accumulated depreciation
of $24,004 in 1999 and $20,954 in 1998 15,441 12,200
Investment in unconsolidated investee 15,070 13,457
Goodwill 34,140 4,128
Other assets 11,316 1,931
---------- ----------
Total assets $1,170,363 $1,012,685
========== ==========
26
Liabilities and shareholders' equity
Liabilities:
Unpaid losses and settlement expenses $ 520,494 $ 415,523
Unearned premiums 167,044 142,023
Reinsurance balances payable 44,279 32,161
Income taxes -- current -- 2,124
Income taxes -- deferred 41,662 48,421
Notes payable, short-term 78,397 39,644
Other liabilities 25,418 38,830
---------- ----------
Total liabilities 877,294 718,726
---------- ----------
Shareholders' equity:
Common stock ($1 par value, authorized 50,000,000 shares,
issued 12,804,558 shares in 1999 and 12,790,428 shares in 1998) 12,804 12,790
Paid-in capital 70,531 71,093
Accumulated other comprehensive earnings net of tax 99,801 110,372
Retained earnings 189,250 163,324
Deferred compensation 4,705 3,461
Unearned ESOP shares, at cost (70,400 shares) -- (2,501)
Treasury stock, at cost (2,931,212 shares in 1999 and
2,384,736 shares in 1998) (84,022) (64,580)
Total shareholders' equity 293,069 293,959
---------- ----------
Total liabilities and shareholders' equity $1,170,363 $1,012,685
========== ==========
The accompanying notes are an integral part of the
consolidated financial statements.
27
Consolidated Statements of Earnings and Comprehensive Earnings
RLI Corp. and Subsidiaries
Years ended December 31,
(in thousands, except per share data) 1999 1998 1997
Net premiums earned $195,274 $142,324 $141,884
Net investment income 26,015 23,937 24,558
Net realized investment gains 4,467 1,853 2,982
-------- -------- --------
Consolidated revenue 225,756 168,114 169,424
-------- -------- --------
Losses and settlement expenses 96,457 64,728 61,251
Policy acquisition costs 66,552 44,281 43,140
Insurance operating expenses 15,130 16,526 18,742
Interest expense on debt 4,104 2,280 1,548
General corporate expenses 2,091 3,915 4,172
-------- -------- --------
Total expenses 184,334 131,730 128,853
-------- -------- --------
Equity in earnings of unconsolidated investee 1,613 1,337 951
-------- -------- --------
Earnings before income taxes 43,035 37,721 41,522
-------- -------- --------
Income tax expense (benefit):
Current 13,659 10,065 11,698
Deferred (2,075) (583) (347)
-------- -------- --------
Income tax expense 11,584 9,482 11,351
-------- -------- --------
Net earnings $ 31,451 $ 28,239 $ 30,171
======== ======== ========
Other comprehensive earnings (loss), net of tax
Unrealized gains (losses) on securities:
Unrealized holding gains (losses)
arising during the period $ (7,689) $24,259 $37,682
Less: Reclassification adjustment for gains
included in net earnings (2,882) (740) (1,438)
-------- -------- --------
Other comprehensive earnings (loss) (10,571) 23,519 36,244
-------- -------- --------
Comprehensive earnings $ 20,880 $ 51,758 $ 66,415
======== ======== ========
28
Earnings per share:
Basic
Net earnings per share from operations $2.82 $2.58 $2.71
Realized gains, net of tax 0.29 0.11 0.19
-------- -------- --------
Basic net earnings per share $3.11 $2.69 $2.90
======== ======== ========
Basic comprehensive earnings per share $2.06 $4.92 $6.38
======== ======== ========
Diluted
Net earnings per share from operations $2.79 $2.54 $2.50
Realized gains, net of tax 0.29 0.11 0.16
-------- -------- --------
Diluted net earnings per share $3.08 $2.65 $2.66
======== ======== ========
Diluted comprehensive earnings per share $2.04 $4.87 $5.76
======== ======== ========
Weighted average number of common shares outstanding:
Basic 10,124 10,514 10,402
-------- -------- --------
Diluted 10,222 10,638 11,714
-------- -------- --------
The accompanying notes are an integral part of the
consolidated financial statements.
29
Consolidated Statements of Shareholders' Equity
RLI Corp. and Subsidiaries
Accumulated
Other Total
Compre- Deferred Unearned Treasury Share-
(in thousands, Common Paid-in hensive Retained Compen- ESOP Stock holders'
except per share data) Stock Capital Earnings Earnings sation shares at Cost Equity
Balance, January 1, 1997 $ 8,453 $31,692 $ 50,609 $115,164 $ (5,879) $200,039
Net earnings 30,171 30,171
Other comprehensive
earnings, net of tax 36,244 36,244
Net change from conversion
of convertible debentures 1,769 43,485 45,254
Treasury shares purchased
(1,204,625 shares) (39,670) (39,670)
Shares issued from exercise
of stock options 8 154 162
Other capital items, including
CatEPuts amortization (745) (745)
Dividends declared
($.47 per share) (4,903) (4,903)
- ------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 $10,230 $74,586 $ 86,853 $140,432 $(45,549) $266,552
Net earnings 28,239 28,239
Other comprehensive
earnings, net of tax 23,519 23,519
Treasury shares purchased
(390,464 shares) (15,570) (15,570)
5-for-4 stock split 2,558 (2,574) (16)
Adjustment to accounting for
deferred compensation plans 3,461 (3,461) 0
Shares issued from exercise
of stock options 2 60 62
Other capital items, including
CatEPuts amortization (979) (979)
Unearned ESOP shares
purchased (2,501) (2,501)
Dividends declared
($.51 per share) (5,347) (5,347)
- ------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 $12,790 $71,093 $110,372 $163,324 $3,461 $(2,501) $(64,580) $293,959
30
Net earnings 31,451 31,451
Other comprehensive
earnings, net of tax (10,571) (10,571)
Treasury shares purchased
(546,476 shares) (18,198) (18,198)
Adjustment to accounting for
deferred compensation plans 1,244 (1,244) 0
Shares issued from exercise
of stock options 14 288 302
Other capital items, including
CatEPuts amortization (850) (850)
Unearned ESOP shares
purchased 2,501 2,501
Dividends declared
($.55 per share) (5,525) (5,525)
- ------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1999 $12,804 $70,531 $99,801 $189,250 $4,705 $0 $(84,022) $293,069
- ------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the
consolidated financial statements.
31
Consolidated Statements of Cash Flows
RLI Corp. and Subsidiaries
Years ended December 31,
---------------------------
(in thousands) 1999 1998 1997
Cash Flows from Operating Activities
Net earnings $31,451 $28,239 $30,171
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Net realized investment (gains) (4,467) (1,853) (2,982)
Depreciation 2,663 2,070 2,290
Other items, net (4,643) (4,525) (327)
Change in:
Accrued investment income (340) (109) (512)
Premiums and reinsurance balances receivable
(net of direct write-offs and commutations) (5,789) (9,949) 7,470
Reinsurance balances payable 5,678 7,771 691
Ceded unearned premium 17,935 (10,103) 4,028
Reinsurance balances recoverable on unpaid losses 8,704 (12,550) 2,284
Deferred policy acquisition costs (10,243) (526) (5,321)
Unpaid losses and settlement expenses 6,134 11,260 (1,538)
Unearned premiums 14,414 13,480 (1,239)
Income taxes:
Current 313 (578) 567
Deferred (2,075) (583) (347)
Changes in investment in unconsolidated investee:
Undistributed earnings (1,613) (1,337) (951)
Dividends received -- 1,495 --
Net proceeds from trading portfolio activity 239 1,376 738
-------- -------- --------
Net cash provided by operating activities 58,361 23,578 35,022
-------- -------- --------
32
Cash Flows from Investing Activities
Purchase of:
Fixed maturities, held-to-maturity (49,750) (29,793) (56,645)
Fixed maturities, available-for-sale (15,651) (8,898) (8,890)
Equity securities, available-for-sale (15,873) (15,790) (10,609)
Short-term investments, net (13,359) (7,799) --
Property and equipment (5,710) (2,529) (2,745)
Unconsolidated investee ownership interest -- -- (3,694)
Interest in Underwriters Indemnity Holdings (40,700) -- --
Issuance of note receivable (10,000) -- --
Proceeds from sale of:
Fixed maturities, available-for-sale 11,111 772 8,386
Equity securities, available-for-sale 18,671 8,207 5,780
Short-term investments, net -- -- 22,127
Property and equipment 276 646 195
Proceeds from call or maturity of:
Fixed maturities, held-to-maturity 38,560 34,596 29,083
Fixed maturities, available-for-sale 9,836 5,511 1,304
-------- -------- --------
Net cash used in investing activities (72,589) (15,077) (15,708)
-------- -------- --------
Cash Flows from Financing Activities
Proceeds from issuance of debt 35,189 14,744 24,900
Fractional shares paid -- (16) (1)
Shares issued under stock option plan 302 62 162
Unearned ESOP shares 2,501 (2,501) --
Treasury shares purchased (18,198) (15,570) (39,670)
Cash dividends paid (5,566) (5,220) (4,705)
-------- -------- --------
Net cash provided by (used in) financing activities 14,228 (8,501) (19,314)
-------- -------- --------
Net decrease in cash 0 0 0
Cash at beginning of year 0 0 0
-------- -------- --------
Cash at end of year $ 0 $ 0 $ 0
======== ======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
33
1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A. DESCRIPTION OF BUSINESS: RLI Corp. is a holding company that, through
its subsidiaries, underwrites selected property and casualty insurance products.
The property and casualty insurance segment, RLI Insurance Group (the
Group), is composed of four insurance companies. RLI Insurance Company, the
principal subsidiary, writes multiple lines of insurance on an admitted basis in
all 50 states, the District of Columbia and Puerto Rico. Mt. Hawley Insurance
Company, a subsidiary of RLI Insurance Company, writes surplus lines insurance
in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and
Guam. Underwriters Indemnity Company (UIC), a subsidiary of RLI Insurance
Company, writes multiple lines of insurance on an admitted basis in 23 states
and the District of Columbia. UIC writes surplus lines insurance in an
additional 12 states. Planet Indemnity Company (PIC), a subsidiary of UIC,
writes multiple lines of insurance on an admitted basis in seven states. PIC
writes surplus lines insurance in an additional 16 states and the District of
Columbia.
B. PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION: The accompanying
consolidated financial statements were prepared in conformity with generally
accepted accounting principles (GAAP), which differ in some respects from those
followed in reports to insurance regulatory authorities. The consolidated
financial statements include the accounts of RLI Corp. and its subsidiaries (the
Company). All significant intercompany balances and transactions have been
eliminated. Certain reclassifications were made to the prior years' financial
statements to conform with the classifications used in 1999.
In January 1999, RLI Insurance Company acquired Underwriters Indemnity
Holdings, Inc. (UIH), located in Houston, Texas. UIH specializes in the
marketing and underwriting of surety products for oil, gas, mining and other
energy-related exposures.
RLI paid $40.7 million in cash in exchange for all outstanding shares of
UIH. Included in the transaction were both of UIH's insurance operating
subsidiaries, Underwriters Indemnity Company and Planet Indemnity Company.
The transaction was financed through short-term borrowings and has been
accounted for under the purchase method of accounting. See note 11 for
further discussion and related disclosures.
In January 1997, the Company paid $3.7 million for an additional 10%
ownership interest in Maui Jim, Inc., bringing the Company's total minority
interest in Maui Jim, Inc. to 44%.
C. INVESTMENTS: In compliance with FASB Statement No. 115, "Accounting
for Certain Investments in Debt and Equity Securities," the Company
classifies its investments in all debt securities and those equity securities
with readily determinable fair values into one of three categories:
held-to-maturity, trading, or available-for-sale.
HELD-TO-MATURITY SECURITIES
Debt securities that the Company has 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. The Company has
classified approximately 86% of its portfolio of debt securities 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. The Company has classified approximately
2% of its portfolio of debt securities as trading.
AVAILABLE-FOR-SALE SECURITIES
All other debt and equity securities not included in the above categories are
classified as available-for-sale and reported at fair value. 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 the Company's equity securities
and approximately 12% of debt securities are classified as available-for-sale.
Short-term investments are carried at cost, which approximates fair value.
The Company continuously monitors the values of its investments in
fixed maturities and equity securities. If this review shows that a decline
in fair value is other than temporary, the Company's carrying value in the
investment is reduced to its estimated realizable value through an adjustment
to earnings. Realized gains and losses on disposition of investments are
based on specific identification of the investments sold.
Interest on fixed maturities and short-term investments is credited to
earnings as it accrues. Dividends on equity securities are credited to
earnings on the ex-dividend date.
D. REINSURANCE: Ceded unearned premiums and reinsurance balances
recoverable on unpaid losses and settlement expenses are reported separately
as assets, instead of being netted with the appropriate liabilities, since
reinsurance does not relieve the Company of its legal liability to its
policyholders.
34
The Company continuously monitors the financial condition of its
reinsurers. The Company's policy is to periodically charge to earnings an
estimate of unrecoverable amounts from troubled or insolvent reinsurers. No
charges occurred in 1997, 1998 or 1999. The Company believes that current
reserve levels for uncollectible reinsurance are sufficient to cover the
related exposure.
E. UNPAID LOSSES AND SETTLEMENT EXPENSES: The liability for unpaid
losses and settlement expenses represents estimates of amounts needed to pay
reported and unreported claims and related expenses. The estimates are based
on certain actuarial and other assumptions related to the ultimate cost to
settle such claims. Such assumptions are subject to occasional changes due to
evolving economic, social and political conditions. All estimates are
periodically reviewed and, as experience develops and new information becomes
known, the reserves are adjusted as necessary. Such adjustments are reflected
in the results of operations in the period in which they are determined. Due
to the inherent uncertainty in estimating reserves for losses and settlement
expenses, there can be no assurance that the ultimate liability will not
exceed recorded amounts, with a resulting adverse effect on the Company.
Based on the current assumptions used in calculating reserves, management
believes that the Company's overall reserve levels at December 31, 1999, are
adequate to meet its future obligations.
F. REVENUE RECOGNITION: Insurance premiums are recognized ratably over
the term of the contracts, net of ceded reinsurance. Unearned premiums are
calculated on the monthly pro rata basis.
G. POLICY ACQUISITION COSTS: The costs of acquiring insurance premiums
- -- principally commissions and brokerage, sales compensation, premium taxes,
and other direct underwriting expenses -- net of reinsurance commissions
received, are amortized over the life of the policies in order to properly
match policy acquisition costs to the related premium revenue. The method
followed in computing deferred policy acquisition costs limits the amount of
such deferred costs to their estimated realizable value, which gives effect
to the premium to be earned, related investment income, losses and settlement
expenses and certain other costs expected to be incurred as the premium is
earned.
H. PROPERTY AND EQUIPMENT: Property and equipment are depreciated on a
straight-line basis for financial statement purposes over periods ranging from
three to 10 years for equipment and up to 40 years for buildings and
improvements.
I. INTANGIBLE ASSETS: Goodwill is amortized on a straight-line basis for
financial statement purposes over periods ranging from 10 to 20 years.
J. INCOME TAXES: The Company files a consolidated income tax return. Tax
provisions are computed and apportioned to the subsidiaries on the basis of
their taxable income.
K. EARNINGS PER SHARE: Pursuant to disclosure requirements contained in
FASB Statement 128, the following represents a reconciliation of the numerator
and denominator of the basic and diluted EPS computations contained in the
financial statements. Conversion of the Company's $46.0 million convertible
debenture occurred in July 1997. See note 4 for further discussion and related
disclosures.
Income Shares Per Share
(in thousands, except per share data) (Numerator) (Denominator) Amount
FOR THE YEAR ENDED DECEMBER 31, 1999
BASIC EPS
Income available to
common shareholders 31,451 10,124 3.11
Incentive stock options -- 98
DILUTED EPS
Income available to common share-
holders and assumed conversions 31,451 10,222 3.08
For the year ended December 31, 1998
BASIC EPS
Income available to
common shareholders 28,239 10,514 2.69
Incentive stock options -- 124
DILUTED EPS
Income available to common share-
holders and assumed conversions 28,239 10,638 2.65
For the year ended December 31, 1997
BASIC EPS
Income available to
common shareholders 30,171 10,402 2.90
EFFECT OF DILUTIVE SECURITIES
Convertible debentures 1,012 1,230
Incentive stock options -- 82
DILUTED EPS
Income available to common share-
holders and assumed conversions 31,183 11,714 2.66
L. COMPREHENSIVE EARNINGS: FASB Statement No. 130, "Reporting
Comprehensive Income," was adopted by the Company in 1997. The primary
difference between reporting the Company's net and comprehensive earnings is
that comprehensive earnings include unrealized gains/losses net of tax.
Traditional reporting of net earnings directly credits or charges
shareholders' equity with unrealized gains/losses, rather than including them
in earnings. In reporting the components of comprehensive earnings on a net
basis in the income statement, the Company has used a 35% tax rate.
35
Other comprehensive income (loss), as shown, is net of tax expense (benefit)
of ($5.7 million), $12.7 million, and $19.5 million, respectively, for 1999,
1998, and 1997.
M. FAIR VALUE DISCLOSURES: The following methods were used to estimate the
fair value of each class of financial instruments for which it was practicable
to estimate that value. Fixed maturities and equity securities are valued using
quoted market prices, if available. If a quoted market price is not available,
fair value is estimated using independent pricing services or quoted market
prices of similar securities. Fair value disclosures for investments are
included in note 2. Due to the relatively short-term nature of cash, short-term
investments, accounts receivable, accounts payable and short-term debt, their
carrying amounts are reasonable estimates of fair value. Fair value of long-term
debt is based on quoted market prices if available or quoted market prices of
similar issues.
N. STOCK BASED COMPENSATION: The Company grants to officers and directors
stock options for shares with an exercise price equal to the fair market value
of the shares at the date of grant. The Company accounts for stock option grants
in accordance with APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and accordingly recognizes no compensation expense for the stock
option grants. See note 8 for further discussion and related disclosures.
O. RISKS AND UNCERTAINTIES: Certain risks and uncertainties are inherent
to the Company's day-to-day operations and to the process of preparing its
financial statements. The more significant risks and uncertainties, as well
as the Company's methods for mitigating, quantifying, and minimizing such,
are presented below and throughout the notes to the consolidated financial
statements.
CATASTROPHE EXPOSURES
The Company's past and present insurance coverages include exposure to
catastrophic events. Catastrophic events such as earthquakes, floods, and
windstorms are covered by certain of the Company's property policies. The
Company has a concentration of such coverages in California (51.6% of gross
property premiums written during 1999). Using computer-assisted modeling
techniques, the Company quantifies and monitors its exposure to catastrophic
events. The Company limits its risk to such catastrophes through the purchase of
reinsurance. Utilizing the above, the Company attempts to limit its net
aggregate exposure to a single catastrophic event to less than 10% of
shareholders' equity.
ENVIRONMENTAL EXPOSURES
The Company is subject to environmental claims and exposures through its
commercial umbrella, general liability and discontinued assumed reinsurance
lines of business. Although exposure to environmental claims exists in these
lines of business, management has sought to mitigate or control the extent of
this exposure through the following methods: 1) the Company's policies include
pollution exclusions that have been continually updated to further strengthen
the exclusion; 2) the Company's policies primarily cover moderate hazard risks;
and 3) the Company began writing this business after the industry became aware
of the potential pollution liability exposure.
The Company has made loss and settlement expense payments on environmental
liability claims and has loss and settlement expense reserves for others. The
Company includes this historical environmental loss experience with the
remaining loss experience in the applicable line of business to project ultimate
incurred losses and settlement expenses and related "incurred but not reported"
loss and settlement expense reserves.
Although historical experience on environmental claims may not
accurately reflect future environmental exposures, the Company has 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 the Company from its primary liability to
policyholders, and to the extent that a reinsurer is unable to meet its
obligations, the Company would be liable. The Company continuously monitors the
financial condition of prospective and existing reinsurers. As a result, the
Company currently attempts to purchase reinsurance from a limited number of
financially strong reinsurers. The Company provides a reserve for reinsurance
balances deemed uncollectible.
FINANCIAL STATEMENTS
The preparation of the consolidated financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the reported
financial statement balances as well as the disclosure of contingent assets and
liabilities. Actual results could differ from those estimates. The most
significant of these amounts is the liability for unpaid losses and settlement
expenses. Management continually updates its estimates as additional data
becomes available and adjusts the financial statements as deemed necessary.
Other estimates such as the recoverability of reinsurance balances, deferred tax
assets and deferred policy acquisition costs are regularly monitored, evaluated,
and adjusted. Although recorded estimates are supported by actuarial
computations
36
and other supportive data, the estimates are ultimately based on management's
expectations of future events.
EXTERNAL FACTORS
The Company's 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 products. The Company is also subject to insolvency and
guarantee fund assessments for various programs designed to ensure policyholder
indemnification. The Company generally accrues the full amount of the assessment
upon notification.
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. The Company regularly
monitors its subsidiaries' internal capital requirements and the NAIC's RBC
developments. The Company has determined that its capital levels are well in
excess of the minimum capital requirements for all RBC action levels, and that
its capital levels are sufficient to support the level of risk inherent in its
operations.
2 INVESTMENTS
A summary of net investment income is as follows:
Investment Income (in thousands) 1999 1998 1997
Interest on fixed maturities $19,837 $19,479 $19,659
Dividends on equity securities 7,120 6,718 6,361
Interest on short-term investments 2,318 1,296 1,531
Gross investment income 29,275 27,493 27,551
Less investment expenses 3,260 3,556 2,993
Net investment income $26,015 $23,937 $24,558
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) 1999 1998 1997
Net realized investment gains (losses)
Fixed maturities
Held-to-maturity $ 7 $ 34 $ 27
Trading (446) 179 117
Available-for-sale (494) (9) 175
Equity securities 4,928 1,148 2,037
Other 472 501 626
4,467 1,853 2,982
Net changes in unrealized gains
(losses) on investments
Fixed maturities
Held-to-maturity (14,533) 3,779 4,030
Available-for-sale (945) (147) 100
Equity securities (15,318) 36,330 55,660
(30,796) 39,962 59,790
Net realized investment gains and
changes in unrealized gains
(losses) on investments $(26,329) $41,815 $62,772
Following is a summary of the disposition of fixed maturities for the
years ended December 31, with separate presentations for sales and
calls/maturities.
SALES Proceeds Gross Realized Net Realized
(in thousands) From Sales Gains Losses Gain (Loss)
1999 -- Available-for-sale $10,210 $188 $(829) $(641)
Trading 4,222 15 (34) (19)
1998 -- Available-for-sale 772 -- -- --
Trading 9,358 131 (17) 114
1997 -- Available-for-sale 8,386 259 (84) 175
Trading 4,354 16 (25) (9)
CALLS/MATURITIES Proceeds Gross Realized Net Realized
(in thousands) From Sales Gains Losses Gain (Loss)
1999 -- Held-to-maturity $48,560 $ 7 -- $ 7
Available-for-sale 12,537 151 $ (4) 147
Trading 257 -- -- --
1998 -- Held-to-maturity 34,596 46 (12) 34
Available-for-sale 5,511 1 (10) (9)
Trading 70 -- -- --
1997 -- Held-to-maturity 29,083 48 (20) 28
Available-for-sale 1,304 -- -- --
Trading 55 -- -- --
37
The following is a schedule of amortized costs and estimated fair values
of investments in fixed maturities and equity securities as of December 31, 1999
and 1998.
Amortized Estimated Gross Unrealized
(in thousands) Cost Fair Value Gains Losses
1999
Held-to-maturity
U.S. government $121,788 $120,074 $ 115 $(1,829)
States, political subdi-
visions & revenues 172,411 170,145 511 (2,777)
Total held-to-maturity $294,199 $290,219 $ 626 $(4,606)
Trading
U.S. government $ 4,240 $ 4,081 $ 2 $ (161)
Corporate 3,447 3,370 -- (77)
States, political subdi-
visions & revenues 200 200 -- --
Total trading $ 7,887 $ 7,651 $ 2 $ (238)
Available-for-sale
U.S. government $ 25,472 $ 25,153 $ 8 $ (327)
States, political subdi-
visions & revenues 15,805 15,510 24 (319)
Fixed maturities 41,277 40,663 32 (646)
Equity securities 130,808 284,639 157,761 (3,930)
Total available-for-sale $172,085 $325,302 $157,793 $(4,576)
Total $474,171 $623,172 $158,421 $(9,420)
1998
Held-to-maturity
U.S. government $124,419 $128,814 $4,395 --
States, political subdi-
visions & revenues 159,573 165,730 6,173 (16)
Total held-to-maturity $283,992 $294,544 $ 10,568 $ (16)
Trading
U.S. government $ 3,652 $ 3,726 $ 80 $ (6)
Corporate 4,103 4,216 113 --
States, political subdi-
visions & revenues 402 406 4 --
Total trading $ 8,157 $ 8,348 $ 197 $ (6)
Available-for-sale
U.S. government $ 15,177 $ 15,528 $ 351 --
Corporate 9,150 8,893 255 (512)
States, political subdi-
visions & revenues 11,858 12,095 241 (4)
Fixed maturities 36,185 36,516 847 (516)
Equity securities 127,367 296,521 170,357 (1,203)
Total available-for-sale $163,552 $333,037 $171,204 $(1,719)
Total $455,701 $635,929 $181,969 $(1,741)
The amortized cost and estimated fair value of fixed-maturity securities
at December 31, 1999, by contractual maturity, are shown as follows.
Amortized Estimated
(in thousands) Cost Fair Value
Held-to-maturity
Due in one year or less $ 26,410 $ 26,580
Due after one year through five years 86,690 85,808
Due after five years through ten years 128,188 126,726
Due after ten years 52,911 51,105
$294,199 $290,219
Trading
Due in one year or less $ 500 $ 500
Due after one year through five years 3,321 3,277
Due after five years through ten years 2,889 2,740
Due after ten years 1,177 1,134
$ 7,887 $ 7,651
Available-for-sale
Due in one year or less $ 7,833 $ 7,839
Due after one year through five years 24,977 24,588
Due after five years through ten years 6,206 6,102
Due after ten years 2,261 2,134
$ 41,277 $ 40,663
Expected maturities may differ from contractual maturities due to call
provisions present on some existing securities. Management believes the impact
of any calls should be slight and intends to follow its policy of matching
assets against anticipated liabilities.
At December 31, 1999, the net unrealized appreciation of
available-for-sale fixed maturities and equity securities totaled $99.8
million. This amount was net of deferred taxes of $53.4 million. At December
31, 1998, the net unrealized appreciation of available-for-sale fixed
maturities and equity securities totaled $110.4 million. This amount is net
of deferred taxes of $59.1 million.
The Company is party to a securities lending program where-by
fixed-income securities are loaned to third parties, primarily major
brokerage firms. As of December 31, 1999 and 1998, fixed maturities with a
fair value of $13.1 million and $25.1 million, respectively, were loaned.
Agreements with custodian banks facilitating such lending generally require
102% of the value of the loaned securities to be separately maintained as
collateral for each loan. Pursuant to FASB Statements 125 and 127, an
invested asset and a corresponding liability have been recognized for this
collateral amount. To further minimize the credit risks related to this
lending program, the Company monitors the financial condition of counter
parties to these agreements.
38
As required by law, certain fixed maturities and short-term investments
amounting to $20.6 million at December 31, 1999, were on deposit with either
regulatory authorities or banks. Additionally, the Company has certain fixed
maturities held in trust amounting to $7.7 million at December 31, 1999.
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) 1999 1998 1997
Deferred policy acquisition costs,
beginning of year $22,510 $21,985 $16,664
Deferred policy acquisition costs,
UIH, Inc. - Acquisition Date 1,604
Deferred:
Direct commissions 64,312 55,035 57,034
Premium taxes 5,982 4,489 4,382
Other direct underwriting expenses 26,340 20,335 16,340
Ceding commissions (20,450) (33,644) (27,812)
Net deferred 76,184 46,215 49,944
Amortized 65,940 45,690 44,623
Deferred policy acquisition costs,
end of year $34,358 $22,510 $21,985
Policy acquisition costs:
Amortized to expense 65,940 45,690 44,623
Period costs:
Ceding commission-D contingent (3,159) (6,604) (4,400)
Other 3,771 5,195 2,917
Total policy acquisition costs $66,552 $44,281 $43,140
4 DEBT
On July 28, 1993, the Company issued $46.0 million of 6.0% convertible
debentures that were to mature July 15, 2003, and pay interest semiannually. On
June 20, 1997, the Company announced that it was calling for redemption all
convertible debentures. The entire issue was redeemed for cash on July 22, 1997,
at 103% of its principal amount, plus accrued interest. Holders of the debenture
had the option to convert, at any time prior to the close of business on July
21, 1997, the debentures at an exchange rate of 48.0769 shares of RLI common
stock for each $1,000 principal amount of convertible debt. On July 22, 1997,
the entire $46.0 million was converted into RLI common stock. This conversion
created an additional 2,211,499 new shares of RLI common stock.
The Company continued the use of short-term credit facilities through
reverse repurchase transactions. During 1999, the Company borrowed $42.8 million
in reverse repurchase agreements, in part, to finance the January acquisition of
Underwriters Indemnity Holdings.
Interest paid on outstanding debt for 1999, 1998, and 1997, amounted to
$3.5 million, $2.3 million, and $2.8 million, respectively.
The Company maintains a $30.0 million revolving line of credit from one
financial institution. The facility has a three-year term that expires on
December 31, 2001. As of December 31, 1999, the Company had $19.6 million in
outstanding debt from this facility. The weighted-average interest rate on this
line of credit was 5.98% for 1999. Additionally, the Company was party to five
reverse repurchase transactions totaling $58.8 million.
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 effected under reinsurance contracts known as treaties and, in
some instances, by negotiation on each individual risk. In addition, there
are excess of loss and catastrophe reinsurance contracts that protect against
losses over stipulated amounts arising from any one occurrence or event. The
arrangements provide greater diversification of business and serve to limit
the maximum net loss on catastrophes and large and unusually hazardous risks.
Through the purchase of reinsurance, the Company generally limits the
loss on any individual risk to $700,000. Additionally, through extensive use
of computer-assisted modeling techniques, the Company monitors the
concentration of risks exposed to catastrophic events (predominantly
earthquakes). The Company seeks to limit its estimated net aggregate exposure
to a single catastrophic event to less than 10% of shareholders' equity.
In 1996, the Company entered into an innovative catastrophe reinsurance
and loss financing program with Zurich Reinsurance NA (Zurich Re). The
program, called Catastrophe Equity Puts (CatEPuts), augments the Company's
traditional reinsurance by integrating its loss financing needs with a
pre-negotiated sale of securities linked to exchange-traded shares. CatEPuts
allows the
39
Company to put up to $50.0 million of its convertible preferred
shares to Zurich Re at a pre-negotiated rate in the event of a catastrophic
loss, provided the loss does not reduce GAAP equity to less than $55.0
million. CatEPuts began as a multi-year program and is designed to enable the
Company to continue operating after a loss of such magnitude that its
reinsurance capacity is exhausted. If the Company exercises its option to put
preferred shares to Zurich Re, then Zurich Re, in turn, has the option to
reinsure certain business written by the Company on a prospective basis. This
agreement is scheduled for renewal at July 1, 2000.
Premiums written and earned along with losses and settlement expenses
incurred for the years ended December 31 are summarized as follows:
(in thousands) 1999 1998 1997
WRITTEN
Direct $332,275 $288,135 $265,850
Reinsurance assumed 7,300 2,938 12,993
Reinsurance ceded (111,951) (145,372) (134,170)
Net $227,624 $145,701 $144,673
EARNED
Direct $314,111 $274,996 $268,569
Reinsurance assumed 11,049 2,597 11,513
Reinsurance ceded (129,886) (135,269) (138,198)
Net $195,274 $142,324 $141,884
LOSSES AND SETTLEMENT
EXPENSES INCURRED
Direct $189,394 $112,325 $ 96,379
Reinsurance assumed 3,299 6,887 5,960
Reinsurance ceded (96,236) (54,484) (41,088)
Net $ 96,457 $ 64,728 $ 61,251
At December 31, 1999, the Company had prepaid reinsurance premiums and
reinsurance recoverables on paid and unpaid losses and settlement expenses with
American Re-Insurance Company and with Transatlantic Reinsurance Company (both
rated A++ "Superior" by A.M. Best Company) that amounted to $66.3 million and
$31.0 million, respectively. All other reinsurance balances recoverable, when
considered by individual reinsurer, are less than 10% of shareholders' equity.
6 UNPAID LOSSES AND SETTLEMENT EXPENSES
The following table reconciles the Company's liability for unpaid
losses and settlement expenses (LAE) for the three years ended December 31,
1999. Since reserves are based on estimates, the ultimate net cost may vary
from the original estimate. As adjustments to these estimates become
necessary, they are reflected in current operations. As part of the reserving
process, historical data is reviewed and consideration is given to the
anticipated impact of various factors such as legal developments and economic
conditions, including the effects of inflation. Changes in reserves from the
prior years' estimates are calculated based on experience as of the end of
each succeeding year (loss and LAE development).
(in thousands) 1999 1998 1997
Unpaid losses and LAE
at beginning of year:
Gross $415,523 $404,263 $405,801
Ceded (168,261) (155,711) (157,995)
Net 247,262 248,552 247,806
Unpaid losses and LAE
UIH, Inc.-DAcquisition Date:
Gross 74,979
Ceded (67,642)
Net 7,337
Increase (decrease) in incurred
losses and LAE:
Current accident year 101,053 68,131 61,771
Prior accident years (4,596) (3,403) (520)
Total incurred 96,457 64,728 61,251
Loss and LAE payments for
claims incurred:
Current accident year (21,675) (14,762) (11,284)
Prior accident years (53,892) (54,927) (49,023)
Total paid (75,567) (69,689) (60,307)
Insolvent reinsurer charge off (1,000) 7,911 (627)
Loss reserves commuted 425 (4,240) 429
Net unpaid losses and LAE
at end of year $274,914 $247,262 $248,552
Unpaid losses and LAE
at end of year:
Gross 520,494 15,523 404,263
Ceded (245,580) (168,261) (155,711)
Net $274,914 $247,262 $248,552
40
During the three years, overall development on prior accident-year loss
and settlement expense reserves was insignificant to recorded loss and
settlement expense reserves.
The Company is subject to environmental claims and exposures through its
commercial umbrella, general liability, and discontinued assumed reinsurance
lines of business. Within these lines, the Company's environmental exposures
include environmental site cleanup, asbestos removal, and mass tort liability.
The majority of the exposure is in the excess layers of the Company's commercial
umbrella and assumed reinsurance books of business.
The following table represents inception-to-date paid and unpaid
environmental claims data (including incurred but not reported losses) for the
periods ended 1999, 1998 and 1997:
Inception-to-date December 31,
(in thousands) 1999 1998 1997
Loss and LAE payments for
claims incurred
Gross $22,565 $15,269 $11,570
Ceded (13,671) (9,354) (7,646)
Net 8,894 $ 5,915 $ 3,924
Unpaid losses and LAE at end of year
Gross $16,125 $18,226 $14,880
Ceded (8,566) (9,391) (8,842)
Net $ 7,559 $ 8,835 $ 6,038
Although the Company's environmental exposure is limited as a result of
entering liability lines after the industry had already recognized it as a
problem, management cannot determine the Company's ultimate liability with
any reasonable degree of certainty. This ultimate liability is difficult to
assess due to evolving legislation on such issues as joint and several
liability, retroactive liability, and standards of cleanup. Additionally, the
Company participates primarily in the excess layers, making it even more
difficult to assess the ultimate impact.
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
in the following table.
(in thousands) 1999 1998 1997
Deferred tax assets:
Tax discounting of claim reserves $ 16,989 $ 15,388 $ 14,775
Unearned premium offset 8,285 5,757 5,521
Other, net 1,772 2,551 3,016
27,046 23,696 23,312
Less valuation allowance (300) (300) (300)
Total deferred tax assets $ 26,746 $ 23,396 $ 23,012
Deferred tax liabilities:
Net unrealized appreciation
of securities $ 53,421 $ 59,113 $ 46,448
Deferred policy acquisition costs 12,025 7,879 7,695
Book/tax depreciation 1,298 1,328 1,606
Other, net 1,664 3,497 3,603
Total deferred tax liabilities 68,408 71,817 59,352
Net deferred tax asset (liability) $(41,662) $(48,421) $(36,340)
Management feels it is more likely than not that a portion of the
Company's deferred tax assets will not be realized. Therefore, an allowance has
been established for certain deferred tax assets that have an indefinite
reversal pattern. Management also believes the Company's remaining deferred tax
assets will be fully realized through deductions against future taxable income.
Income tax expense attributable to income from operations for the years
ended December 31, 1999, 1998, and 1997, differed from the amounts computed by
applying the U.S. federal tax rate of 35% to pretax income from continuing
operations as demonstrated in the following table.
(in thousands) 1999 1998 1997
Provision for income taxes at
the statutory federal tax rates $15,062 $13,202 $14,533
Increase (reduction) in taxes
resulting from:
Dividends received deduction (1,492) (1,409) (1,322)
ESOP dividends paid deduction (245) (231) (236)
Tax exempt interest income (2,576) (2,271) (1,876)
Goodwill 513 -- --
State income tax provision 164 170 160
Other items, net 158 21 92
$11,584 $ 9,482 $11,351
41
The Company has recorded its deferred tax assets and liabilities using the
statutory federal tax rate of 35%. Management believes when these deferred items
reverse in future years, the Company's taxable income will be taxed at an
effective rate of 35%.
Net federal and state income taxes paid in 1999, 1998, and 1997, amounted
to $13.3 million, $10.6 million, and $11.1 million, respectively.
The Internal Revenue Service (IRS) has examined the Company's income
tax returns through the tax year ended December 31, 1994. The IRS is not
currently examining any of the Company's income tax returns.
8 EMPLOYEE BENEFITS
PENSION PLAN
The Company maintains a noncontributory defined benefit pension plan
covering substantially all employees meeting age and service requirements. The
plan provides a benefit based on a participant's service and the highest five
consecutive years' average compensation out of the last 10 years. The Company
funds pension costs as accrued, except that in no case will the Company
contribute amounts less than the minimum contribution required under the
Employee Retirement Income Security Act of 1974 or more than the maximum tax
deductible contribution for the year. The plan reached the full funding
limitation in 1986 and remained fully funded through 1993. During 1999, 1998,
and 1997, the Company made the maximum tax deductible contribution allowed,
totaling $448,695, $422,489, and $453,146, respectively, to adequately meet the
funding requirements of the plan.
The Company has made various amendments to the plan in order to comply
with certain Internal Revenue Code changes.
The financial status of the plan for each of the three years ended
December 31 is illustrated in the following tables:
For the year ended December 31,
1999 1998 1997
Components of pension cost
Service cost $672,939 $ 530,886 $ 414,301
Interest cost 373,514 336,573 291,324
Expected return on plan assets (489,319) (427,320) (354,166)
Recognized prior service cost 3,051 3,051 3,051
Recognized net loss -- -- 1,353
Amortization of transition
(asset) obligation (32,566) (32,566) (32,566)
Pension cost $527,619 $ 410,624 $ 323,297
Accumulated benefit obligation $3,593,215 $3,854,111 $3,222,460
For the year ended December 31,
1999 1998 1997
Change in plan assets
Fair value of plan assets
at January 1 $ 4,716,875 $4,157,321 $3,328,525
Actual return on plan assets (147,904) 600,966 852,855
Employer contribution 448,695 422,489 453,146
Benefit payments (487,801) (463,901) (477,205)
Fair value of plan assets
at December 31 $ 4,529,865 $ 4,716,875 $4,157,321
Change in projected
benefit obligation
Projected benefit obligation
at January 1 $ 5,337,974 $ 4,416,028 $4,039,460
Service cost 672,939 530,886 414,301
Interest cost 373,514 336,573 291,324
Actuarial (gains) losses (994,808) 518,388 148,148
Benefit payments (487,801) (463,901) (477,205)
Projected benefit obligation
at December 31 $ 4,901,818 $ 5,337,974 $4,416,028
Funded status $ (371,953) $ (621,099) $ (258,707)
Unrecognized net loss 100,806 458,391 113,649
Unamortized prior service cost 163 3,214 6,265
Unrecognized transition
(asset) obligation (136,781) (169,347) (201,913)
(Accrued) prepaid at
December 31 $ (407,765) $ (328,841) $ (340,706)
Amounts recognized in the statement of
financial position consist of:
Accrued benefit liability $ (407,765) $ (328,841) $ (340,706)
Net amount recognized $ (407,765) $ (328,841) $ (340,706)
Rates
Discount rate 8.00% 7.00% 7.25%
Compensation increase 6.00% 6.00% 6.00%
Expected return on
plan assets 10.00% 10.00% 10.00%
At December 31, 1999, plan assets at fair value are comprised of
approximately 93% equity securities and 7% invested cash.
EMPLOYEE STOCK OWNERSHIP AND BONUS AND INCENTIVE PLANS
The Company has an Employee Stock Ownership Plan (ESOP) and executive
performance incentive plans. The Company evaluates the funding of the latter
plans through Market Value Potential (MVP), which ensures that the interests
of the Company's executives correspond with those of our shareholders.
42
MVP requires that the Company generate a return on equity in excess of its
cost of capital before the payment of bonuses. Under MVP, funds in excess of the
cost of capital are first designated to fund the Company's ESOP up to the
maximum allowable contribution of 15% of eligible wages. MVP in excess of the
ESOP funding is then shared by the associates.
Under the executive performance incentive plans, participants can receive
a maximum of 1% of the excess on an after-tax basis, while officers can receive
a maximum of approximately 8% of the excess on an after-tax basis. All remaining
funds are reinvested in the Company for the benefit of the shareholders. MVP
further limits the officer payout in a given year to 50% (60% prior to 1998) of
the combination of bonuses earned in the previous fiscal year plus any unpaid
balance carried forward from prior years. The remaining balance is at risk and
is retained by the Company. This amount is posted to a participant's "bank
account" and is subject to achieving the MVP target return in the succeeding
fiscal year.
The following table illustrates the amount earned, the percentage of MVP
earned, and the subsequent amount paid for each year:
(in thousands) 1999 1998 1997
Earned (current year)
Executives $(1,126) $3,114 $5,390
Percent of MVP 7.90% 8.10% 7.91%
Paid (subsequent year)
Executives $894 $2,204 $3,858
In addition to the executive amount paid in 1999, an additional $54,000
was deferred toward Company stock plans as discussed below.
The Company's ESOP covers substantially all employees meeting
eligibility requirements. ESOP contributions are determined annually by the
Company's board of directors and are expensed in the year earned.
ESOP-related expenses were $2.9 million in 1999 and 1998 and $2.6 million in
1997. At its December 1999 meeting, the board approved a contribution.
Contributions were authorized in 1998 and 1997, as well.
During the third quarter of 1998, the Company leveraged the ESOP and
purchased a total of 70,400 shares at an average price of $35.58 per share
($2.5 million) in advance of the actual contribution to the plan in January
1999. There were no additional shares purchased in 1999. As a result of the
1997 ESOP contribution made in January 1998, the ESOP purchased 61,802 shares
on the open market at an average price of $38.54 ($2.4 million). During 1997,
the ESOP purchased 79,801 shares of the Company's common stock on the open
market at an average price of $26.62 ($2.1 million). Shares held by the ESOP
are treated as outstanding in computing the Company's earnings per share. At
December 31, 1998, unearned leveraged shares were not considered outstanding
for calculating earnings per share.
Dividends on earned ESOP shares are passed through to the participants.
DEFERRED COMPENSATION
The Company maintains a Rabbi Trust for deferred compensation plans for
directors, key employees and executive officers through which company shares
are purchased. During 1998, the Emerging Issues Task Force reached its
consensus on issue 97-14 relative to Rabbi Trusts. This prescribed an
accounting treatment whereby the employer stock in the plan is classified and
accounted for in equity, in a manner consistent with the accounting for
treasury stock. This increased the Company's treasury stock by $3.5 million
in 1998. The deferred compensation obligation is classified as an equity
instrument. This treatment was applied prospectively by the Company in 1998.
The expense associated with funding these plans is recognized through
salary, bonus, and ESOP expenses for key employees and executive officers as
disclosed in prior notes. The expense recognized from the directors deferred
plan was $162,700, $175,900, and $158,600 in 1999, 1998 and 1997,
respectively. In 1999, the Rabbi Trusts purchased 38,837 shares of the
Company's common stock on the open market at an average price of $32.97
($1,280,347). In 1998, the Rabbi Trusts purchased 15,521 shares of the
Company's common stock on the open market at an average price of $37.20
($577,409). In 1997, the Rabbi Trusts purchased 9,679 shares of the Company's
common stock on the open market at an average price of $31.62 ($306,027). At
December 31, 1999, the Trusts' assets were valued at $7.3 million.
STOCK OPTION PLANS
During 1995, the Company 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). The Company accounts for these plans in accordance with APB
Opinion No. 25, under which no compensation cost is recognized.
43
Had compensation cost for the plan been determined consistent with FASB
Statement No. 123, "Accounting for Stock-Based Compensation," the Company's net
income and earnings per share would have been reduced to the following pro forma
amounts:
(in thousands, except per share data) 1999 1998 1997
Net income: As reported $31,451 $28,239 $30,171
Pro forma 30,608 27,592 29,789
Diluted EPS: As reported $3.08 $2.65 $2.66
Pro forma $2.99 $2.59 $2.63
These pro forma amounts may not be representative of the effects of
FASB Statement No. 123 on pro forma net income for future years because
options vest over several years and additional awards may be granted in the
future.
Under the Incentive Plan, an officer may be granted an option to
purchase shares at 100% of the grant date fair market value (110% if the
optionee and affiliates own 10% or more of the shares), payable as determined
by the Company's board of directors. An option may be granted only during the
10-year period ending in May 2005. An optionee must exercise an option within
10 years (five years if the optionee and affiliates own 10% or more of the
shares) from the grant date. Full vesting of options granted occurs at the
end of five years.
Under the Directors' Plan, shares granted do not qualify as tax-favored
incentive stock options. Directors may be granted non-qualified options to
purchase shares at 100% of the grant date fair market value. An optionee must
exercise an option within 10 years from the grant date. Full vesting occurs
at the end of three years, except in the case of death, disability, or
termination of Director status, at which time all options become fully vested
and exercisable.
Additionally, subject to the Directors' Plan's approval by
shareholders, the Directors' Plan included a grant of 30,000 shares (3,750
per Director) effective on May 2, 1996. Shareholder approval occurred at the
May 1997 shareholder meeting. As a result, 1996 plan data, as provided, has
been restated to include the impact of this grant.
The Company may grant options for up to 1,562,500 shares under the
Incentive Plan and 250,000 shares under the Directors' Plan. Through December
31, 1999, the Company has granted 587,551 options under these plans. Under
both plans, the option exercise price equals the stock's fair market value on
the date of grant.
A summary of the status of the plans at December 31, 1999, 1998 and
1997, and changes during the years then ended are presented in the following
table and narrative:
1999 1998 1997
Weighted- Weighted- Weighted-
Average Average Average
Number Exercise Number Exercise Number Exercise
of Shares Price of Shares Price of Shares Price
Outstanding
at beginning
of year 385,074 $27.78 277,347 $21.15 181,626 $17.72
Granted 162,200 32.02 134,252 42.06 104,500 26.87
Exercised 14,623 20.70 3,231 18.77 8,779 18.38
Forfeited 5,920 30.88 23,294 32.22 -- --
Outstanding at
end of year 526,731 29.25 385,074 27.78 277,347 21.14
Exercisable at
end of year 180,174 23.16 112,652 19.46 50,413 17.45
Weighted-avg.
fair value of
options granted
during year $ 9.87 $12.49 $ 8.78
The fair market value of each option grant is estimated on the date of
grant using the Black-Scholes option pricing model with the following
weighted-average assumptions used for grants in 1999, 1998 and 1997,
respectively: risk-free interest rates of 5.45%, 5.66% and 6.64%; expected
dividend yields of 2.55%, 2.87% and 3.10%; expected lives of 10 years; and
expected volatility of 23.56%, 23.79% and 26.30%.
Information on the range of exercise prices for options outstanding as
of December 31, 1999, is as follows:
Options Outstanding Options Exercisable
Weighted-
Average Weighted- Weighted-
Outstanding Remaining Average Exercisable Average
Range of as of Contractual Exercise as of Exercise
Exercise Price 12/31/99 Life Price 12/31/99 Price
$ 0.00-D $16.88 65,502 5.4 $16.48 52,591 $16.48
$16.89-D $21.10 82,851 6.3 $18.36 59,251 $18.35
$21.11-D $29.54 90,176 7.3 $26.09 39,175 $26.15
$29.55-D $33.76 157,825 9.3 $31.94 1,750 $32.70
$33.77-D $37.98 10,625 8.8 $35.09 2,050 $35.90
$37.99-D $42.20 119,752 8.3 $42.07 25,357 $41.93
526,731 7.8 $29.25 180,174 $23.16
44
POST-RETIREMENT BENEFITS OTHER THAN PENSION
The Company does not provide post-retirement or post-employment benefits
to employees and therefore does not have any liability under FASB Statement No.
106, "Employer's Accounting for Post-retirement Benefits Other Than Pensions'
or FASB Statement No. 112, "Employers' Accounting for Post-employment
Benefits."
9 STATUTORY INFORMATION AND DIVIDEND RESTRICTIONS
The Company's 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.
Reconciliations of net income and shareholders' equity (statutory surplus),
as reported in conformity with statutory reporting practices to that reported
in the accompanying financial statements on the basis of GAAP, are shown in
the following tables. Consolidated net income, statutory basis, includes the
results of UIC and PIC only from the date of acquisition, January 29, 1999.
Year ended December 31,
Net Income (in thousands) 1999 1998 1997
Consolidated net income,
statutory basis $22,147 $29,404 $26,897
Deferred policy acquisition costs 10,243 526 5,321
Deferred income tax benefit 2,075 583 347
Net income of non-insurance operations,
interest expense on debt and
general corporate expense (3,278) (1,859) (2,328)
Other 264 (415) (66)
As reported in accompanying
financial statements $31,451 $28,239 $30,171
December 31,
Shareholders' Equity (in thousands) 1999 1998
Consolidated surplus, statutory basis $286,247 $314,484
Deferred policy acquisition costs 34,358 22,510
Goodwill 5,651 --
Nonadmitted assets 6,397 3,399
Subsidiary ownership in RLI Corp. (10,193) (9,894)
Deferred tax liability (41,662) (48,421)
Statutory liability for reinsurance 290 525
Equity of non-insurance companies 12,232 10,504
Other (251) 852
As reported in accompanying
financial statements $293,069 $293,959
Dividend payments to the Company from its principal insurance subsidiary
are restricted by state insurance laws as to the amount that may be paid without
prior notice or approval of the regulatory authorities of Illinois and
California. The maximum dividend distribution is limited by Illinois and
California law to the greater of: 10% of RLI Insurance Company's policyholder
surplus as of December 31 of the preceding year, or the net income of RLI
Insurance Company for the 12-month period ending December 31 of the preceding
year. Therefore, the maximum dividend distribution that can be paid by RLI
Insurance Company during 2000 without prior notice or approval is $28.6 million
- -- 10% of RLI Insurance Company's 1999 policyholder surplus. The actual amount
paid to the Company during 1999 was $24.9 million.
10 COMMITMENTS AND CONTINGENT LIABILITIES
The Company is involved in certain legal proceedings and disputes
considered by management to be ordinary and incidental to the business, or
which have no foundation in fact. Management believes that valid defenses
exist as to all such litigation and disputes and is of the opinion that these
will not have a material effect on the Company's financial statements.
The Company leases regional office facilities and automobiles under
operating leases expiring in various years through 2004. Minimum future
rental payments under noncancellable operating leases are as follows:
2000 $1,514,179
2001 1,321,003
2002 968,896
2003 532,217
2004 212,931
Total minimum future rental payments $4,549,226
11 ACQUISITION
On January 29, 1999, RLI Insurance Company purchased Underwriters
Indemnity Holdings (UIH) for $40.7 million. The purchase was financed
entirely through short-term debt. UIH is the insurance holding company for
Planet Indemnity Company and Underwriters Indemnity Company. As a
property/casualty insurance group these companies have combined to offer
primarily surety and inland marine coverages on commercial risks relating to
the exploration, drilling, producing and gathering activities of the oil and
gas industry. Also provided to a lesser degree were control of well and
general liability insurance. The genuine value of this
45
operation was found almost exclusively in the surety operations. The casualty
book was considered incidental to the overall business while the property
business contained deficient premiums to an unknown extent. All property
coverages are being non-renewed in accordance with allowable policy
provisions.
The acquisition is being accounted for under the purchase method of
accounting for business combinations. RLI Corp.'s 1999 financial statements
include the results of UIH's operations from January 29, 1999, through
December 31, 1999. Accounting guidance derived primarily from APB 16
regarding business combinations dictates that the purchase price be allocated
to the assets acquired less liabilities assumed with any excess being
recorded as goodwill. The allocation of the purchase price results in
goodwill of $32.0 million that will be amortized over 20 years.
The table below summarizes, on a proforma basis, the Company's
consolidated results of operations as if the purchase of UIH had taken place
as of January 1, 1998.
Years ended December 31,
1999 1998
Consolidated revenue $224,560 $175,446
Net earnings 25,489 29,490
Net earnings per share:
Basic $2.52 $2.80
Diluted $2.49 $2.77
The dilutive effect on pro forma earnings was the result of recognizing
pre-acquisition premium deficiency and reserve strengthening on the property
business. As indicated above, the Company does not intend to pursue this line
of business and consequently, does not anticipate any future earnings impact.
12 INDUSTRY SEGMENT INFORMATION
The following table summarizes the Company's segment data as specified
by FASB Statement No. 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
Company management.
The segments of the property/casualty operations of the Company include
property, casualty and surety. The property segment is comprised of insurance
products providing physical damage coverage for commercial and personal
risks. These risks are exposed to a variety of perils including earthquakes,
fires and hurricanes. Losses are developed in a relatively short period of
time.
The casualty segment includes liability products where loss and related
settlement expenses must be estimated, as the ultimate disposition of claims
may take several years to fully develop. Policy coverage is more
significantly impacted by evolving legislation and court decisions.
The surety segment offers a selection of small- and medium-sized
commercial products related to the statutory requirement for bonds on
construction and energy-related projects. The results of this segment are
characterized by relatively low loss ratios. However, expense ratios tend to
be higher due to the high volume of transactions at lower premium levels.
The investment income segment is the by-product of the interest and
dividend income streams from the Company's 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 other
segments. Investee earnings represent the Company's share in Maui Jim, Inc.
earnings. The Company owns approximately 44% of the unconsolidated investee,
which operates in sunglass and optical goods industries.
The following table provides data on each of the Company's segments as
used by company 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 the Company's expense
allocation system, the related assets are not allocated for management use
and, therefore, are not included in this schedule. Goodwill amortization
resulting from the UIH acquisition was allocated entirely to the surety
segment.
46
Depreciation
(in thousands) Net Earnings Revenues and Amortization
- ---------------------------------------------------------------------------------------------------------------
1999 1998 1997 1999 1998 1997 1999 1998 1997
- ---------------------------------------------------------------------------------------------------------------
Property $17,064 $19,800 $ 21,410 $ 51,390 $52,281 $62,028 $1,047 $1,048 $927
Casualty (2,328) (2,292) (3,185) 118,472 71,736 68,365 1,381 993 904
Surety 2,399 (719) 526 25,412 18,307 11,491 2,037 280 169
Net investment income 26,015 23,937 24,558 26,015 23,937 24,558 68 81 91
Realized gains 4,467 1,853 2,982 4,467 1,853 2,982
General corporate
and interest on debt (6,195) (6,195) (5,720) 112 113 99
Equity in earnings of
unconsolidated investee 1,613 1,337 951
- ---------------------------------------------------------------------------------------------------------------
Total segment earnings
before income taxes 43,035 37,721 41,522
- ---------------------------------------------------------------------------------------------------------------
Income taxes 11,584 9,482 11,351
- ---------------------------------------------------------------------------------------------------------------
Total $ 31,451 $ 28,239 $30,171 $225,756 $168,114 $169,424 $4,645 $2,515 $2,190
- ---------------------------------------------------------------------------------------------------------------
13 UNAUDITED INTERIM FINANCIAL INFORMATION
Selected quarterly information is as follows:
(in thousands, except per share data) First Second Third Fourth Year
1999
Net premiums earned $45,789 $47,672 $50,992 $50,821 $195,274
Net investment income 6,234 6,194 6,737 6,850 26,015
Net realized investment gains 23 2,235 2,265 (56) 4,467
Earnings before income taxes 8,659 12,285 11,941 10,150 43,035
Net earnings 6,578 9,021 8,471 7,381 31,451
Basic earnings per share(1) $0.63 $0.89 $0.85 $0.74 $3.11
Basic operating earnings per share(1)(2) $0.63 $0.75 $0.70 $0.75 $2.82
Diluted earnings per share(1) $0.63 $0.88 $0.84 $0.74 $3.08
Diluted operating earnings per share(1)(2) $0.63 $0.74 $0.69 $0.74 $2.79
1998
Net premiums earned $34,915 $35,085 $35,951 $36,373 $142,324
Net investment income 5,945 5,741 6,180 6,071 23,937
Net realized investment gains 573 66 32 1,182 1,853
Earnings before income taxes 9,422 10,393 7,137 10,769 37,721
Net earnings 6,976 7,625 5,578 8,060 28,239
Basic earnings per share(1) $0.66 $0.72 $0.53 $0.78 $2.69
Basic operating earnings per share(1)(2) $0.62 $0.72 $0.53 $0.71 $2.58
Diluted earnings per share(1) $0.65 $0.71 $0.53 $0.77 $2.65
Diluted operating earnings per share(1)(2) $0.62 $0.71 $0.53 $0.70 $2.54
(1) Since the weighted-average shares for the quarters are calculated
independently of the weighted-average shares for the year, and due to the
exclusion of the antidilutive effects as discussed in note 1K, quarterly
earnings per share may not total to annual earnings per share.
(2) Operating earnings per share is calculated by reducing net earnings by
the after-tax impact of net realized investment gains.
47
Report of Independent Auditors
The board of directors and shareholders
RLI Corp.
We have audited the accompanying consolidated balance sheets of RLI Corp. and
Subsidiaries as of December 31, 1999 and 1998, and the related consolidated
statements of earnings and comprehensive earnings, shareholders' equity, and
cash flows for each of the years in the three-year period ended December 31,
1999. 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 generally accepted auditing
standards. 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 RLI Corp.
and Subsidiaries at December 31, 1999 and 1998, and the results of their
operations and their cash flows for each of the years in the three-year
period ended December 31, 1999, in conformity with generally accepted
accounting principles.
KPMG LLP
January 18, 2000
KPMG
Certified Public Accountants
303 East Wacker Drive
Chicago, Illinois 60601
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 generally accepted
accounting principles and include amounts that are based on management's
estimates and judgments.
The accompanying financial statements have been audited by KPMG LLP (KPMG),
independent certified public accountants, selected by the audit committee and
approved by the shareholders. Management has made available to KPMG all 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.
Management has established and maintains a system of internal controls
throughout its operations that are 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. The system of internal
controls provides for appropriate division of responsibility and is
documented by written policies and procedures that are updated by management
as necessary. As part of its audit of the financial statements, KPMG
considers certain aspects of the system of internal controls to the extent
necessary to form an opinion on the financial statements and not to provide
assurance on the system of internal controls. Management considers the
recommendations of its internal auditor and independent public accountants
concerning the Company's internal controls and takes the necessary actions
that are cost effective in the circumstances to respond appropriately to the
recommendations presented. Management believes that as of December 31, 1999,
the Company's system of internal controls was adequate to accomplish the
objectives described herein.
The audit committee is comprised solely of three non-employee 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 public accountants and the internal auditor have ready access to
the audit committee.
Gerald D. Stephens, CPCU
President, RLI Corp.
Joseph E. Dondanville, CPA
Vice President, Chief Financial Officer, RLI Corp.
48
Selected Financial Data
The following is selected financial data of RLI Corp. and Subsidiaries for the
eleven years ended December 31, 1999.
(amounts in thousands,
except per share data) 1999 1998 1997 1996 1995
Operating results
Gross sales $ 370,057 316,863 306,383 301,500 293,922
Total revenue $ 225,756 168,114 169,424 155,354 155,954
Net operating earnings
(loss)(1) $ 28,547 27,035 28,233 25,035 7,648
Net earnings (loss) $ 31,451 28,239 30,171 25,696 7,950
Comprehensive earnings
(loss)(2) $ 20,880 51,758 66,415 41,970 31,374
Net cash provided from
operating activities $ 48,361 23,578 35,022 48,947 24,649
Net premiums written to
statutory surplus 79% 46% 54% 64% 76%
GAAP combined ratio 91.2 88.2 86.8 87.4 107.5
Statutory combined ratio 90.1(4) 88.4 90.4 89.1 106.5
- ----------------------------------------------------------------------------------
Financial condition
Total investments $ 691,244 677,294 603,857 537,946 471,599
Total assets $1,170,363 1,012,685 911,741 845,474 810,200
Unpaid losses and
settlement expenses $ 520,494 415,523 404,263 405,801 418,986
Total debt $ 78,397 39,644 24,900 46,000 48,800
Total shareholders' equity $ 293,069 293,959 266,552 200,039 158,608
Statutory surplus $ 286,247 314,484 265,526 207,787 172,313
- ----------------------------------------------------------------------------------
Share information
Net operating earnings
(loss) per share:
Basic(3) $ 2.82 2.58 2.71 2.54 0.78(5)
Diluted(3) $ 2.79 2.54 2.50 2.22 0.78(5)
Net earnings (loss)
per share:
Basic(3) $ 3.11 2.69 2.90 2.60 0.81(5)
Diluted(3) $ 3.08 2.65 2.66 2.28 0.81(5)
Comprehensive earnings
(loss) per share:(2)
Basic(3) $ 2.06 4.92 6.38 4.25 3.20(5)
Diluted(3) $ 2.04 4.87 5.76 3.62 2.77(5)(6)
Cash dividends declared
per share $ 0.55 0.51 0.47 0.44 0.41
Book value per share $ 29.68 28.44 24.70 20.46 16.16
Closing stock price $ 34.00 33.25 39.85 26.70 20.00
Stock split 125% 125%
Weighted average shares
outstanding:
Basic(3) 10,124 10,514 10,402 9,871 9,812
Diluted(3) 10,222 10,638 11,714 12,105 9,812
Common shares outstanding 9,873 10,335 10,793 9,777 9,814
(amounts in thousands, 1994 1993 1992 1991 1990 1989
except per share data)
Operating results
Gross sales 295,966 266,480 220,048 215,498 181,216 149,230
Total revenue 156,722 143,100 117,582 102,343 92,958 89,984
Net operating earnings
(loss)(1) (2,403) 14,118 15,599 15,986 14,998 7,960
Net earnings (loss) (4,776) 15,948 16,207 16,800 14,267 8,200
Comprehensive earnings
(loss)(2) (8,513) 21,175 18,548 22,430 11,952 11,105
Net cash provided from
operating activities 27,041 73,629 43,619 22,918 45,388 22,801
Net premiums written to
statutory surplus 108% 94% 110% 95% 112% 96%
GAAP combined ratio 116.9 97.2 91.4 85.2 85.1 97.8
Statutory combined ratio 116.9 87.9(7) 95.8 91.6 92.2 99.5
- ----------------------------------------------------------------------------------------
Financial condition
Total investments 413,835 401,609 281,113 237,932 213,160 177,025
Total assets 751,086 667,650 526,351 483,572 432,380 402,906
Unpaid losses and
settlement expenses 394,966 310,767 268,043 244,667 235,807 230,524
Total debt 52,255 53,000 7,000 9,400 7,000 9,700
Total shareholders' equity 131,170 140,706 117,393 99,678 79,851 70,276
Statutory surplus 136,125 152,262 100,585 88,605 70,410 68,571
- ----------------------------------------------------------------------------------------
Share information
Net operating earnings
(loss) per share:
Basic(3) (0.25)(5) 1.49 1.74 1.81 1.70 0.89
Diluted(3) (0.25)(5) 1.42 1.74 1.81 1.70 0.89
Net earnings (loss)
per share:
Basic(3) (0.49)(5) 1.68(8) 1.81 1.90 1.61 0.91
Diluted(3) (0.49)(5) 1.60(8) 1.81 1.90 1.61 0.91
Comprehensive earnings
(loss) per share:(2)
Basic(3) (0.87)(5) 2.23(8) 2.07 2.54 1.35 1.24
Diluted(3) (0.87)(5) 2.10(8) 2.07 2.54 1.35 1.24
Cash dividends declared
per share 0.36 0.34 0.32 0.30 0.27 0.24
Book value per share 13.37 14.60 13.04 11.27 9.03 7.95
Closing stock price 13.12 16.96 15.84 10.56 9.28 5.44
Stock split
Weighted average shares
outstanding:
Basic(3) 9,733 9,499 8,949 8,842 8,842 8,986
Diluted(3) 9,732 10,451 8,949 8,842 8,842 8,986
Common shares outstanding 9,812 9,639 9,002 8,842 8,842 8,842
(1) For all periods presented, net operating earnings represent the Company's
net earnings reduced by after-tax realized gains. For 1993, the financial
impact of FASB Statement No. 109 has also been deducted in arriving at
operating earnings.
(2) See note 1.L to the consolidated financial statements.
(3) See note 1.K to the consolidated financial statements.
(4) The statutory combined ratio presented includes the results of UIC and
PIC only from the date of acquisition, January 29, 1999.
(5) The combined effects of the Northridge Earthquake -- including losses,
expenses and the reduction in revenue due to the reinstatement of
reinsurance coverages -- reduced 1994 after-tax earnings by $25.0 million
($2.57 per basic share, $2.10 per diluted share) and 1995 after-tax
earnings by $18.6 million ($1.90 per basic share, $1.54 per diluted
share).
(6) For 1995, diluted earnings per share on a GAAP basis were
antidilutive. As such, GAAP diluted and basic earnings per share were
equal. Diluted comprehensive earnings per share, however, were not
antidilutive. The number of diluted shares used for this calculation was
9,619.
(7) Contingent commission income recorded during 1993, from the
cancellation of a multiple-year, retrospectively-rated reinsurance
contract, reduced the statutory expense and combined ratio 10.3 points.
(8) Basic and diluted earnings per share include $.18 and $.16 per share,
respectively, from the initial application of FASB Statement No. 109
"Accounting for Income Taxes."
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