UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the period ended September 30, 1999 ------------------------------------------- or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from to --------------- --------------- Commission File Number: 0-6612 ----------------------------------------- RLI Corp. ----------------------------------------------------------------- (Exact name of registrant as specified in its charter) ILLINOIS 37-0889946 ----------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 9025 North Lindbergh Drive, Peoria, IL 61615 ----------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (309) 692-1000 ----------------------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: As of November 8, 1999 the number of shares outstanding of the registrant's Common Stock was 9,923,787. Page 1 of 21 PART I Item 1. Financial Statements RLI Corp. & Subsidiaries Condensed Consolidated Statement of Earnings and Comprehensive Earnings For the Three-Month Period Ended September 30, (Unaudited) 1999 1998 ----------- ----------- Net premiums earned $50,991,644 $35,950,695 Net investment income 6,737,007 6,179,146 Net realized investment gains 2,264,925 32,773 ------------ ----------- 59,993,576 42,162,614 ------------ ----------- Losses and settlement expenses 27,104,767 20,242,656 Policy acquisition costs 15,304,061 10,513,079 Insurance operating expenses 4,097,696 3,501,110 Interest expense on debt 1,076,296 615,440 General corporate expenses 680,954 644,079 ------------ ----------- 48,263,774 35,516,364 ------------ ----------- Equity in earnings of uncons. investee 210,771 490,968 ------------ ----------- Earnings before income taxes 11,940,573 7,137,218 Income tax expense 3,469,082 1,558,720 ------------ ----------- Net earnings $8,471,491 $5,578,498 ============ ============ Other comp. earnings (loss), net of tax (21,189,824) (16,348,118) ------------ ----------- Comprehensive earnings (loss) ($12,718,333) ($10,769,620) ============ ============ Earnings per share: Basic: Net earnings per share from operations $0.70 $0.53 Realized gains, net of tax $0.15 $0.00 ------------ ----------- Basic net earnings per share $0.85 $0.53 ============ =========== Basic comp. Earnings (loss) per share ($1.27) ($1.03) ============ =========== Diluted: Net earnings per share from operations $0.69 $0.53 Realized gains, net of tax $0.15 $0.00 ------------ ----------- Diluted net earnings per share $0.84 $0.53 ============ =========== Diluted comp. Earnings (loss) per share ($1.26) ($1.02) ============ =========== Weighted average number of common shares outstanding Basic 10,015,096 10,477,837 Diluted 10,129,261 10,602,524 Cash dividends declared per common share $0.14 $0.13 The accompanying notes are an integral part of the financial statements. 2 RLI Corp. & Subsidiaries Condensed Consolidated Statement of Earnings and Comprehensive Earnings For the Nine-Month Period Ended September 30, (Unaudited) 1999 1998 ------------ ------------ Net premiums earned $144,453,076 $105,951,174 Net investment income 19,165,187 17,865,524 Net realized investment gains 4,522,892 671,319 ------------ ------------ 168,141,155 124,488,017 ------------ ------------ Losses and settlement expenses 70,203,818 47,805,352 Policy acquisition costs 48,938,152 34,410,820 Insurance operating expenses 12,253,391 12,323,890 Interest expense on debt 2,905,051 1,659,625 General corporate expenses 2,383,848 2,764,314 ------------ ------------ 136,684,260 98,964,001 ------------ ------------ Equity in earnings of uncons. investee 1,428,151 1,428,243 ------------ ------------ Earnings before income taxes 32,885,046 26,952,259 Income tax expense 8,814,982 6,772,745 ------------ ------------ Net earnings $24,070,064 $20,179,514 ============ ============ Other comp. earnings (loss), net of tax (13,577,938) 1,240,108 ------------ ------------ Comprehensive earnings $10,492,126 $21,419,622 ============ ============ Earnings per share: Basic: Net earnings per share from operations $2.07 $1.87 Realized gains, net of tax $0.29 $0.04 ------------ ------------ Basic net earnings per share $2.36 $1.91 ============ =========== Basic comp. earnings per share $1.03 $2.03 ============ =========== Diluted: Net earnings per share from operations $2.05 $1.85 Realized gains, net of tax $0.29 $0.04 ------------ ----------- Diluted net earnings per share $2.34 $1.89 ============ =========== Diluted comp. earnings per share $1.02 $2.00 ============ =========== Weighted average number of common shares outstanding Basic 10,193,015 10,562,051 Diluted 10,290,735 10,693,122 Cash dividends declared per common share $0.41 $0.38 The accompanying notes are an integral part of the financial statements. 3 RLI Corp. and Subsidiaries Condensed Consolidated Balance Sheet September 30, 1999 December 31, 1998 ASSETS (Unaudited) -------------- -------------- Investments Fixed maturities Held-to-maturity, at amortized cost $305,645,516 $283,991,524 Trading, at market value 7,701,741 8,348,141 Available-for-sale, at market value 40,557,934 36,516,393 Equity securities, at fair value 277,838,043 296,520,399 Short-term investments, at cost 43,971,127 51,917,333 -------------- -------------- Total investments 675,714,361 677,293,790 Accrued investment income 6,368,529 6,457,473 Premiums and reinsurance balances receivable 94,861,750 46,666,743 Ceded unearned premium 45,053,773 59,779,814 Reinsurance balances recoverable on unpaid losses 254,256,868 168,260,816 Income taxes-current 2,443,816 0 Deferred policy acquisition costs 34,805,430 22,510,141 Property and equipment 14,962,471 12,199,800 Investment in unconsolidated investee 14,885,395 13,457,367 Goodwill 34,530,391 4,127,586 Other assets 8,416,364 1,931,507 -------------- -------------- TOTAL ASSETS $1,186,299,148 $1,012,685,037 ============== ============== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Unpaid losses and settlement expenses $532,148,836 $415,523,392 Unearned premiums 165,676,663 142,022,972 Reinsurance balances payable 35,124,141 32,160,867 Short-term debt and notes payable 79,539,568 39,643,965 Income taxes-current 0 2,124,460 Income taxes-deferred 41,671,965 48,420,667 Other liabilities 45,354,237 38,830,060 -------------- -------------- TOTAL LIABILITIES 899,515,410 718,726,383 -------------- -------------- Shareholders' Equity: Common stock ($1 par value, authorized) (12,804,558 shares issued at 9/30/99) (12,789,935 shares issued at 12/31/98) 12,804,558 12,789,935 Paid-In Capital 70,743,700 71,093,124 Accumulated other comprehensive earnings 96,793,523 110,371,461 Retained Earnings 183,182,037 163,324,161 Deferred compensation 4,510,704 3,460,606 Less: Unearned ESOP shares at cost (70,400 shares at 12/31/98) 0 ( 2,500,999) Less: Treasury shares at cost (2,854,941 shares at 9/30/99) (2,384,736 shares at 12/31/98) (81,250,784) ( 64,579,634) -------------- -------------- TOTAL SHAREHOLDERS' EQUITY 286,783,738 293,958,654 -------------- -------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,186,299,148 $1,012,685,037 ============== ============== The accompanying notes are an integral part of the financial statements. 4 RLI Corp. and Subsidiaries Condensed Consolidated Statements of Cash Flows (Unaudited) For the Nine-Month Period Ended September 30, -------------------------- 1999 1998 ----------- ----------- Net cash provided by operating activities $34,627,063 $26,454,635 ----------- ----------- Cash Flows from Investing Activities Investments purchased (54,251,597) (37,826,525) Investments sold 18,629,145 3,885,579 Investments called or matured 23,650,563 24,616,600 Net (increase) decrease in short-term investments 2,858,716 (10,243,864) Net property and equipment purchased (4,154,528) (1,081,714) Investment in Underwriters Indemnity Holdings (40,700,000) 0 ----------- ----------- Net cash (used in) investing activities (53,967,701) (20,649,924) ----------- ----------- Cash Flows from Financing Activities Cash dividends paid (4,172,608) (3,993,547) Proceeds from issuance of notes payable 36,330,603 13,891,250 Change in contributed capital 302,696 60,639 Fractional shares paid -- (16,099) Treasury shares purchased (15,621,052) (13,288,543) Unearned ESOP shares purchased 2,500,999 (2,458,411) ----------- ----------- Net cash provided by (used in) financing activities 19,340,638 (5,804,711) ----------- ----------- Net increase in cash 0 0 ----------- ----------- Cash at the beginning of the year 0 0 ----------- ----------- Cash at September 30 $ 0 $ 0 =========== =========== The accompanying notes are an integral part of the financial statements. 5 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - The financial information is prepared in conformity with generally accepted accounting principles and such principles are applied on a basis consistent with those reflected in the 1998 annual report filed with the Securities and Exchange Commission. The financial information included herein has been prepared by management without audit by independent certified public accountants who do not express an opinion thereon. The condensed consolidated balance sheet as of December 31, 1998 has been derived from, and does not include all the disclosures contained in the audited consolidated financial statements for the year ended December 31, 1998. The information furnished includes all adjustments and normal recurring accrual adjustments which are, in the opinion of management, necessary for a fair statement of results for the interim periods. Results of operations for the nine-month periods ended September 30, 1999 and 1998 are not necessarily indicative of the results of a full year. The accompanying financial data should be read in conjunction with the notes to the financial statements contained in the 1998 10-K Annual Report. EARNINGS PER SHARE: Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the dilution that could occur if securities or other contracts to issue common stock (common stock equivalents) were exercised or converted into common stock. When inclusion of common stock equivalents increases the earnings per share or reduces the loss per share, the effect on earnings is antidilutive. Under these circumstances, the diluted net earnings or net loss per share is computed excluding the common stock equivalents. Pursuant to disclosure requirements contained in Statement 128, the following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the financial statements. For the Nine-Month Period Ended September 30, 1999 Income Shares Per Share (Numerator) (Denominator) Amount - ------------------------------------------------------------------------------ BASIC EPS Income available to $24,070,064 10,193,015 2.36 common stockholders EFFECT OF DILUTIVE SECURITIES Incentive Stock Options -- 97,720 - ------------------------------------------------------------------------------ DILUTED EPS Income available to common $24,070,064 10,290,735 2.34 - ------------------------------------------------------------------------------ 6 For the Nine-Month Period Ended September 30, 1998 Income Shares Per Share (Numerator) (Denominator) Amount - ------------------------------------------------------------------------------ BASIC EPS Income available to $20,179,514 10,562,051 1.91 common stockholders EFFECT OF DILUTIVE SECURITIES Incentive Stock Options -- 131,071 - ------------------------------------------------------------------------------ DILUTED EPS Income available to common $20,179,514 10,693,122 1.89 - ------------------------------------------------------------------------------ OTHER 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. In October 1998, the AICPA issued Statement of Position (SOP) 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." SOP 98-7 provides guidance on how to account for insurance and reinsurance contracts that do not transfer insurance risk. The method used for these contracts is referred to as deposit accounting. This SOP specifies that at inception, a deposit asset or liability should be recognized for insurance and reinsurance contracts accounted for under deposit accounting and should be measured based on the consideration paid or received, less any explicitly identified premiums or fees to be retained by the insurer or reinsurer, irrespective of the experience of the contract. This SOP is effective for financial statements for fiscal years beginning after June 15, 1999. The Company does not have any insurance or reinsurance contracts that are required to be accounted for under the deposit method as of September 30, 1999. 7 2. INDUSTRY SEGMENT INFORMATION - Selected information by industry segment for the nine months ended September 30, 1999 and 1998 is presented below. SEGMENT DATA--(in thousands) EARNINGS REVENUES 1999 1998 1999 1998 ---- ---- ---- ---- Property 12,963 14,540 37,902 40,196 Casualty (1,711) (2,068) 87,473 52,629 Surety 1,806 (1,061) 19,078 13,126 Net investment income 19,165 17,866 19,165 17,866 Realized gains 4,523 671 4,523 671 General corporate expense and interest on debt (5,289) (4,424) Equity in earnings of unconsolidated investee 1,428 1,428 ------ ------ Total segment earnings before income taxes 32,885 26,952 ------ ------ Income taxes 8,815 6,773 ------ ------ Total 24,070 20,179 168,141 124,488 ------ ------ ------- ------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. "SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: This discussion and analysis may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Various risk factors that could affect future results are listed in the company's filings with the Securities Exchange Commission, including the Form 10-K for the year ended December 31, 1998. OVERVIEW RLI Corp. (the Company) is a holding company that, through its subsidiaries, underwrites selected property and casualty insurance products. The most significant operation is RLI Insurance Group (the Group), which provides specialty property and casualty coverages for primarily commercial risks. The Group accounted for 86% of the Company's total revenue for the nine months ended September 30, 1999. 8 BUSINESS COMBINATION - PURCHASE ACCOUNTING 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 operation was found almost exclusively in the surety operations, which approximated $35 million. 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. 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 $31.8 million that will be amortized over 20 years. NINE MONTHS ENDED SEPTEMBER 30, 1999, COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 1998 Consolidated gross sales, which consist of gross premiums written, net investment income and realized investment gains totaled $278.4 million for the first nine months of 1999 compared to $233.1 million for the same period in 1998. Gross writings of the Insurance Group improved 18.7% over 1998 levels fueled by a $30 million increase in casualty premiums. Consolidated revenue for the first nine months of 1999 increased $43.7 million or 35.1% from the same period in 1998. Net premiums earned alone increased 36.3% due to the Group's implementation of a combined casualty reinsurance contract, which resulted in increased retentions of premium while eliminating ceding commissions. Net investment income improved 7.3% to $19.2 million. Realized investment gains totaled $4.5 million for the first nine months of 1999 compared to $700,000 for the same period in 1998 due to the strategic sale of several equity positions in the second and third quarters. The net after-tax earnings for the first nine months of 1999 totaled $24.1 million, $2.34 per diluted share, compared to $20.2 million, $1.89 per share, for the same period in 1998. Net operating earnings, which consist of the Company's net earnings reduced by after-tax realized investment gains, totaled $21.1 million, $2.05 per share, compared to $19.7 million, $1.85 per share, for the same period in 1998. Comprehensive earnings, which includes net earnings plus unrealized gains/losses net of tax, totaled $10.5 million, $1.02 per share, compared to $21.4 million, $2.00 per share, for the same period in 1998. Unrealized losses, net of tax, for the first nine months of 1999 were $13.6 million, $1.32 per share compared to unrealized gains of $1.2 million, $0.11 per share, for the same period in 1998. The decline in the stock market in the first and third quarters of 1999 accounted for the decrease in unrealized gains. 9 RLI INSURANCE GROUP Gross written premium for the Group increased by $40.1 million to $254.7 million for the first nine months of 1999 compared to $214.6 million for the same period in 1998. This 18.7% improvement came from the casualty and property segments where various growth initiatives are taking effect. Profitability increased with $13.1 million in pretax underwriting profit compared to $11.4 million last year. The GAAP combined ratio was 91.0 for the first nine months of 1999 compared to 89.2 for the first nine months of 1998. This increase is the result of an increase in the loss ratio to 48.6 for the first nine months of 1999 from 45.1 for the same period in 1998. Partially offsetting this increase was a decrease in the expense ratio to 42.4 through September 30, 1999, compared to 44.1 through September 30, 1998. The Group's property segment increased premium writings by 11.8% in the first nine months of 1999. Difference in conditions (DIC) premiums continue to decline as a result of rate reductions. This trend was offset by a 37% increase in fire premiums in the first nine months along with some production from new product lines. The property segment generated pre-tax underwriting profits of $13.0 million for the first nine months of the year compared to $14.5 million last year. This decline in profitability reflects the increasing mix of fire lines with higher loss ratios relative to the DIC book with lower loss ratios. This is also reflected in the 1999 combined ratio of 65.8 compared to 63.8 a year ago. Casualty segment gross written premiums were $137.0 million for the first nine months of 1999 compared to $107.0 million for the prior year. The driving forces behind this improvement were increases in the commercial umbrella product of $10.8 million and the transportation product of $9.7 million. At the beginning of 1999 a combined casualty reinsurance contract was implemented to take advantage of the growth in premiums and improved economies of scale. This arrangement will result in assuming less exposure per risk while improving the overall combined ratio of this segment. Although there are no ceding commissions recognized with this agreement, the Group retains more premium. This was evidenced by the GAAP combined ratio falling to 102.0 for the first nine months compared to 104.0 last year. This new reinsurance contract will also improve cash flow and thereby generate additional investment income in the future. Even at a combined ratio of 102.0, the management of the Company believes reserves to be adequate and a significant source of future earnings potential from investment income. Surety segment gross written premiums stayed steady at $23.5 million for the first nine months of 1999 compared to $23.4 million for the same period in 1998. This stable trend was the result of the Company's disassociation with a particular producer late in 1998, offset by $5.7 million in premium for the period from the newly acquired surety operation in Houston - Underwriters' Indemnity. The GAAP combined ratio for the surety segment has dropped sharply to 90.5 in the first nine months from 108.1 a year ago. A charge of $2.6 million related to unfavorable loss development late in the third quarter of 1998 on the contract surety book caused the loss ratio to increase to 40.8. Without the effect of this charge the loss ratio would have been 20.9, which is more in line with the loss ratio of 19.3 experienced through the first nine months of 1999. 10 INVESTMENT INCOME The Company's investment portfolio generated net dividends and interest income of $19.2 million during the first nine months of 1999, an increase of 7.3% over that reported for the same period in 1998. The increase is primarily due to the company's overall premium growth as well as the impact of the first quarter acquisition of Underwriters Indemnity Holdings, Inc. Invested assets at September 30, 1999 decreased by $1.6 million, or 0.2%, and are relatively unchanged from December 31, 1998. For the nine months ended September 30, 1999, the Company experienced a $20.9 million pre-tax unrealized loss on its investment portfolio. Short-term investments decreased to $44.0 million down $8.0 million from December 31, 1998. Virtually all the Company's fixed income portfolio consists of securities rated A or better and 95% were rated AA or better. The year-to-date yields on the Company's fixed income investments for the nine-month periods ended September 30, 1999 and 1998 are as follows: 1999 1998 ---- ---- Taxable 6.55% 6.54% Non-taxable 4.76% 4.96% Yields on taxable securities are relatively unchanged from the same period last year as maturity proceeds have been reinvested with similarly yielding securities. A decrease in non-taxable yields resulted from proceeds of numerous calls on higher yielding holdings being replaced with lower yielding municipals. The Company's available-for-sale portfolio of debt and equity securities had a net unrealized loss before tax of $20.9 million for the first nine months of 1999 compared to net unrealized gains before tax of $1.9 million for the same period in 1998. The 1999 year-to-date loss reflects stock market fluctuations and the impact of an increasing interest rate environment. Net unrealized gains before tax were $148.6 million and $169.5 million at September 30, 1999 and December 31, 1998, respectively. Unrealized appreciation on securities, net of tax, is reflected in accumulated other comprehensive earnings, a component of shareholders' equity. Interest expense on debt obligations increased to $2.9 million for the first nine months of 1999, a $1.2 million increase from the same period in 1998. This change is related to an increase in outstanding debt balances, primarily due to the January 1999 acquisition of Underwriters Indemnity Holdings, Inc. At September 30, 1999, outstanding short-term debt totaled $79.5 million. 11 INCOME TAXES The Company's effective tax rate for the first nine months of 1999 was 27% compared to 25% for the same period in 1998. This increase is primarily due to goodwill amortization from the acquisition of Underwriters' Indemnity in 1999 not being deductible for tax purposes. Income tax expense attributable to income from operations differed from the amounts computed by applying the U.S. federal tax rate of 35% to pretax income for the first nine months of 1999 and 1998 as a result of the following: 1999 1998 Amount % Amount % ------ --- ------ --- Provision for income taxes at the statutory rate of 35% $11,509,766 35% $ 9,433,291 35% Increase (reduction) in taxes resulting from: Tax exempt interest income (1,916,438) ( 6%) (1,661,771) (6%) Dividends received deduction (1,120,546) ( 3%) (1,048,852) (4%) Dividends paid deduction (183,071) ( 1%) (172,078) (1%) Goodwill amortization 280,707 1% -- - Other items, net 244,564 1% 222,155 1% ----------- ---- ----------- --- Total tax expense $ 8,814,982 27% $ 6,772,745 25% LIQUIDITY AND CAPITAL RESOURCES Historically, the primary sources of the Company's liquidity have been funds generated from insurance premiums and investment income (operating activities) and maturing investments (investing activities). In addition, the Company has occasionally received proceeds from financing activities such as the sale of common stock, the sale of public debt, and short-term borrowings. During the first nine months of 1999, the Company repurchased 470,200 of its outstanding shares at a cost of $15.6 million. This repurchase program has been funded through operating cash flow and short-term borrowings. These treasury shares are reflected as a separate component of shareholders' equity. Third quarter 1999 operating cash flow continues to show improvement over the same period in 1998. The Company's premium growth along with the impact of the new global casualty reinsurance treaty contributed to this increase. At September 30, 1999 the Company had short-term investments, cash and other investments maturing within one year, of approximately $79.0 million and additional investments of $130.3 million maturing within five years. The Company maintains one source of credit, a $30.0 million line of credit, available on a secured or unsecured basis that cannot be canceled during its annual term. As of September 30, 1999, the Company had $19.6 million in outstanding short-term borrowings on this facility. Additionally, the Company was party to five reverse repurchase transactions totaling $59.4 million and other miscellaneous short-term debt of $500,000. 12 Management believes that cash generated by operations, cash generated by investments, and cash available from financing activities will provide sufficient sources of liquidity to meet its anticipated needs over the next twelve to twenty-four months. 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 date fields. 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. In 1997, the Company began work on a five-phase program for Y2K compliance. Phase I was to identify those primary and mission-critical business systems, those essential to continuing operations, which presented Y2K issues. This phase was a four-month process beginning in August of 1997. Phase II was to form a committee by business unit to identify all secondary and general infrastructure issues which would need to be addressed for Y2K compliance. This phase began in December of 1997 and was completed in April of 1998, with the evaluation and initial identification of secondary Y2K exposures, which needed attention. Phase III was the modification and testing of mission-critical systems identified in Phase I. Phase III included changes to the Company's property and casualty systems, accounts receivable, custom business processing, general ledger, accounts payable, external business interfaces, digital image processing and accounting interface systems. The status of completion of Phase III is discussed below. Phase IV, which began in May 1998, included the development of plans to address secondary infrastructure issues, line of business strategies to address exposures associated with the Company's insurance products and a process to survey key vendors and business partners. This phase has extended into the third quarter of 1999 and is targeted for completion in November of 1999. Phase V is designed to refine operational and contingency plans for Y2K cut-over. This phase began in the first quarter of 1999 and carries through the first quarter of the year 2000. Items carried through the first quarter of the year 2000 are considered non-critical and incidental to the Company's operations. The Company has 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's MIS Steering Committee, Audit Committee and the Board of Directors regularly review Y2K compliance and progress. 13 In accordance with Phase I of the program, the Company completed an internal review of all primary and mission-critical systems and contacted related software suppliers to determine major areas of exposure by December of 1997. As an element of Phase III, in November of 1998 the Company successfully completed the modification, testing and implementation of Y2K-compliant core property and casualty systems, accounts receivable, custom business processing, general ledger, accounts payable and accounting interfaces. The Company's new reinsurance system, implemented in early 1998, was already identified as Y2K compliant. Business transactions are presently being processed and premiums are being earned on in-force policies with Y2K expiration dates. Digital image processing upgrades were completed in January of 1999. External business interfaces have been addressed within core systems efforts but may require additional modifications for any subsequent changes implemented by external parties. These activities concluded the successful completion of Phase III efforts. As a component of Phase IV, the Company completed the development of strategies by line of business, which it feels will effectively manage Y2K related exposures and coverages. This exposure is divided into two distinct areas: business partners and insurance coverage issues for our policyholders/customers. In August of 1998, all significant vendors and business partners were surveyed for compliance efforts and the Company's internal audit and compliance unit has reviewed responses for further steps and action. Efforts have been made to evaluate the individual responses and follow up with those business partners who did not respond to the initial request for information. Of the responses received from vendors and business partners, a significant number state that they are Y2K compliant or intend to be Y2K compliant by December 31, 1999. Additionally, in April of 1999 the Company took action to evaluate and assess the preparedness of the physical branch locations managed by external entities. The Company will continue to make efforts to ensure its business partners and vendors are Y2K compliant; however, the ultimate state of compliance of these providers is beyond the Company's control and could impact the Company's operations and financial results in future periods. 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 directors & officers, miscellaneous professional liability and property policies, in terms of both frequency and severity. The Company has 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, which is being sent out to inquiries from producers and insureds. Individuals or entities requiring information on the Company's position with Y2K matters may reference the current statement on the Company's Internet site at www.rlicorp.com. 14 As an element of Phase V, the Company has system contingency services contracted through a major third-party provider and successfully conducted a Y2K test for critical systems in June of 1999. The Company continues to enhance and update the present business contingency plan to address specific Y2K related exposures. The specific requirements associated with a Y2K operational support plan for the millennium weekend, including on-site staff and on-call support will be communicated in a detailed plan by mid-November of 1999. Management and control of new or developing Y2K exposures will continue through the first quarter of 2000. The Company has incurred $1.2 million in expenses to complete the core system modifications for Y2K. It required over 26,000 hours of technical staff effort and changes to systems representing 12.5 million lines of program code. It was originally estimated that the Company would incur an additional $300,000 of expenses in 1999 to upgrade telephone systems, corporate e-mail solutions, and to ensure the necessary services are in place for contingency efforts. The Company implemented new e-mail solutions in April of 1999 and new corporate phone system and switch in May of 1999. As of this date the company has incurred approximately $250,000 of the estimated additional expenses with a remaining estimated $80,000 to be incurred late in 1999 and early 2000. Actual expenses are not significantly greater than those originally forecasted for 1999. A re-evaluation of all personal computer hardware, network components and software began in May of 1999 and was completed by the end of October 1999. Presently, all network servers are Y2K compliant and 75% of personal computer workstations have been evaluated and remedied. The Company conducted a successful Y2K simulation, cutover and operation of core business systems during a disaster recovery test in June of 1999. Executive management is continuing to place focus and emphasis on eliminating major issues associated with potential Y2K related failures and as of this date has not experienced Y2K related problems. THREE MONTHS ENDED SEPTEMBER 30, 1999, COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 1998 Consolidated gross sales totaled $100.1 million for the third quarter of 1999 compared to $80.0 million for the same period in 1998. As detailed in the discussion of RLI Insurance Group that follows, third quarter 1999 gross premiums improved $17.3 million, or 23.4%, over third quarter 1998 levels. Consolidated revenue for the third quarter of 1999 increased $17.8 million, or 42.3%, from the same period in 1998. Net premiums earned in the third quarter of 1999 improved $15.0 million compared to 1998, and investment income and investment gains improved $2.8 million over third quarter 1998 levels. The net after-tax earnings for the third quarter of 1999 totaled $8.5 million, $0.84 per diluted share, compared to $5.6 million, $0.53 per share, for the same period in 1998. Net operating earnings, which consist of the Company's net earnings reduced by after-tax realized investment gains, improved to $7.0 million, $0.69 per share, compared to $5.6 million, $0.53 per share, for the same period in 1998. 15 Comprehensive losses, which includes net earnings plus unrealized losses net of tax, totaled $12.7 million, $1.26 per share, compared to $10.8 million, $1.02 per share, for the same period in 1998. Unrealized losses, net of tax, for the third quarter of 1999 were $21.2 million, $2.10 per share compared to $16.3 million, $1.55 per share, for the same period in 1998. This increase in losses is attributable to the stock market declines of August and September, 1999. RLI INSURANCE GROUP Gross written premium for the third quarter of 1999 totaled $91.1 million, compared to $73.8 million reported for the same period in 1998. Much of this improvement came from the casualty segment as mentioned previously. Pretax underwriting profit increased to $4.5 million in the third quarter of 1999 compared to $1.7 million for the same period last year. This equates to GAAP combined ratios of 91.2 for the third quarter of 1999 compared to 95.3 for the third quarter of 1998. Property segment gross written premiums increased by 19.9% to $33.1 million in the third quarter of 1999. This is due to a 43% increase in fire premiums to $10.7 million for the third quarter of 1999, compared to $7.5 million for the same period in 1998, as well as some production from new product lines. Property segment underwriting profits were $4.0 million for the third quarter of the year compared to $3.9 million last year. The GAAP combined ratio for the property segment increased to 69.3 for the third quarter of 1999 compared to 68.0 for the same period last year. This increase was due to the increasing mix of fire lines with higher loss ratios, as mentioned previously. Gross written premiums for the casualty segment were $48.1 million for the third quarter of 1999 compared to $39.1 million for the prior year. This is primarily due to the increases in the commercial umbrella and the transportation products mentioned previously. Commercial umbrella gross written premium increased by $2.4 million and the transportation product by $4.0 million from the third quarter of 1998. The GAAP combined ratio fell slightly to 101.6 for the third quarter compared to 102.1 last year. The Group's surety segment gross written premiums increased by 40.0% to $9.9 million for the third quarter of 1999 compared to $7.1 million for the same period in 1998. This increase was primarily due to $2.4 million in premium for the quarter from Underwriters' Indemnity in Houston. The GAAP combined ratio for the surety segment fell to 85.6 in the third quarter from 137.7 a year ago. This was the result of the charge to reserves late in the third quarter of 1998, as mentioned previously. Without the effect of this charge, the GAAP combined ratio would have been 84.8, which is more in line with the 85.6 combined ratio realized for the third quarter of 1999. 16 INVESTMENT INCOME The Company's investment portfolio generated net dividends and interest income of $6.7 million during the third quarter of 1999, an increase of 9.0% over that reported for the same period in 1998. This is the result of an increase in cash flow due to the Company's premium growth and the impact of the new global casualty reinsurance treaty. In addition, the Company recognized realized investment gains of $2.3 million in the third quarter of 1999 compared to $32,000 in the third quarter of 1998. Third quarter of 1999 includes the sale of certain equity securities, as discussed previously. INCOME TAXES The Company's effective tax rate for the third quarter of 1999 was 29% compared to 22% for the same period in 1998. This increase is due to goodwill amortization from the acquisition of Underwriters' Indemnity in 1999 not being deductible for tax purposes, as well as an increase in underwriting income for the quarter, which is taxed at 35%. Income tax expense attributable to income from operations differed from the amounts computed by applying the U.S. federal tax rate of 35% to pretax income for the third quarter of 1999 and 1998 as a result of the following: 1999 1998 Amount % Amount % ------ --- ------ --- Provision for income taxes at the statutory rate of 35% $ 4,179,201 35% $ 2,498,026 35% Increase (reduction) in taxes resulting from: Tax exempt interest income (652,423) (5%) (578,181) (8%) Dividends received deduction (368,891) (3%) (349,255) (5%) Dividends paid deduction (62,533) (1%) (59,927) (1%) Goodwill amortization 280,707 2% -- - Other items, net 93,021 1% 48,057 1% ----------- ---- ----------- --- Total tax expense $ 3,469,082 29% $ 1,558,720 22% ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 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 RLI Corp.'s investment decisions and objectives. The Company manages its exposure to market risk by using the following: 1. Monitoring on a constant basis the fair market value of all financial assets; 2. Changing the character of future investments purchases; and 3. Re-balancing its existing asset and liability portfolios. 17 The Company's primary risk exposures are to changes in interest rates and equity prices, as it has no derivatives or foreign exchange risk as of September 30, 1999. INTEREST RATE RISK The Company's primary exposure to interest rate risk is with its fixed income investment portfolio, but on a smaller scale, it also incurs similar risk with its short-term debt instruments. Modified duration analysis is used to measure the sensitivity of the fixed income investment portfolio to changes in interest rates, providing a measure of price percentage volatility. The Company attempts to minimize interest rate risk by matching the duration of its assets to that of its liabilities. The Company limits the impact of changes in interest rates on its financial statements by designating a majority of the fixed income holdings as held-to-maturity. This designation is chosen for the securities for which the Company has the intent and ability to hold to stated maturity. These securities are carried at amortized cost and, except for declines that are other than temporary, changes in fair market value are not reflected on the financial statements. As of September 30, 1999, the Company had classified 86% of its fixed income securities portfolio as held-to-maturity. The balance of the Company's fixed income portfolio is classified as either available-for-sale or trading. Interest rate risk could also impact the Company's income statement due to its impact on interest expense. The Company's current debt obligations are short term in nature with no long-term debt outstanding as of September 30, 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 the decline of 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 September 30, 1999, the Company's equity portfolio has a beta of 0.68 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 equity investment philosophy. Historically, dividend-paying common stocks have demonstrated superior down-market performance characteristics. Additional risk management techniques include: 1. Restricting individual security weightings to less than 3% of the equity portfolio's market value; and 2. Reducing the exposure to sector risk by limiting the market value invested in any one particular industry sector to 25% of the equity portfolio. 18 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 tables below detail information on the market risk exposure for the Company's financial investments as of September 30, 1999. Listed on each table is the September 30, 1999 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 non-trading purposes. The examples given are not predictions of future market events, but rather illustrations of the impact such events may have on the market value of the Company's investment portfolio. As of September 30, 1999, the Company's fixed income portfolio had a market value of $353.7 million. This sensitivity analysis uses scenarios of interest rates increasing 100 and 200 basis points from their September 30, 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 $27.7 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 only be affected by holdings designated as trading. As of September 30, 1999, the Company's equity portfolio had a market value of $277.8 million. This base sensitivity analysis uses market scenarios of the S&P 500 index declining both 10 percent and 20 percent. These scenarios would result in approximate decreases in the market value of the equity portfolio of $18.9 million and $37.8 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. The income statement will also be impacted by interest expense. As of September 30, 1999, the Company had $79.5 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 interest expense by $800,000 and a 200 basis point increase would increase annual 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 following tables. 19 TABLE 1 (IN THOUSANDS) Effect of a 100 basis point increase in interest rates and a 10% decline in the S&P 500: 9/30/99 Interest Equity MKT. VALUE RATE RISK RISK ---------- --------- ------ Held for Trading Purposes Fixed Maturity Securities $ 7,702 ($ 253) -- Total Trading $ 7,702 ($ 253) -- Held for Non-Trading Purposes Fixed Maturity Securities $345,951 ($13,934) -- Equity Securities $277,838 -- ($18,893) Total Non-Trading $623,789 ($13,934) ($18,893) Total Trading & Non-Trading $631,491 ($14,187) ($18,893) TABLE 2 (IN THOUSANDS) Effect of a 200 basis point increase in interest rates and a 20% decline in the S&P 500: 9/30/99 Interest Equity MKT. VALUE RATE RISK RISK ---------- --------- ------ Held for Trading Purposes Fixed Maturity Securities $ 7,702 ($ 492) -- Total Trading $ 7,702 ($ 492) -- Held for Non-Trading Purposes Fixed Maturity Securities $345,951 ($27,177) -- Equity Securities $277,838 -- ($37,786) Total Non-Trading $623,789 ($27,177) ($37,786) Total Trading & Non-Trading $631,491 ($27,669) ($37,786) TABLE 3 (IN THOUSANDS) Effect of a 100 basis point decrease in interest rates and a 10% increase in the S&P 500: 9/30/99 Interest Equity Mkt. Value Rate Risk Risk ---------- --------- ------ Held for Trading Purposes Fixed Maturity Securities $ 7,702 $ 261 -- Total Trading $ 7,702 $ 261 -- Held for Non-Trading Purposes Fixed Maturity Securities $345,951 $ 13,008 -- Equity Securities $277,838 -- $ 18,893 Total Non-Trading $623,789 $ 13,008 $ 18,893 Total Trading & Non-Trading $631,491 $ 13,269 $ 18,893 20 TABLE 4 (IN THOUSANDS) Effect of a 200 basis point decrease in interest rates and a 20% increase in the S&P 500: 9/30/99 Interest Equity Mkt. Value Rate Risk Risk ---------- --------- ------ Held for Trading Purposes Fixed Maturity Securities $7,702 $513 -- Total Trading $7,702 $513 -- Held for Non-Trading Purposes Fixed Maturity Securities $345,951 $25,479 -- Equity Securities $277,838 -- $37,786 Total Non-Trading $623,789 $25,479 $37,786 Total Trading & Non-Trading $631,491 $25,992 $37,786 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS - Not Applicable ITEM 2. CHANGE IN SECURITIES - Not Applicable ITEM 3. DEFAULTS UPON SENIOR SECURITIES - Not Applicable ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - Not Applicable ITEM 5. OTHER INFORMATION - Not Applicable ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Not Applicable (b) The Company did not file any reports on Form 8-K during the nine months ended September 30, 1999. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. RLI Corp. /s/ Joseph E. Dondanville ---------------------------------- Joseph E. Dondanville Vice President, Chief Financial Officer (Duly authorized and Principal Financial and Accounting Officer) Date: November 11, 1999 21