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 March 31, 1999
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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.
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(Exact name of registrant as specified in its charter)
ILLINOIS 37-0889946
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
9025 North Lindbergh Drive, Peoria, IL 61615
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(Address of principal executive offices) (Zip Code)
(309) 692-1000
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(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 May 11, 1999 the number of shares outstanding of the registrant's Common
Stock was 10,204,957.
Page 1 of 17
PART I
Item 1. Financial Statements
RLI Corp. & Subsidiaries
Condensed Consolidated Statement of Earnings and Comprehensive Earnings
For the Three-Month Period Ended March 31,
(Unaudited) 1999 1998
----------- -----------
Net premiums earned $45,789,478 $34,915,110
Net investment income 6,234,223 5,944,520
Net realized investment gains 23,333 572,563
------------- -----------
52,047,034 41,432,193
------------- -----------
Losses and settlement expenses 21,072,462 12,423,081
Policy acquisition costs 17,322,607 14,017,205
Insurance operating expenses 3,662,168 4,363,357
Interest expense on debt 889,295 403,796
General corporate expenses 895,374 1,166,880
------------- -----------
43,841,906 32,374,319
------------- -----------
Equity in earnings of uncons. investee 454,053 363,954
------------- -----------
Earnings before income taxes 8,659,181 9,421,828
Income tax expense 2,081,400 2,445,800
------------- -----------
Net earnings $ 6,577,781 $ 6,976,028
============= ===========
Other compre. (loss) earnings, net of tax ( 4,959,241) 17,416,125
------------- -----------
Comprehensive earnings $ 1,618,540 $24,392,153
============= ===========
Earnings per share:
Basic:
Net earnings per share from operations $0.63 $0.62
Realized gains, net of tax $0.00 $0.04
------------- -----------
Basic net earnings per share $0.63 $0.66
============= ===========
Basic compre. earnings per share $ .16 $2.28
============= ===========
Diluted:
Net earnings per share from operations $0.63 $0.61
Realized gains, net of tax $0.00 $0.03
------------ -----------
Diluted net earnings per share $0.63 $0.64
============ ===========
Diluted compre. earnings per share $ .15 $2.26
============ ===========
Weighted average number of common shares outstanding
Basic 10,394,709 10,683,853
Diluted 10,480,013 10,816,039
Cash dividends declared per common share $0.13 $0.12
The accompanying notes are an integral part of the financial statements.
2
RLI Corp. and Subsidiaries Condensed Consolidated Balance Sheet
March 31, 1999 December 31, 1998
ASSETS (Unaudited)
Investments -------------- -----------------
Fixed maturities
Held-to-maturity, at amortized cost $300,240,409 $ 283,991,524
Trading, at market value 8,263,512 8,348,141
Available-for-sale, at market value 36,482,744 36,516,393
Equity securities, at fair value 290,345,559 296,520,399
Short-term investments, at cost 36,208,266 51,917,333
------------ -------------
Total investments 671,540,490 677,293,790
Accrued investment income 5,919,537 6,457,473
Premiums and reinsurance balances receivable 78,825,712 46,666,743
Ceded unearned premium 44,929,668 59,779,814
Reinsurance balances recoverable on unpaid losses 213,617,373 168,260,816
Deferred policy acquisition costs 32,238,675 22,510,141
Property and equipment 13,870,033 12,199,800
Investment in unconsolidated investee 13,911,420 13,457,367
Goodwill 30,188,000 4,127,586
Other assets 4,304,287 1,931,507
--------------- --------------
TOTAL ASSETS $1,109,345,195 $1,012,685,037
=============== ==============
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Unpaid losses and settlement expenses $ 472,162,460 $ 415,523,392
Unearned premiums 149,263,642 142,022,972
Reinsurance balances payable 41,669,276 32,160,867
Short-term debt, LOC and notes payable 74,897,005 39,643,965
Income taxes-current 2,381,231 2,124,460
Income taxes-deferred 46,020,867 48,420,667
Other liabilities 30,465,425 38,830,060
-------------- --------------
TOTAL LIABILITIES 816,859,906 718,726,383
-------------- --------------
Shareholders' Equity:
Common stock ($1 par value, authorized)
(12,789,935 shares issued at 12/31/98)
(12,795,765 shares issued at 3/31/99) 12,795,765 12,789,935
Paid-In Capital 70,985,530 71,093,124
Accumulated other comprehensive earnings 105,412,220 110,371,461
Retained Earnings 168,565,624 163,324,161
Deferred compensation 4,440,358 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
(2,384,736 shares at 12/31/98)
(2,522,713 shares at 3/31/99) ( 69,714,208) ( 64,579,634)
-------------- --------------
TOTAL SHAREHOLDERS' EQUITY 292,485,289 293,958,654
-------------- --------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,109,345,195 $1,012,685,037
============== ==============
The accompanying notes are an integral part of the financial statements.
3
RLI Corp. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Unaudited)
For the Three-Month Period
Ended March 31,
---------------------------
1999 1998
------------ -------------
Net cash provided by (used in)
operating activities $ 10,053,670 $ (10,926,179)
------------ -------------
Cash Flows from Investing Activities
Investments purchased (10,438,950) (13,007,456)
Investments sold 1,277,325 1,674,437
Investments called or matured 4,035,000 11,230,900
Net increase in short-term investments 8,598,674 10,195,882
Net property and equipment purchased ( 1,544,489) 163,807
Investment in Underwriters Indemnity Holdings (40,700,000) 0
------------ -------------
Net cash (used in)
provided by investing activities (38,772,440) 10,257,570
------------ -------------
Cash Flows from Financing Activities
Cash dividends paid ( 1,426,182) ( 1,261,894)
Proceeds from issuance of notes payable 31,688,040 12,887,000
Change in contributed capital 110,735 0
Fractional shares paid -- 0
Treasury shares purchased ( 4,154,822) (10,956,497)
Unearned ESOP shares purchased 2,500,999 0
------------ -------------
Net cash provided by financing activities 28,718,770 668,609
------------ -------------
Net increase in cash 0 0
------------ -------------
Cash at the beginning of the year 0 0
------------ -------------
Cash at December 31 $ 0 $ 0
=========== ============
The accompanying notes are an integral part of the financial statements.
4
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 three month periods ended March 31, 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 Three-Month Period Ended March 31, 1999
Income Shares Per Share
(Numerator) (Denominator) Amount
- ------------------------------------------------------------------------------
BASIC EPS
Income available to $6,577,781 10,394,709 .63
common stockholders
EFFECT OF DILUTIVE SECURITIES
Incentive Stock Options -- 85,304
- ------------------------------------------------------------------------------
DILUTED EPS
Income available to common $6,577,781 10,480,013 .63
- ------------------------------------------------------------------------------
5
Note that 1998 share and per share data has been restated to reflect the 5/4
stock split that occurred on June 19, 1998.
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 is effective for all fiscal quarters of
fiscal years beginning after June 15, 1999. Although the Company does not
currently invest in derivative instruments, this recently issued Statement is
under evaluation.
2. INDUSTRY SEGMENT INFORMATION - Selected information by industry segment for
the three months ended March 31, 1999 and 1998 is presented below.
SEGMENT DATA--(in thousands) EARNINGS REVENUES
1999 1998 1999 1998
---- ---- ---- ----
Property 4,070 5,123 11,937 14,638
Casualty (816) (1,203) 27,832 16,486
Surety 478 191 6,021 3,791
Net investment income 6,234 5,945 6,234 5,944
Realized gains 23 573 23 573
General corporate expense
and interest on debt (1,784) (1,571)
Equity in earnings of
unconsolidated investee 454 364
------ ------
Total segment earnings before
income taxes 8,659 9,422
------ ------
Income taxes 2,081 2,446
------ ------
Total 6,578 6,976 52,047 41,432
------ ------ ------ ------
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.
6
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 88% of the Company's total revenue for the
three months ended March 31, 1999.
THREE MONTHS ENDED MARCH 31, 1999, COMPARED TO THREE MONTHS ENDED MARCH 31,
1998
Consolidated gross sales, which consist of gross premiums written, net
investment income and realized investment gains totaled $81.2 million for the
first three months of 1999 compared to $69.2 million for the same period in
1998. Gross writings of the Insurance Group improved 19.7% over 1998 levels
fueled by a $12 million increase in casualty premiums. Consolidated revenue
for the first three months of 1999 increased $10.6 million or 25.6% from the
same period in 1998. Net premiums earned alone increased 31.1% due to the
Group's implementation of a combined casualty reinsurance contract, which
resulted in increased retentions of business while eliminating ceding
commissions. While net realized investment gains declined slightly, net
investment income improved 4.9% to $6.2 million.
The net after-tax earnings for the first three months of 1999 totaled $6.6
million, $.63 per diluted share, compared to $7.0 million, $.62 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 $6.6 million, $.63 per share, compared to $6.6 million, $.62 per
share, for the same period in 1998.
Comprehensive earnings, which includes net earnings plus unrealized
gains/losses net of tax, totaled $1.6 million, $.15 per share, compared to
$24.4 million, $2.26 per share, for the same period in 1998. Unrealized
losses, net of tax, for the first three months of 1999 were $5.0 million,
$0.48 per share compared to gains of $17.4 million, $1.61 per share, for the
same period in 1998.
RLI INSURANCE GROUP
Gross written premium for the Group increased to $75.0 million for the first
quarter of 1999 compared to $62.6 million for the same period in 1998. Much
of this improvement came from the casualty segment where various growth
initiatives are taking effect. Profitability remained relatively steady with
$3.7 million in pretax underwriting profit compared to $4.1 million last
year. This equates to GAAP combined ratios of 91.8 for the first quarter of
1999 compared to 88.2 for the first quarter of 1998. The slight decline is
attributed to the change in the Group's mix of business. Casualty segment
premiums accounted for 57% of the total premium in the first three months of
1999 compared to 49% for the same period in 1998.
7
The Group's property segment increased premium writings slightly by 3.5% in
the first quarter of 1999. Difference in conditions premiums continue to
decline as a result of rate reductions. This trend was offset by a 36%
increase in fire premiums in the first quarter along with some production
from new product lines. The property segment generated solid underwriting
profits at $4.1 million for the first three months of the year compared to
$5.1 million last year. Despite the lower volume of profit, the GAAP combined
ratio remained steady at 66.0 compared to 65.0 a year ago.
Casualty segment gross written premiums were $43.0 million for the first
quarter of 1999 compared to $30.9 for the prior year. The driving force
behind this improvement were increases in the commercial umbrella product of
$4.9 million and the transportation product of $3.9 million. During the first
quarter 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 103.0 for
the first quarter compared to 107.3 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 103.0, 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 fell to $6.0 million for the first
three months of 1999 compared to $6.6 million for the same period in 1998.
This decline was the result of the Company's disassociation with a particular
producer late in 1998. Partially offsetting this decrease was $1.3 million in
premium for the quarter from the newly acquired surety operation in Houston
- -Underwriters' Indemnity. The GAAP combined ratio for the surety segment fell
to 92.0 in the first quarter from 95.0 a year ago. This was mostly the result
of improved efficiencies as reflected in the expense ratio.
INVESTMENT INCOME
The Company's investment portfolio generated net dividends and interest
income of $6.2 million during the first three months of 1999, an increase of
4.9% 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.
Invested assets at March 31, 1999 decreased by $5.8 million, or 0.8%, from
December 31, 1998. For the three months ended March 31, 1999, the Company
experienced a $7.6 million pre-tax unrealized loss on its investment
portfolio. Additionally, short-term investments decreased to $36.2 million,
down $15.7 million from December 31, 1998.
8
Virtually all the Company's fixed income portfolio consists of securities
rated A or better and 96% were rated AA or better. The year-to-date yields on
the Company's fixed income investments for the three month periods ended
March 31, 1999 and 1998 are as follows:
1999 1998
---- ----
Taxable 6.58% 6.81%
Non-taxable 4.89% 5.02%
Yields on taxable and non-taxable securities declined through the first three
months of 1999 due to maturities and calls of higher yielding securities from
the portfolio. In a period of declining interest rates, these securities were
replaced with lower yielding securities, including an increase in municipal
investments.
The Company's available-for-sale portfolio of debt and equity securities had
a net unrealized loss before tax of $7.6 million for the first three months
of 1999 compared to net unrealized gains before tax of $26.8 million for the
same period in 1998. The difference can be attributed to the market expansion
in the first quarter of 1999 which was driven primarily by growth and
technology stocks, while RLI's investment philosophy remains focused on value
issues. Also, the first quarter correction in the bond market adversely
affected the company's holdings in the utility sector. Net unrealized gains
before tax were $161.9 million and $169.5 million at March 31, 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 $889,000 for the first
three months of 1999, a $485,000 increase from the same period in 1998. This
change is related to an increase in outstanding debt balances. The
acquisition of Underwriters Indemnity Holdings, Inc. in January, 1999 was
funded through $42.8 million in reverse repurchase agreements from RLI
Insurance Company. This increase was partially offset by debt payments
resulting in an outstanding short-term debt balance of $74.9 million at March
31, 1999.
9
INCOME TAXES
The Company's effective tax rate for the first three months of 1999 was 24%
compared to 26% for the same period in 1998. This decrease is primarily
attributable to reduced underwriting income, which is taxable 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 first three 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% $ 3,030,713 35% $ 3,297,639 35%
Increase (reduction) in taxes
resulting from:
Tax exempt interest income ( 623,632) ( 7%) ( 529,773) ( 5%)
Dividends received deduction ( 378,062) ( 4%) ( 353,845) ( 4%)
Dividends paid deduction ( 61,183) ( 1%) ( 55,675) ( 1%)
Other items, net 113,564 1% 87,454 1%
----------- ---- ----------- ---
Total tax expense $ 2,081,400 24% $ 2,445,800 26%
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 three months of 1999, the Company repurchased 137,977 of its
outstanding shares at a cost of nearly $4.2 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
First quarter, 1999 operating cash flow shows significant 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 March 31, 1999 the Company had short-term investments, cash and other
investments maturing within one year, of approximately $70.7 million and
additional investments of $121.9 million maturing within five years. The
Company maintains one source of credit, a $30.0 million secured/unsecured
line of credit that cannot be canceled during its annual term. As of March
31, 1999, the Company had $13.4 million in outstanding short-term borrowings.
Additionally, the Company was party to six reverse repurchase transactions
totaling $61.5 million.
10
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 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 1997 and was completed in April 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
Phase III completion 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 is scheduled to be completed within the first quarter of
1999. Phase V is designed to refine operational and contingency plans for Y2K
cut-over. This phase is scheduled to begin in the first quarter of 1999 and
carry 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 as critical for successful Y2K
compliance: (1) accounting and premium processing systems, (2) terms and
conditions of existing insurance contracts, and (3) third-party
relationships. Y2K compliance and progress is regularly reviewed by the
Company's MIS steering committee, audit committee and the board of directors.
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 1997. As
an element of Phase III, in November 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
11
processing upgrades were completed in January 1999. External business
interfaces have been addressed within core systems efforts but may require
additional modification for any subsequent changes implemented by external
parties. These activities concluded 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 1998, all significant vendors and business partners were surveyed
for compliance efforts and responses are being evaluated by the Company's
internal audit and compliance unit for further steps and action, prior to the
end of the first quarter of 1999. 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. 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 coverages. Although uncertainty
exists with respect to the nature and intent of Y2K liability, it is
anticipated that if Y2K claims are received, the majority will stem from
directors & officers and miscellaneous professional liability 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 is available
for underwriters' use if needed. Additionally, a Y2K team of underwriters and
claims personnel has been assembled to prepare for the proper handling of Y2K
claims. All claims will be handled on an individual basis in accordance with
policy terms and conditions.
As an element of Phase V, the Company has system-contingency services
contracted through a major third-party provider and is presently refining
support related to potential Y2K issues. In addition, the Company plans to
develop a Y2K operational support plan for the millennium weekend, including
on-site staff and on-call support, by the third quarter of 1999. Exposure and
risk management of new or developing Y2K exposures will continue through the
first quarter of 2000.
The Company has incurred $1.2 million in expenses over the last two years 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 is estimated that the Company will incur an
additional $300,000 of expense in 1999 to upgrade telephone systems,
corporate e-mail solutions, and to ensure the necessary services are in place
for contingency efforts.
12
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
(COMPANY) 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.
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 March
31, 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 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 March 31, 1999, the Company had classified 87% 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 March, 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.
13
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 March 31, 1999, the Company's equity
portfolio has a beta of 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 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.
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 March 31, 1999. Listed on each table is
the March 31, 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 March 31, 1999, the Company's fixed income portfolio had a market value
of $352.8 million. This sensitivity analysis uses scenarios of interest rates
increasing 100 and 200 basis points from their March 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 $12.3 million and $24.7
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.
14
As of March 31, 1999, the Company's equity portfolio had a market value of
$290.3 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 $19.5 million and $38.9 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 March
31, 1999, the Company had $74.9 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 $0.7 million and a 200 basis point increase would increase annual
interest expense by $1.5 million. Conversely, falling interest rates would
result in equivalent reductions in interest expense. These numbers are not
included in the following tables.
TABLE 1 (IN THOUSANDS)
Effect of a 100 basis point increase in interest rates and a 10% decline in the
S&P 500:
3/31/99 Interest Equity
Mkt. Value Rate Risk Risk
---------- --------- ------
Held for Trading Purposes
Fixed Maturity Securities $ 8,263 ($ 235) --
Total Trading $ 8,263 ($ 235) --
Held for Non-Trading Purposes
Fixed Maturity Securities $344,530 ($12,079)
Equity Securities $290,346 -- ($19,453)
Total Non-Trading $634,876 ($12,079) ($19,453)
Total Trading & Non-Trading $643,139 ($12,314) ($19,453)
TABLE 2 (IN THOUSANDS)
Effect of a 200 basis point increase in interest rates and a 20% decline in the
S&P 500:
3/31/99 Interest Equity
Mkt. Value Rate Risk Risk
---------- --------- ------
Held for Trading Purposes
Fixed Maturity Securities $ 8,263 ($ 458) --
Total Trading $ 8,263 ($ 458) --
Held for Non-Trading Purposes
Fixed Maturity Securities $344,530 ($24,247) --
Equity Securities $290,346 -- ($38,907)
Total Non-Trading $634,876 ($24,247) ($38,907)
Total Trading & Non-Trading $643,139 ($24,705) ($38,907)
15
TABLE 3 (IN THOUSANDS)
Effect of a 100 basis point decrease in interest rates and a 10% increase in the
S&P 500:
3/31/99 Interest Equity
Mkt. Value Rate Risk Risk
----------- --------- ------
Held for Trading Purposes
Fixed Maturity Securities $ 8,263 $ 252 --
Total Trading $ 8,263 $ 252 --
Held for Non-Trading Purposes
Fixed Maturity Securities $344,530 $ 11,667 --
Equity Securities $290,346 -- $ 19,453
Total Non-Trading $634,876 $ 11,667 $ 19,453
Total Trading & Non-Trading $643,139 $ 11,919 $ 19,453
TABLE 4 (IN THOUSANDS)
Effect of a 200 basis point decrease in interest rates and a 20% increase in the
S&P 500:
3/31/99 Interest Equity
Mkt. Value Rate Risk Risk
---------- --------- ------
Held for Trading Purposes
Fixed Maturity Securities $ 8,263 $ 519 --
Total Trading $ 8,263 $ 519 --
Held for Non-Trading Purposes
Fixed Maturity Securities $344,530 $ 23,589 --
Equity Securities $290,346 -- $ 38,907
Total Non-Trading $634,876 $ 23,589 $ 38,907
Total Trading & Non-Trading $643,139 $ 24,108 $ 38,907
16
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 three
months ended March 31, 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: May 14, 1999
17