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 June 30, 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
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Commission File Number: 0-6612
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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 August 10, 1999 the number of shares outstanding of the registrant's
Common Stock was 10,024,726.
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 June 30,
(Unaudited) 1999 1998
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Net premiums earned $47,671,954 $35,085,369
Net investment income 6,193,957 5,741,858
Net realized investment gains 2,234,634 65,983
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56,100,545 40,893,210
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Losses and settlement expenses 22,026,589 15,139,615
Policy acquisition costs 16,311,484 9,880,536
Insurance operating expenses 4,493,527 4,459,423
Interest expense on debt 939,460 640,389
General corporate expenses 807,520 953,355
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44,578,580 31,073,318
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Equity in earnings of uncons. investee 763,327 573,321
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Earnings before income taxes 12,285,292 10,393,213
Income tax expense 3,264,500 2,768,225
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Net earnings $ 9,020,792 $ 7,624,988
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Other compre. earnings, net of tax 12,571,127 172,101
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Comprehensive earnings $21,591,919 $ 7,797,089
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Earnings per share:
Basic:
Net earnings per share from operations $0.75 $0.72
Realized gains, net of tax $0.14 $0.00
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Basic net earnings per share $0.89 $0.72
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Basic compre. earnings per share $2.12 $0.74
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Diluted:
Net earnings per share from operations $0.74 $0.71
Realized gains, net of tax $0.14 $0.00
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Diluted net earnings per share $0.88 $0.71
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Diluted compre. earnings per share $2.10 $0.73
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Weighted average number of common shares outstanding
Basic 10,173,411 10,526,727
Diluted 10,267,103 10,663,068
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 Six-Month Period Ended June 30,
(Unaudited) 1999 1998
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Net premiums earned $93,461,432 $70,000,479
Net investment income 12,428,180 11,686,378
Net realized investment gains 2,257,967 638,546
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108,147,579 82,325,403
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Losses and settlement expenses 43,099,051 27,562,696
Policy acquisition costs 33,634,091 23,897,741
Insurance operating expenses 8,155,695 8,822,780
Interest expense on debt 1,828,755 1,044,185
General corporate expenses 1,702,894 2,120,235
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88,420,486 63,447,637
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Equity in earnings of uncons. investee 1,217,380 937,275
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Earnings before income taxes 20,944,473 19,815,041
Income tax expense 5,345,900 5,214,025
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Net earnings $15,598,573 $14,601,016
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Other compre. earnings, net of tax 7,611,886 17,588,226
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Comprehensive earnings $23,210,459 $32,189,242
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Earnings per share:
Basic:
Net earnings per share from operations $1.38 $1.34
Realized gains, net of tax $0.14 $0.04
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Basic net earnings per share $1.52 $1.38
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Basic compre. earnings per share $2.26 $3.04
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Diluted:
Net earnings per share from operations $1.36 $1.32
Realized gains, net of tax $0.14 $0.04
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Diluted net earnings per share $1.50 $1.36
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Diluted compre. earnings per share $2.24 $3.00
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Weighted average number of common shares outstanding
Basic 10,283,449 10,604,856
Diluted 10,372,947 10,739,120
Cash dividends declared per common share $0.27 $0.25
The accompanying notes are an integral part of the financial statements.
3
RLI Corp. and Subsidiaries Condensed Consolidated Balance Sheet
June 30, 1999 December 31, 1998
(Unaudited)
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ASSETS
Investments
Fixed maturities
Held-to-maturity, at amortized cost $286,240,893 $ 283,991,524
Trading, at market value 8,038,160 8,348,141
Available-for-sale, at market value 46,434,285 36,516,393
Equity securities, at fair value 307,142,752 296,520,399
Short-term investments, at cost 43,962,269 51,917,333
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Total investments 691,818,359 677,293,790
Accrued investment income 6,255,121 6,457,473
Premiums and reinsurance balances receivable 89,091,742 46,666,743
Ceded unearned premium 44,830,122 59,779,814
Reinsurance balances recoverable on unpaid losses 220,878,691 168,260,816
Deferred policy acquisition costs 34,128,196 22,510,141
Property and equipment 14,310,155 12,199,800
Investment in unconsolidated investee 14,670,386 13,457,367
Goodwill 29,248,057 4,127,586
Other assets 9,903,577 1,931,507
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TOTAL ASSETS $1,155,134,406 $1,012,685,037
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LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Unpaid losses and settlement expenses $ 484,139,521 $ 415,523,392
Unearned premiums 157,384,417 142,022,972
Reinsurance balances payable 44,488,823 32,160,867
Short-term debt and notes payable 74,560,143 39,643,965
Income taxes-current 1,413,480 2,124,460
Income taxes-deferred 53,583,162 48,420,667
Other liabilities 34,725,971 38,830,060
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TOTAL LIABILITIES 850,295,517 718,726,383
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Shareholders' Equity:
Common stock ($1 par value, authorized)
(12,789,935 shares issued at 12/31/98)
(12,803,652 shares issued at 6/30/99) 12,803,652 12,789,935
Paid-In Capital 70,941,379 71,093,124
Accumulated other comprehensive earnings 117,983,346 110,371,461
Retained Earnings 176,174,873 163,324,161
Deferred compensation 4,462,027 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)
(2,749,701 shares at 6/30/99) ( 77,526,388) ( 64,579,634)
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TOTAL SHAREHOLDERS' EQUITY 304,838,889 293,958,654
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TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,155,134,406 $1,012,685,037
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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 Six-Month Period
Ended June 30,
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1999 1998
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Net cash provided by
operating activities $ 19,187,390 $ 1,801,540
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Cash Flows from Investing Activities
Investments purchased (12,244,042) (27,550,910)
Investments sold 8,595,525 3,374,563
Investments called or matured 6,965,000 17,596,600
Net increase in short-term investments 1,371,685 5,277,522
Net property and equipment purchased ( 2,604,784) (333,495)
Investment in Underwriters Indemnity Holdings (40,700,000) 0
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Net cash (used in)
investing activities (38,616,616) ( 1,635,720)
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Cash Flows from Financing Activities
Cash dividends paid ( 2,764,588) ( 2,646,444)
Proceeds from issuance of notes payable 31,351,178 13,470,000
Change in contributed capital 286,970 47,436
Fractional shares paid -- (16,109)
Treasury shares purchased (11,945,333) (11,020,703)
Unearned ESOP shares purchased 2,500,999 0
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Net cash provided by (used in) financing
activities 19,429,226 (165,820)
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Net increase in cash 0 0
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Cash at the beginning of the year 0 0
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Cash at December 31 $ 0 $ 0
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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 six-month periods ended June 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 Six-Month Period Ended June 30, 1999
Income Shares Per Share
(Numerator) (Denominator) Amount
- ------------------------------------------------------------------------------
BASIC EPS
Income available to $15,598,573 10,283,449 1.52
common stockholders
EFFECT OF DILUTIVE SECURITIES
Incentive Stock Options -- 89,498
- ------------------------------------------------------------------------------
DILUTED EPS
Income available to common $15,598,573 10,372,947 1.50
- ------------------------------------------------------------------------------
6
For the Six-Month Period Ended June 30, 1998
Income Shares Per Share
(Numerator) (Denominator) Amount
- ------------------------------------------------------------------------------
BASIC EPS
Income available to $14,601,016 10,604,856 1.38
common stockholders
EFFECT OF DILUTIVE SECURITIES
Incentive Stock Options -- 134,264
- ------------------------------------------------------------------------------
DILUTED EPS
Income available to common $14,601,016 10,739,120 1.36
- ------------------------------------------------------------------------------
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 June 30, 1999.
7
2. INDUSTRY SEGMENT INFORMATION - Selected information by industry segment
for the six months ended June 30, 1999 and 1998 is presented below.
SEGMENT DATA--(in thousands) EARNINGS REVENUES
1999 1998 1999 1998
---- ---- ---- ----
Property 8,940 10,607 24,802 27,883
Casualty (1,206) (1,680) 56,265 33,906
Surety 839 790 12,394 8,211
Net investment income 12,428 11,686 12,428 11,686
Realized gains 2,258 639 2,258 639
General corporate expense
and interest on debt (3,532) (3,164)
Equity in earnings of
unconsolidated investee 1,217 937
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Total segment earnings before
income taxes 20,944 19,815
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Income taxes 5,346 5,214
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Total 15,598 14,601 108,147 82,325
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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 six
months ended June 30, 1999.
8
SIX MONTHS ENDED JUNE 30, 1999, COMPARED TO SIX MONTHS
ENDED JUNE 30, 1998
Consolidated gross sales, which consist of gross premiums written, net
investment income and realized investment gains totaled $178.2 million for the
first six months of 1999 compared to $153.1 million for the same period in 1998.
Gross writings of the Insurance Group improved 16.2% over 1998 levels fueled by
a $21 million increase in casualty premiums. Consolidated revenue for the first
six months of 1999 increased $25.8 million or 31.4% from the same period in
1998. Net premiums earned alone increased 33.5% 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 6.3% to $12.4 million. Realized investment gains
totaled $2.3 million for the first six months of 1999 compared to $600,000 for
the same period in 1998 due to the strategic sale of several equity positions
late in the second quarter.
The net after-tax earnings for the first six months of 1999 totaled $15.6
million, $1.50 per diluted share, compared to $14.6 million, $1.36 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
$14.1 million, $1.36 per share, compared to $14.2 million, $1.32 per share, for
the same period in 1998.
Comprehensive earnings, which includes net earnings plus unrealized gains/losses
net of tax, totaled $23.2 million, $2.24 per share, compared to $32.1 million,
$3.00 per share, for the same period in 1998. Unrealized gains, net of tax, for
the first six months of 1999 were $7.6 million, $0.74 per share compared to
$17.6 million, $1.64 per share, for the same period in 1998. The decline in the
stock market in the first quarter of 1999 coupled with the unusually high rise
in the stock market during the first quarter of 1998 accounted for the decrease
in unrealized gains.
RLI INSURANCE GROUP
Gross written premium for the Group increased to $163.6 million for the first
six months of 1999 compared to $140.8 million for the same period in 1998. Much
of this improvement came from the casualty segment where various growth
initiatives are taking effect. Profitability declined with $8.6 million in
pretax underwriting profit compared to $9.7 million last year. This equates to
GAAP combined ratios of 90.8 for the first six months of 1999 compared to 86.1
for the first six months of 1998. The decline in profitability is attributed to
the increase in the Group's casualty writings, which are booked at a somewhat
higher loss ratio than other lines of business. Casualty segment premiums
accounted for 54% of the total premium in the first six months of 1999 compared
to 48% for the same period in 1998.
The Group's property segment increased premium writings by 7.8% in the first six
months of 1999. Difference in conditions premiums continue to decline as a
result of rate reductions. This trend was offset by a 53% increase in fire
premiums in the first six months along with some production from new product
lines. The property segment generated solid underwriting profits at $8.9 million
for the first six months of the year compared to $10.6 million last year.
Despite the lower volume of profit, the GAAP combined ratio remained steady at
63.9 compared to 61.9 a year ago.
9
Casualty segment gross written premiums were $89.0 million for the first six
months of 1999 compared to $67.9 million for the prior year. The driving forces
behind this improvement were increases in the commercial umbrella product of
$8.3 million and the transportation product of $5.7 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 102.1 for the first six months compared to 105.0 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
102.1, 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 $13.6 million for the first six
months of 1999 compared to $16.3 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 $3.3 million in
premium for the period from the newly acquired surety operation in Houston -
Underwriters' Indemnity. Also as a result of the disassociation with the
producer mentioned above, the GAAP combined ratio for the surety segment rose to
93.3 in the first six months from 90.4 a year ago as expenses did not fall in
proportion to the lost premium.
INVESTMENT INCOME
The Company's investment portfolio generated net dividends and interest income
of $12.4 million during the first six months of 1999, an increase of 6.3% 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 June 30, 1999 increased by $14.5 million, or 2.1%, from
December 31, 1998. For the six months ended June 30, 1999, the Company
experienced a $11.7 million pre-tax unrealized gain 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 94% were rated AA or better. The year-to-date yields on the
Company's fixed income investments for the six-month periods ended June 30, 1999
and 1998 are as follows:
1999 1998
---- ----
Taxable 6.76% 6.58%
Non-taxable 5.06% 4.98%
10
Yields on taxable and non-taxable securities were higher through the first six
months of 1999 due to a change in the accounting treatment for amortization in
June of 1998, which resulted in a slightly negative impact on yields in the
second quarter of 1998. The addition of Underwriters Indemnity Holding's
portfolios in the first quarter of 1999 also contributed to the higher yields.
The Company's available-for-sale portfolio of debt and equity securities had a
net unrealized gain before tax of $11.7 million for the first six months of 1999
compared to net unrealized gains before tax of $27.1 million for the same period
in 1998. The 1999 year-to-date gain, though falling short of last year's
phenomenal growth for the same period, is attributable entirely to the equity
portfolio's strong performance. Net unrealized gains before tax were $181.2
million and $169.5 million at June 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 $1.8 million for the first six
months of 1999, a $785,000 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 June 30,
1999, outstanding short-term debt totaled $74.6 million.
INCOME TAXES
The Company's effective tax rate for the first six months of 1999 and 1998 was
26%. 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 six 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% $ 7,330,566 35% $ 6,935,264 35%
Increase (reduction) in taxes
resulting from:
Tax exempt interest income (1,264,015) ( 6%) (1,083,591) ( 5%)
Dividends received deduction ( 751,655) ( 3%) ( 699,597) ( 4%)
Dividends paid deduction ( 120,537) ( 1%) ( 112,151) ( 1%)
Other items, net 151,541 1% 174,100 1%
----------- ---- ----------- ---
Total tax expense $ 5,345,900 26% $ 5,214,025 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.
11
During the first six months of 1999, the Company repurchased 364,965 of its
outstanding shares at a cost of $11.9 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.
Second 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 June 30, 1999 the Company had short-term investments, cash and other
investments maturing within one year, of approximately $86.6 million and
additional investments of $124.8 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
June 30, 1999, the Company had $12.6 million in outstanding short-term
borrowings. Additionally, the Company was party to six reverse repurchase
transactions totaling $61.2 million and other miscellaneous short-term debt of
$700,000.
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
second quarter 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.
12
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.
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.
13
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 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 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 will be
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. The statement will also
be posted on the Company's Internet site for quick reference by interested
parties.
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 is continuing to enhance and
update the present business contingency plan to address specific Y2K related
exposures. The Company is determining the specific requirements associated with
a Y2K operational support plan for the millennium weekend, including on-site
staff and on-call support to be defined by the third quarter 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 is
estimated that the Company will 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 has
implemented a new e-mail solution in April of 1999 and new corporate phone
system and switch in May of 1999. Several new Y2K personal computer compliant
software applications have already been implemented or are in the process of
being implemented to minimize Y2K exposures with personal computer software.
A formal re-evaluation of all personal computer hardware, network components and
software began in May of 1999 and is expected to be completed in September of
1999. The Company conducted a successful Y2K simulation 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.
14
THREE MONTHS ENDED JUNE 30, 1999, COMPARED TO THREE MONTHS
ENDED JUNE 30, 1998
Consolidated gross sales totaled $97.0 million for the second quarter of 1999
compared to $83.9 million for the same period in 1998. As detailed in the
discussion of RLI Insurance Group that follows, second quarter 1999 gross
premiums improved $10.5 million, or 13.4%, over second quarter 1998 levels.
Consolidated revenue for the second quarter of 1999 increased $15.2 million, or
37.2%, from the same period in 1998. Net premiums earned in the second quarter
of 1999 improved $12.6 million compared to 1998, and investment income and
investment gains improved $2.6 million over second quarter 1998 levels.
The net after-tax earnings for the second quarter of 1999 totaled $9.0 million,
$0.88 per diluted share, compared to $7.6 million, $0.71 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 $7.6
million, $0.74 per share, compared to $7.6 million, $0.71 per share, for the
same period in 1998.
Comprehensive earnings, which includes net earnings plus unrealized gains/losses
net of tax, totaled $21.6 million, $2.10 per share, compared to $7.8 million,
$0.73 per share, for the same period in 1998. Unrealized gains, net of tax, for
the second quarter of 1999 were $12.6 million, $1.22 per share compared to
$172,000, $0.02 per share, for the same period in 1998. This increase is
attributable to the stock market rallies of April and June, 1999.
RLI INSURANCE GROUP
Gross written premium for the second quarter of 1999 totaled $88.6 million,
compared to $78.1 million reported for the same period in 1998. Much of this
improvement came from the casualty segment as mentioned previously. Pretax
underwriting profit declined to $4.8 million in the second quarter of 1999
compared to $5.6 million for the same period last year. This equates to GAAP
combined ratios of 89.8 for the second quarter of 1999 compared to 84.0 for the
second quarter of 1998. The decline in profitability is attributed to the change
in the Group's mix of business as mentioned previously.
Property segment gross written premiums increased by 11.2% to $35.0 million in
the second quarter of 1999. This is due to a 33% increase in fire premiums to
$13.3 million for the second quarter of 1999, compared to $10.0 million for the
same period in 1998. The increase was partially offset by the continued decline
of difference in condition premiums as a result of rate reductions. Property
segment underwriting profits were $4.9 million for the second quarter of the
year compared to $5.5 million last year. The GAAP combined ratio for the
property segment increased to 62.2 for the second quarter of 1999 compared to
58.6 for the same period last year. This slight increase was due to an increase
in fire losses during the period.
Gross written premiums for the casualty segment were $46.0 million for the
second quarter of 1999 compared to $37.0 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 $3.4 million and the transportation product by $1.8 million from
the second quarter of 1998. The GAAP combined ratio fell slightly to 101.3 for
the second quarter compared to 102.7 last year.
15
The Group's surety segment gross written premiums fell by 21.6% to $7.6 million
for the second quarter of 1999 compared to $9.7 million for the same period in
1998. This decline was the result of the Company's disassociation with a
particular producer late in 1998 as mentioned previously. This decline was
partially offset by $2.0 million in premium for the quarter from Underwriters'
Indemnity in Houston. The GAAP combined ratio for the surety segment rose to
94.3 in the second quarter from 86.5 a year ago as expenses did not fall in
proportion to lost premium as a result of the Company's disassociation with a
particular producer.
INVESTMENT INCOME
The Company's investment portfolio generated net dividends and interest income
of $6.2 million during the second quarter of 1999, an increase of 7.9% 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.
In addition, the Company recognized realized investment gains of $2.2 million in
the second quarter of 1999 compared to $66,000 in the second quarter of 1998.
Second quarter of 1999 includes the sale of certain equity securities, as
discussed previously.
INCOME TAXES
The Company's effective tax rate for the second quarter of 1999 and 1998 was
27%. 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 second 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% $ 4,299,852 35% $ 3,637,625 35%
Increase (reduction) in taxes
resulting from:
Tax exempt interest income ( 640,383) ( 5%) ( 553,818) ( 5%)
Dividends received deduction ( 373,593) ( 3%) ( 345,745) ( 3%)
Dividends paid deduction ( 59,354) -- ( 56,477) ( 1%)
Other items, net 37,978 -- 86,640 1%
----------- ---- ----------- ---
Total tax expense $ 3,264,500 27% $ 2,768,225 27%
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:
16
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 June 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 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 June
30, 1999, the Company had classified 84% 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 June 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 June 30, 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.
17
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 June 30, 1999. Listed on each table is the
June 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 June 30, 1999, the Company's fixed income portfolio had a market value of
$341.9 million. This sensitivity analysis uses scenarios of interest rates
increasing 100 and 200 basis points from their June 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 $12.9 million and $25.2 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 June 30, 1999, the Company's equity portfolio had a market value of $307.1
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 $20.6
million and $41.2 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.
18
The income statement will also be impacted by interest expense. As of June 30,
1999, the Company had $74.6 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 $700,000
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:
6/30/99 Interest Equity
Mkt. Value Rate Risk Risk
---------- --------- ------
Held for Trading Purposes
Fixed Maturity Securities $ 8,038 ($ 213) --
Total Trading $ 8,038 ($ 213) --
Held for Non-Trading Purposes
Fixed Maturity Securities $333,818 ($12,653)
Equity Securities $307,143 -- ($20,579)
Total Non-Trading $640,961 ($12,653) ($20,579)
Total Trading & Non-Trading $648,999 ($12,866) ($20,579)
TABLE 2 (IN THOUSANDS)
Effect of a 200 basis point increase in interest rates and a 20% decline in the
S&P 500:
6/30/99 Interest Equity
Mkt. Value Rate Risk Risk
---------- --------- ------
Held for Trading Purposes
Fixed Maturity Securities $ 8,038 ($ 416) --
Total Trading $ 8,038 ($ 416) --
Held for Non-Trading Purposes
Fixed Maturity Securities $333,818 ($ 24,833) --
Equity Securities $307,143 -- ($41,157)
Total Non-Trading $640,961 ($ 24,833) ($41,157)
Total Trading & Non-Trading $648,999 ($ 25,249) ($41,157)
19
TABLE 3 (IN THOUSANDS)
Effect of a 100 basis point decrease in interest rates and a 10% increase in
the S&P 500:
6/30/99 Interest Equity
Mkt. Value Rate Risk Risk
---------- --------- ------
Held for Trading Purposes
Fixed Maturity Securities $ 8,038 $ 227 --
Total Trading $ 8,038 $ 227 --
Held for Non-Trading Purposes
Fixed Maturity Securities $333,818 $ 11,521 --
Equity Securities $307,143 -- $20,579
Total Non-Trading $640,961 $ 11,521 $20,579
Total Trading & Non-Trading $648,999 $ 11,748 $20,579
TABLE 4 (IN THOUSANDS)
Effect of a 200 basis point decrease in interest rates and a 20% increase in
the S&P 500:
6/30/99 Interest Equity
Mkt. Value Rate Risk Risk
---------- --------- ------
Held for Trading Purposes
Fixed Maturity Securities $ 8,038 $ 468 --
Total Trading $ 8,038 $ 468 --
Held for Non-Trading Purposes
Fixed Maturity Securities $333,818 $ 22,772 --
Equity Securities $307,143 -- $ 41,157
Total Non-Trading $640,961 $ 22,772 $ 41,157
Total Trading & Non-Trading $648,999 $ 23,240 $ 41,157
20
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 six
months ended June 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: August 12, 1999
21