We do not reserve for natural or man-made catastrophes until an event has occurred. Shortly after such occurrence, we review insured locations exposed to the event and industry loss estimates of the event. We also consider our knowledge of frequency and severity from early claim reports to determine an appropriate reserve for the catastrophe. These reserves are reviewed frequently to consider actual losses reported and appropriate changes to our estimates are made to reflect the new information.
In addition to the review of historical claim reporting and payment patterns, we also incorporate estimated losses relative to premium (loss ratios) by year into the analysis. The expected loss ratios are based on a review of historical loss performance, trends in frequency and severity and price level changes. The estimates are subject to judgment including consideration given to available internal and industry data, growth and policy turnover, changes in policy limits, changes in underlying policy provisions, changes in legal and regulatory interpretations of policy provisions and changes in reinsurance structure. For the most current year, these are equivalent with the ratios used in the initial IBNR generation process. Increased recognition is given to actual emergence as the years age.
Quantitative criteria considered during this process include, but are not limited to: the degree and duration of current fair value as compared to the cost (amortized, in certain cases) of the security, degree and duration of the security’s fair value being below cost and, for fixed maturities, whether the issuer is in compliance with the terms and covenants of the security. Qualitative criteria include the credit quality, current economic conditions, the anticipated speed of cost recovery, the financial health of and specific prospects for the issuer, as well as the absence of intent to sell or requirement to sell fixed income securities prior to recovery. In addition, we consider price declines of fixed income securities in our OTTI analysis where such price declines provide evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration as opposed to rising interest rates.
Favorable development on prior accident years’ loss reserves benefited underwriting earnings in each of the past three years, though the benefit in 2017 was smaller than the two previous years. The total benefit from favorable development on prior years’ reserves was $17.5 million for 2017, with the bulk of the development attributable to accident years 2014 through 2016. Products which generated the majority of the favorable development included umbrella, general liability, executive products, small commercial and professional services. The reduced benefit for 2017 was driven mainly by lower levels of favorable development on our general liability, commercial umbrella and small commercial lines compared to the two previous years. Our transportation business experienced adverse development on prior years’ reserves for the second consecutive year, though the level of adverse development was considerably smaller in 2017. We began re-underwriting our transportation book in the fourth quarter 2016 in response to adverse commercial auto loss trends, with a focus on obtaining appropriate rate increases and improving risk selection. While some unfavorable development was experienced in the first quarter of 2017, loss development results improved for the remainder of the year. Our transportation re-underwriting efforts were completed during the second half of 2017. In total, prior accident years’ reserve development for transportation was unfavorable by $7.4 million and $15.4 million in 2017 and 2016, respectively, and favorable by $5.4 million in 2015.
As of December 31, 2017, our corporate debt portfolio totaled $519.0 million (31 percent) of the fixed income portfolio compared to $508.4 million (32 percent) as of December 31, 2016. The corporate allocation includes floating rate bank loans
The amortized cost and fair value of fixed income securities at December 31, 2017, by contractual maturity, are shown as follows:
Our largest source of cash is from premiums received from our customers, which we receive at the beginning of the coverage period for most policies. Our largest cash outflow is for claims that arise when a policyholder incurs an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various investment securities that earn interest and dividends. We use cash to pay commissions to brokers and agents, as well as to pay for ongoing operating expenses such as salaries, rent, taxes and interest expense. We also utilize reinsurance to manage the risk that we take on our policies. We cede, or pay out, part of the premiums we receive to our reinsurers and collect cash back when losses subject to our reinsurance coverage are paid.
Our capital structure is comprised of equity and debt obligations. As of December 31, 2017, our capital structure consisted of $148.9 million in 10-year maturity senior notes (long-term debt) and $853.6 million of shareholders’ equity. Debt outstanding comprised 15 percent of total capital as of December 31, 2017.
Our products are designed and underwritten by individuals with deep expertise. We are a niche participant in our chosen markets, offering convenient solutions to consumers who have unique needs, difficulty finding coverage or a need for specialized claims-handling. Our ownership culture and focus on underwriting discipline, coupled with a diverse portfolio of specialty products, have served us well in all markets. We expect price stabilization and some firming throughout 2018, which should allow current accident years’ margins to stabilize or improve slightly. We also expect moderate growth in our top line and an underwriting profit overall, assuming normal catastrophe activity. Some additional detail by segment follows.
For the first time in several years, the property segment has the opportunity to grow in 2018. Commercial property, which focuses on catastrophe coverages, is seeing broad rate stabilization and rate increases in loss impacted areas. Reinsurance costs are expected to rise and should result in the primary carriers passing on this expense to their insureds. The degree of rate change will likely be less than what the industry was hoping for, following a year of nearly $85 billion in catastrophe losses, but any increase will improve a product line where margins were getting too thin relative to the risk. Investments in marketing
As of December 31, 2017, we had a 23 percent interest in the equity and earnings of Prime Holdings Insurance Services, Inc. (Prime), which is accounted for by the equity method. Prime writes business through two Illinois domiciled insurance carriers, Prime Insurance Company, an excess and surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company. Our investment in Prime was $12.4 million at December 31, 2017 and $9.6 million at December 31, 2016. In 2017, we recorded $2.8 million in investee earnings for Prime, compared to $1.1 million in 2016 and $1.0 million in 2015. Additionally, we maintain a 25 percent quota share reinsurance treaty with Prime, which contributed $29.6 million of gross premiums written and $21.0 million of net premiums earned during 2017, compared to $13.4 million of gross premiums written and $11.4 million of net premiums earned during 2016 and $11.3 million of gross premiums written and $10.9 million of net premiums earned during 2015.
As previously disclosed for our medical professional liability reporting unit, rate and volume declines coupled with adverse loss experience resulted in a triggering event during the second quarter of 2016. A fair value was determined by using a weighted average of a market approach valuation and income approach (or discounted cash flow method) valuation. It was determined that the carrying cost of our medical professional liability goodwill exceeded the fair value, resulting in a $7.2 million non-cash impairment charge. Further adverse loss experience triggered the need to test the medical professional liability reporting unit during the second quarter of 2017, resulting in an additional $3.4 million non-cash impairment charge. A fair value for the medical professional liability reporting unit’s agency relationships, carried as a definite-lived intangible, was determined by using a discounted cash flow valuation. The carrying value exceeded the fair value, resulting in a $1.8 million non-cash impairment charge. Similar to in 2016, a fair value for the medical professional liability reporting unit’s goodwill was determined by using a weighted average of a market approach and discounted cash flow valuation. The carrying value exceeded the fair value, resulting in a $1.6 million non-cash impairment charge. All impairment charges were recorded as net realized losses in the respective period’s consolidated statement of earnings. The annual impairment testing indicated no further impairment and no additional triggering events occurred subsequent to the second quarter of 2017.
Due to the relatively short-term nature of cash, short-term investments, accounts receivable and accounts payable, their carrying amounts are reasonable estimates of fair value. Our investments in a business development company and a global credit fund, classified as other invested assets, are measured using the investments’ net asset value per share and are not categorized within the fair value hierarchy. The fair value of our long-term debt is discussed further in note 4.
In 2017, the company adopted FASB ASU 2016-09, which requires the excess tax benefit on share-based compensation to flow through income tax expense. Prior to the adoption, excess tax benefits on share-based compensation were recorded directly to shareholders’ equity and had no impact on the effective tax rate. Due to the new accounting method, we recognized a $5.8 million tax benefit in 2017, decreasing the effective tax rate by 6.9 percent.