· The occurrence of a discrete credit event resulting in the issuer defaulting on a material obligation, the issuer seeking protection from creditors under the bankruptcy laws, or the issuer proposing a voluntary reorganization under which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than par value of their claims,
For mortgage-backed securities and asset-backed securities that have significant unrealized loss positions and major rating agency downgrades, credit impairment is assessed using a cash flow model that estimates likely payments using security-specific collateral and transaction structure. All of our mortgage-backed and asset-backed securities remain AAA-rated by the major rating agencies and the fair value is not significantly less than amortized cost.
Underwriting income for the casualty segment was $55.6 million in 2013, compared to $25.4 million in 2012 and $61.4 million in 2011. These results translated into combined ratios of 82.8, 90.5 and 74.0 for 2013, 2012 and 2011, respectively. Favorable development on prior accident years’ loss reserves totaled $61.8 million, $40.4 million and $83.9 million, for 2013, 2012 and 2011, respectively. In each of these years, actuarial studies indicated that cumulative experience attributable to many casualty coverages for mature accident years was lower than carried reserves, resulting in the release of reserves. Loss frequency and severity trends were favorable, which resulted in reserves developing below our actuaries’ initial estimates. We believe these improved trends are due in part to the quality of our underwriters’ risk selection, which has served to offset prior year rate declines and an assumed increase in loss cost trends. In 2013, favorable development was experienced across multiple products, with a majority occurring in accident years 2005 through 2012, with more recent years representing a larger portion of the release. Similarly in 2012, favorable development was experienced across multiple products. Accident years 2007 through 2010 accounted for the majority of favorable experience in 2012. In 2011, favorable development was concentrated in accident years 2006 through 2009.
As of December 31, 2013, our investment portfolio had the following asset allocation breakdown:
oriented and security selection takes precedence over market timing. Likewise, low turnover throughout our long investment horizon minimizes transaction costs and taxes. During 2013, the total return on our equity portfolio on a mark-to-market basis was 27.4 percent, underperforming broader benchmarks like the S&P 500 due to our preference for less volatile equity sectors with higher dividend yields.
An asset-backed security (ABS) or commercial mortgage-backed security (CMBS) is a securitization collateralized by the cash flows from a specific pool of underlying assets. These asset pools can include items such as credit card payments, auto loans and residential or commercial mortgages. As of December 31, 2013, ABS/CMBS investments were $106.3 million (7 percent) of the fixed income portfolio, compared to $77.3 million (6 percent) as of December 31, 2012. The entire ABS/CMBS portfolio was rated AA or higher as of December 31, 2013. We believe that ABS/CMBS investments add diversification and additional yield to the portfolio while often adding superior cash flow stability over mortgage pass-throughs or CMOs.
When making investments in MBS/ABS/CMBS, we evaluate the quality of the underlying collateral, the structure of the transaction (which dictates how any losses in the underlying collateral will be distributed) and prepayment risks. Ninety-nine percent of our collateralized securities carry the highest credit rating by one or more major rating agency and continue to pay according to contractual terms. We had $7.7 million in unrealized losses in this asset class as of December 31, 2013.
The following table illustrates the distribution by sector of our equity portfolio as of December 31, 2013, including fair value, cost basis and unrealized gains and losses:
We have posted positive operating cash flow in each of the last three years. Variations in operating cash flow between periods are largely driven by the volume and timing of premium receipt, claim payments, reinsurance and taxes. In addition, fluctuations in insurance operating expenses impact operating cash flow. The decrease in 2012 is largely due to a $50.0 million cash deposit that we received from a commercial surety customer in lieu of a letter of credit during 2011. The $50.0 million in cash was returned during 2012. During 2013, 2012 and 2011, the majority of cash flows were used in financing activities. In each period, we paid special dividends, totaling $64.5 million in 2013, $106.3 million in 2012 and $105.8 million in 2011.
· The occurrence of a discrete credit event resulting in the issuer defaulting on a material obligation, the issuer seeking protection from creditors under the bankruptcy laws, the issuer proposing a voluntary reorganization under which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than par value,
We perform an annual impairment review of our investment in our unconsolidated investee, which considers current valuation and operating results. Based upon the most recent review, this asset was not impaired.
The aforementioned definite-lived intangible assets are amortized against future operating results based on their estimated useful lives. Amortization of intangible assets resulting from the acquisitions of CBIC and Rockbridge was $1.2 million for 2013.
Corporate, Agencies, Government and Municipal Bonds: The pricing vendor employs a multi-dimensional model which uses standard inputs including (listed in order of priority for use) benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, market bids/offers and other reference data. The pricing vendor also monitors market indicators, as well as industry and economic events. All bonds valued using these techniques are classified as Level 2. All Corporate, Agencies, Government and Municipal securities are deemed Level 2.
In 2013, 2012 and 2011, we incurred interest expense on our senior notes in the amounts of $8.1 million, $6.0 million and $6.0 million, respectively. The average rate on debt in 2013, 2012 and 2011 was 5.71 percent, 6.02 percent and 6.02 percent, respectively.
Through the purchase of reinsurance, we also generally limit our net loss on any individual risk to a maximum of $3.0 million, although retentions can range from $0.7 million to $8.8 million.
The following table is a reconciliation of our unpaid losses and settlement expenses (LAE) for the years 2013, 2012 and 2011.
generate earnings in excess of this required return. While some management incentive plans may be affected somewhat by other performance factors, the larger influence of corporate performance ensures that the interests of our executives, managers and associates correspond with those of our shareholders.
In 2011, 595,900 options were granted with an average exercise price of $27.51 and an average fair value of $6.45. Of these grants, 402,000 were granted at the board meeting in May with a calculated fair value of $6.46. We recognized $3.5 million of expense during 2011 related to options vesting. Since options granted under our plan are non-qualified, we recorded a tax benefit of $1.2 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $3.6 million, which will be recognized over the remainder of the vesting period.
As discussed in note 1.A., our insurance subsidiaries are organized in a vertical structure with RLI Ins. as the first-level, or principal, insurance subsidiary of RLI Corp. At the holding company (RLI Corp.) level, we rely largely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt, corporate expenses and dividends to RLI Corp. shareholders. As discussed further below, dividend payments to RLI Corp. from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the insurance regulatory authorities of Illinois. As a result, we may not be able to receive dividends from such subsidiary at times and in amounts necessary to pay desired dividends to RLI Corp. shareholders. On a GAAP basis, as of December 31, 2013, our holding company had $829.0 million in equity. This includes amounts related to the equity of our insurance subsidiaries, which is subject to regulatory restrictions under state insurance laws. The unrestricted portion of holding company net assets is comprised primarily of investments and cash, including $32.0 million in liquid assets, which approximate annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and dividend payments to our shareholders. If necessary, the holding company also has other potential sources of liquidity that could provide for additional funding to meet corporate obligations or pay shareholder dividends, which include a revolving line of credit, as well as issuances of common stock and debt.
The segments of our insurance operations include casualty, property and surety. The casualty portion of our business consists largely of general liability, personal umbrella, transportation, executive products, commercial umbrella, package business and other specialty coverages, such as our professional liability for design professionals. We also offer fidelity and crime coverage for commercial insureds and select financial institutions and recently expanded our casualty offerings to include medical professional liability coverage in the excess and surplus market. The casualty business is subject to the risk of estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty segment is also subject to inflation risk and may be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses.