We evaluate segment profit or loss based upon operating and investment results. Segment profit or loss described in the following sections of Management’s Discussion and Analysis is reported on a pre-tax basis. Additional segment information is presented in Part II, Item 8, Note 11 “Segment Information” to the Consolidated Financial Statements.
For 2011, the pricing for our non-catastrophe reinsurance program, which excludes our property catastrophe program, increased approximately 4.0 percent due to losses in 2010 in the first and second layers of our casualty program. Our catastrophe reinsurance program pricing decreased approximately 8.0 percent because of the soft market conditions and because we had no losses to the program during 2010. We had no significant changes to coverage, limits, or retentions for our catastrophe or non-catastrophe programs.
We experienced favorable development in all lines of business with the exception of fire and allied lines, which experienced a slight deficiency, primarily due to Hurricane Katrina development. Our workers’ compensation line had a significant decrease in losses as a result of a reduction in frequency as well as favorable reserve development on resolved cases. Additionally, we experienced an overall decrease in claims severity accompanied by a slight decrease in claims frequency, which contributed to the improvement.
In 2008, our loss ratio was significantly impacted by pre-tax catastrophe losses totaling $54.5 million, which reflected our second highest year for catastrophe losses in the past decade. A portion of these losses was attributable to a $10.8 million judgment, net of reinsurance, for Hurricane Katrina litigation that was under appeal in 2008, but which we lost on appeal in 2009.
Construction defect claims generally relate to allegedly defective work performed in the construction of structures such as apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. Such claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. The reporting of such claims can be quite delayed due to an extended statute of limitations, sometimes up to ten years. Court decisions have expanded insurers’ exposure to construction defect claims as well.
Our surety products guarantee performance and payment by our bonded principals. Our contract bonds protect owners from failure to perform on the part of our principals. In addition, our surety bonds protect material suppliers and subcontractors from nonpayment by our contractors. When surety losses occur, our loss is determined by estimating the cost to complete the remaining work and to pay the contractor’s unpaid bills, offset by contract funds due to the contractor, reinsurance, and the value of any collateral to which we may have access. The net loss ratio in this line was 16.4 percent in 2010, 8.6 percent in 2009 and 18.5 percent in 2008.
In 2010, we experienced an increase in interest on policyholders’ accounts due to the higher average deferred annuity balance in 2010 compared to 2009. In 2009, we experienced an increase in this line, which is reflective of the increase in annuity deposits during the year and the lowest level of surrenders and withdrawals experienced since 2005. In 2008, we experienced a decrease in this line, as surrenders and withdrawals exceeded deposits, due to our annuitants seeking alternative options for their money.
Amortization of DAC increased from $9.3 million in 2009 to $10.7 million in 2010. This was due to a combination of changes in the amortization schedules for the universal life and deferred annuity lines to reflect, mostly, changes in market investment yields and related interest spreads, as well as allocated capital gains to these lines for 2010, as compared to capital losses for 2009. The net effect of this was an increase in amortization of $2.6 million. Offsetting this was a reduction in traditional life amortization, due to improved persistency, amounting to $1.1 million
In 2010, our investment income, net of investment expenses, increased $5.6 million to $111.7 million as compared to the same period in 2009. The growth in our annuity sales in 2009 contributed to an increase in our invested assets and our 2010 net investment income, even in spite of historically low interest rates.
Duration relates primarily to our life insurance segment because the long-term nature of these reserve liabilities increases the importance of projecting estimated cash flows over an extended time frame. At December 31, 2010, our life insurance segment had $948.9 million in deferred annuity liabilities that were specifically allocated to investments in fixed maturity securities.
We base our investment decisions on the credit characteristics of individual securities; however, we have within our municipal bond portfolio a number of securities whose ratings were enhanced by third-party insurance for the payment of principal and interest in the event of an issuer default. A downgrade in the credit ratings of the insurers of these securities in 2010 and 2009 resulted in a corresponding downgrade in the ratings of the securities. Of the insured municipal securities in our investment portfolio, 88.4 percent and 95.1 percent were rated single “A” or above, and 65.4 percent and 70.0 percent were rated “AA” or above at December 31, 2010 and 2009, respectively, without the benefit of insurance. Due to the underlying financial strength of the issuers of the securities, we believe that the loss of insurance would not have a material impact on our operations, financial position, or liquidity.
We invest funds required for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. At December 31, 2010, our cash and cash equivalents included $34.4 million related to these money market accounts, compared with $96.2 million at December 31, 2009.
We offer our agents a profit-sharing plan as an incentive for them to place high-quality property and casualty insurance business with us. We estimate property and casualty agencies will receive profit-sharing payments of $7.0 million in 2011, based on business produced by the agencies in 2010.
Critical accounting estimates are defined as those that are representative of significant judgments and uncertainties and that potentially may result in materially different results under different assumptions and conditions. We base our discussion and analysis of our results of operations and financial condition on the amounts reported in our Consolidated Financial Statements, which we have prepared in accordance with GAAP. As we prepare these Consolidated Financial Statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities; and the disclosure of contingent assets and liabilities at the date of the financial statements; and the reported amounts of revenues and expenses for the reporting period. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. We believe that our most critical accounting estimates are as follows.
The $5.4 million reported as “disposals” included $1.9 million of corporate bonds that were called as a result of debt restructuring by the issuer and $2.0 million of corporate bonds that matured. Of the $1.9 million, $0.3 million were short-term investments that were transferred to corporate bonds as a result of the restructuring. The remaining $1.5 million in disposals relates to the receipt of principal on calls or sink fund bonds, in accordance with the indentures.
Generally, the loss settlement expense reserves for long-tail lines of business are a greater portion of the overall reserves, as there are often substantial legal fees and other costs associated with the complex liability claims that are associated with long-tail coverages. Because short-tail lines of business settle much more quickly and the costs are easier to determine, loss settlement expense reserves for short-tail claims constitute a smaller portion of the total reserves.
We do not view the result of a single projection method as superior over the results of a combination of projection methods. That is, our actuary has not selected one method on which to evaluate our reserves for reasonableness. The results of Regnier’s use of various methods, in conjunction with their actuarial judgment, leads to the actuarially-determined estimate of the reserves. The impact of reasonably likely changes in the reserving variables is implicitly considered in Regnier’s use of several reserving methods.
United Fire & Casualty Company (“United Fire”) and its consolidated subsidiaries and affiliate is engaged in the business of writing property and casualty insurance and life insurance and selling annuities through a network of independent agencies. We report our operations in two business segments: property and casualty insurance and life insurance. We are licensed as a property and casualty insurer in 43 states plus the District of Columbia and as a life insurer in 28 states.
For 2010, 2009 and 2008, we recognized stock-based compensation expense of $1,787,000, $2,084,000 and $1,780,000, respectively. As of December 31, 2010, we have $3,229,000 in stock-based compensation expense that has yet to be recognized through our results of operations. This compensation expense will be recognized over a term of five years as reported in the following table, except with respect to awards that are accelerated by the Board of Directors, in which case any remaining compensation expense would be recognized in the period in which the awards are accelerated.
The amortized cost and fair value of held-to-maturity, available-for-sale and trading securities at December 31, 2010, by contractual maturity, are shown in the following table. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities and collateralized mortgage obligations may be subject to prepayment risk and are therefore not categorized by contractual maturity.
A summary of realized investment gains (losses) for 2010, 2009 and 2008, is as follows:
Current accounting guidance on fair value measurements includes the application of a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Our financial instruments that are recorded at fair value are categorized into a three-level hierarchy, which is based upon the priority of the inputs to the valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the instrument.
The ceding of insurance does not legally discharge United Life from primary liability under its policies. United Life must pay the loss if the reinsurer fails to meet its obligations. We periodically monitor the financial condition of our reinsurers to confirm that they are financially stable. We believe that all of our reinsurers are in an acceptable financial condition. Approximately 99.0 percent of ceded life insurance in force as of December 31, 2010, has been ceded to five reinsurers.
Our property and casualty and life insurance subsidiaries are required to file financial statements with state regulatory authorities. The accounting principles used to prepare these statutory-basis financial statements follow prescribed or permitted accounting practices that differ from GAAP. Prescribed statutory accounting principles include state laws, regulations and general administrative rules issued by the state of domicile, as well as a variety of publications and manuals of the NAIC. Permitted accounting practices encompass all accounting practices not prescribed, but allowed by the state of domicile. No permitted accounting practices were used to prepare our statutory-basis financial statements during 2010, 2009 and 2008.
A reconciliation of income tax expense (benefit) computed at the applicable federal tax rate of 35 percent to the amount recorded in the accompanying Consolidated Statements of Income is as follows:
As of December 31, 2010, we had six external investment managers that are allowed to exercise investment discretion, subject to limitations, if any, established by the investment/retirement committee. We utilize multiple investment managers in order to maximize the pension plan’s investment return while minimizing risk. None of our investment managers uses leverage in managing the pension plan. Annually, the investment/retirement committee meets with each investment manager to review the investment manager’s goals, objectives and the performance of the assets they manage. The decision to establish or terminate a relationship with an investment manager is at the discretion of our investment/retirement committee.