We own three buildings: a five-story office building, a two-story office building and an eight-story office building in which a portion of the first floor (approximately 5.7 percent of the building’s square footage) is leased to tenants, and related parking facilities in Cedar Rapids, Iowa, that we use as our corporate headquarters. All three buildings are connected by a skywalk system. The first floors and basements of our three owned buildings in Cedar Rapids, Iowa underwent extensive reconstruction due to flooding that occurred in June 2008. We completed renovation of these buildings during 2009.
In November 2009, we completed the construction of a 250-space parking ramp, which is located adjacent to our corporate headquarters, for use by the company. The parking ramp replaced a paved parking lot of which we own approximately 70 percent of the land, while the remaining portion of the land will continue to be leased from the owner.
The following table shows a brief description of our owned and leased office space. We believe our current facilities are adequate to meet our needs with additional space available for future expansion, if necessary, at each of our leased and owned facilities.
The following table sets forth certain selected financial data from our Consolidated Financial Statements. We derived the financial data from the Consolidated Financial Statements of United Fire and its subsidiaries and affiliate. The data should be read in conjunction with Part II,
This report may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and/or projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about our company, the industry in which we operate, and beliefs and assumptions made by management. Words such as “expect(s),” “anticipate(s),” “intend(s),” “plan(s),” “believe(s),” “continue(s),” “seek(s),” “estimate(s),” “goal(s),” “target(s),” “forecast(s),” “project(s),” “predict(s),” “should,” “could,” “may,” “will continue,” “might,” “hope,” “can” and other words and terms of similar meaning or expression in connection with a discussion of future operating, financial performance or financial condition, are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Among the factors that could cause our actual outcomes and results to differ are:
The resolution of regulatory issues and litigation pertaining to and arising out of Hurricane Katrina.
The increased costs and risk associated with the security of our data.
Additional government and NASDAQ policies or regulations relating to corporate governance, and the cost to comply.
These are representative of the risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report or as of the date they are made. Except as required under the federal securities laws and the rules and regulations of the SEC, we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
The purpose of Management’s Discussion and Analysis is to provide an understanding of our results of operations and consolidated financial position. Our Management’s Discussion and Analysis should be read in conjunction with Part II, Item 6, “Selected Financial Data” and Part II, Item 8, “Financial Statements and Supplementary Data.”
We operate property and casualty and life insurance businesses, marketing our products through independent agents. Although we maintain a broad geographic presence that includes most of the United States, more than half of our property and casualty business is generated in Texas, Iowa, Louisiana, Missouri and Colorado. Approximately three-fourths of our life insurance business is generated in Iowa, Nebraska, Minnesota, Wisconsin, and Illinois.
The following is a summary of our financial performance over the last three years and the factors that have affected our performance.
Our premium writings decreased 5.9 percent for 2009, due to continued competition and the weak economy, which has led to a decline in both the residential housing market (especially in our western states) and in government-funded projects. This reduced the volume of business of the commercial and residential contractors that we insure and bond. Also contributing to the reduction in net premiums written was the nonrenewal of accounts that no longer meet our underwriting or pricing guidelines. As pricing in the industry continues to decrease, we avoid accounts that have become too underpriced for the risk.
During 2009, our other liability line had a significant increase in IBNR reserves, due to trends toward larger jury awards in this line and continuing construction defect claims and loss expenses.
Though the insurance industry experienced low levels of catastrophe losses in 2009 compared with 2008, we had an average historical level of catastrophe loss activity. Our catastrophes losses in 2009 totaled $22.4 million compared to $76.1 million in 2008. Hurricane activity was nearly nonexistent, but we had an active season of Midwestern storms. Catastrophe losses, without Hurricane Katrina, contributed 5.1 percent to our 2009 combined ratio, which is in-line with our historic annual average. In 2007, we experienced lower than average catastrophe losses, which totaled $14.1 million.
Our combined ratio was 115.2 percent for 2009, indicating an underwriting loss, compared to 113.9 percent and 81.3 percent for 2008 and 2007, respectively. In 2009, we incurred additional loss and loss settlement expenses related to Hurricane Katrina claims litigation, while our premium writings were affected by the struggling economy and the competitiveness of the market. An increase of 1.9 percentage points in our expense ratio contributed to our combined ratio, as we were not able to defer underwriting expenses (primarily agent commissions and employee salaries) at the same level in 2009 as we were able to in 2008 due to lower net premiums written.
The carrying value of our investment portfolio fluctuated due to the volatility in the financial markets, ending 2009 with net unrealized gains, after tax, of $82.5 million compared to $25.5 million and $85.6 million for the years ended 2008 and 2007, respectively.
Despite our results in 2009, our book value per share increased by $1.25 to $25.35 from $24.10 in 2008. Book value per share in 2007 was $27.63. The change in 2009 is attributable to an increase in our net unrealized gains, after tax, which reflects the rising market values of our equity security holdings and an increase in the fair value of our fixed maturity securities as interest rates decreased.
Premium writings decreased in both the residential housing market in our western states and in government-funded projects, which reduced the volume of business of the commercial and residential contractors that we insure and bond.
Our policy retention rate in both the personal and commercial lines of business was approximately 80.0 percent in 2009, which was a slight decrease from 2008, as our underwriters continue to focus on writing good business at an adequate price, preferring quality to volume. Despite continued competition, particularly on medium and large commercial accounts, we have been able to renew a select number of accounts at a higher rate/premium level in 2009 compared to 2008.
The insurance marketplace remained competitive in our commercial lines of business in 2009. We experienced a modest decrease (less than 1 percent) in commercial lines premium level in the fourth quarter of 2009, reflecting a continuation of a trend of gradual decreases in premium level for some lines of business dating back to 2004. On personal lines business, we averaged low- to mid-single-digit percentage increases in premium level for our homeowner and personal automobile lines of business in 2009.
The Statutory Financial Measures section of this report defines data prepared in accordance with statutory accounting practices, which is a comprehensive basis of accounting other than U.S. GAAP.
Our property and casualty insurance segment reported a pre-tax loss of $39.9 million and $36.4 million in 2009 and 2008, respectively, compared to pre-tax income of $139.0 million in 2007. The deterioration in our 2009 results, compared to 2008, was due in part to a decline in our net premiums written, which directly affects net premiums earned. Our premium writings have been affected by continued competition and the weak economy, which has led to a decline both in the residential housing market in our western states and in government-funded projects. This reduced the volume of business of the commercial and residential contractors that we insure and bond. Additionally, we incurred OTTI charges of $9.8 million, $38.0 million in adverse development from Hurricane Katrina and an increase in IBNR reserves in 2009, all of which impacted our pre-tax earnings.
The deterioration in our 2008 results, as compared to 2007 was due to the significant number of catastrophe losses we experienced in 2008. The financial impact from these catastrophes was largely realized on our commercial property line of business. Also contributing to the decline was an increase in the severity of non-catastrophe losses and the impact of competitive market conditions on pricing.
Hurricane Katrina made landfall in New Orleans, Louisiana, on August 29, 2005, causing an estimated $80 billion in damages. Over 95.0 percent of our policyholders in the New Orleans area suffered damage from Hurricane Katrina, with over 11,000 claims reported; we have concluded 96.7 percent of those claims. Our loss and loss settlement expenses inception to date (net of reinsurance) attributable to Hurricane Katrina totaled $288.9 million as of December 31, 2009, of which $38.0 million was incurred in 2009. The loss and loss settlement expenses incurred in 2009 includes an IBNR reserve increase for Hurricane Katrina claims litigation of $16.2 million, primarily due to the continuing unfavorable legal environment related to Hurricane Katrina in Louisiana. In 2009, we continued to settle unresolved litigation related to Hurricane Katrina, concluding approximately 50 percent of the claims that were in litigation as of December 31, 2008. Our 2009 combined ratio was impacted 8.7 percent by Hurricane Katrina loss development.
Since the occurrence of Hurricane Katrina in 2005, we have focused on reducing our risk exposure in Southern Louisiana by decreasing the number of insured properties, raising rates and purchasing additional reinsurance coverage. As of December 31, 2009, our current exposure level in Southern Louisiana is satisfactory, however, we will continue to monitor the situation closely and make additional adjustments as needed.
In January 2010, we ceased renewing policies or writing new business in the state of Louisiana through Lafayette Insurance Company. As a result, policyholders will be unable to litigate most issues in the Louisiana state court system, where we have experienced results that are inconsistent and unpredictable. We will continue to provide personal and commercial insurance coverage in Louisiana under United Fire & Casualty Company and our subsidiary, United Fire & Indemnity Company. Policyholders under these policies will be required to litigate in Federal courts, instead of Louisiana courts. All current Lafayette Insurance Company policyholders in Louisiana will be offered the opportunity to renew their policy in 2010 under United Fire & Indemnity Company, unless the policyholder has not paid their premium or the policy is being nonrenewed for a specific underwriting reason, such as failure to comply with loss control recommendations.
Our planned reduction in Southern Louisiana that began after Hurricane Katrina has reduced our estimated 100-year maximum probable loss by over 58.0 percent as of December 31, 2009. To maintain profitability of our remaining Southern Louisiana business, we have employed portfolio optimizing techniques (i.e., proximity to the coast, type of construction, the reduction of geographic risk concentration and higher deductibles) to reduce the impact of any one future catastrophe. As an example of the effectiveness of our risk-reduction efforts, we estimate that we incurred $12.8 million less in losses related to Hurricane Gustav in 2008 than we would have if we had not undertaken these measures.
We use many reinsurers, both domestic and foreign, which helps us to avoid concentrations of credit risk associated with our reinsurance. All reinsurers must meet the following minimum criteria: capital and surplus of at least $250.0 million and an A.M. Best rating of at least A- or an S&P rating of at least A-. If a reinsurer is rated by both rating agencies, then both ratings must be at least an A-. The table below represents the primary reinsurers we utilize and their financial strength ratings as of December 31, 2009.
For 2010, the pricing for our core reinsurance program, which excludes our property catastrophe treaty, decreased 6.6 percent due to market conditions and a small reduction in coastal exposure in Southern Louisiana. Some of the key changes to our 2010 core program include: incorporating the umbrella coverage into our casualty excess of loss treaty, which prior to 2010 was a separate treaty; increasing the property excess of loss treaty to $15.0 million from $12.0 million; increasing our casualty per occurrence limit from $20.0 million to $40.0 million; expanding some of our aggregate limits; and renewing the $2.0 million stated retention limit on our casualty and property excess of loss treaties.
Refer to Part II, Item 8, Note 5, “Reinsurance” for further discussion of our reinsurance programs.
The Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”) was signed into law on December 27, 2007. TRIPRA coverage includes most direct commercial lines of business, including coverage for losses from nuclear, biological and chemical exposures if coverage was afforded by an insurer, with exclusions for commercial automobile insurance, burglary and theft insurance, surety, professional liability insurance and farm owners multiple peril insurance. Under TRIPRA, each insurer has a deductible amount, which is 20.0 percent of the prior year’s direct commercial lines earned premiums for the applicable lines of business, and retention of 15.0 percent above the deductible. No insurer that has met its deductible shall be liable for the payment of any portion of that amount that exceeds the annual $100.0 trillion aggregate loss cap specified in TRIPRA. TRIPRA provides marketplace stability. As a result, coverage for terrorist events in both the insurance and reinsurance markets is often available. The amount of aggregate losses necessary for an act of terrorism to be certified by the U.S. Secretary of Treasury, the Secretary of State and the Attorney General was $100.0 million for 2009 and remains the same for 2010. Our TRIPRA deductible was $64.8 million for 2009 and our TRIPRA deductible will be $60.2 million for 2010. Our core and catastrophe reinsurance treaties provide limited coverage for terrorism exposure excluding nuclear, biological and chemical related claims.
Workers’ compensation and other liability are considered to be long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as the legal environment, inflation and medical costs. We consider all of these factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly. Refer to “Critical Accounting Estimates” in this section for a more detailed discussion of our property and casualty segment’s loss and loss settlement expenses and reserves.
In 2009, we increased our case reserves on prior year losses partially due to an increase in late reported claims. In addition, we have focused on establishing reserves for reported claims more quickly. In the fourth quarter 2009, we increased IBNR reserves for claims that occurred in prior years. Our other liability line had a significant increase in IBNR reserves, due to trends toward larger jury awards in this line and continuing construction defect claims and loss expenses. Overall, claims frequency decreased, which is a trend we have seen for several quarters. Claims severity has flattened for a majority of lines, with a slight increase in certain liability lines, specifically automobile and other liability as compared to 2008.
Overall, we experienced a net deficiency in our prior year reserves of $26.2 million for 2009. The primary components of this deficiency was the deterioration in our other liability lines of business, which resulted in a deficiency in these lines of $21.8 million, and adverse development from Hurricane Katrina claims and litigation totaling $38.0 million, which resulted in a deficiency in the fire and allied lines of business of $16.9 million.
Also contributing to our net deficiency in prior year reserves was an increase in general liability losses, which includes both other and products liability lines. Claims for construction defect losses are included in the products liability line of business. Incurred losses from construction defect claims for prior years were $7.7 million in 2008. These losses contributed to a deficiency in the other liability and products liability lines of business totaling $5.8 million.
The following table illustrates the primary components of the net redundancy (deficiency) we experienced in our reserves for 2009, 2008 and 2007.
Our “other” redundancy (deficiency) is attributable to both the payment of claims in amounts other than the amounts reserved and changes in reserves due to additional information on individual claims that we received after the reserves for those claims had been established. The additional information we consider is unique to each claim. Such information may include facts that reveal we have no coverage obligation for a particular claim, changes in applicable laws that reduce or increase our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable or unfavorable court rulings that changes our liability for a particular claim. Also, additional information relating to severity is unique to each claim. For example, we may learn during the course of a claim that bodily injuries may be less or more severe than originally believed or that damage to a structure is merely cosmetic instead of structural.
The following table depicts our net loss ratio for 2009, 2008 and 2007.
The net loss ratio in our commercial lines of business was 85.8 percent in 2009, 82.1 percent in 2008 and 51.8 percent in 2007. Several factors contributed to the deterioration of our loss ratio in 2009 and 2008.
Our other liability losses and loss settlement expenses incurred increased to $119.2 million in 2009, compared to $93.0 million in 2008 and $55.4 million in 2007. In 2009, the deterioration was attributable to an increase in IBNR reserves and a slight increase in severity from trends such as larger jury awards and continuing construction defect claims and loss settlement expenses. Incurred losses from construction defect claims totaled $6.0 million in 2009 as compared to $11.0 million and $5.4 million in 2008 and 2007, respectively.
Continued expansion of the use of pre-surveys prior to quoting larger new business accounts.
Reducing our risk exposure in Southern Louisiana by decreasing the number of insured properties and increasing our premium rates.
Premiums earned in these lines have decreased from $117.5 million in 2007 to $109.2 million in 2008 to $102.3 million in 2009. Our premium writings have been affected by continued competition and the weak economy, which has led to a decline in both the residential housing market in our western states and in government-funded projects. This reduced the volume of business of the commercial and residential contractors that we insure. Also contributing to the reduction in direct premiums written is the nonrenewal of accounts that no longer meet our underwriting or pricing guidelines. As pricing in the industry continues to decrease, we avoid accounts that have become too underpriced for the risk.
Losses from construction defect claims decreased in 2009 to $6.0 million compared to $11.0 million and $5.4 million in 2008 and 2007, respectively. At December 31, 2009, we established $15.2 million in construction defect loss and loss settlement expense reserves, excluding IBNR reserves, which consisted of 234 claims, compared with $16.0 million, excluding IBNR reserves, consisting of 243 claims, at December 31, 2008.
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. Defense costs are also a part of the insured expenses covered by liability policies and can be significant, sometimes greater than the cost of the actual paid claims.
A majority of our exposure to construction defect claims has been in Colorado and surrounding states. We historically have insured small-to-medium sized contractors in this geographic area. In an effort to limit the number of future claims from multi-unit buildings, we have implemented new policy exclusions limiting sub-contractor coverage on any building project with more than 12 units or on single family homes in any subdivision where the contractor is working on more than 15 homes. We have changed our underwriting guidelines to add a professional liability exclusion when a contractor prepares its own design work or blue prints. In 2009, we implemented the multi-family exclusion and tract home building limitation form in additional regions.
Because of the long-tail nature of liability claims, significant periods of time, ranging up to several years, may elapse between the occurrence of the loss, the reporting of the loss to us and the settlement of the claim. In both 2009 and 2008, over 37.0 percent of our other liability losses incurred (other than construction defect) resulted from losses that occurred in prior years. For 2009, the prior years that were most significantly impacted were 1997 and 2004 through 2008. For 2008, the prior years that were most significantly impacted were 2001 and 2003 through 2007.
The deterioration in the net loss ratio in 2007 was primarily related to an increase in severity as compared to the prior year. We had several large liability losses in 2007, but did not detect a trend related to the cause or geographic locations of the losses.
In recent years, we began to use our loss control department more extensively in an attempt to return this line of business to a higher level of profitability. For example, our loss control department has representatives make multiple annual visits to businesses and jobsites to ensure safety, rather than just one. We are also nonrenewing accounts that no longer meet our underwriting or pricing guidelines. As pricing in the industry continues to decrease, we avoid accounts that have become too underpriced for the risk.
Our commercial automobile insurance covers physical damage to an insured’s vehicle, as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by the insured, uninsured or underinsured motorists and the legal costs of defending the insured against lawsuits. Generally, our company policy is to write standard automobile insurance. Our net loss ratio in commercial automobile was 76.7 percent in 2009, 71.5 percent in 2008 and 64.1 percent in 2007.
The improvement in our loss and loss settlement expense for 2009 was the result of a slight decrease in claims frequency and related loss settlement expenses. The increase in the loss ratio in 2008 was due to an increase in loss settlement expenses. Since 2007, there have been no new claims that exceeded our $1.5 million reinsurance retention level.
The deterioration in 2008 was primarily the result of catastrophe losses totaling $21.6 million, compared to $1.4 million in 2007, as we experienced a significant level of catastrophe losses as compared to the prior year.
Our assumed reinsurance line of business loss ratio was 67.1 percent in 2009, compared to 14.8 percent and 36.0 percent in 2008 and 2007, respectively. The deterioration in 2009 was due to losses on current contracts related to Hurricanes Gustav and Ike, as well as environmental and asbestos losses on runoff business.
In 2009, we terminated one of our assumed reinsurance contracts and lowered participation on another. In 2008, the decrease in assumed premiums earned was due to the lower level of active assumed contracts we had as compared to prior years. In 2010, we entered into three new assumed contracts, which we anticipate will increase our assumed premiums writings.
In 2008, our commission expense decreased due to lower profit-sharing commissions payable to our agents. This decrease was offset by an increase in the ratio of fixed underwriting expenses to premiums earned.
Our life insurance segment produced pre-tax income of $11.2 million in 2009, compared to $3.3 million in 2008 and $20.3 million in 2007. In both 2009 and 2008, our pre-tax income was lower due to realized investment losses we experienced from OTTI charges in our portfolio of fixed maturity and equity securities. In 2009, 2008 and 2007, OTTI charges recorded totaled $8.5 million, $8.9 million and $.1 million, respectively.
United Life Insurance Company underwrites all of our life insurance business. Our principal life insurance products are deferred and immediate annuities, universal life products and traditional life (primarily single premium whole life insurance) products. We also underwrite and market other traditional products, including term life insurance and whole life insurance. Deferred and immediate annuities (84.1 percent), traditional life products (9.9 percent), universal life products (5.2 percent), and other life products (0.8 percent) comprised our 2009 life insurance premium revenues, as determined on the basis of statutory accounting practices. We do not write variable annuities or variable insurance products.
In 2009, we experienced an increase in interest on policyholders’ accounts, which is reflective of the increase in annuity deposits and the lowest level of surrenders and withdrawals experienced since 2005. In both 2008 and 2007, interest on policyholders’ accounts decreased, as surrenders and withdrawals exceeded deposits, due to our annuitants seeking alternative options for their money.
Due to our determination that we may not be able to fully realize the benefits of American Indemnity Financial Corporation’s NOLs, we have recorded a valuation allowance against the NOLs. At December 31, 2009, this valuation allowance totaled $5.6 million and remained unchanged from December 31, 2007. The valuation allowance was reduced by $.5 million in 2007 due to utilization of the NOLs. Based on a yearly review we determine whether the benefit of the NOLs can be realized, and, if so, the decrease in the valuation allowance is recorded as a reduction to current federal income tax expense. In future years, decreases to the valuation allowance, if applicable, will continue to be recognized as a reduction to current federal income tax expense.
The securities in our fixed maturity portfolio at December 31, 2009, continued to be affected by downgrades of our municipal bond holdings that occurred during 2008 and 2009.
We base our investment decisions on the credit characteristics of individual securities; however, within our municipal bond portfolio are 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 2009 and 2008 has resulted in a corresponding downgrade in the ratings of the securities. Of the insured municipal securities in our investment portfolio, 95.1 percent and 95.3 percent were rated single A or above, and 70.0 percent and 68.9 percent were rated AA or above at December 31, 2009 and 2008, 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 reviewed our investment portfolio pertaining to securities guaranteed by third parties, with both direct and indirect exposure. We have no direct exposure in any of the guarantors that guarantee our investments. Our largest indirect exposure with a single guarantor totaled $129.7 million or 31.5 percent of our insured municipal securities for December 31, 2009 as compared to $133.5 million or 31.7 percent for December 31, 2008. Our five largest indirect exposures to financial guarantors accounted for 79.6 percent and 79.0 percent of our insured municipal securities at December 31, 2009 and 2008, respectively.
The weighted average duration of our fixed maturity available-for-sale, held-to-maturity and trading portfolios, at December 31, 2009 is 6.0 years compared to 6.3 years at December 31, 2008.
For our life insurance segment, the weighted average duration of our fixed maturity available-for-sale, held-to-maturity and trading portfolios, at December 31, 2009 and 2008 is 4.3 years.
In 2009, our net investment income (pre-tax) declined $1.5 million to $106.1 million as compared to the same period in 2008. The decline was due to the following factors: lower market interest rates earned on our investment portfolio, which also affected the returns on our short-term investments and cash and cash equivalents; agency bonds that were called during 2009, the proceeds of which we reinvested at lower interest rates than the called bonds carried; and the reduction or discontinuation of dividend payments by some of our equity securities that previously had paid regular dividends.
The following table details our yield on average invested assets for 2009, 2008 and 2007, which is based on our invested assets (including money market accounts) at the beginning and end of the year divided by net investment income (after the deduction of investment expenses and excluding realized gains and losses).
In 2009, we reported realized investment losses of $13.2 million, compared to losses of $10.4 million and gains of $9.7 million in 2008 and 2007, respectively. The following table summarizes the components of our realized investment gains or losses:
As of December 31, 2009, net unrealized gains, after tax, totaled $82.5 million, compared to $25.5 million and $85.6 million as of December 31, 2008 and 2007, respectively. In 2009, an improvement in the equity markets and a decrease in market interest rates led to an increase in the carrying value of our fixed maturity and equity securities, which improved our net unrealized gains. In 2008 and 2007, depressed bond and stock prices, particularly for our holdings of investments in financial institutions, contributed to the decrease in net unrealized gains. We have and will continue to closely monitor market conditions and evaluate the long-term impact of the market volatility experienced in recent years on all of our investment holdings.
Changes in unrealized gains on available-for-sale securities do not affect net income (loss) and earnings (loss) per share but do impact comprehensive income (loss), stockholders’ equity and book value per share. We believe that our unrealized losses on available-for-sale securities at December 31, 2009 are temporary based upon both our current analysis of the issuers of the securities that we hold and on current market conditions. It is possible that we could recognize impairment losses in future periods on securities that we own at December 31, 2009, if future events and information cause us to determine that a decline in value is other-than-temporary. However, we endeavor to invest in high quality assets to provide protection from future credit quality issues and corresponding impairment write-downs.
The following table summarizes the change in our net unrealized appreciation:
Refer to “Critical Accounting Estimates” in this section for a detailed discussion of our policy for recording OTTI charges.
Our cash flows from operations were sufficient to meet our liquidity needs in 2009, 2008 and 2007.
We invest funds required for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. At December 31, 2009, our cash and cash equivalents included $96.2 million related to these money market accounts, compared with $70.7 million at December 31, 2008.
If our operating and investing cash flows are not sufficient to support our operations, we may also borrow up to $50.0 million on a bank line of credit. Under the terms of our credit agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate, minus 1.0 percent. We did not utilize our line of credit during 2009 or 2008, other than to secure letters of credit utilized in our reinsurance operations. As of December 31, 2009, none of our line of credit was allocated for that purpose compared to $.2 million as of December 31, 2008.
Net cash flows provided by operating activities totaled $100.4 million in 2009, compared to $43.9 million in 2008 and $105.8 million in 2007, respectively. Significant sources of operating cash flows are derived from underwriting operations and net investment income. Cash flows for 2009 reflect an increase in loss payments; a reduction in other assets of $29.0 million for the conclusion of certain litigation related to Hurricane Katrina; and a reduction in reinsurance recoveries due to the collection of payments during the year and the improvement in our catastrophe experience in 2009 as compared to 2008.
Net cash flows in 2008 were reduced primarily due to the increase in claims incurred, (including the impact of higher catastrophe losses). In addition, in 2008 we were required to make a cash deposit of $29.0 million in connection with certain litigation related to Hurricane Katrina.
Net cash flows used in investment activities totaled $130.1 million in 2009, compared to $107.3 million in 2008 and $16.3 million in 2007. The availability of more cash from financing activities in 2009, primarily due to the higher level of annuity deposits, allowed us to invest at a level similar to 2008.
Net cash flows provided by financing activities totaled $111.0 million in 2009, compared to net cash used of $79.6 million and $91.9 million in 2008 and 2007, respectively. Net cash flows from financing activities improved significantly in 2009, primarily due to the life insurance segment’s annuity and universal life contract deposits exceeding withdrawals. We began to experience a slowdown in the amount of withdrawals in 2008, which is indicative of the change in economic conditions and the inclination of consumers to choose products with less risk and guaranteed returns. This slowdown continued into 2009, with 2009 experiencing the largest reduction of withdrawals since 2005.
Net cash flows from financing activities were impacted by a combination of factors in 2008 and 2007. Cash outflows associated with our life insurance segment’s annuity portfolio had increased from historical levels in connection with the increased level of surrenders and withdrawals experienced in recent years. Net cash used in these activities totaled $48.8 million and $61.7 million for 2008 and 2007, respectively. The increase in withdrawals is described in the earlier “Life Insurance Segment” section.
Stockholders’ equity increased from $641.7 million at December 31, 2008, to $672.7 million at December 31, 2009, an increase of 4.8 percent. The increase in stockholders’ equity between years is primarily due to an increase in net unrealized appreciation on investments of $56.9 million, after-tax. This was somewhat offset by a net loss of $10.4 million; dividends paid of $16.0 million; repurchase of common stock of $1.5 million; and the change in underfunded status of our employee benefit plans of $.2 million, net of tax. The book value per share of our common stock was $25.35 at December 31, 2009, compared with $24.10 at December 31, 2008.
Catastrophe modeling requires a significant amount of judgment and a number of assumptions and relies upon inputs based on experience, science, engineering and history. We utilize various tools and techniques to evaluate our catastrophe exposures including utilizing multiple catastrophe models, analysis of realistic disaster scenarios, evaluation of total insured values and exposure aggregates. Such models may fail to account for risks that are outside of the range of normal probability or that are otherwise unforeseeable. Consequently, catastrophe modeling estimates are subject to significant uncertainty. In addition, more than one such event could occur in any period.
We validate the prices obtained from pricing services and brokers prior to their use for reporting purposes by evaluating their reasonableness on a monthly basis. Our validation process includes a review for unusual fluctuations. In our opinion, the pricing obtained at December 31, 2009, was reasonable.
We review our fair value hierarchy categorizations on a quarterly basis, at which time the classification of certain financial instruments may change if the input observations have changed. The following table presents the categorization for our financial instruments measured at fair value on a recurring basis in our Consolidated Balance Sheets at December 31, 2009:
The fair value of securities that are categorized as Level 2 is determined by management in reliance on market values obtained from independent pricing services and brokers. Such estimated fair values do not necessarily represent the values for which these securities could have been sold at the reporting date. Our independent pricing services and brokers obtain prices from reputable pricing vendors in the marketplace. They continually monitor and review the external pricing sources, while actively participating to resolve any pricing issues that may arise.
The amount reported in the previous table as “transfers in” consisted of $22.7 million in available-for-sale fixed maturities that were primarily private placement securities that had no observable price available at December 31, 2009, and $3.3 million of available-for-sale fixed maturities that were subsequently reclassified, as a disposal, to other long-term investments due to bankruptcy reorganization. The $4.1 million in “transfers out” resulted from available-for-sale fixed maturities and equity securities that previously had no observable price at December 31, 2008, but for which observable prices were available at December 31, 2009.
The following table summarizes DAC for December 31, 2009 and 2008.
Costs that vary with and relate to the acquisition of life insurance and annuity business are deferred and recorded as DAC asset. Such costs consist principally of commissions and policy issue expenses.
We defer and amortize policy acquisition costs, with interest, on traditional life insurance policies, over the anticipated premium-paying period in proportion to the present value of expected gross premium. The present value of expected premiums is based upon the premium requirement of each policy and assumptions for mortality, morbidity, persistency and investment returns at policy issuance. These assumptions are not revised after policy issuance unless the deferred acquisition cost balance is deemed to be unrecoverable from future expected profits. Absent a premium deficiency, variability in amortization after policy issuance is caused only by variability in premium volumes.
Reserves for losses and loss settlement expenses are reported using our best estimate of ultimate liability for claims that occurred prior to the end of any given accounting period but have not yet been paid. Before credit for reinsurance recoverables, these reserves were $606.0 million and $586.1 million at December 31, 2009 and 2008, respectively. We purchase reinsurance to mitigate the impact of large losses and catastrophic events. Loss and loss settlement reserves ceded to reinsurers were $33.8 million for 2009 and $52.5 million for 2008. Our reserves by line of business as of December 31, 2009, were as follows.
Estimating case reserves is subjective and complex and requires us to make estimates about the future payout of claims, which is inherently uncertain. When we establish and adjust reserves, we do so based on our knowledge of the circumstances and facts of the claim. Upon notice of a claim, we establish a factor reserve based on the claim information reported to us at that time. Subsequently, we conduct an investigation of each reported claim, which allows us to more fully understand the factors contributing to the loss and our potential exposure. This investigation may extend over a long period of time. As our investigation of a claim develops, and as our claims personnel identify trends in claims activity, we may refine and adjust our estimates of case reserves. To evaluate and refine our overall reserving process, we track and monitor all claims until they are settled and paid in full, with all salvage and subrogation claims being resolved.
IBNR reserves are estimated liabilities, which we establish because claims are not always reported promptly upon occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions, which may include litigation.
For our short-tail lines of business, IBNR reserves constitute a small portion of the overall reserves. This is because claims are generally reported and settled shortly after the loss occurs. In our long-tail lines of business, IBNR reserves constitute a relatively higher proportion of total reserves, because, for many liability claims, significant periods of time may elapse between the initial occurrence of the loss, the reporting of the loss to us and the ultimate settlement of the claim.
Generally, the loss settlement expense reserves for long-tail lines 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 lines. Because short-tail lines 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.
No new judicial decisions or regulatory actions will increase our case-basis obligations;
As an example, if our reserve for loss and loss settlement expenses of $606.0 million as of December 31, 2009, is 10 percent inadequate, we would experience a reduction in future earnings of up to $6.1 million, pre-tax. This reduction could be recorded in one year or multiple years, depending on when we identify the deficiency. The deficiency would also affect our financial position in that our equity would be reduced by an amount equivalent to the reduction in net income. Any deficiency is recognized in the reserve for loss and loss settlement expenses and, accordingly, it usually does not have a material effect on our liquidity because the claims have not been paid. Conversely, if our estimates of ultimate unpaid loss and loss settlement expense liabilities prove to be redundant, our future earnings and financial position would be improved.
Other liability is considered a long-tail line of business, as it can take a relatively long period of time to settle claims from prior accident years. This is partly due to the lag time between the date when a loss or event occurs that triggers coverage and the date when the claim is actually reported. Defense costs are also a part of the insured expenses covered by liability policies and can be significant, sometimes greater than the cost of the actual paid claims. For the majority of our products, defense costs are outside of the policy limit, meaning that the amounts paid for defense costs are not subtracted from the available policy limit.
Factors that can cause reserve uncertainty in estimating reserves in this line include: reporting lag; the number of parties involved in the underlying tort action; whether the “event” triggering coverage is confined to only one time period or is spread over multiple time periods; the potential dollars involved (in the individual claim actions); whether such claims were reasonably foreseeable and intended to be covered at the time the contracts were written (i.e., coverage disputes); and the potential for mass claim actions.
Our reserve for other liability claims at December 31, 2009, is $253.9 million and consists of 5,363 claims, compared with $214.7 million, consisting of 4,878 claims at December 31, 2008. Of the $253.9 million total reserve for other liability claims, $71.9 million is identified as defense costs and $19.9 million is identified as general overhead required in the settlement of claims. If our reserve for other liability loss and loss settlement expenses is overstated or understated by 10 percent, the potential impact to our Consolidated Financial Statements would be approximately $25.4 million, before federal income taxes.
Included in the other liability line of business are gross reserves for construction defect losses and settlement expenses. Construction defect is a liability allegation relating to defective work performed in the construction of structures such as commercial buildings, apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. These claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. At December 31, 2009, we established $15.2 million in construction defect loss and loss settlement expense reserves, excluding IBNR reserves, which consisted of 234 claims, compared with $16.0 million, excluding IBNR reserves, consisting of 243 claims, at December 31, 2008. The reporting of such claims can be delayed, as the statute of limitations can be up to 10 years. Also, recent court decisions have expanded insurers’ exposure to construction defect claims. As a result, claims may be reported more than 10 years after a project has been completed, as litigation can proceed for several years before an insurance company is identified as a potential contributor. Claims have also emerged from parties claiming additional insured status on policies issued to other parties, such as contractors seeking coverage from a subcontractor’s policy.
Like the other liability line of business, workers’ compensation losses and loss settlement expense reserves are based upon variables that create imprecision in estimating the ultimate reserve. Estimates for workers’ compensation are particularly sensitive to assumptions about medical cost inflation, which has been steadily increasing over the past few years. Other variables that we consider and that contribute to the uncertainty in establishing reserves for workers’ compensation claims include: the state legislative and regulatory environments; trends in jury awards; and mortality rates. Because of these variables, the process of reserving for the ultimate loss and loss settlement expense requires the use of informed judgment and is inherently uncertain. Consequently, actual loss and loss settlement expense reserves may deviate from our estimates. Such deviations may be significant. Our reserve for workers’ compensation claims at December 31, 2009, is $131.7 million and consists of 3,416 claims, compared with $126.6 million, consisting of 3,386 claims, at December 31, 2008. If our reserve for workers’ compensation loss and loss settlement expenses is overstated or understated by 10 percent, the potential impact to our Consolidated Financial Statements would be approximately $13.2 million, before federal income taxes.
Generally, we base reserves for each claim on the estimated ultimate exposure for that claim, determined from a pessimistic point of view. We believe that in determining reserves, it is appropriate and reasonable to establish a best estimate within a range of reasonable estimates, especially when we are reserving for claims for bodily injury, disabilities and similar claims, for which settlements and verdicts can vary widely. Our reserving philosophy may result in favorable development in future years that will decrease loss and loss settlement expenses for prior year claims in the year of adjustment. While we realize that this philosophy, coupled with what we believe to be aggressive and successful claims management and loss settlement practices, has resulted in year-to-year redundancies in reserves, we believe our approach is better than experiencing year-to-year uncertainty as to the adequacy of our reserves.
Establishing reserves that are appropriate and reasonable, but assuming a pessimistic view of potential outcomes.
We engage an independent actuarial firm to render opinions as to the reasonableness of the statutory reserves we establish. There was no material differences between our statutory reserves and those established under GAAP. During 2009 and 2008, we engaged the services of Regnier Consulting Group, Inc. as our “independent actuarial firm” for the property and casualty insurance segment. We anticipate that this engagement will continue in 2010.
We establish reserves for amounts that are payable under traditional insurance policies, including traditional life insurance, disability income, and income annuities. Reserves are calculated as the present value of future benefits expected to be paid, reduced by the present value of future expected premiums. Our estimates use methods and underlying assumptions that are in accordance with GAAP and applicable actuarial standards. The key assumptions that we utilize in establishing reserves are mortality, morbidity, policy lapse, renewal, retirement, investment returns, inflation, and expenses. Future investment return assumptions are determined based upon prevailing investment yields as well as estimated reinvestment yields. Mortality, morbidity and policy lapse assumptions are based on our experience. Expense assumptions include the estimated effects of inflation and expenses to be incurred beyond the premium-paying period. These assumptions are established at the time the policy is issued, are consistent with assumptions for determining DAC amortization for these contracts, and are generally not changed during the policy coverage period. However, if actual experience emerges in a manner that is significantly adverse relative to the original assumptions, adjustments to reserves (or DAC) may be required resulting in a charge to earnings which could have a material adverse effect on our operating results and financial condition.
Other policyholder reserves include claims that have been reported but not settled and claims incurred but not reported on life and disability income insurance. We use our own historical experience and other assumptions such as any known or anticipated developments or trends to establish reserves for these unsettled or unreported claims. The effects of changes in our estimated reserves are included in the results of operations in the period in which the changes occur.
Annually, we review our estimates of reserves and deferred policy acquisition cost assets and compare them with actual experience. Differences between actual experience and the assumptions that we used in the pricing of policies, guarantees and riders and in the establishment of the related reserves result in variances in profit and could result in changes in net income. The effects of the changes in such estimated reserves are included in the results of operations in the period in which the changes occur.
The following table reflects the estimated pre-tax impact to DAC, net of unearned revenue liabilities to our universal life and fixed annuity products that could occur in a twelve-month period on account of an unlocking adjustment due to reasonably likely changes in significant assumptions. Changes in assumptions of the same magnitude in the opposite direction would have an impact of a similar magnitude but opposite direction of the examples provided.
We engage an independent actuarial firm to render opinions as to the reasonableness of the statutory reserves we establish. Statutory reserves are established using considerably more conservative assumptions regarding future investment earnings and contractual benefit payments, than are used for GAAP reserves. During 2009 and 2008, we engaged the services of Griffith, Ballard and Company as our “independent actuarial firm” for the life insurance segment. We anticipate that this engagement will continue in 2010.
The following definitions of key statutory measures are provided for our readers’ convenience. United Fire is not required to reconcile data prepared under statutory accounting principles to those prepared under U.S. GAAP because Regulation G excludes data prepared under a system of regulation of a government or governmental authority or self-regulatory organization that is applicable to the registrant.
When prepared in accordance with U.S. GAAP, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premiums earned. The expense ratio is calculated by dividing nondeferred underwriting expenses and amortization of DAC by net premiums earned.
When prepared in accordance with statutory accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premium earned and the expense ratio is calculated by dividing underwriting expenses by net premiums written.
We believe that disclosure of certain Non-GAAP financial measures enhances investor understanding of our financial performance. The following Non-GAAP financial measure is utilized in this filing:
Catastrophe losses utilize the designations of the Insurance Services Office (“ISO”) and are reported with loss and loss settlement expense amounts net of reinsurance recoverables, unless specified otherwise. According to the ISO, a catastrophe loss is a single unpredictable incident or series of closely related incidents causing severe insured losses that cause $25.0 million or more in industry-wide direct insured losses to property and that affect a significant number of insureds and insurers (“ISO catastrophes”). We also include as catastrophes those events we believe are, or will be, material to our operations, either in amount or in number of claims made. Management at times may determine for comparison purposes that it is more meaningful to exclude unusual catastrophe losses or litigation resulting from a catastrophe. The frequency and severity of catastrophic losses we experience in any year affect our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. Portions of our catastrophe losses may be recoverable under our catastrophe reinsurance agreements. We include a discussion of the impact of catastrophes because we believe it is meaningful for investors to understand the variability in periodic earnings.
Premiums are reported in income on a daily pro rata basis over the terms of the respective policies. Unearned premium reserves are established for the portion of premiums written applicable to the unexpired term of policies in-force.
To establish loss and loss settlement expense reserves, we make estimates and assumptions about the future development of claims. Actual results could differ materially from those estimates, which are subjective, complex and inherently uncertain. When we establish and adjust reserves, we do so given our knowledge at that time of the circumstances and facts of known claims. To the extent that we have overestimated or underestimated our loss and loss settlement expense reserves, we adjust the reserves in the period in which such adjustment is determined.
Liabilities for future policy benefits for traditional products are computed by the net level premium method, using interest assumptions ranging from 4.5 percent to 6.0 percent and withdrawal, mortality and morbidity assumptions appropriate at the time the policies were issued. Liabilities for non-traditional business are stated at policyholder account values before surrender charges. Liabilities for traditional immediate annuities are based primarily upon future anticipated cash flows using statutory mortality and interest rates, which produce results that are not materially different from GAAP. Liabilities for deferred annuities are carried at the account value.
Investments in held-to-maturity fixed maturities are recorded at amortized cost. We have the ability and positive intent to hold these investments until maturity. Available-for-sale fixed maturities, trading securities and equity securities are recorded at fair value. Other long-term investments are recorded on the equity method of accounting. Mortgage loans are recorded at cost. Policy loans are recorded at the outstanding loan amount due from policyholders. Included in investments at December 31, 2009 and 2008, are securities on deposit with, or available to, various regulatory authorities as required by law, with fair values of $1,464,406,000 and $1,270,181,000, respectively.
We made payments for income taxes of $4,324,000, $13,817,000 and $50,513,000 during 2009, 2008 and 2007, respectively. In addition, we received refunds totaling $10,256,000, $2,904,000 and $7,783,000 in 2009, 2008 and 2007, respectively, due to the carryback of losses. There were no significant payments of interest in 2009, 2008 and 2007, other than payments to policyholders’ accounts related to non-traditional life insurance business.
Our intangibles are composed entirely of agency relationships, which are being amortized by the straight-line method over periods of up to 10 years. We regularly review the carrying value of our intangibles for impairment in the recoverability of the underlying asset, with any impairment being charged to operations in the period that the impairment was recognized. We did not recognize an impairment write-down to the carrying value of our intangibles in 2009, 2008 or 2007.
Amortization expense totaled $60,000 for each of the three years ended December 31, 2009, 2008 and 2007.
We file income tax returns under U.S. federal and various state jurisdictions. We are no longer subject to U.S. federal income tax examination by tax authorities for years before 2004 and state income tax examination for years before 2004. There are no ongoing examinations of income tax returns by federal or state tax authorities.
Several actions pending against various insurers, including us, were consolidated for purposes of pretrial discovery and motion practice under the caption In re Katrina Canal Breaches Consolidated Litigation, Civil Action No. 05-4182 in the United States District Court, Eastern District of Louisiana. In August 2009, the Federal trial court ruled that certification of policyholder claims as a class would be inappropriate. This ruling has been appealed by the plaintiff policyholders. Lafayette Insurance Company, as a Louisiana domiciled insurance company, is subject to jurisdiction in state court, and this ruling will not be determinative of class certification decisions in those state court suits seeking class certification.
We intend to continue to defend the cases related to losses incurred as a consequence of Hurricane Katrina. We have established our loss and loss settlement expense reserves on the assumption that the application of the Valued Policy Law will not result in our having to pay damages for perils not otherwise covered. We believe that, in the aggregate, these reserves are adequate. However, our evaluation of these claims and the adequacy of recorded reserves may change if we encounter adverse developments in the further defense of these claims.
For 2009, 2008 and 2007, we recognized stock-based compensation expense of $2,084,000, $1,780,000 and $1,377,000, respectively. As of December 31, 2009, we have $3,739,000 in stock-based compensation expense that has yet to be recognized through our results of operations. This compensation will be recognized over a term of five years, 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.
In February 2010, the FASB updated the accounting guidance on evaluating subsequent events. The updated guidance continues to require an entity to evaluate subsequent events through the date the entity’s financial statements are issued, however, the entity is no longer required to disclose the date through which subsequent events were evaluated. The updated guidance was effective upon issuance. We did not identify any material subsequent events for reporting in the Consolidated Financial Statements.
In April 2009, the FASB issued interpretative guidance on determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions are not orderly. Under the guidance, transactions or quoted prices may not accurately reflect fair value if an entity determines that there has been a significant decrease in the volume and level of activity for the asset or the liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities). In addition, if there is evidence that the transaction for the asset or liability is not orderly, the entity shall place little, if any weight on that transaction price as an indicator of fair value. The guidance is effective for interim or annual periods ending after June 15, 2009. The adoption of the guidance did not have any impact on the amounts reported in our Consolidated Financial Statements.
In April 2009, the FASB issued accounting guidance on the recognition and presentation of OTTI charges for fixed maturity securities that are classified as available-for-sale and held-to-maturity. The guidance replaces the current requirement that an entity have the positive intent and ability to hold an impaired security until recovery of its amortized cost basis in order to conclude an impairment was not other-than-temporary. The guidance adds the requirement that management not intend to sell the impaired security and that it is more likely than not it will not be required to sell the impaired security before the recovery of its amortized cost basis. If management concludes a security is other-than-temporarily impaired, the guidance requires that the difference between the fair value and the amortized cost of the security be presented as an OTTI charge with an offset for any noncredit-related loss component of the OTTI charge to be recognized in accumulated other comprehensive income. Accordingly, only the credit loss component will have an impact on earnings for the reporting period.
The guidance also requires extensive disclosures for both fixed maturity securities and equity securities on an interim and annual basis to provide further disaggregated information as well as information about how the credit loss component of the OTTI charge was determined along with a roll forward of such amount for each reporting period. The guidance is effective for interim and annual periods ending after June 15, 2009. The adoption of the guidance did not have any impact on our consolidated financial position or results of operations.
In January 2010, the FASB issued revised accounting guidance that clarifies and provides additional disclosure requirements related to recurring and non-recurring fair value measurements. The guidance requires separate disclosures for the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements along with an explanation for the transfers. Additionally, a separate disclosure is required for purchases, sales, issuances and settlements on a gross basis for Level 3 fair value measurements. The guidance also provides additional clarification for both the level of disaggregation reported for each class of assets or liabilities and disclosures of inputs and valuation techniques used to measure fair value for both recurring and non-recurring fair value measurements, categorized as Level 2 or Level 3. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010. Our adoption of the guidance effective January 1, 2010, will not have a material impact on our consolidated financial position or results of operations. However, we are currently evaluating the impact the adoption of the guidance will have on the disclosures made in our Consolidated Financial Statements.
A reconciliation of the amortized cost (cost for equity securities) to fair value of investments in held-to-maturity and available-for-sale fixed maturity and equity securities as of December 31, 2009 and 2008, is as follows:
There were no sales of held-to-maturity securities in 2009, 2008 and 2007.
Our investment portfolio includes trading securities with embedded derivatives. These securities, which are primarily convertible redeemable preferred debt securities, are recorded at fair value. Income or loss, including the change in the fair value of these trading securities, is recognized currently in earnings as a component of realized investment gains and losses. Our portfolio of trading securities had a fair value of $12,613,000 and $8,055,000 at December 31, 2009 and 2008, respectively.
A summary of realized investment gains (losses) and a summary of net changes in unrealized investment appreciation, less applicable income taxes, are as follows:
Net investment income for the years ended December 31, 2009, 2008 and 2007, is composed of the following:
The tables on the following pages present a summary of fixed maturity and equity securities that were in an unrealized loss position at December 31, 2009 and 2008. It is possible that we could recognize OTTI charges in future periods on securities that we held at December 31, 2009, if future events or information cause us to determine that a decline in fair value is other-than-temporary.
In most cases, we use quoted market prices to determine the fair value of fixed maturities, equity securities, trading securities and short-term investments. Where quoted market prices do not exist, we base fair values on pricing or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement of the financial instrument. Such inputs may reflect management’s own assumptions about the assumptions a market participant would use in pricing the financial instrument.
We base the estimated fair value of mortgage loans on discounted cash flows, utilizing the market rate of interest for similar loans in effect at the valuation date.
In order to determine the proper classification in the fair value hierarchy for each security where the price is obtained from an independent pricing service, we obtain and evaluate the vendors’ pricing procedures and inputs used to price the security, which include unadjusted quoted market prices for identical securities, such as a New York Stock Exchange closing price and quoted prices for identical securities in markets that are not active. For fixed maturity securities, an evaluation of interest rates and yield curves observable at commonly quoted intervals, volatility, prepayment speeds, and credit risks and default rates may also be performed. We have determined that these processes and inputs result in fair values and classifications consistent with the applicable FASB guidance on fair value measurements.
The following tables present the categorization for our financial instruments measured at fair value on a recurring basis in our Consolidated Balance Sheets at December 31, 2009 and 2008:
The amount reported in the previous table as “transfers in” consisted of $22,760,000 in available-for-sale fixed maturities that were primarily private placement securities that had no observable price available at December 31, 2009, and $3,250,000 of available-for-sale fixed maturities that were subsequently reclassified, as a disposal, to other long-term investments due to bankruptcy reorganization. The $4,051,000 in “transfers out” resulted from available-for-sale fixed maturities and equity securities that previously had no observable market price at December 31, 2008, but for which observable prices were available at December 31, 2009.
The following table provides a summary of the changes in fair value of our Level 3 securities for 2008:
The amounts reported in the previous table as realized and unrealized losses and transfers in relate primarily to the life insurance segment’s holdings of certain fixed maturity securities in default, for which an OTTI charge of $8,473,000 was recorded in 2008.
We account for premiums, written and earned, and losses incurred net of reinsurance ceded. The ceding of insurance does not legally discharge us from primary liability under our policies, and we must pay the loss if the reinsurer fails to meet its obligation. 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. At December 31, 2009, there were no reinsurance balances for which collection is at risk that would result in a material impact on our Consolidated Financial Statements.
We assume both property and casualty insurance from other insurance or reinsurance companies. Most of the business we have assumed is property insurance, with an emphasis on catastrophe coverage. The majority of our assumed reinsurance business expired on or before December 31, 2000. In 2006, we made the decision to cancel one of our largest remaining assumed contracts. This decision was made in response to the loss of available reinsurance protection, leaving us with a larger percentage of the total exposure than we were comfortable with. We limit our exposure on our remaining assumed reinsurance contracts through selective renewal. However, we still have exposure related to the assumed reinsurance contracts that we have elected to continue writing and those that are in runoff status.
We began the assumption of credit life and accident and health insurance in 2002. We discontinued this practice in 2004. We have an immaterial exposure related to our assumed reinsurance contracts that are in a runoff status.
The following table provides an analysis of changes in our property and casualty loss and loss settlement expense reserves for 2009, 2008 and 2007 (net of reinsurance amounts). The deficiency in 2009 and 2008 was attributable to an increase we made in our prior accident year loss reserves due to additional development from Hurricane Katrina. The additional development included a federal court ruling and subsequent judgment, for which the awarded amount of $28,868,000 was paid in 2009, and deterioration in our other liability lines of business, which includes claims for construction defects.
The favorable development in 2007 resulted from a re-estimation of loss reserves recorded at December 31 of the prior year. This reestimation is primarily attributable to both the payment of claims in amounts less than the amounts reserved and from changes in loss reserves due to additional information on individual claims that we received after the reserves for those claims had been established. Another factor contributing to the redundancy recognized is the development of reserves for IBNR loss and loss settlement expenses at a level significantly less than anticipated at December 31 of the prior year. We attribute the favorable development in 2007 to the fact that during preceding years, we had experienced abnormally low levels of noncatastrophe claims frequency, due to improvements in our underwriting process.
Statutory capital and surplus in regards to policyholders at December 31, 2009, 2008 and 2007 and net income (loss) for the years then ended are as follows:
All states require domiciled insurance companies to prepare statutory-basis financial statements in conformity with the NAIC Accounting Practices and Procedures Manual, subject to any deviations prescribed or permitted by the applicable insurance commissioner and/or director. Statutory accounting practices primarily differ from GAAP in that policy acquisition and certain sales inducement costs are charged to expense as incurred, life insurance reserves are established based on different actuarial assumptions and the values reported for investments and deferred taxes are established on a different basis.
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 2009, 2008 and 2007.
The State of Iowa Insurance Department governs the amount of dividends that we may pay to stockholders without prior approval by the department. Based on these restrictions, we are allowed to make a maximum of $55,626,000 in dividend distributions to stockholders in 2010 without prior approval. We paid dividends of $15,951,000, $16,162,000 and $15,293,000 in 2009, 2008 and 2007, respectively. Dividend payments by the insurance subsidiaries to United Fire are subject to similar restrictions in the states in which they are domiciled. In 2009, 2008 and 2007, United Fire received $4,000,000 in dividends from United Life Insurance Company. Also, in 2007, United Fire received an $8,000,000 dividend from American Indemnity Financial Corporation. These intercompany dividend payments are eliminated in our Consolidated Financial Statements.
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 Financial Statements is as follows:
The significant components of the net deferred tax liability (asset) at December 31, 2009 and 2008 are as follows:
We also offer a health and dental benefit plan (“other retiree plan”) to all of our eligible employees and retirees, which is composed of two programs: (1) the self-funded retiree health and dental benefit plan and (2) the self-funded employee health and dental benefit plan. The other retiree plan provides health and dental benefits to our employees and retirees (and covered dependents) who have met the service and participation requirements stipulated by the other retiree plan. The other retiree plan’s contract administrators are responsible for making medical and dental care benefit payments. Participants are required to submit claims for reimbursement or payment to the claims administrator within twelve months after the end of the calendar year in which the charges were incurred. An unfunded benefit obligation is reported for the other retiree plan, which relates primarily to our postretirement benefit program.
The pension plan’s assets are invested in fixed maturity securities, equity securities, an annuity and cash and cash equivalents:
Equity securities may include various types of stock, such as large-cap, mid-cap and small-cap stocks, international stocks and United Fire & Casualty Company common stock.
As of December 31, 2009, 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 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.
The following is a summary of the pension plan’s actual and target asset allocations at December 31, 2009 and 2008 by asset category:
The United Life annuity is credited with compound interest on the average fund balance for the year. The interest rate is equivalent to the ratio of net investment income to mean assets of United Life Insurance Company.
The following table presents the categorization of the pension plan’s financial instruments measured at fair value on a recurring basis at December 31, 2009:
Our accumulated pension benefit obligation was $63,431,000 and $58,227,000 at December 31, 2009 and 2008, respectively.
The following table displays the effect that our unrecognized prior service costs and actuarial loss had on accumulated other comprehensive income (“AOCI”).
The unrecognized prior service cost and the unrecognized actuarial loss are being amortized on a straight-line basis over an average period of approximately 10 years. This period represents the average remaining employee service period until the date of full eligibility. We anticipate amortization of prior service costs and net losses for our pension plan in 2010 to be $11,000 and $2,181,000, respectively.
We have a profit-sharing plan in which employees who meet service requirements are eligible to participate. The amount of our contribution is discretionary and is determined annually, but cannot exceed the amount deductible for federal income tax purposes. Our contribution to the profit-sharing plan for 2009, 2008 and 2007, was $927,000, $974,000 and $4,107,000, respectively.
The United Fire & Casualty Company 2008 Stock Plan (“the 2008 Stock Plan”) authorizes the issuance of restricted stock awards, stock appreciation rights, incentive stock options, and nonqualified stock options for up to 1,900,000 shares of United Fire common stock to employees, with 919,525 authorized shares available for future issuance at December 31, 2009. The 2008 Stock Plan is administered by the Board of Directors, which determines which employees will receive awards under the 2008 Stock Plan, when awards will be granted, and the terms and conditions of the awards. The Board of Directors may also take any action it deems necessary and appropriate for the administration of the 2008 Stock Plan. Pursuant to the 2008 Stock Plan, the Board of Directors may, in its sole discretion, grant awards to employees of United Fire or any of its affiliated companies who are in positions of substantial responsibility with United Fire.
Option awards granted pursuant to the 2008 Stock Plan are granted to buy shares of United Fire’s common stock at the market value of the stock on the date of grant. All outstanding option awards vest and are exercisable in installments of 20.0 percent of the number of shares covered by the option award each year from the grant date, unless the Board of Directors authorizes the acceleration of vesting. To the extent not exercised, vested option awards accumulate and are exercisable by the awardee, in whole or in part, in any subsequent year included in the option period, but not later than 10 years from the grant date. Restricted stock awards granted pursuant to the 2008 Stock Plan fully vest after five years from the date of issuance, unless accelerated upon the approval of the Board of Directors, at which time United Fire common stock will be issued to the awardee. Restricted stock awards are generally granted free of charge to the eligible employees of United Fire as designated by the Board of Directors.
The activity in the 2008 Stock Plan is displayed in the following table.
We write both commercial and personal lines of property and casualty insurance. We focus on our commercial lines, which represented 91.8 percent of our property and casualty insurance premiums earned for 2009. Our personal lines represented 8.2 percent of our property and casualty insurance premiums earned for 2009.
The pricing of our property and casualty insurance products are based on many factors including state regulation and legislation, competition, business and economic conditions such as: inflation, market rates of interest, expenses, the frequency and severity of claims, and the outcome of judicial decisions. Additionally, many state regulators consider investment income when establishing or approving rates, which can reduce the margin for profit that we include in the rating formula.
Our property and casualty insurance segment experiences some seasonality with regard to premiums written, which are generally highest in January and July and lowest during the fourth quarter. Although we experience some seasonality in our premiums written, premiums are earned ratably over the period of coverage. Losses and loss settlement expenses incurred tend to remain consistent throughout the year, with the exception of when a catastrophe occurs. Catastrophes inherently are unpredictable and can occur at any time during the year from man-made or natural disaster events that include, but which are not limited to, hail, tornadoes, hurricanes and windstorms.
In June 2008, our corporate headquarters was forced to close temporarily due to historic flooding in Cedar Rapids, Iowa, that caused extensive damage to the first and lower levels of our buildings. We recorded flood-related charges of $6,803,000, net of insurance, in 2008 and net insurance recoveries of $1,468,000 in 2009. These charges primarily relate to costs incurred to clean up and restore our Cedar Rapids, Iowa home office and contents. We have received insurance reimbursements totaling $1,822,000 and $3,106,000, in 2009 and 2008, respectively, which offset all of the charges incurred in 2009 and a portion of the charges incurred in 2008.
In September 2008, our New Orleans, Louisiana claims office in Metairie closed for three days due to Hurricane Gustav and our Gulf Coast regional office in Galveston, Texas was temporarily closed for three weeks due to Hurricane Ike. We recorded $133,000, net of insurance, and $399,000 of hurricane-related expenses in 2009 and 2008, respectively, which primarily relates to costs incurred to remove damaged contents from the affected areas and establish a temporary facility for our Gulf Coast regional office. We have received insurance reimbursements totaling $275,000 in 2009, which offset a portion of the charges incurred in 2009. There were no such reimbursements recorded in 2008.
We believe that any additional disaster charges and other related expenses incurred in 2010 would be minimal and immaterial to our results of operations.
Life insurance in-force, before ceded reinsurance, totaled $4,715,258,000 and $4,589,010,000 as of December 31, 2009 and 2008, respectively. Traditional life insurance products represented 62.8 percent and 61.0 percent of our insurance in-force at December 31, 2009 and 2008, respectively. Universal life insurance represented 34.3 percent and 35.8 percent of insurance in-force at December 31, 2009 and 2008, respectively.
Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the reporting period. Diluted earnings per share gives effect to all dilutive common shares outstanding during the reporting period. The dilutive shares we consider in our diluted earnings per share calculation relate to our outstanding stock options.
Comprehensive income (loss) includes changes in stockholders’ equity during a period except those resulting from investments by and dividends to stockholders. The following table sets forth the components of comprehensive income (loss) and the related tax effects for 2009, 2008 and 2007.
At December 31, 2009, we were obligated under noncancelable operating lease agreements for office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $4,209,000, $4,085,000 and $4,785,000 for 2009, 2008 and 2007, respectively. Our most significant lease arrangement is for office space for our regional office in Galveston, Texas. This lease expires in December 2014. The annual lease payments for this office space total approximately $2,100,000.
We have audited the accompanying consolidated balance sheets of United Fire & Casualty Company (United Fire) as of December 31, 2009 and 2008, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the financial statement schedules of United Fire listed in Item 15(a)(2). These financial statements and schedules are the responsibility of United Fire’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire & Casualty Company at December 31, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of United Fire’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report, dated March 1, 2010, expressed an unqualified opinion thereon.
As of December 31, 2009, United Fire & Casualty Company’s management assessed the effectiveness of internal control over financial reporting based on the criteria for effective internal control over financial reporting established in “Internal Control - Integrated Framework,” issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. Based on the assessment, United Fire & Casualty Company’s management determined that effective internal control over financial reporting is maintained as of December 31, 2009, based on those criteria.
Ernst & Young LLP, the independent registered public accounting firm that audited the Consolidated Financial Statements of United Fire & Casualty Company included in this Annual Report on Form 10-K, has audited the effectiveness of internal control over financial reporting as of December 31, 2009. Their report, which expresses an unqualified opinion on the effectiveness of United Fire & Casualty Company’s internal control over financial reporting as of December 31, 2009, is included in this item under the heading “Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting.”
In our opinion, United Fire & Casualty Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the COSO criteria.