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. We previously leased a portion of the building located at 109 Second Street SE in Cedar Rapids, Iowa as reported in our 2007 Form 10-K. Following the significant flooding of Cedar Rapids in June 2008 we took the opportunity to purchase and renovate the building. The first floors and basements of our three owned buildings in Cedar Rapids, Iowa have undergone extensive reconstruction due to the flood.
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 “expects,” “anticipates,” “intends,” “plans,” “believes,” “continues,” “seeks,” “estimates,” “predicts,” “should,” “could,” “may,” “will continue,” “might,” “hope,” “can” and variations of such words and similar expressions are intended to identify such 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:
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 Iowa, Texas, Colorado, Louisiana and Missouri. Approximately three-fourths of our life insurance business is generated in Iowa, Minnesota, Wisconsin, Nebraska and Illinois.
Our premium written is cyclical in nature and is influenced by many factors, including price competition, economic conditions, interest rates, weather-related events and other catastrophes including natural disasters (e.g. hurricanes and tornados) and man-made disasters, state regulations, court decisions and changes in the law.
On June 6, 2008, we received notice of an adverse decision by a Federal Court jury in New Orleans, Louisiana in a lawsuit related to Hurricane Katrina. We are appealing the jury’s decision, which according to Louisiana law required us to place $29.0 million on deposit with the State of Louisiana. We recorded a net loss after reinsurance of $10.8 million ($7.0 million after-tax) related to this decision. We continue to settle lawsuits related to Hurricane Katrina and, as of December 31, 2008, we have in excess of 420 individual policyholder cases as well as 11 class-action lawsuits pending. Refer to Note 1. “Significant Accounting Policies” under the heading “Contingent Liabilities” contained in Part II, Item 8, “Financial Statements and Supplementary Data.” for a further discussion of the current status of our ongoing Hurricane Katrina litigation and its potential impact to our operations.
We recorded $6.8 million of flood-related expenses, net of insurance, in 2008, which primarily relates to costs incurred to clean up and restore our buildings and their contents, and we anticipate incurring additional expenses for reconstruction and other related costs in 2009. We believe that any additional costs to be incurred would be minimal and immaterial to our results of operations. A portion of these costs may be subject to recovery. We have received insurance reimbursements totaling $3.1 million, which have offset the expenses incurred through December 31, 2008. Since December 31, 2008 we have received an additional $1.0 million in insurance recoveries.
On September 1, 2008, Hurricane Gustav made landfall along the Louisiana coast near Cocodrie, Louisiana. On September 13, 2008, Hurricane Ike made landfall in Galveston, Texas. Hurricanes Gustav and Ike together were considerable financial events for us, resulting in more than $36.0 million in incurred losses and loss settlement expenses during 2008. These hurricanes made fairly direct hits on two of our three largest Gulf Coast exposures that we monitor - the southeastern Louisiana and Galveston-Houston areas. We do not expect that further development on our losses from Hurricane Gustav will require us to utilize our catastrophe reinsurance coverage, which has a loss retention limit of $20.0 million. We are encouraged that the losses for Hurricane Ike, which have exceeded our catastrophe reinsurance loss retention, will not have a material impact on our future results of operations as any further development will be ceded under our catastrophe reinsurance coverage.
This has been a difficult year for our company, but with the support of our employees and customers, we have been able to meet the challenges created by these natural disasters with almost no disruption in service to our agents and policyholders. Our overall disaster preparedness allowed us to continue to settle claims, process new business and service existing accounts despite the temporary office closings. For the most part it was business as usual for our customers despite these natural disasters.
The global investment markets have experienced extraordinary volatility in 2008, especially in the last six months of the year. We have been impacted by this volatility, with our available-for-sale fixed maturity securities and our equity securities generating an unrealized loss of $128.6 million for 2008 compared to an unrealized loss of $8.4 million for 2007 and an unrealized gain of $1.7 million for 2006. We are committed to a general buy-and- hold philosophy in relationship to our investment portfolio, with the ability and intention of holding our investments to maturity or until a recovery in value occurs. Despite the calamities of the past year, we remain in a strong capital position, with less than a 15 percent decline in our stockholders’ equity from 2007 to 2008.
Our policy has been to pay quarterly cash dividends, and we intend to continue that policy. We have paid dividends every quarter since March 1968. Payment of any future dividends, however, will depend upon factors such as net income, financial condition, capital requirements, and general business conditions. For a more detailed accounting of dividends paid during 2008 and 2007, refer to Part II, Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”
As part of our risk management process, we use third-party proprietary computer modeling of windstorm/hail, hurricane and earthquake events, to aid in estimating the likelihood that the loss from a single event occurring in a one-year timeframe will equal or exceed a particular amount.
Catastrophe modeling requires a significant amount of judgment and a number of assumptions and relies upon inputs based on experience, science, engineering and history. As a result, 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.
Please refer to the Non-GAAP financial measures section of this report for further explanation of this measure.
The following table shows our premiums written and earned for 2008, 2007 and 2006.
Direct premiums written is the total policy premiums, net of cancellations, associated with policies issued and underwritten by our property and casualty insurance segment. Assumed premiums written is the total premiums associated with the insurance risk transferred to us by other insurance and reinsurance companies pursuant to reinsurance contracts. Ceded premiums written is the portion of direct premiums written that we cede to our reinsurers under our reinsurance contracts. Net premiums earned are recognized over the life of a policy and differ from net premiums written, which are recognized on the effective date of the policy.
In the months following Hurricane Katrina, we made the decision to reduce our property exposures along the Gulf Coast. Due to regulatory constraints, we were required to wait until 2007 to initiate our plan. Through 2008, we have exceeded our goal of reducing our property exposures in Louisiana, reducing the exposure by over one-third. Our planned reduction has also reduced our estimated 100-year maximum probable loss by over 50 percent. To maintain profitability of our remaining Gulf Coast 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 than we would have if we had not undertaken these measures. In an effort to reduce our exposure to future catastrophes, over the last several years we have also increased our reinsurance limit from $125.0 million in 2005 to $200.0 million in 2008.
Other changes in loss development included loss redundancies in the following lines of business: commercial auto liability ($3.2 million), workers’ compensation ($7.2 million) and assumed reinsurance ($5.2 million).
The 2008 number includes a $10.8 million judgment, net of reinsurance, which was entered and incurred in 2008 in a lawsuit related to Hurricane Katrina, which is currently pending the results of an appeal.
Our “other” redundancy 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 our liability or coverage exposure on a particular claim, facts that implicate other parties as being liable on a particular claim and favorable court rulings that decrease the likelihood that we would be liable 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 are less severe than originally believed or that damage to a structure is merely cosmetic instead of structural.
The table on the following page depicts our net loss ratio for 2008, 2007 and 2006.
In 2008, commercial lines catastrophe losses totaled $54.5 million, compared to $12.7 million in 2007. In 2007, our results in commercial lines had improved over 2006, due primarily to the lower catastrophe losses experienced in 2007 than in 2006. The 2006 results in these lines were impacted by further development from Hurricane Katrina losses. In each of the three years, 2006 through 2008, our profitability in commercial lines was negatively impacted by soft market conditions, as characterized by reductions in premium pricing.
While losses incurred have increased, a decrease in premiums earned in the commercial property lines of business has also contributed to the 2006-2008 declining profitability. Premiums earned in these lines have decreased from $124.9 million in 2006 to $109.2 million in 2008. This decrease in premiums resulted from the competitive insurance market and the continued reduction in pricing, which has impacted our commercial property lines more than our other insurance business. In addition, beginning in 2006, we reduced the number of policies that we write in catastrophe-prone areas along the Gulf Coast, primarily in Louisiana, and this has lead to a decline in premiums earned over the past three years.
Losses from construction defect claims have increased from $4.2 million in 2006 to $5.4 million in 2007 to $11.0 million in 2008. We currently have $16.0 million in loss and loss settlement expense reserves for open construction defect claims. 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. Much of the recent claims activity has been generated by plaintiffs’ lawyers who approach new homeowners, and in many cases homeowner associations with large numbers of homeowners in multi-residential complexes, about defects or other flaws in their homes. The reporting of such claims can be quite delayed as the statute of limitations is an extended period of time sometimes up to ten years. Court decisions have expanded insurers’ exposure to construction defect claims as well. 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 are implementing 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 are also implementing policy language excluding coverage for architects and engineers who do not carry their own professional liability insurance coverage. Finally, we are adding a limiting endorsement making our policy coverage in excess of any other insurance coverage.
Like a majority of our business, the competitive market has limited our growth in premiums in other liability insurance, though to a lesser extent than in our property lines of business.
The deterioration in this line during 2007 was primarily due to a 3.8 percent increase in claim frequency as compared to 2006.
The improvement in results in 2007 was due to lower severity, a slight decrease in our frequency and improvements in our medical review programs.
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 18.5 percent in 2008, 9.7 percent in 2007 and 35.2 percent in 2006.
The improvement in 2007 as compared to 2006 was the result of stricter underwriting guidelines, as well as a decrease in frequency and severity. In 2007, there were no new claims that exceeded our $1.5 million reinsurance retention level, compared to three such claims in 2006. The 2006 underwriting results were adversely impacted primarily by bonded principals that defaulted on their bonded obligations after a determination was made that they did not have the financial wherewithal to complete the bonded projects, which required us to pay the outstanding obligations associated with those projects.
Our 2008 core and catastrophe reinsurance programs remained relatively unchanged from our 2007 programs. Neither terms and conditions nor pricing were materially different. During 2008, we exceeded our catastrophe retention of $20.0 million with Hurricane Ike, and recorded $2.4 million in ceded losses recoverable from this catastrophe.
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 either an A.M. Best rating of at least A- or an S&P rating of at least A-; if 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, 2008.
Refer to Part II, Item 8, Note 5, “Reinsurance” for a more detailed discussion of our reinsurance programs.
In recent years, we have reduced the level of our assumed reinsurance business. In 2008, assumed premiums earned were $13.0 million, compared to $17.6 million in 2007 and $18.8 million in 2006. We continue to have exposure, primarily with respect to catastrophe coverage related to the runoff of some business, as well as to the small number of assumed reinsurance contracts that we have continued to underwrite.
The Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”) was signed into law by President Bush 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 2008 and remains the same for 2009. Our TRIPRA deductible was $66.7 million for 2008 and our TRIPRA deductible will approximate $64.8 million for 2009. Our core and catastrophe reinsurance treaties provide limited coverage for terrorism exposure excluding nuclear, biological and chemical related claims.
As a percentage of premiums earned, our other underwriting expenses were consistent between 2007 and 2008, with underwriting expense ratios of 29.3 percent and 29.4 percent, respectively. In 2008, our commission expense decreased due to lower profit-sharing commissions payable to our agents. Offsetting this decrease was an increase in the ratio of fixed underwriting expenses to premiums earned. In 2007, we experienced an increase in our underwriting expenses that were attributable to an increase in benefit expenses, an increase in accounts receivable charged off and a fixed level of operating expenses on flat premium revenue growth.
Our life insurance segment produced pre-tax income of $3.3 million in 2008, compared to $20.3 million in 2007 and $21.9 million in 2006. Pre-tax income decreased in 2008 due to the realized investment losses we experienced from other-than-temporary impairment write-downs, which primarily were related to fixed maturity securities. Net premium earned increased to $37.8 million in 2008, compared to $32.6 in 2007 and $36.1 million in 2006. The decrease in net premium earned from 2006 to 2007 was due to a decrease in sales of our single premium whole life insurance and the run-off of our credit life insurance. The increase in net premium earned in 2008 is attributable to increased sales in single premium whole life products and to our increased marketing efforts. Net investment income decreased to $74.1 million in 2008 compared to $79.1 million in 2007 and $81.8 million in 2006, due to declining invested assets and short-term market interest rates. Consolidated investment results are discussed in more detail later in this section under the caption “Investments.”
The realized investment losses for 2008, as compared with modest gains in 2007 and 2006, are primarily the result of losses in our fixed maturity securities portfolio; specifically, the write-downs of Lehman Brothers and Kaupthing Bank holdings due to current financial market conditions resulting from the credit crisis. In 2008, 2007 and 2006, other-than-temporary impairments recorded totaled $9.0 million, $.1 million and $.2 million, respectively.
We experienced a decrease in interest on policyholders’ accounts each year since 2006, due primarily to a reduction in annuity balances. We attribute the level of annuity surrenders and withdrawals over this time period to the perceived attractiveness of other investment options.
As of December 31, 2008, we have a net operating loss (“NOL”) carryforward of $17.2 million, all of which is due to our purchase of American Indemnity Financial Corporation in 1999. Such net operating losses are currently available to offset future taxable income of our property and casualty companies. NOLs totaling $.8 million and $5.5 million expire in 2010 and 2011, respectively.
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, 2008, this valuation allowance totaled $5.6 million and remained unchanged from December 31, 2007. The valuation allowance was reduced by $.5 million in 2007 and $1.1 million in 2006 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.
With respect to our fixed maturity securities, our general investment philosophy is to purchase financial instruments with the expectation that we will hold them to their maturity. However, close management of our available-for-sale portfolio is considered necessary to maintain an approximate matching of assets to liabilities and to adjust the portfolio to respond to changing financial market conditions and tax considerations.
Average of invested assets (including money market accounts) at beginning and end of year.
In 2008, we incurred realized investment losses of $10.4 million, compared with realized investment gains of $9.7 million and $10.0 million in 2007 and 2006, respectively. The losses experienced in 2008 are due primarily to $9.9 million in pre-tax other-than-temporary impairment write-downs in our fixed maturity securities and equity securities portfolio, including Lehman Brothers and Kaupthing Bank, both of which are held by our life insurance segment. The write-downs that occurred in 2008 represent 0.5 percent of our investment portfolio.
As of December 31, 2008, net unrealized gains, after tax, totaled $25.5 million, compared to $85.6 million as of December 31, 2007 and $93.5 million as of December 31, 2006. In 2008 and 2007, depressed bond and stock prices, particularly for our holdings of investments in financial institutions, contributed to the decrease in unrealized gains. We continue to closely monitor current market conditions and evaluate the long-term impact of recent market volatility on all of our investment holdings.
Available-for-sale fixed maturities are carried at fair value. Held-to-maturity fixed maturities are carried at amortized cost.
The change in credit rating of our fixed maturity securities portfolio at December 31, 2008 as compared to December 31, 2007, was due primarily to downgrades of our municipal bond holdings that occurred during 2008. Municipal bonds can either be insured or uninsured. Municipal bonds that are insured have a credit rating that is equal to the credit rating of the insuring company or the underlying security, whichever is greater. Municipal bonds that are uninsured are rated using the credit rating of the underlying security. During 2008, many of the insurance companies that insure municipal bonds had their credit rating downgraded because of the recent economic turmoil and financial market crisis.
For our property and casualty insurance segment, the weighted average duration of our fixed maturity available-for-sale, held-to-maturity and trading security portfolios, including convertible bonds, at December 31, 2008 is 7.7 years compared to 7.9 years at December 31, 2007.
For our life insurance segment, the weighted average duration of our fixed maturity available-for-sale, held-to-maturity and trading security portfolios, at December 31, 2008 is 4.3 years compared to 4.8 years at December 31, 2007.
Liquidity measures our ability to generate sufficient cash flows to meet our short- and long-term cash obligations. Our sources of cash inflows are premiums, annuity deposits, sales, calls or maturity of investments, and investment income. Historically, we have generated substantial cash inflows from operations because cash from premium payments is usually received in advance of cash payments made to settle losses. When investing the cash generated from operations, we invest in securities with maturities that approximate the anticipated timing of payments for losses and loss settlement expenses of the underlying insurance policies. The majority of our assets are invested in fixed maturity securities.
We invest funds required for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. At December 31, 2008, our cash and cash equivalents included $70.7 million related to these money market accounts, compared with $110.5 million at December 31, 2007.
Net cash flows used in investment activities totaled $107.3 million in 2008, compared to $16.3 million in 2007 and $30.1 million in 2006. In 2008, we substantially increased our purchases of corporate fixed maturity securities, as the interest rates on these securities increased.
Stockholders’ equity decreased from $751.5 million at December 31, 2007, to $641.7 million at December 31, 2008, a decrease of 14.6 percent. The decrease in stockholders’ equity between years included a net loss of $13.1 million; dividends paid of $16.2 million; a reduction in net unrealized appreciation on investments of $60.0 million, net of tax; repurchase of common stock of $14.8 million; and the change in underfunded status of our employee benefit plans of $7.6 million, net of tax. The book value per share at December 31, 2008, of our common stock was $24.10, compared with $27.63 at December 31, 2007.
Payment amounts for future policy benefit reserves must be actuarially estimated and are not determinable from the contract. The projected payments illustrated above are based on the assumption that the holders of our annuities and life insurance policies will withdraw their account balances from our company upon the expiration of their contracts. Actual cash withdrawals could differ significantly from these estimates, depending upon the interest rate environment at the time the contracts expire.
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, 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.
Upon acquisition, we classify investment securities as held-to-maturity, available-for-sale, or trading. We record investments in held-to-maturity fixed maturities at amortized cost. We record available-for-sale fixed maturity securities, trading securities and equity securities at fair value. Other long-term investments are recorded on the equity method of accounting. We record mortgage loans at amortized cost and policy loans at the outstanding loan amount due from policyholders.
We value our available-for-sale fixed maturities, trading securities, equity securities, short-term investments and money market accounts at fair value in accordance with SFAS No. 157 “Fair Value Measurements.” We exclude unrealized appreciation or depreciation on investments carried at fair value, with the exception of trading securities, from net income and report it, net of applicable deferred income taxes, as a component of accumulated other comprehensive income in stockholders’ equity.
The fair value of securities that are categorized as Level 1 was based on quoted market prices that are readily and regularly available.
The securities categorized as Level 3 includes holdings in certain private placement fixed maturity and equity securities and certain impaired securities for which there is not an active market. The fair value of our Level 3 impaired securities was determined primarily based upon management’s assumptions regarding the timing and amount of future cash inflows.
If the security has been written down or is in bankruptcy, management relies in part on outside opinions from rating agencies, our lien position on the security, general economic conditions and management’s expertise to determine fair value. We have the ability and positive intent to hold these securities until such time that we are able to recover all or a portion of our original investment. If the security does not have a market at the balance sheet date, management will estimate the security’s fair value based on other securities in the market. Management will continue to monitor the security after the balance sheet date to confirm that their estimated fair value is reasonable.
Realized gains (losses) are recorded as a component of current operations whereas unrealized gains (losses) are recorded as a component of comprehensive income (loss).
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires us to record other-than-temporary impairment charges when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in fair value of the equity security will not occur in a reasonable amount of time. We include other-than-temporary impairment charges on investments in net realized investment gains and losses based on the fair value of the investments at the measurement date. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery. As of December 31, 2008, we had a number of securities where fair value was less than our cost. The total unrealized depreciation on these securities totaled $82.6 million at December 31, 2008, compared with $17.6 million at December 31, 2007. At December 31, 2008, the largest unrealized loss, after tax, on any single fixed maturity or equity investment was $4.1 million. Our rationale for not recording other-than-temporary impairments on these securities is discussed in Part II, Item 8, Note 2, “Summary of Investments.”
We record an asset for deferred policy acquisition costs, such as commissions, premium taxes and other variable costs incurred in connection with the writing of our property and casualty lines of business. As of December 31, 2008 and 2007, we reported $52.2 million and $58.3 million in deferred policy acquisition costs, respectively. This asset is amortized over the life of the policies written, generally one year. We assess the recoverability of deferred policy acquisition costs on a quarterly basis by line of business. This assessment is performed by comparing recorded unearned premium to the sum of unamortized deferred policy acquisition costs and estimates of expected losses and loss settlement expenses. If the sum of these costs exceeds the amount of recorded unearned premium, that is, the line of business is expected to generate an operating loss; the excess is recognized as an offset against the asset established for deferred policy acquisition costs. This offset is referred to as a premium deficiency charge. If the amount of the premium deficiency charge is greater than the unamortized deferred policy acquisition cost asset, a liability will be recorded for the excess.
To calculate the premium deficiency charge, we estimate expected losses and loss settlement expenses by using an assumed loss and loss settlement expense ratio which approximates that of the recent past. This is the only assumption we utilize in our calculation. Changes in this assumption can have a significant impact on the amount of premium deficiency charge calculated. We do not consider anticipated investment income in determining the recoverability of deferred costs.
Actual future results could differ materially from our current estimates, requiring adjustments to the recorded deferred policy acquisition cost asset. Such adjustments are recorded through operations in the period the adjustments are identified. Due to changes in the estimated recoverability of our deferred policy acquisition costs, the premium deficiency charge calculated at December 31, 2008 increased $1.2 million from the premium deficiency charge calculated at December 31, 2007. There was an immaterial change in premium deficiency between December 31, 2007 and December 31, 2006. An increase in the premium deficiency charge allows us to defer comparatively less underwriting costs period over period, resulting in a relatively smaller deferred acquisition cost asset. The changes in the estimated recoverability of our deferred policy acquisition costs are attributable to deterioration in our underwriting experience in recent years.
At December 31, 2008, we had $106.1 million in deferred policy acquisition costs related to our life insurance segment, compared to $70.7 million at December 31, 2007. The majority of this asset relates to our universal life and investment (i.e. annuity) contracts, hereafter referred to as non-traditional business.
A material change in these assumptions could have a negative or positive effect on our reported deferred policy acquisition cost asset, earnings and stockholders’ equity.
“Fire and allied lines” includes fire, allied lines, homeowners and inland marine.
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.
In all but one of the past ten years, our net reserves for losses and loss settlement expenses have exceeded our net incurred losses and loss settlement expenses. In 2008, our net reserves for prior years were deficient by $.5 million. The reserves in 2008 was negatively impacted by an increase we made in our prior accident year loss reserves due to additional development from Hurricane Katrina, which included a federal court ruling and judgment which is currently under appeal, and deterioration in our other liability lines of business which includes claims for construction defects.
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 2008 and 2007, 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 2009.
It is management’s policy to utilize staff adjusters to develop our estimate of case-basis loss reserves. IBNR and loss settlement expense reserves are established through various formulae that utilize pertinent, recent company historical data. The calculations are supplemented with knowledge of current trends and events that could result in adjustments to the level of IBNR and loss settlement expense reserves. In addition, management consults with Regnier Consulting Group throughout the year as deemed necessary. Management annually compares our estimate of total reserves to point estimates prepared by Regnier Consulting Group by line of business to ensure that our estimates are within the actuary’s acceptable range. Regnier Consulting Group performs an extensive review of loss and loss settlement expense reserves at each year end using generally accepted actuarial guidelines to ensure that the recorded reserves appear reasonable. If the carried reserves were deemed unreasonable, we would adjust reserves. In 2008 and 2007, after considering the actuary’s range of reasonable point estimates, management believed that carried reserves were reasonable and therefore did not adjust the recorded amount.
Regnier Consulting Group uses four projection methods in their actuarial analysis of our loss reserves and uses the paid-to-paid projection method in their analysis of our loss settlement expense reserves. Based on the results of the projection methods, the actuaries select an actuarial central estimate of the reserves. They then compare their estimate to our carried reserves to evaluate the reasonableness of the carried reserves. The four methods utilized by Regnier Consulting Group are: paid loss development; reported loss development; expected loss emergence based on paid losses; and expected loss emergence based on reported losses.
We periodically review the adequacy of these reserves and recoverability of DAC for these contracts on an aggregate basis using actual experience. In the event that actual experience is significantly adverse compared to the original assumptions, any remaining unamortized DAC balance must be expensed to the extent not recoverable and the establishment of a premium deficiency reserve may be required. The effects of changes in reserve estimates are reported in the results of operations in the period in which the changes are determined. We have not made any changes in methods or assumptions for estimated reserves in the past three years. We anticipate that mortality, investment and reinvestment yields, and policy terminations are the factors that would be most likely to require adjustment to these reserves or related DAC. Assumptions are established when the policy is issued. If actual experience is less favorable than assumptions, we may need to increase our reserves, resulting in a charge to policyholder benefits and claims.
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 2008 and 2007, 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 2009.
Incorporated by reference from Note 1 “Significant Accounting Policies” under the heading “Pending Accounting Standards,” contained in Part II, Item 8 “Financial Statements and Supplementary Data.”
Premiums written is a measure of our overall business volume. Net premiums written comprise direct and assumed premiums written, net of what we are charged for reinsurance policies. Direct premiums written is the amount of premiums charged for policies issued during the period. Assumed premiums written is consideration or payment we receive in exchange for reinsurance we provide to other insurance companies. We report these premiums as revenue as they are earned over the underlying policy period. We report premiums written applicable to the unexpired term of a policy as unearned premium subject to reinsurance. We evaluate premiums written as a measure of business production for the period under review.
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. 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 programs. We include a discussion of the impact of catastrophes because we believe it is meaningful for investors to understand the variability in periodic earnings.
Combined ratio is a commonly used financial measure of underwriting performance. A combined ratio below 100 percent generally indicates a profitable book of business. The combined ratio is the sum of two separately calculated ratios, the loss and loss settlement expense ratio (referred to as the “net loss ratio”) and the underwriting expense ratio (the “expense ratio”). When prepared in accordance with GAAP, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premium earned. The expense ratio is calculated by dividing nondeferred underwriting expenses and amortization of deferred policy acquisition costs 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; the expense ratio is calculated by dividing underwriting expenses by net premiums written.
Note 7. Statutory Reporting, Capital Requirements, and Dividends and Retained Earnings Restrictions
United Fire Lloyds is organized as a Texas Lloyds plan, which is an aggregation of underwriters who, under a common name, engage in the business of insurance through a corporate attorney-in-fact. United Fire Lloyds is financially and operationally controlled by United Fire & Indemnity Company, its corporate attorney-in-fact, pursuant to three types of agreements: trust agreements between United Fire & Indemnity Company and certain individuals who agree to serve as trustees; articles of agreement among the trustees who agree to act as underwriters to establish how the Lloyds plan will be operated; and powers of attorney from each of the underwriters appointing a corporate attorney-in-fact, who is authorized to operate the Lloyds plan. Because United Fire & Indemnity Company can name the trustees, the Lloyds plan is perpetual, subject only to United Fire & Indemnity Company’s desire to terminate it.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The financial statement categories that are most dependent on management estimates and assumptions include investments, deferred policy acquisition costs and future policy benefits and losses, claims and loss settlement expenses.
The costs of acquiring new life business, principally commissions, certain variable underwriting, agency and policy issue expenses, have been deferred. These costs are amortized to income over the premium-paying period of the related traditional policies in proportion to the ratio of the expected annual premium revenue to the expected total premium revenue and over the anticipated terms of non-traditional policies in proportion to the ratio of the expected annual gross profits to the expected total gross profits. Policy acquisition costs deferred in 2008, 2007 and 2006 were $10,620,000, $10,511,000 and $9,295,000, respectively. Amortization of deferred policy acquisition costs in 2008, 2007 and 2006 totaled $11,568,000, $13,385,000 and $8,142,000 respectively. The expected premium revenue and gross profits are based upon the same mortality and withdrawal assumptions used in determining future policy benefits. For non-traditional policies, changes in the amount or timing of expected gross profits result in adjustments to the cumulative amortization of these costs. The effect on the amortization of deferred policy acquisition costs for revisions to estimated gross profits is reported in earnings in the period such estimated gross profits are revised.
For purposes of reporting cash flows, cash and cash equivalents include cash, nonnegotiable certificates of deposit with original maturities of 12 months or less and money market accounts.
We made payments for income taxes of $13,817,000, $50,513,000 and $25,306,000 during 2008, 2007 and 2006, respectively. In addition, we received refunds totaling $2,904,000 and $7,783,000 in 2008 and 2007, respectively, due to the carryback of losses. There were no significant payments of interest in 2008, 2007 and 2006, other than payments to policyholders’ accounts related to non-traditional life insurance business.
Amortization expense totaled $60,000 for each of the three years ended December 31, 2008, 2007 and 2006.
In June 2006, FASB Interpretation (“FIN”) 48, “Accounting for Uncertainty in Income Taxes,” was issued to clarify accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, as well as the derecognition of a tax position previously recognized in the financial statements. FIN 48 also prescribes expanded disclosure requirements for unrecognized tax benefits recorded. Our adoption of this interpretation effective January 1, 2007, had no impact on our consolidated financial position.
We have recognized no liability for unrecognized tax benefits at December 31, 2008 or 2007 or at any time during 2008 or 2007. In addition, we have not accrued for interest and penalties related to unrecognized tax benefits. However, if interest and penalties would need to be accrued related to unrecognized tax benefits, such amounts would be recognized as a component of federal income tax expense.
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 2003. There are no ongoing examinations of income tax returns by federal or state tax authorities.
We have been named as a defendant in various lawsuits, including actions seeking certification from the court to proceed as a class action suit and actions filed by individual policyholders, relating to disputes arising from damages that occurred as a result of Hurricane Katrina in 2005. As of December 31, 2008, there were in excess of 420 individual policyholder cases pending, and an additional 11 class action cases pending. These cases have been filed in both Louisiana state courts and federal district courts and involve, among other claims, disputes as to the amount of reimbursable claims in particular cases, as well as the scope of insurance coverage under homeowners and commercial property policies due to flooding, civil authority actions, loss of use and business interruption. Certain of these cases also claim a breach of duty of good faith or violations of Louisiana insurance claims-handling laws or regulations and involve claims for punitive or exemplary damages while other cases claim that under Louisiana’s so-called “Valued Policy Law”, the insurers must pay the total insured value of a home that is totally destroyed if any portion of such damage was caused by a covered peril, even if the principal cause of the loss was an excluded peril. Other cases challenge the scope or enforceability of the water damage exclusion in the policies.
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 June 2008, a commercial policyholder was awarded approximately $21,000,000 in additional Hurricane Katrina damages by a Federal Court jury sitting in New Orleans. The claims associated with this litigation represent what we consider to be our single largest exposure as a result of that hurricane. In response to this verdict, we recorded an incurred loss, net of excess of loss of reinsurance, of $10,790,000 in 2008. However, we have filed an appeal of this verdict, as we believe that the award includes damages that were attributable to flooding (and thus excluded from coverage) and that there were other errors at trial prejudicial to us. According to Louisiana law we were required to place $29,026,000 on deposit with the State of Louisiana for this case while we pursue an appeal. This appeal remains pending at December 31, 2008.
For our nonqualified stock options, we utilize the Black-Scholes option pricing method to establish the fair value of options granted under our stock award plans. Our determination of the fair value of stock-based payment awards on the date of grant using this option-pricing model is affected by our stock price, as well as assumptions regarding a number of complex and subjective variables, which include the expected volatility in our stock price, the expected dividends to be paid over the term of the awards, the risk-free interest rate and actual and projected employee stock award exercise activity. Any changes in these assumptions may materially affect the estimated fair value of the award. For our restricted stock awards, we utilize the fair value of our common stock on the date of grant to determine the fair value of the award.
In April 2008, we began participating in a securities lending program, which generates investment income and discounts other investments fees we are charged, by lending certain investments to other institutions for short periods of time. Borrowers of these securities must deposit collateral, in the form of cash or U.S. Treasury securities, with Northern Trust, the third-party custodian. Collateral deposited by borrowing institutions must be equal to at least 102 percent of the market value of the securities loaned plus accrued interest. Northern Trust monitors the market value of our loaned securities on a daily basis. As the market value of loaned securities fluctuates, in order to maintain collateral values of at least 102 percent, the borrower either deposits additional collateral or Northern Trust refunds collateral to the borrower. If a borrower defaults under the lending agreement, Northern Trust will use the deposited collateral to purchase the same or similar security as a replacement for the security that was not returned by the borrower. However, if Northern Trust is unable to purchase the same or similar security, we will receive the deposited collateral in place of the borrowed security.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations,” a replacement of SFAS No. 141, “Business Combinations.” SFAS No. 141(R) provides revised guidance on how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree. In addition, SFAS No. 141(R) provides revised guidance on the recognition and measurement of goodwill, as well as guidance specific to the recognition, classification, and measurement of assets and liabilities related to insurance and reinsurance contracts acquired in a business combination. We are required to apply SFAS No. 141(R) prospectively to business combinations occurring on or after January 1, 2009. Therefore, the adoption of SFAS No. 141(R) will have no impact on the amounts reported in our Consolidated Financial Statements at December 31, 2008.
The amortized cost and fair value of held-to-maturity, available-for-sale and trading securities at December 31, 2008, by contractual maturity, are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from sales of available-for-sale securities during 2008, 2007 and 2006 were $6,724,000, $3,689,000 and $2,400,000, respectively. Gross gains of $151,000, $929,000 and $235,000 and gross losses of $74,000, $0 and $16,000 were realized on those sales in 2008, 2007 and 2006, respectively.
Proceeds from the sale of trading securities were $7,910,000, $5,815,000 and $995,000 in 2008, 2007 and 2006, respectively. Gross gains of $1,994,000, $2,081,000, and $232,000 and gross losses of $71,000, $29,000 and $42,000 were realized on these sales in 2008, 2007 and 2006, respectively. Additional gross gains (losses) of $(1,528,000), $(480,000), and $1,367,000 were realized in 2008, 2007 and 2006, respectively, which were attributable to the change in fair value of these securities.
There were no sales of held-to-maturity securities during 2008, 2007 or 2006.
A summary of net realized investment gains (losses) resulting from sales, calls and other-than-temporary impairments and a summary of net changes in unrealized investment appreciation, less applicable income taxes, is as follows:
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires that other-than-temporary impairment charges be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security, or that the anticipated recovery in fair value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date and are included in net realized investment gains and losses. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which fair value has been less than cost; the financial condition and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery.
The following pages present a summary of fixed maturity and equity securities that were in an unrealized loss position at December 31, 2008 and 2007.
We attribute the deterioration in value of our equity security portfolio to the current economic conditions that resulted in extreme market volatility in fourth quarter 2008 and not to an explicit matter impacting the financial position of the underlying companies in which we are invested. We have evaluated the unrealized losses reported for all of our equity securities at December 31, 2008, and have concluded that the duration and severity of these losses do not warrant the recognition of an other-than-temporary impairment charge in 2008. Specifically, the unrealized losses reported for individual securities that have been in an unrealized loss position for greater than 12 months has fluctuated significantly during 2008. The largest such loss at December 31, 2008, totaled $2,372,000, for which the fair value (i.e., quoted market price) of the underlying security had approximated our cost basis earlier in the year. We have no intention to sell any of these securities prior to a recovery in value, but will continue to monitor the fair value reported for these securities as part of our overall process to evaluate investments for impairment recognition.
In most cases, quoted market prices were used to determine the fair value of fixed maturities, equity securities, trading securities and short-term investments. Where quoted market prices do not exist, fair values are based 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.
The estimated fair value of mortgage loans is based upon discounted cash flows, utilizing the market rate of interest for similar loans in effect at the valuation date.
In October 2008, the FASB issued FSP SFAS No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active,” with an immediate effective date. FSP SFAS No. 157-3 amends SFAS No. 157 to clarify the application of fair value in inactive markets and allows for the use of management’s internal assumptions about future cash flows with appropriately risk-adjusted discount rates when relevant observable market data does not exist. The objective of SFAS No. 157 has not changed and continues to be the determination of the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date.
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 due 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.
The ceding of insurance does not legally discharge United Life Insurance Company from primary liability under its policies. United Life Insurance Company 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 92.8 percent of ceded life insurance in force as of December 31, 2008, has been ceded to four reinsurers (Generali USA Reassurance Company, Hannover Life Reassurance Company of America, American United Life Insurance Company and RGA Reinsurance Company).
The table below provides an analysis of changes in our property and casualty loss and loss settlement expense reserves for 2008, 2007 and 2006 (net of reinsurance amounts). The deficiency in 2008 was attributable to an increase we made in our prior accident year loss reserves due to additional development from Hurricane Katrina, which included a federal court ruling and judgment which is currently under appeal, and deterioration in our other liability lines of business which includes claims for construction defects.
The favorable development in 2007 and 2006 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 claims and loss settlement expenses at a level significantly less than anticipated at December 31 of the prior year. We attribute this favorable development to the fact that during recent years, we have 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, 2008, 2007 and 2006 and net income (loss) for the years then ended are as follows:
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 2008, 2007 and 2006.
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 $55,306,000 in dividend distributions to stockholders in 2009 without prior approval. We paid dividends of $16,162,000, $15,293,000 and $13,196,000 in 2008, 2007 and 2006, respectively. Dividend payments by the insurance subsidiaries to United Fire are subject to similar restrictions in the states in which they are domiciled. In 2008, 2007 and 2006, 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.
As of December 31, 2008, we have a gross deferred tax asset for net operating loss carryforwards totaling $17,215,000, all of which was acquired as part of our purchase of American Indemnity Financial Corporation. Net operating loss carryforwards totaling $769,000 and $5,491,000 expire in 2010 and 2011, respectively, and can only be used to offset future income of our property and casualty insurance segment. We are required to establish a valuation allowance for any portion of the gross deferred tax asset that we believe may not be realized. At December 31, 2008, we recorded a valuation allowance of $5,647,000. As we determine that the benefit of these net operating losses can be realized, the related reduction in the deferred tax asset valuation allowance will be recorded as a reduction to our current federal income tax expense.
We offer a noncontributory defined benefit pension plan in which all of our employees are eligible to participate after they have completed one year of service, attained 21 years of age and have met the hourly service requirements. Retirement benefits under our pension plan are based on the number of years of service and level of compensation. Our policy is to fund this plan on a current basis to the extent that the contribution is deductible under existing tax regulations. We estimate that we will contribute approximately $4,000,000 to the plan in 2009.
We also offer a health and dental benefit 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 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 plan. The 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 12 months after the end of the calendar year in which the charges were incurred. An unfunded benefit obligation is reported for the plan, which relates primarily to our postretirement benefit program.
Investments in equity securities are stated at fair value based upon quoted market prices reported on recognized securities exchanges on the last business day of the year. Investments in fixed maturity securities are stated at fair value based upon quoted market prices reported on recognized securities exchanges on the last business day of the year. Purchases and sales of securities are recorded as of the trade date.
The following is a summary of the plan’s weighted average asset allocations at December 31, 2008 and 2007 by asset category:
Dividends on shares of United Fire common stock totaled $121,000, $109,000 and $100,000 in 2008, 2007 and 2006, respectively. The annuity fund purchased from United Life Insurance Company is credited with compound interest on the average fund balance for the year. The interest rate will be equivalent to the ratio of net investment income to mean assets of United Life Insurance Company. It is our policy to structure our pension plan portfolio based upon a long-term, strategic outlook of the investment markets. We utilize historical and forward-looking return forecasts to establish future return expectations for our various asset categories. These investment return expectations are used to develop our asset allocation based on the specific needs of the pension plan. We utilize multiple investment managers in order to maximize the plan’s return while minimizing risk.
The preparation of financial statements in conformity with GAAP requires us to make various estimates and assumptions that affect the reporting of net periodic benefit cost, plan assets and plan obligations at the date of the financial statements. Actual results could differ from these estimates. One significant estimate relates to the calculation of plan obligations. We annually establish the discount rate, which is an estimate of the interest rate at which the plan benefits could be effectively settled, that is used to determine the present value of the respective plans benefit obligations as of December 31. In estimating the discount rate, we look to rates of return on high-quality, fixed-income investments currently available and expected to be available during the period to maturity of the respective plans benefit obligations. Another significant assumption utilized is the expected long-term rate of return on the invested pension plan assets, which is an assumption as to the average rate of earnings expected on the pension plan funds invested, or to be invested, to provide for the settlement of benefits included in the projected pension benefit obligation. Investment securities, in general, are exposed to various risks, such as fluctuating interest rates, credit standing of the issuer of the security and overall market volatility. Annually, we perform an analysis of expected long-term rates of return based on the composition and allocation of our pension plan assets and recent economic conditions.
For the noncontributory defined pension benefit plan, the benefit obligation is the projected benefit obligation. For the other retiree benefit plan, the benefit obligation is the accumulated postretirement benefit obligation.
The following table displays the effect that our unrecognized prior service costs and actuarial loss had on accumulated other comprehensive income (loss).
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 2009 to be $75,000 and $2,394,000, 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 plan for 2008, 2007 and 2006, was $974,000, $4,107,000 and $3,892,000, respectively.
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 1,021,025 authorized shares available for future issuance at December 31, 2008. The plan is administered by the Board of Directors. The board has the authority to determine which employees will receive awards under the plan, when awards will be granted, and the terms and conditions of the awards. The board may also take any action it deems necessary and appropriate for the administration of the plan. Pursuant to the plan, the board 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.
The activity in our 2008 Stock Plan is displayed in the following table.
The analysis below details the activity of both of our stock option plans and the ad hoc options, which were granted prior to the adoption of the other plans, for 2008. Information on the options outstanding at December 31, 2008, is also presented.
The weighted-average grant-date fair value of the options granted under the plan has been estimated using the Black-Scholes option pricing model with the following weighted-average assumptions.
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 $6,803,000 of flood-related expenses, net of insurance, in 2008, which primarily relates to costs incurred to clean up and restore our Cedar Rapids, Iowa home office and contents, and we anticipate incurring additional expenses for reconstruction and other related costs. A portion of these costs may be subject to recovery. We have received insurance reimbursements totaling $3,106,000, which have offset the expenses incurred through December 31, 2008. Since December 31, 2008 we have received an additional $978,000 in insurance recoveries.
United Life Insurance Company underwrites all of our life insurance business. Our principal life insurance products are single premium 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. We do not write variable annuities or variable insurance products.
Total revenue by segment includes sales to outside customers and intersegment sales that are eliminated to arrive at the total revenues as reported in the accompanying Consolidated Statements of Income. We account for intersegment sales on the same basis as sales to outside customers. The following table sets forth certain data for each of our business segments and is reconciled to our Consolidated Financial Statements. Depreciation expense and property and equipment acquisitions for 2008, 2007 and 2006, are reported in the property and casualty insurance segment.
We determine the dilutive effect of our stock options outstanding using the “treasury stock” method. Under this method, we assume the exercise of all of the outstanding options whose exercise price is less than the weighted-average fair market value of our stock during the reporting period. This method also assumes that the proceeds from the hypothetical stock option exercises are used to repurchase shares of common stock at the weighted-average fair market value of the stock during the reporting period. The net of the assumed options exercised and assumed common shares repurchased represent the number of dilutive common shares, which we add to the denominator of the earnings per share calculation.
As of December 31, 2008, 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, 2008, 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, 2008. 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, 2008, is included in this item under the heading “Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting.”
We have audited the internal control over financial reporting of United Fire & Casualty Company (United Fire) as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). United Fire’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on United Fire’s internal control over financial reporting based on our audit.
In our opinion, United Fire & Casualty Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.