We own five commercial buildings on our 23 acre corporate campus in Peoria, Illinois. Our primary building is a two-story 77,000 square foot office building, which serves as our corporate headquarters. Located on the same campus is a 24,000 square foot building which is used by two branch offices of RLI Ins. We also own a 26,000 square foot multi-story building used for record storage and office space, a 12,000 square foot building used as storage for furniture and equipment and a 15,000 square foot office building.
(2) Ratios and surplus information are presented on a statutory basis. As discussed in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, statutory accounting principles differ from GAAP and are generally based on a solvency concept. Further discussion is included in note 9 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data. Reporting of statutory surplus is a required disclosure under GAAP.
(3) On January 15, 2014, our stock split on a 2-for-1 basis. All share and per share data has been retroactively stated to reflect this split.
2011, to shareholders of record as of November 30, 2011, and totaled $105.8 million. On November 14, 2012, the Board declared a special cash dividend of $2.50 per share. The dividend was paid on December 20, 2012, to shareholders of record as of November 30, 2012, and totaled $106.3 million. On November 14, 2013, the Board declared a special cash dividend of $1.50 per share. The dividend was paid on December 20, 2013, to shareholder of record as of November 29, 2013, and totaled $64.5 million. The special dividend produced corresponding decreases to book value per share, as well as decreases on stock price.
(7) On October 2, 2013, we successfully completed a public debt offering, issuing $150.0 million in senior notes maturing September 15, 2023. This offering generated proceeds, net of discount and commission, of $148.6 million. In December 2013, we redeemed $100.0 million in senior notes that were issued in 2003 and were set to mature in January 2014.
(8) Operating cash flow for 2011 includes a $50.0 million cash deposit that we received from a commercial surety customer in lieu of credit. The return of this $50.0 million deposit is reflected in operating cash flow for 2012.
RLI Corp. underwrites selected property and casualty insurance through major subsidiaries collectively known as RLI Insurance Group. As a niche company with a specialty focus, we offer insurance coverages in both the specialty admitted and excess and surplus markets. Coverages in the specialty admitted market, such as our oil and gas surety bonds, are for risks that are unique or hard-to-place in the standard market, but must remain with an admitted insurance company for regulatory or marketing reasons. In addition, our coverages in the specialty admitted market may be designed to meet specific insurance needs of targeted insured groups, such as our professional liability and package coverages for design professionals and our stand-alone personal umbrella policy. The specialty admitted market is subject to more state regulation than the excess and surplus market, particularly with regard to rate and form filing requirements, restrictions on the ability to exit lines of business, premium tax payments and membership in various state associations, such as state guaranty funds and assigned risk plans. We also underwrite coverages in the excess and surplus market. The excess and surplus market, unlike the admitted market, is less regulated and more flexible in terms of policy forms and premium rates. This market provides an alternative for customers with risks or loss exposures that generally cannot be written in the standard market. This typically results in coverages that are more restrictive and more expensive than coverages in the admitted market. When we underwrite within the excess and surplus market, we are selective in the lines of business and type of risks we choose to write. Using our non-admitted status in this market allows us to tailor terms and conditions to manage these exposures effectively. Often, the development of these coverages is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients or loss exposures. Once a proposal is submitted, our underwriters determine whether it would be a viable product based on our business objectives.
We measure the results of our insurance operations by monitoring certain measures of growth and profitability across three distinct business segments: casualty, property and surety. Growth is measured in terms of gross premiums written, and profitability is analyzed through combined ratios, which are further subdivided into their respective loss and expense
The surety segment specializes in writing small-to-large commercial and contract surety coverages, as well as those for the energy, petrochemical and refining industries. We offer miscellaneous bonds including license and permit, notary and court bonds. Often, our surety coverages involve a statutory requirement for bonds. While these bonds typically maintain a relatively low loss ratio, losses may fluctuate due to adverse economic conditions affecting the financial viability of our insureds. The contract surety product guarantees the construction work of a commercial contractor for a specific project. Generally, losses occur due to the deterioration of a contractor’s financial condition. This line has historically produced marginally higher loss ratios than other surety lines during economic downturns.
not yet been reported to us. Loss reserves do not represent an exact calculation of liability, but instead represent our estimates, generally utilizing individual claim estimates, actuarial expertise and estimation techniques at a given accounting date. The loss reserve estimates are expectations of what ultimate settlement and administration of claims will cost upon final resolution. These estimates are based on facts and circumstances then known to us, review of historical settlement patterns, estimates of trends in claims frequency and severity, projections of loss costs, expected interpretations of legal theories of liability and many other factors. In establishing reserves, we also take into account estimated recoveries from reinsurance, salvage and subrogation. The reserves are reviewed regularly by a team of actuaries we employ.
specific claim. An example of ULAE would be the cost of an internal claim examiner to manage or investigate a reported claim.
Our crop reinsurance business is unique and is subject to an inherently higher degree of estimation risk during interim periods. As a result, the interim reports and professional judgments of our ceding company’s actuaries and crop business experts provide important information which assists us in estimating our carried reserves.
· Small volume or lacking internal data requiring significant utilization of external data,
· Unique reinsurance features including those with aggregate stop-loss, reinstatement clauses, commutation provisions or clash protection,
· Longer emergence patterns with exposures to latent unforeseen mass tort,
The historical and prospective loss and ALAE estimates, along with the risks listed, are the basis for determining our initial and subsequent carried reserves. Adjustments in the initial loss ratio by product and segment are made where necessary and reflect updated assumptions regarding loss experience, loss trends, price changes and prevailing risk factors.
· Operational or internal processes affecting the timing of loss and LAE transactions,
human element in the application of judgment is unavoidable when faced with uncertainty. Different experts will choose different assumptions based on their individual backgrounds, professional experiences and areas of focus. Hence, the estimates selected by various qualified experts may differ significantly from each other. We consider this uncertainty by examining our historic reserve accuracy and through an internal peer review process.
Upon completion of our full loss and LAE estimation analysis, the results are discussed with the LRC. As part of this discussion, the analysis supporting the actuarial central estimate of the IBNR reserve by product is reviewed. The actuaries also present explanations supporting any changes to the underlying assumptions used to calculate the indicated central estimate. A review of the resulting variance between the indicated reserves and the carried reserves takes place. Quarterly, we also consider the most recent actual loss emergence compared to the expected loss emergence derived using the last full loss and ALAE analyses. Our actuaries make a recommendation to management in regards to booked reserves that reflect their analytical assessment and view of estimation risk. After discussion of these analyses and all relevant risk factors, the LRC determines whether the reserve balances require adjustment. Resulting reserve balances have always fallen within our actuaries’ reasonable range of estimates.
values. Periodic adjustments to these estimates will likely occur as the actual loss emergence reveals itself over time. Our loss reserving processes reflect accepted actuarial practices and our methodologies result in a reasonable provision for reserves as of December 31, 2013.
· The probability that we will recover the entire amortized cost basis of our fixed income securities prior to maturity or
· A downgrade in credit quality by a major rating agency.
Part of our evaluation of whether particular securities are other-than-temporarily impaired involves assessing whether we have both the intent and ability to continue to hold equity securities in an unrealized loss position. For fixed income securities, we consider our intent to sell a security (which is determined on a security-by-security basis) and whether it is more likely than not we will be required to sell the security before the recovery of our amortized cost basis. Significant changes in these factors could result in a charge to net earnings for impairment losses. Impairment losses result in a reduction of the underlying investment’s cost basis.
Periodically, management reviews our deferred tax positions to determine if it is more likely than not that the assets will be realized. These reviews include, among other things, the nature and amount of the taxable income and expense items, the expected timing of when assets will be used or liabilities will be required to be reported, as well as the reliability of historical profitability of businesses expected to provide future earnings. Furthermore, management considers tax-planning strategies it can use to increase the likelihood that the tax assets will be realized. After conducting the periodic review, if management determines that the realization of the tax asset does not meet the more likely than not criteria, an
Consolidated revenue, as displayed in the table that follows, totaled $705.6 million for 2013, compared to $660.8 million for 2012 and $619.2 million in 2011.
Consolidated revenue increased 7 percent in 2013, after also advancing 7 percent in 2012. Premiums earned from insurance operations have improved in each of the past three years and have served to offset declines in investment income over this same period. Net premiums earned advanced 9 percent in 2013, following a 7 percent and 9 percent increase in 2012 and 2011, respectively. Premium growth for 2013 was experienced across our diversified portfolio of products, particularly within our casualty segment, as both established product lines and newer initiatives contributed to the improved result. Newer products, primarily within our property and casualty segments, continue to post premium increases as investments in expansion, both geographically and in product offerings, begin to gain scale. In addition, moderate rate increases for most products, but in particular within casualty, held steady throughout 2013 and contributed to the improved premium. The improved rate environment seen recently for casualty is a reversal from a declining rate environment experienced as recently as 2011. Given our growth and the improved rate environment, we increased retentions on select lines, which also served to increase consolidated revenues. Investment income declined for the third consecutive year in 2013. Despite an increase in market yields during the year, reinvestment rates remained below the portfolio’s average yield and contributed to the continued decline. In addition, a higher allocation to tax-exempt municipals in 2013, which have lower nominal yields than taxable alternatives, also impacted investment results. We recorded net realized investment gains on our investment portfolio in each of the past three years. The majority of gains realized over this period related to sales activities versus calls or maturities. Sales activities were the result of normal portfolio rebalancing, as well as raising cash to support special dividends paid in each of the last three years.
Bonus and profit-sharing amounts earned by executives, managers and associates are predominately influenced by corporate performance including operating earnings, combined ratio and return on capital. Operating earnings refers to net earnings excluding after-tax net realized investment gains. Return on capital measures components of comprehensive earnings against a minimum required return on capital. Return on capital is the primary measure of executive bonus achievement and a significant component of manager and associate bonus targets. Bonus and profit sharing-related expenses attributable to the aforementioned favorable reserve developments totaled $9.7 million, $8.1 million and $14.1 million for 2013, 2012 and 2011, respectively. These performance-related expenses impact policy acquisition, insurance operating and general corporate expenses line items in the financial statements. Partially offsetting the 2013, 2012 and 2011 increases were $1.2 million, $4.2 million and $1.7 million, respectively, in reductions to bonus and profit-sharing earned due to losses associated with hurricanes and spring storms.
The industry benefited from a very light catastrophe year in 2013, with no hurricanes making landfall and wind-related events also down relative to recent years. The rate environment has continued to build on momentum established in 2012 with rates showing modest improvements on an overall basis in 2013. Though modestly improved from a broad view, the direction and magnitude of rate changes has varied across our product portfolio. The most positive pricing trends have been experienced within our casualty segment, while property and surety rates have remained flat in response to competitive pressures in these markets. Insurance premiums in our markets are heavily dependent on customers’ revenues, values transported, miles traveled and number of new projects initiated. Expansion efforts and new product initiatives, coupled with the acquisition of CBIC, have served to offset the challenging market conditions seen in recent years and resulted in growth in gross premiums written. New product initiatives over the last several years added approximately $220 million in gross premiums written in 2013 after adding nearly $190 million to premiums in 2012 and $150 million in 2011. Our efforts from 2012, including the acquisition of Rockbridge and expansion into recreational vehicle and security guard coverages, accounted for $31 million of premium in 2013. Gross premiums written, as reflected in the table that follows, increased 7 percent in 2013 after advancing 12 percent in 2012 and 10 percent in 2011. On a net basis, premiums increased 12 percent in 2013, due largely to increased retentions selected during our 2013 casualty reinsurance renewal. Due to upward momentum in pricing, we increased retentions on certain casualty products in 2013. Overall, gross casualty writings increased 17 percent in 2013 following a 20 percent increase in 2012 and a 4 percent increase in 2011. For the second consecutive year, improved pricing and expansion efforts resulted in top line growth for most casualty coverages. Within our property segment, premium decreased 3 percent in 2013 after increasing 4 percent in 2012 and 15 percent in 2011. Growth achieved from newer product initiatives was more than offset by declines resulting from competitive pressures and re-underwriting efforts in this book. As anticipated, gross premiums written from our surety segment were flat in 2013 after posting increased premiums in the two previous years. Premium production within surety continues to be impacted by increased competition.
Casualty gross premiums written of $457.0 million were up 17 percent in 2013, following an increase of 20 percent in 2012 and an increase of 4 percent in 2011. Nearly all products within the casualty segment experienced growth in gross premiums written in 2013. Growth in established products was reflective of increases in both rates and exposures, while newer products advanced as coverages were added and geographic expansion continued. Growth in established products was led by commercial transportation, executive products and umbrella. After declining for several consecutive years ending in 2011, transportation and executive products posted increased gross premiums written in 2013 and 2012. Transportation premiums advanced 56 percent and 16 percent in 2013 and 2012, respectively, while executive products advanced 4 percent and 9 percent over these same periods. The decline in prior years was due to competitive pressures and a weak economy, which reduced the revenues that transportation insurance premiums are based upon. For commercial umbrella, gross premiums advanced 13 percent in 2013 after doubling in 2012. On average, rates were up nearly 15 percent over the last two years and we have found opportunities to write new business, including adding umbrella coverage, over our existing general liability policies. For general liability, historically our largest product in this segment, gross premiums totaled $83.0 million in 2013, down 11 percent, after increasing 4 percent in 2012. While rates continued to increase modestly for these coverages, up 4 percent in 2013 and 5 percent in 2012, re-underwriting efforts in the habitational (owner, landlord and tenant/non-construction) component of the book resulted in the overall premium decline in 2013. Over the last several years, the habitational component of the general liability book sustained adverse loss experience. In 2012, the habitational component represented nearly 50 percent of general liability revenue. At the end of 2013, the percentage had declined to nearly 25 percent. Re-underwriting efforts resulted in the nonrenewal of certain policies, as well as rate increases on policies where pricing was inadequate to cover loss experience. The combination of these efforts resulted in lost business, which negatively impacted premiums written. The increased rates and improved mix of business, however, has resulted in improved underwriting results in the current accident year.
Newer products within our casualty business experienced growth. Our professional services product continued to expand its product offerings and geographic penetration. This product, which was launched in 2009 to provide professional liability coverage for design professionals and now offers additional coverages to its target market, posted $60.0 million in gross premiums written in 2013, up 38 percent, after advancing 30 percent during 2012. Medical professional liability, which we added in late 2012 through the acquisition of Rockbridge, posted $16.7 million in gross premiums written in 2013. In addition, our expansion into coverages for security guards in late 2012 added $2.8 million in gross premiums in 2013. Lastly, gross premiums from the addition of CBIC’s package business advanced 10 percent in 2013 to $37.0 million, compared to $33.7 million in 2012 and $20.3 million in 2011 with only eight months of production.
The segment’s loss ratio was 48.1 in 2013, compared to 57.2 in 2012 and 50.1 in 2011. The aforementioned increased hurricane and storm activity accounted for the increases in 2012 and 2011. The expense ratio for the property segment was 38.1 in 2013, compared to 37.1 in 2012 and 35.0 in 2011. The increase from 2012 is due largely to bonus and profit sharing expenses. Over the three year period, however, expenses have trended upward. This trend is due to continued investment in expansion, as well as a shift in mix of business toward products with higher acquisition costs.
Gross premiums written for surety were flat in 2013 after increasing 7 percent in 2012 and 21 percent in 2011. The addition of CBIC amplified growth in 2012 and 2011, while all periods were influenced by underwriter additions and geographic expansion. CBIC added $21.2 million in gross premiums written in 2012 in the first full year of production, after adding $15.7 million in gross premiums written for the eight months subsequent to the acquisition date in 2011. Commercial and contract surety increased modestly in all three periods. Miscellaneous surety declined 1 percent in 2013, after increasing in 2012 and 2011, while oil and gas surety declined 5 percent in 2013, following a year of flat production in 2012. Premium within the segment continues to be challenged by the slow economic recovery and increased competition.
integration of CBIC, including severance-related expenses, as well as continued investment in expansion. As premium earned from these investments continued to increase and cost synergies were realized, the expense ratio declined in subsequent periods.
We realized a total of $22.0 million in net investment gains in 2013. Included in this number is $21.5 million in net realized gains in the equity portfolio, $1.3 million in net realized gains in the fixed income portfolio and $0.8 million in other net realized losses. In 2012, we realized $25.4 million in net investment gains. We realized $15.1 million in net realized gains in the equity portfolio, $13.2 million in net realized gains in the fixed income portfolio and $2.9 million in net realized losses inclusive of an impairment of a long-lived asset. In 2011, we realized net investment gains of $17.0 million. Included in this number are net realized gains of $5.9 million in the equity portfolio and net realized gains of $11.1 million in the fixed income portfolio.
The fixed income portfolio contained 337 positions at an unrealized loss as of December 31, 2013. Of these 337 securities, two have been in an unrealized loss position for 12 consecutive months or longer and represent $0.2 million in unrealized losses. The majority of fixed income unrealized losses can be attributed to the increases in interest rates during the final three quarters of the year and are not credit related. All fixed income securities in the investment portfolio continue to pay the expected coupon payments under the contractual terms of the securities. Based on our analysis, our fixed income portfolio is of a high credit quality and we believe we will recover the amortized cost basis.
Key components to our OTTI procedures are discussed in our critical accounting policy on investment valuation and OTTI and in note 2 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data. Based on our analysis, we have concluded that the securities in an unrealized loss position were not other-than-temporarily impaired at December 31, 2013.
We maintain a diversified investment portfolio with an 80 percent fixed income and 20 percent equity target. We continually monitor economic conditions, our capital position and the insurance market to determine our tactical equity allocation. As of December 31, 2013, the portfolio had a fair value of $1.9 billion, an increase of $81.2 million from the end of 2012.
We determined the fair value of certain financial instruments based on their underlying characteristics and relevant transactions in the marketplace. GAAP guidance requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance also describes three levels of inputs that may be used to measure fair value.
In selecting the maturity of securities in which we invest, we consider the relationship between the duration of our fixed income investments and the duration of our liabilities, including the expected ultimate payout patterns of our reserves. We believe that both liquidity and interest rate risk can be minimized by such asset/liability management. As of December 31, 2013, our fixed income portfolio’s duration was 5.0 years. During 2013, the total return on our bond portfolio on a tax-adjusted, mark-to-market basis was -1.6 percent.
As of December 31, 2013, our fixed income portfolio had the following rating distributions:
Our allocation to agency mortgage-backed securities totaled $244.4 million as of December 31, 2013. MBS represented 17 percent of the fixed income portfolio compared to $250.4 million or 18 percent of that portfolio as of
As of December 31, 2013, municipal bonds totaled $522.7 million (36 percent) of our fixed income portfolio, compared to $434.0 million (31 percent) as of December 31, 2012. We increased our allocation to the sector as tax-exempt municipals presented better risk adjusted income potential than corporate bonds during 2013. We believe municipal fixed income securities can provide diversification and additional tax-advantaged yield to our portfolio. Our objective for the municipal fixed income portfolio is to provide reasonable cash flow stability and increased after-tax yield.
As of December 31, 2013, our corporate debt portfolio totaled $526.0 million (37 percent) of the fixed income portfolio compared to $580.7 million (42 percent) as of December 31, 2012. Our allocation to the corporate debt portfolio decreased during the year as other fixed income classes provided more relative value. The corporate debt portfolio has an overall quality rating of single A, diversified among 199 issuers.
We believe corporate debt investments add diversification and additional yield to our portfolio. With our high quality, diversified portfolio, the corporate debt investments will continue to be a significant part of our investment program.
The amortized cost and fair value of fixed income securities at December 31, 2013, by contractual maturity, are shown as follows:
As of December 31, 2013, our equity portfolio totaled $418.7 million (22 percent) of the investment portfolio, compared to $375.8 million (20 percent) as of December 31, 2012. The increase in value of our common stock portfolio in 2013 was due to the strong performance of the equity market throughout the year. The securities within the equity portfolio remain primarily invested in large-cap issues with a focus on dividend income. In addition, we have investments in three exchange traded funds that track to major indices. In 2013, we did not recognize any impairment losses in the equity portfolio. During 2012, we recorded $1.2 million in impairment losses associated with equity securities.
Interest expense increased in 2013 as long-term debt outstanding increased during the year. We completed a public debt offering in October 2013, issuing $150.0 million in senior notes, and used a portion of the proceeds to repay $100.0 million in senior notes that were originally set to mature in January 2014. At December 31, 2013, our long-term debt consisted of $150.0 million in senior notes maturing September 15, 2023, and paying interest semi-annually at the rate of 4.875 percent. At December 31, 2012, and 2011, our long-term debt consisted of $100.0 million in senior notes that paid interest semi-annually at the rate of 5.95 percent. We incurred $8.1 million of interest expense on outstanding debt during 2013, compared to $6.0 million in 2012 and 2011, respectively.
As discussed previously, general corporate expenses tend to fluctuate relative to our incentive compensation plans. Our compensation model measures components of comprehensive earnings against a minimum required return on our capital. Bonuses are earned as we generate earnings in excess of this required return. In 2013, 2012 and 2011, we exceeded the required return, resulting in the accrual of executive bonuses. Excluding this variable component tied to performance, other general corporate expenses were relatively flat in 2013, 2012 and 2011.
We maintain a 40 percent equity interest in Maui Jim, a manufacturer of high-quality polarized sunglasses. Maui Jim’s chief executive officer owns a controlling majority of the outstanding shares of Maui Jim. Maui Jim is a private company, and as such, the market for its stock is limited. Our investment in Maui Jim is carried at the holding company, RLI Corp., level as it is not core to our insurance operations. As a minority shareholder, we are subject to the decisions of the controlling shareholder, which may impact the value of our investment. In 2013, we recorded $10.9 million in earnings from this investment compared to $8.9 million in 2012 and $6.5 million in 2011. Sunglass sales were up 6 percent in 2013, after increasing 4 percent in 2012 and 18 percent in 2011, due to domestic and international product expansion.
Investments in expansion and improved cost of sales in 2013 benefited earnings.
In 2013 and 2012, we received dividends from Maui Jim. Dividends from Maui Jim have been irregular in nature and while they provide added liquidity when received, we do not rely on those dividends to meet our liquidity needs. While these dividends do not flow through the investee earnings line, they do result in the recognition of a tax benefit, which is discussed in the income tax section that follows.
Our effective tax rates were 28.1 percent, 27.6 percent and 31.0 percent for 2013, 2012 and 2011, respectively. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate for 2013 was higher than 2012 due to an increase in underwriting income notwithstanding an overall increase in tax-exempt income and dividends qualifying for preferential tax treatment, specifically as noted below from Maui Jim.
The liability can be split into two parts: (1) case reserves representing estimates of losses and settlement expenses on known claims and (2) IBNR reserves representing estimates of losses and settlement expenses on claims that have occurred but have not yet been reported to us. Our gross liability for both case and IBNR reserves is reduced by reinsurance balances recoverable on unpaid losses and settlement expenses to calculate our net reserve balance. This net reserve balance decreased to $774.5 million at December 31, 2013, from $798.6 million as of December 31, 2012. This reflects incurred losses of $259.8 million in 2013 offset by paid losses of $283.9 million compared to incurred losses of $271.6 million offset by $270.0 million paid in 2012. The overall decrease in our net loss and LAE reserves between 2013 and 2012 was small, but there were changes by segment as discussed in note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Gross reserves (liability) and the reinsurance balances recoverable (asset) were both subject to the same influences that affected net reserves and behaved similarly. Total gross and ceded loss and LAE reserves decreased to $1.13 billion and $355.6 million, respectively, at December 31, 2013, from $1.16 billion and $359.9 million, respectively, at December 31, 2012.
The next largest contractual obligation relates to long-term debt outstanding. On October 2, 2013, we completed a public debt offering of $150.0 million in senior notes maturing September 15, 2023, (a 10-year maturity) and paying interest semi-annually at the rate of 4.875 percent. The notes were issued at a discount resulting in proceeds, net of discount
The timing of our cash flows from operating activities can vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant, so their timing can influence cash flows from operating activities in any given period. We are subject to the risk of incurring significant losses on catastrophes, both natural (such as earthquakes and hurricanes) and man-made (such as terrorism). If we were to incur such losses, we would have to make significant claims payments in a relatively concentrated period of time.
Our capital structure is comprised of equity and debt obligations. As of December 31, 2013, our capital structure consisted of $149.6 million in 10-year maturity senior notes (long-term debt) and $829.0 million of shareholders’ equity. Debt outstanding comprised 15 percent of total capital as of December 31, 2013.
In December 2012, we filed a universal shelf registration statement with the SEC for the potential offering and sale of securities, including equity, debt and other forms of securities. The shelf registration facilitated our $150.0 million public debt offering completed in October 2013.
At the holding company (RLI Corp.) level, we rely largely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt, corporate expenses and dividends to RLI Corp. shareholders. As discussed further below, dividend payments to RLI Corp. from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the insurance regulatory authorities of Illinois. As a result, we may not be able to receive dividends from such subsidiary at times and in amounts necessary to pay desired dividends to RLI Corp. shareholders. On a GAAP basis, as of December 31, 2013, our holding company had $829.0 million in equity. This includes amounts related to the equity of our insurance subsidiaries, which is subject to regulatory restrictions under state insurance laws. The remaining holding company equity is not restricted and is comprised primarily of investments and cash, including $32.0 million in liquid assets, which approximates annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and dividend payments to our shareholders. If necessary, the holding company also has other potential sources of liquidity that could provide for additional funding to meet corporate obligations or pay shareholder dividends, which include a revolving line of credit, as well as issuances of common stock and debt.
Our 151st consecutive dividend payment was declared in February 2014 and will be paid on March 20, 2014, in the amount of $0.17 per share. Since the inception of cash dividends in 1976, we have increased our annual dividend every year.
The insurance marketplace, and in particular the excess and surplus lines segment, is subject to cycles involving alternating periods of price increases (hard markets) and price decreases (soft markets). In 2013, both industry and our company financial results improved as a direct consequence of abnormally low natural catastrophe activity in the United States. The pricing environment has improved since late 2011 with moderate, year-over-year rate increases through 2013. Loss cost trends continue to be tepid, which has allowed for some margin expansion and continued favorable prior year loss development. Offsetting this is a lackluster economic recovery, falling investment yields and excess capital. Without noticeable improvement in the economic environment, any significant top line revenue expansion that can contribute to underwriting profitability will likely need to come from acquisitions of people and/or businesses. Excess capital, most recently coming from alternative capital sources, will lead to increasing pressure on reinsurance rates. We believe this will likely have a “trickle down” effect on the primary market pricing over 2014 with price increases giving way to flattening and sometimes decreasing, rate levels as the year plays out. We would expect that the combination of all these competing pressures and a return to a more “normal” natural catastrophe year will lead to moderate top line premium growth and make it challenging for the industry to replicate the overall financial results produced in 2013.
We continue to invest in new products and underwriting talent. We expect to see moderate organic premium growth in most of our products in 2014 and underwriting income overall barring any unusual catastrophe events. We will see more significant growth from some of our more recently added products including recreational vehicles, professional services and property and casualty packages. We continue to diversify our portfolio of products, growing those that still provide an opportunity for underwriting profit and shrinking and rehabilitating those that are inadequately priced. At the beginning of 2014, we renewed our major property and casualty reinsurance treaties, which resulted in over $10.0 million of savings while keeping our overall loss retentions largely unchanged. Specific details regarding our insurance segments follow.
We believe property pricing will decline in 2014 as a result of alternative capital providing cheaper capacity in this space. This competition is particularly felt in the critical catastrophe zones of Florida wind and California earthquake. As a result of declining market pricing, we do not expect to see any appreciable growth in our catastrophe exposures or our maximum exposure to a single event in 2014. We will continue our underwriting discipline and diversify our catastrophe portfolio, which should increase the amount of premium we receive for these exposures on the margins. Our marine business will continue to be focused on re-underwriting and we do not expect to see growth from this business while anticipating some improvement in profitability. We expect to see some moderate growth in our property segment driven by our recreational vehicles program, geographic penetration of our fire business and our assumed reinsurance operation. We expect moderate overall top line growth and to maintain our excluding-catastrophe underwriting margins in this segment for 2014. However, a return to a more normal catastrophe year may make replicating our 2013 underwriting margins challenging.
The surety segment, like our other segments, is expected to feel pressure from the weak economy and increased competition. There have been a significant number of new entrants into this space due to the positive underwriting results of the overall industry. Unfortunately, this has led to some undisciplined competition by the general market with increasing commissions and loosening of collateral and personal indemnity requirements. In 2008 through 2012, we expanded our geographic footprint in miscellaneous, commercial and contract surety and acquired CBIC, which writes select miscellaneous and small-contract surety business. In 2013, we took a very cautious approach and our top line remained flat. We plan to continue our underwriting discipline in the surety business in 2014 in light of the challenging economic recovery and competitive landscape. Despite this challenge, our experienced underwriting staff coupled with our effective use of technology should allow us to maintain our overall underwriting margins while expecting a flat top-line in 2014.
A. DESCRIPTION OF BUSINESS: We underwrite selected property and casualty insurance coverages. We conduct operations principally through four insurance companies. These companies are organized in a vertical structure beneath RLI Corp. with RLI Insurance Company (RLI Ins.) as the first-level, or principal, insurance subsidiary. RLI Ins. writes multiple lines of insurance on an admitted basis in all 50 states, the District of Columbia and Puerto Rico. Mt. Hawley Insurance Company, a subsidiary of RLI Ins., writes surplus lines insurance in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. RLI Indemnity Company (RIC), a subsidiary of Mt. Hawley Insurance Company, has authority to write multiple lines of insurance on an admitted basis in 48 states and the District of Columbia. Contractors Bonding and Insurance Company (CBIC), a subsidiary of RLI Ins., has authority to write multiple lines of insurance on an admitted basis in all 50 states and the District of Columbia.
ASU 2012-02, Intangibles-Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment
This ASU permits an entity the option to first assess qualitative factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired. The results of the qualitative assessment are used as a basis in determining whether it is necessary to perform the two-step quantitative impairment test. If the qualitative assessment supports the conclusion that it is more likely than not that the fair value of the asset exceeds its carrying amount, the entity would not need to perform the two-step quantitative impairment test. The focus of the guidance is to reduce the cost and complexity of performing impairment tests for indefinite-lived intangible assets other than goodwill and to improve consistency in impairment testing among long-lived asset categories.
ASU 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income
This ASU was issued to improve the reporting of reclassifications out of accumulated other comprehensive income. The guidance requires an entity to present, either on the face of the statement where net earnings is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items in the statement of earnings. The intent of the guidance is to provide financial statement users with a single location to determine the effect of reclassification adjustments on the financial statements.
We adopted ASU 2013-02 on January 1, 2013. The required disclosures have been included in note 1.P. to these consolidated financial statements.
E. INVESTMENTS: We classify our investments in all debt and equity securities into one of three categories: available-for-sale, held-to-maturity or trading.
Debt and equity securities not included as held-to-maturity are classified as available-for-sale and reported at fair value. Unrealized gains and losses on these securities are excluded from net earnings but are recorded as a separate component of comprehensive earnings and shareholders’ equity, net of deferred income taxes. All of our equity securities and approximately 99 percent of debt securities are classified as available-for-sale.
Debt securities that we have the positive intent and ability to hold to maturity are classified as held-to-maturity and carried at amortized cost. Except for declines that are other-than-temporary, changes in the fair value of these securities are not reflected in the financial statements. We have classified less than 1 percent of our debt securities portfolio as held-to-maturity.
For the years ended December 31, 2013, 2012 and 2011, no securities were transferred from held-to-maturity to available-for-sale or trading.
· For our equity securities, our expectation of recovery to cost within a reasonable period of time.
H. POLICY ACQUISITION COSTS: We defer commissions, premium taxes and certain other costs that are incrementally or directly related to the successful acquisition of new or renewal insurance contracts. Acquisition-related costs may be deemed ineligible for deferral when they are based on contingent or performance criteria beyond the basic acquisition of the insurance contract or when efforts to obtain or renew the insurance contract are unsuccessful. All eligible costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premiums to be earned and anticipated losses and settlement expenses, as well as certain other costs expected to be incurred as the premiums are earned. Judgments as to the ultimate recoverability of such deferred costs are reviewed on a segment basis and are highly dependent upon estimated future loss costs associated with the premiums written. This deferral methodology applies to both gross and ceded premiums and acquisition costs.
I. PROPERTY AND EQUIPMENT: Property and equipment are presented at cost less accumulated depreciation and are depreciated on a straight-line basis for financial statement purposes over periods ranging from 3 to 10 years for equipment and up to 30 years for buildings and improvements.
M. INSURANCE REVENUE RECOGNITION: Insurance premiums are recognized ratably over the term of the contracts, net of ceded reinsurance. Unearned premiums are calculated on a monthly pro rata basis.
· Pricing Level 1 is applied to valuations based on readily available, unadjusted quoted prices in active markets for identical assets. These valuations are based on quoted prices that are readily and regularly available in an active market.
· Pricing Level 2 is applied to valuations based upon quoted prices for similar assets in active markets, quoted prices for identical or similar assets in inactive markets; or valuations based on models where the significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities) or can be corroborated by observable market data.
· Pricing Level 3 is applied to valuations that are derived from techniques in which one or more of the significant inputs are unobservable. Financial assets are classified based upon the lowest level of significant input that is used to determine fair value.
As a part of management’s process to determine fair value, we utilize a widely recognized, third-party pricing source to determine our fair values. We have obtained an understanding of the third-party pricing source’s valuation methodologies and inputs. The following is a description of the valuation techniques used for financial assets that are measured at fair value, including the general classification of such assets pursuant to the fair value hierarchy.
Mortgage-backed Securities (MBS)/Collateralized Mortgage Obligations (CMO) and Asset-backed Securities (ABS): The pricing vendor evaluation methodology includes principally interest rate movements and new issue data. Evaluation of the tranches (non-volatile, volatile or credit sensitivity) is based on the pricing vendors’ interpretation of accepted modeling and pricing conventions. This information is then used to determine the cash flows for each tranche, benchmark yields, prepayment assumptions and to incorporate collateral performance. To evaluate CMO volatility, an option adjusted spread model is used in combination with models that simulate interest rate paths to determine market price information. This process allows the pricing vendor to obtain evaluations of a broad universe of securities in a way that reflects changes in yield curve, index rates, implied volatility, mortgage rates and recent trade activity. MBS/CMO and ABS with corroborated, observable inputs are classified as Level 2. All of our MBS/CMO and ABS are deemed Level 2.
Due to the relatively short-term nature of cash, short-term investments, accounts receivable and accounts payable, their carrying amounts are reasonable estimates of fair value. The fair value of our long-term debt is discussed further in note 4. See note 13 for fair value of assets and liabilities acquired with CBIC and Rockbridge.
Our insurance coverages include exposure to catastrophic events. We monitor all catastrophe exposures by quantifying our exposed policy limits in each region and by using computer-assisted modeling techniques. Additionally, we limit our risk to such catastrophes through restraining the total policy limits written in each region and by purchasing reinsurance. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. In 2013, for this coverage, we had protection of $300 million in excess of $25 million first-dollar retention for earthquakes in California and $330 million
in excess of a $20 million first-dollar retention for earthquakes outside of California. These amounts are subject to certain co-participations by us on losses in excess of the $25 million or $20 million retentions. Our second largest catastrophe exposure is to losses caused by hurricanes to commercial properties throughout the Gulf and East Coasts, as well as to homes we insure in Hawaii. In 2013, these coverages were supported by $230 million in excess of a $20 million first-dollar retention in traditional catastrophe reinsurance protection, subject to certain retentions by us in the excess layers. In addition, we have incidental exposure to international catastrophic events.
In 2009, as an extension of our excess and surplus lines general liability product, we expanded our offerings into low to moderate environmental liability exposures for small contractors and asbestos and mold remediation specialists. The business unit also provides limited coverage for individually underwritten underground storage tanks. We attempted to mitigate the overall exposure by focusing on smaller risks with low to moderate exposures. A large portion of this business is also offered on a claims-made basis with relatively low limits. We avoid risks that have large-scale exposures including petrochemical, chemical, mining, manufacturers and other risks that might be exposed to superfund sites. This business is covered under our casualty ceded reinsurance treaties. Since 2009, we have written $9.3 million of premium from this new product extension with $3.0 million written in 2013.
The National Association of Insurance Commissioners (NAIC) has developed Property/Casualty Risk-Based Capital (RBC) standards that relate an insurer’s reported statutory surplus to the risks inherent in its overall operations. The RBC formula uses the statutory annual statement to calculate the minimum indicated capital level to support asset (investment and credit) risk and underwriting (loss reserves, premiums written and unearned premium) risk. The NAIC model law calls for various levels of regulatory action based on the magnitude of an indicated RBC capital deficiency, if any. We regularly monitor our subsidiaries’ internal capital requirements and the NAIC’s RBC developments. As of December 31, 2013, we determined that our capital levels are well in excess of the minimum capital requirements for all RBC action levels and that our capital levels are sufficient to support the level of risk inherent in our operations. See note 9 for further discussion of statutory information and related insurance regulatory restrictions.
Assets measured at fair value on a recurring basis as of December 31, 2012, are summarized below:
As noted in the previous tables, we did not have any assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of December 31, 2013 and 2012. Additionally, there were no securities transferred in or out of levels 1 or 2 during 2013 or 2012.
The amortized cost and estimated fair value of fixed income securities at December 31, 2013, by contractual maturity, are shown as follows:
In addition, the following table is a schedule of amortized costs and estimated fair values of investments in fixed income and equity securities as of December 31, 2013 and 2012:
Unrealized losses in the municipal bond portfolio increased $12.5 million to $12.7 million in 2013 as interest rates increased during the year. Municipals continue to be a focus area of portfolio strategy and were a large component of net purchases during the year. Ninety-one percent of our municipal securities are rated AA or better while 99 percent are rated A or better.
The following table is also used as part of our impairment analysis and displays the total value of securities that were in an unrealized loss position as of December 31, 2013, and December 31, 2012. The table segregates the securities based on type, noting the fair value, cost (or amortized cost) and unrealized loss on each category of investment as well as in total. The table further classifies the securities based on the length of time they have been in an unrealized loss position.
As of December 31, 2013, we held one equity security that was in an unrealized loss position. The total unrealized loss on this security was $0.3 million. In considering both the significance and duration of the unrealized loss position, we have no equity securities in an unrealized loss position of greater than 20 percent for more than six consecutive months.
· Significant or recurring operating losses, poor cash flows and/or deteriorating liquidity ratios and
As required by law, certain fixed maturity investments amounting to $23.7 million at December 31, 2013, were on deposit with either regulatory authorities or banks.
*Includes asset for value of business acquired (VOBA) in CBIC acquisition.
As of December 31, 2013, outstanding debt balances totaled $149.6 million, net of unamortized discount, all of which were our long-term senior notes.
On October 2, 2013, we completed a public debt offering, issuing $150.0 million in senior notes maturing September 15, 2023, and paying interest semi-annually at the rate of 4.875 percent. The notes were issued at a discount resulting in proceeds, net of discount and commission, of $148.6 million. The amount of the discount is being charged to income over the life of the debt on an effective-yield basis. On December 12, 2013, a portion of the proceeds were used to redeem the $100.0 million in senior notes that were to mature on January 15, 2014, and the remaining proceeds were made available for general corporate purposes. The estimated fair value for the senior note is $150.8 million. The fair value of our long-term debt is estimated based on the limited observable prices that reflect thinly traded securities.
The assumed business is made up of short-tail property, catastrophe and multi-peril crop and hail reinsurance. The majority of this assumed reinsurance is proportional and a large portion of the assumed incurred losses can be attributed to crop-related reinsurance, which we began offering in 2010, and a specialty property treaty that experienced unusually high weather-related loss activity in 2011. Losses for each crop season are ultimately determined and paid subsequent to December 31 of the crop year reinsured.
At December 31, 2013, we had prepaid reinsurance premiums and recoverables on paid and unpaid losses and settlement expenses totaling $362.1 million. Nearly 95 percent of our reinsurance recoverables are due from companies with financial strength ratings of “A” or better by A.M. Best and S&P rating services.
The following table displays net reinsurance balances recoverable, after consideration of collateral, from our top 10 reinsurers as of December 31, 2013. These reinsurers all have financial strength ratings of “A” or better by A.M. Best and Standard and Poor’s ratings services. Also shown are the amounts of written premium ceded to these reinsurers during the calendar year 2013.
Our policy is to charge to earnings, in the form of an allowance, an estimate of unrecoverable amounts from reinsurers. This allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover. Once regulatory action (such as receivership, finding of insolvency, order of conservation, or order of liquidation) is taken against a reinsurer, the paid and unpaid recoverable for the reinsurer are specifically identified and written off through the use of our allowance for estimated unrecoverable amounts from reinsurers. When we write-off such a balance, it is done in full. We then re-evaluate the remaining allowance and determine whether the balance is sufficient as detailed above and if needed, an additional allowance is recognized and income charged. The amounts of allowances for uncollectible amounts on paid and unpaid recoverables were $13.3 million and $14.2 million, respectively, at December 31, 2013. At December 31, 2012, the amounts were $13.5 million and $14.8 million, respectively. We have no receivables with a due date that extends beyond one year that are not included in our allowance for uncollectible amounts, other than the receivable related to our crop reinsurance program. The amount receivable under our crop reinsurance business, which represents $29.4 million of our total premiums and reinsurance balances receivable at December 31, 2013, is not contractually due until the final settlement of the 2013 crop year, which is scheduled to occur during the fourth quarter of 2014.
The differences from our initial reserve estimates emerged as changes in our ultimate loss estimates as we updated those estimates through our reserve analysis process. The recognition of the changes in initial reserve estimates occurred over time as claims were reported, initial case reserves were established, initial reserves were reviewed in light of additional information and ultimate payments were made on the collective set of claims incurred as of that evaluation date. The new information on the ultimate settlement value of claims is continually updated until all claims in a defined set are settled. As a small specialty insurer with a diversified product portfolio, our experience will ordinarily exhibit fluctuations from period to period. While we attempt to identify and react to systematic changes in the loss environment, we also must consider the volume of experience directly available to us and interpret any particular period’s indications with a realistic technical understanding of the reliability of those observations.
2011. During 2011, all of our segments experienced favorable emergence from prior years’ reserve estimates. From the casualty segment there was $83.9 million of favorable development coming mostly from accident years 2006 through 2009. Again this year, the expected loss ratios initially used to establish carried reserves for these accident years proved to be higher than required. This resulted in loss emergence significantly lower than expected. This was predominantly caused by favorable frequency and severity trends that continued to be considerably less than our long-term expectations. In addition, we believe this to be the result of our underwriters’ risk selection, which has mostly offset price declines and loss cost inflation. Nearly all of our casualty products contributed to the favorable development, but this was particularly true for our general liability product. It was by far the largest contributor at $37.3 million and was driven primarily by the construction classes. Other significant favorable development came from our commercial umbrella, personal umbrella and transportation products in amounts of $15.1 million, $7.7 million and $6.9 million, respectively. In addition, our program business, much of which is in runoff, was responsible for $6.2 million of the total. Unfavorable development came from the asbestos and environmental exposures associated with business assumed in the 1970’s and 1980’s, which totaled $1.5 million.
The surety segment contributed $7.7 million of favorable emergence in 2011. Accident years 2010 and 2009 were responsible for the majority of that development. The biggest contributors by product were contract, energy and commercial with favorable development of $3.9 million, $2.2 million and $2.0 million, respectively. We have been monitoring these products for the last few years for signs of adverse experience caused by the economic environment. In prior years we had not seen much evidence of stress on our customers. However, this began to change somewhat in 2011, particularly with respect to contract surety. This did not significantly affect development on prior accident years, but did affect loss estimates for the current accident year.
Calendar year 2013 included an increase in inception-to-date incurred losses on a net and gross basis. The most significant change was an increase in the case reserve for a 1982 claim. The claim is reserved at the policy limit, with a gross increase of $2.2 million and the net increase of $1.8 million. Case reserves were increased for the claim while the amount of gross and net IBNR decreased.
Income tax expense attributable to income from operations for the years ended December 31, 2013, 2012 and 2011, differed from the amounts computed by applying the U.S. federal tax rate of 35 percent to pretax income from continuing operations as demonstrated in the following table:
Dividends paid to our Employee Stock Ownership Plan (ESOP) result in a tax deduction. Special dividends paid to the ESOP in 2013, 2012 and 2011 resulted in tax benefits of $1.7 million, $2.9 million and $2.7 million, respectively. These tax benefits reduced the effective tax rate for 2013, 2012 and 2011 by 1.0 percent, 2.0 percent and 1.5 percent, respectively.
Our net earnings include equity in earnings of unconsolidated investee, Maui Jim. This investee does not have a policy or pattern of paying dividends. As a result, we record a deferred tax liability on the earnings at the corporate capital gains rate of 35 percent. In the fourth quarters of 2013 and 2012, we received a $13.2 and $6.6 million dividend, respectively. In accordance with GAAP guidelines on income taxes, we recognized a $3.7 million tax benefit for 2013 and a $1.8 million tax benefit for 2012 from applying the lower tax rate applicable to affiliated dividends (7 percent), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. Standing alone the dividend resulted in a 2.1 and 1.3 percent reduction to the 2013 and 2012 effective tax rate, respectively. In determining the appropriate tax rate to apply, we anticipate recovering our investment through means other than the receipt of dividends, such as a sale.
In 2011, a deferred tax asset was recorded at $5.5 million for the net operating loss (NOL) carryforward stemming from the CBIC acquisition. This NOL was primarily the result of certain transaction-related items, including employee bonuses that were incurred by CBIC in conjunction with the sale. A portion of the NOL was carried back to recover taxes paid in prior periods. The remaining NOL is being carried forward to future tax years. Due to our consistent history of taxable income, we expect to recover the remaining NOL by the end of 2014.
We maintain ESOP, 401(k) and bonus and incentive plans covering executives, managers and associates. At the board of directors’ discretion, funding of these plans is primarily dependent upon reaching predetermined levels of operating return on equity, combined ratio and Market Value Potential (MVP). MVP is a compensation model that measures components of comprehensive earnings against a minimum required return on our capital. Bonuses are earned as we
Our 401(k) plan allows voluntary contributions by employees and permits ESOP diversification transfers for employees meeting certain age or service requirements. We provide a basic 401(k) contribution of 3 percent of eligible compensation. Participants are 100 percent vested in both voluntary and basic contributions. Additionally, an annual discretionary profit-sharing contribution may be made to the ESOP and 401(k), subject to the achievement of certain overall financial goals and board approval. Profit-sharing contributions vest after three years of plan service.
Our ESOP and 401(k) cover all employees meeting eligibility requirements. ESOP and 401(k) profit-sharing contributions are determined annually by our board of directors and are expensed in the year earned. ESOP and 401(k)-related expenses (basic and profit-sharing) were $12.4 million, $7.8 million and $10.6 million, for 2013, 2012 and 2011, respectively.
Annual bonuses are awarded to executives, managers and associates through our incentive plans, provided certain financial and operational goals are met. Annual expenses for these incentive plans totaled $23.2 million, $16.7 million and $17.4 million for 2013, 2012 and 2011, respectively.
In 2013, the trusts purchased 13,922 shares of our common stock on the open market at an average price of $38.33 ($0.5 million). In 2012, the trusts purchased 14,968 shares of our common stock on the open market at an average price of $34.24 ($0.5 million). In 2011, the trusts purchased 19,562 shares of our common stock on the open market at an average price of $29.75 ($0.6 million). At December 31, 2013, the trusts’ assets were valued at $32.5 million.
During the second quarter of 2010, our shareholders approved the RLI Corp. Long-Term Incentive Plan (LTIP), which replaced the omnibus plan. In conjunction with the adoption of the LTIP, effective May 6, 2010, options will no longer be granted under the omnibus plan. Awards under the LTIP may be in the form of restricted stock, stock options (nonqualified only), stock appreciation rights, performance units, as well as other stock-based awards. Eligibility under the LTIP is limited to employees or directors of the company or any affiliate. The granting of awards under the LTIP is solely at the discretion of the executive resources committee of the board of directors. The total number of shares of common stock available for distribution under the LTIP may not exceed 4,000,000 shares (subject to adjustment for changes in our capitalization). Since 2010, we have granted 2,312,500 stock options under the LTIP, including 632,700 in 2013.
In most instances, the requisite service period and vesting period will be the same. For participants who are retirement
Shares issued may be less than the number of shares actually exercised, as our plan allows net settlement to cover the option exercise price and taxes due upon option exercise. Shares netted are valued at the closing stock price on the date of option exercise. In these instances, the actual number of shares issued will be less than the options exercised and can result in a decrease to shareholders’ equity. Specifically, when options are exercised with significant intrinsic value (i.e. market value in excess of exercise price) and the exercise is facilitated via net settlement, amounts withheld for taxes result in a decrease in shareholders’ equity. During 2013, the aggregate intrinsic value of options exercised was $22.4 million. A majority of these options were exercised via net settlement with taxes withheld at the statutory minimum rate. As shown in the consolidated statements of shareholders’ equity, the exercise of options in 2013 resulted in a decrease to paid-in-capital, as the taxes withheld pursuant to net settlement exceeded amounts paid in for options that were exercised using cash. This was not the case in 2012 or 2011 as the intrinsic value of the options exercised was not as significant ($4.7 million and $12.8 million, respectively). Therefore, the exercise of options in 2012 and 2011 resulted in increases to paid-in-capital.
On November 14, 2013, the board of directors declared a $1.50 per share special cash dividend to be paid on December 20, 2013, to shareholders of record at the close of business on November 29, 2013. To preserve the intrinsic value for option holders, the board also approved, pursuant to the terms of our various stock option plans, a proportional adjustment to both the exercise price and the number of shares covered by each award for all outstanding ISOs and an adjustment to the exercise price (equivalent to the special dividend) for all outstanding non-qualified options. Most (99 percent of) outstanding options at the time of the adjustment were non-qualified. These adjustments did not result in any incremental compensation expense as the aggregate fair value, aggregate intrinsic value and the ratio of the exercise price to the market price are approximately equal immediately before and after the adjustment. Similarly, on November 14, 2012, the board of directors declared a $2.50 per share special cash dividend to be paid on December 20, 2012, to shareholders of record at the close of business on November 30, 2012. On November 17, 2011, the board of directors declared a $2.50 per share special cash dividend to be paid on December 20, 2011, to shareholders of record at the close of business on November 30, 2011. The adjustments made for the 2013 special dividend were also made for the 2012 and 2011 special dividends and did not result in any incremental compensation expense.
The majority of our options are granted annually at our regular board meeting in May. In addition, options are approved at the May meeting for quarterly grants to certain retirement eligible employees. Since grants to retirement eligible employees are fully expensed when issued, the approach allows for a more even expense distribution throughout the year.
In 2012, 669,800 options were granted with an average exercise price of $31.71 and an average fair value of $6.55. Of these grants, 437,800 were granted at the board meeting in May with a calculated fair value of $6.54. We recognized
$3.6 million of expense during 2012 related to options vesting. Since options granted under our plan are non-qualified, we recorded a tax benefit of $1.3 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $4.3 million, which will be recognized over the remainder of the vesting period.
Prior to 2011, directors participated in the Non-Employee Directors’ Stock Plan under which directors could receive awards of company stock. The final award to outside directors under this plan occurred in the 2011 calendar year and totaled 3,082 shares. Shares were awarded at an average share price of $27.48 and we recognized $0.1 million of expense related to these awards. No shares were issued to outside directors in 2012.
In 2013, we began providing restricted common stock to outside directors. Shares are issued to outside directors from the LTIP as part of annual director compensation and are directly owned by each director on the date of issuance. Currently, each director receives restricted shares worth $10,000 at the time of issuance. The shares are issued annually in the first quarter and include a one-year restriction on the sale or transfer of such shares. In the first quarter of 2013, we issued a total of 2,320 restricted shares and recognized $0.1 million of compensation expense.
million as of December 31, 2013, 2012 and 2011, respectively, compared to actual statutory capital and surplus of $859.2 million, $684.1 million and $710.2 million, respectively, for these same periods.
We have operating lease obligations for regional office facilities. These leases expire in various years through 2023.
Expenses associated with these leases totaled $5.7 million in 2013, $5.4 million in 2012 and $5.0 million in 2011. Minimum future rental payments under non-cancellable leases are as follows:
Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions, marine, facultative and treaty reinsurance, including crop and select personal lines policies, including recreational vehicle insurance and Hawaii homeowners coverages. Property insurance and reinsurance results are subject to the variability introduced by perils such as earthquakes, fires and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. Our second largest catastrophe exposure is to losses caused by hurricanes to commercial properties throughout the Gulf and East Coast, as well as to homes we insure in Hawaii. We limit our net aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and through extensive use of computer-assisted modeling techniques. These techniques provide estimates that help us carefully manage the concentration of risks exposed to catastrophic events. Our assumed multi-peril crop and hail treaty reinsurance business covers revenue shortfalls or production losses due to natural causes such as drought, excessive moisture, hail, wind, frost, insects and disease. Significant aggregation of these losses is mitigated by the Federal Government reinsurance program that provides stop loss protection inuring to our benefit.
The following table summarizes our segment data based on the internal structure and reporting of information as it is used by management. The net earnings of each segment are before taxes and include revenues (if applicable), direct product or segment costs (such as commissions and claims costs), as well as allocated support costs from various support departments. While depreciation and amortization charges have been included in these measures via our expense allocation
As discussed in note 1.B., all share and per share data reflect the two-for-one stock split executed on January 15, 2014. Selected quarterly information is as follows:
On November 2, 2012, we acquired Rockbridge, a Houston-based managing general agency. Rockbridge specializes in medical professional liability insurance in the excess and surplus markets. Coverage is offered to individual physicians and physician groups in all 50 states through a network of retail and wholesale brokers. Total consideration for the acquisition was $16.7 million, which included $15.5 million of cash paid at acquisition, and $1.2 million associated with the present value of a contingent earn-out agreement. The earn-out is subject to the achievement of certain loss ratio targets and may be adjusted, either upward or downward, in future periods based on actual performance achieved. As of December 31, 2013, the recorded value of the contingent earn-out agreement was $1.3 million. For 2013, Rockbridge contributed gross premiums written of $16.7 million and net premiums earned of $8.6 million.
Management has established and maintains internal control throughout its operations that is designed to provide reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use and the execution and recording of transactions in accordance with management’s authorization. Internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are updated by management as necessary. Management considers the recommendations of its internal auditor and independent registered public accounting firm concerning the Company’s internal control and takes the necessary actions that are cost effective in the circumstances to respond appropriately to the recommendations presented.