Our other two regional locations in Westminster, Colorado, and Galveston, Texas, and our claims office in Metairie, Louisiana, conduct operations in leased office space.
The following table shows a brief description of our owned and leased office space. We believe our current facilities are adequate to meet our needs with additional space available for future expansion, if necessary, at each of our leased and owned facilities:
The following table sets forth certain selected financial data derived from the Consolidated Financial Statements of United Fire Group, Inc. and its subsidiaries and affiliates. The data should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 8, “Financial Statements and Supplementary Data.”
For further information on this line, please refer to the Measurement of Results section in Part II,
This report may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ from those expected and/or projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about the Company, the industry in which we operate, and beliefs and assumptions made by management. Words such as “expect(s),” “anticipate(s),” “intend(s),” “plan(s),” “believe(s),” “continue(s),” “seek(s),” “estimate(s),” “goal(s),” “target(s),” “forecast(s),” “project(s),” “predict(s),” “should,” “could,” “may,” “will continue,” “might,” “hope,” “can” and other words and terms of similar meaning or expression in connection with a discussion of future operations, financial performance or financial condition, are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in Part II Item 1A, “Risk Factors” of this document. Risks and uncertainties that may affect the actual financial condition and results of the Company include but are not limited to the following:
Occurrence of catastrophic events, occurrence of significant severe weather conditions, climate change, acts of terrorism, acts of war and pandemics;
Developments in the domestic and global financial markets and "other-than-temporary" impairment losses that could affect our investment portfolio;
Lowering of one or more of the financial strength ratings of our operating subsidiaries or our issuer credit ratings and the adverse impact such action may have on our premium writings, policy retention, profitability and liquidity;
Changes in general economic conditions, interest rates, industry trends, increase in competition and significant industry developments;
Originally founded in 1946 as United Fire & Casualty Company, United Fire Group, Inc. ("United Fire", the "Company", "we", "us", "our") and its consolidated insurance subsidiaries provide insurance protection for individuals and businesses through several regional companies. We are licensed as a property and casualty insurer in 43 states plus the District of Columbia and are represented by approximately 1,200 independent agencies. Our life insurance subsidiary is licensed in 36 states and is represented by approximately 900 independent agencies.
property and casualty insurance, which includes commercial insurance, personal insurance, and assumed reinsurance; and
For 2012, property and casualty business accounted for approximately 90.0 percent of our net premiums earned, of which 90.0 percent was generated from commercial insurance. Life insurance business made up approximately 10.0 percent of our net premiums earned, of which over 71.0 percent was generated from traditional life insurance products.
Management evaluates our operations by monitoring key measures of growth and profitability. We believe that disclosure of certain Non-GAAP financial measures enhances investor understanding of our financial performance. The following provides further explanation of the key measures management uses to evaluate our results:
(1) The information presented for 2011 and after includes Mercer Insurance Group's results after the March 28, 2011 acquisition date.
Catastrophe losses is a commonly used non-GAAP financial measure, which 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 defined as a single unpredictable incident or series of closely related incidents that result in $25.0 million or more in U.S. industry-wide direct insured losses to property and that affect a significant number of insureds and insurers (“ISO catastrophe”). In addition to ISO catastrophes, we also include as catastrophes those events (“non-ISO catastrophes”), which may
include U.S. or international losses, that we believe are, or will be, material to our operations, either in amount or in number of claims made. Management, at times, may determine for comparison purposes that it is more meaningful to exclude extraordinary catastrophe losses and resulting litigation. The frequency and severity of catastrophic losses we experience in any year affect our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. Portions of our catastrophe losses may be recoverable under our catastrophe reinsurance agreements. We include a discussion of the impact of catastrophes because we believe it is meaningful for investors to understand the variability in periodic earnings.
The year 2011 will be remembered for its devastating catastrophes, both domestic and abroad. According to various reports, 2011 was the costliest catastrophe year on record for the property and casualty insurance industry globally. We experienced losses in our direct and assumed books of business that negatively impacted our full-year results.
During 2011, we began the process of integrating Mercer Insurance Group into our operations. The integration of the West Coast business of Mercer Insurance Group's policy renewals into our processing systems was completed in 2012. We began the integration of the East Coast policy renewals into our processing systems which are on schedule to be completed in 2013. In addition, effective January 1, 2012, we consolidated Mercer Insurance Group's core and catastrophe reinsurance programs into our programs, resulting in increased coverage and reduction in Mercer Insurance Group's historical costs.
In 2012, we continued to expand the geographical footprint of our life insurance subsidiary by receiving approval to operate in California, Maryland and Delaware after receiving approval in 2011 to operate in New Jersey, North Carolina, Pennsylvania,Virginia and West Virginia, further leveraging the Mercer Insurance Group acquisition. Our life management team continues to improve service to our agents by increasing marketing support and automating life product processes.
At a special meeting held on January 24, 2012, our stockholders approved our reorganization into a new holding company structure. United Fire Group, Inc. has replaced United Fire & Casualty Company as the publicly held corporation, and United Fire & Casualty Company is now a wholly owned subsidiary of United Fire Group, Inc. In addition to creating a more streamlined corporate structure, the new holding company's organizational documents enhanced our stockholder rights by reducing the percentage of stockholders required to amend our Articles of Incorporation, approve the merger or sale of substantially all Company assets, and call a special meeting. This new structure will potentially provide us with more flexibility to operate and finance our businesses, particularly if we should need to raise capital in the future.
(2) The Measurement of Results section of this report defines data prepared in accordance with statutory accounting practices, which is a comprehensive basis of accounting other than GAAP.
For the year ended December 31, 2012, our property and casualty segment reported income before income taxes of $36.1 million compared to losses before income taxes of $24.2 million in the same period in 2011. The increase in income before income taxes during 2012 as compared to 2011 is primarily a result of a 17.9 percent increase in net premiums earned, a decrease in catastrophe losses, and a decrease in the amortization of deferred policy acquisition costs, partially offset by an increase in underwriting expenses, and an increase in loss and loss settlement expenses all discussed in more detail throughout this section.
Amortization of deferred policy acquisition costs decreased as the result of a change in accounting guidance that limits the amount of underwriting expenses eligible for deferral. We prospectively adopted the new accounting guidance effective January 1, 2012. As a result, the amount of underwriting expenses eligible for deferral has decreased, which resulted in the recognition of $8.7 million of additional expense in 2012 in our property and casualty insurance segment than would have been recognized had the guidance remained the same.
The following table shows our premiums written and earned for 2012, 2011 and 2010:
Direct premiums written increased $145.2 million in 2011 as compared to 2010, of which $115.3 million resulted from our acquisition of Mercer Insurance Group. The remaining $29.9 million reflects low-to mid-single-digit rate increases across all lines, along with growth from internal initiatives we implemented at the beginning of 2011.
In 2011, we increased our participation on one active contract, while renewing all other active contracts. Our increased participation and pricing increases in recent years led to the increase in assumed premiums written in 2011 as compared to 2010.
Direct and assumed premiums written are reduced by the ceded premiums that we pay to reinsurers. For 2012, ceded premiums written increased slightly compared to 2011. For 2011, the increase in ceded premiums written is primarily related to our acquisition of Mercer Insurance Group.
In 2012, our pre-tax catastrophe losses were $64.7 million as compared to $80.8 million and $19.8 million in 2011 and 2010, respectively. Our 2012 losses included Super Storm Sandy, which occurred in October 2012, which represented $25.0 million ($20.0 million direct and $5.0 million assumed) of incurred losses and 26 other catastrophes, where our largest single pre-tax catastrophe loss totaled $12.3 million.
Our 2011 losses were the result of several large natural disasters in both our direct business and assumed reinsurance business. The losses in our direct business totaled $59.7 million and resulted from a string of devastating tornadoes that tore through the southern states in April 2011, followed by storms that included a multiple-vortex tornado that destroyed Joplin, Missouri in May 2011. In July 2011, a powerful, long-lasting straightline windstorm known as a derecho hit Iowa, and in August 2011, Hurricane Irene impacted our East Coast policyholders. Our assumed reinsurance business contributed $21.1 million of catastrophe losses from prior year development and current year losses as a result of natural disasters (i.e., earthquakes and tsunamis) in New Zealand and Japan.
Our 2010 losses were the result of 26 catastrophes with our largest single pre-tax catastrophe loss totaling $2.5 million. That loss was the result of a hailstorm that primarily affected the state of Colorado, but also impacted some areas in Wyoming, South Dakota and Nebraska.
In 2012 and 2010, we did not exceed our catastrophe retention of $20.0 million. In 2011, only Mercer Insurance Group exceeded their $5.0 million catastrophe retention due to losses incurred from Hurricane Irene. Effective January 1, 2012, Mercer Insurance Group is included in our catastrophe reinsurance program.
In 2011, we developed earthquake underwriting guidelines to significantly decrease our earthquake exposure in the New Madrid fault area of the Midwest. The guidelines were implemented with most agencies in the New Madrid fault area in July 2011. The reduction in exposure has occurred through business being non-renewed, moved by the agent, the use of sublimits rather than using full earthquake limits, and a waiver signed by the insured rejecting earthquake coverage. As of December 31, 2012, our earthquake exposure has been reduced by $347.0 million, with an ultimate reduction goal of $405.5 million to be accomplished by the end of July 2014.
surplus of at least $250.0 million and an A.M. Best rating or an S&P rating of at least “A-.” If a reinsurer is rated by both rating agencies, then both ratings must be at least an “A-.”
The following table represents the primary reinsurers we utilize and their financial strength ratings as of December 31, 2012:
Primary reinsurers participating on the property and casualty excess of loss programs.
Refer to Part II, Item 8, Note 4 “Reinsurance” for further discussion of our reinsurance programs.
We experienced favorable development in all lines of business with the exception of assumed reinsurance which adversely developed as a result of additional reported losses of $4.6 million on 2011 catastrophe activity, and direct commercial multi-peril, which experienced a slight deficiency. Other liability and products liability had a reduction in legal expenses as a result of an initiative we implemented in 2009, and an overall improvement in our underwriting results.
We experienced favorable development in all lines of business with the exception of assumed reinsurance which adversely developed as a result of additional reported losses of $4.6 million on 2010 catastrophe activity, and direct commercial multi-peril, which experienced a slight deficiency. Our other liability and products liability lines had significant decreases in losses as a result of a lower level of required reserves for IBNR losses in 2011, a reduction in our legal expenses as a result of an initiative we implemented in 2009, and an overall improvement in our underwriting results.
The following table illustrates the major components of the net redundancy we experienced in our reserves for 2012, 2011 and 2010:
Also, additional information relating to severity is unique to each claim. For example, we may learn during the course of a claim that bodily injuries may be less or more severe than originally believed or that damage to a structure is merely cosmetic instead of structural.
Workers’ compensation insurance and other liability insurance are considered to be long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as the legal environment, inflation and medical costs. We consider all of these factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly. Refer to “Critical Accounting Estimates” in this section for a more detailed discussion of our property and casualty insurance segment’s loss and loss settlement expenses reserves.
The following table depicts our net loss ratio for 2012, 2011 and 2010:
The net loss ratio in our commercial lines of business, excluding assumed reinsurance, improved to 66.5 percent in 2012 from 71.3 percent in 2011 and 73.2 percent in 2010. The improvement in 2012 as compared to 2011 was primarily the result of an increase in net premiums earned and a reduction in catastrophe losses.
In 2012, net premiums earned in these lines increased by 12.0 percent to $132.0 million as compared to 2011. The increase in 2012 primarily resulted from an increase in renewal pricing. In 2011, premiums earned in these lines increased to $117.8 million, of which $19.2 million was related to our acquisition of Mercer Insurance Group. Without Mercer Insurance Group, the premiums earned in this line were flat.
Losses from construction defect claims were $9.6 million in 2012 compared to $11.1 million and $9.7 million in 2011 and 2010, respectively. At December 31, 2012, we had $34.0 million in construction defect loss and loss settlement expense reserves (excluding IBNR reserves which is calculated at the overall other liability commercial line), which consisted of 1,839 claims. In comparison, at December 31, 2011 and 2010, we had reserves of $42.3 million and $21.1 million, excluding IBNR reserves, consisting of 1,861 claims and 326 claims, respectively. The acquisition of Mercer Insurance Group contributed $24.9 million in construction defect loss and loss settlement expense reserves at December 31, 2011, representing 1,535 claims.
We have exposure to construction defect liabilities in Colorado, and surrounding states. We have historically insured small- to medium-sized contractors in this geographic area. In an effort to limit the number of future claims from multi-unit buildings, we have implemented policy exclusions in recent years that limit subcontractor 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 also changed our underwriting guidelines to add a professional liability exclusion when contractors prepare their own design work or blueprints and implemented the multi-family exclusion and tract home building limitation form for the state of Colorado and our other western states as a means to reduce our exposure in future years.
Our commercial automobile insurance covers physical damage to an insured’s vehicle, as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by the insured, uninsured or underinsured motorists and the legal costs of defending the insured against lawsuits. Generally, our policy is to write standard automobile insurance. Our net loss ratio in the commercial automobile line was 76.7 percent in 2012, 73.0 percent in 2011 and 71.9 percent in 2010.
Our net loss ratio in the workers’ compensation line of business was 75.8 percent in 2012, 86.7 percent in 2011 and 60.3 percent in 2010. We consider our workers’ compensation business to be a companion product; we rarely write
stand-alone workers’ compensation policies. Our workers’ compensation insurance covers primarily small- to mid-size accounts.
The improvement in this line for 2012 was the result of a decrease in frequency. The deterioration in this line for 2011 was due to an increase in severity and frequency as a result of several large losses that occurred during the year and development in 2011 on claims that occurred in 2010. Generally changes in experience year-over-year in this line are considered normal fluctuations that generally occur in the workers' compensation line of business.
In 2010, we averaged low- to mid-single digit percentage increases in our personal lines premium rates, with a retention rate of approximately 87.0 percent.
We will continue pursuing opportunities to grow our personal lines business in the future. We have added within our CATography™ Underwriter tool the ability to determine whether the premium we charge for an exposure is adequate in areas where hurricanes and earthquakes occur. Some initiatives that we hope to implement include
United Life Insurance Company underwrites all of our life insurance business. Our principal life insurance products are deferred and immediate annuities, universal life products and traditional life (primarily single premium whole life insurance) products. We also underwrite and market other traditional products, including term life insurance and whole life insurance. Deferred and immediate annuities (59.4 percent), traditional life products (30.1 percent), universal life products (9.2 percent), and other life products (1.3 percent) comprised our 2012 life insurance premium revenues, as determined on the basis of statutory accounting practices. We do not write variable annuities or variable insurance products.
In 2012, net investment income decreased 5.3 percent and 8.9 percent, respectively, as compared to 2011 and 2010. This was due to the continuing low interest rate environment. In the fourth quarter of 2011, we began taking advantage of the decreasing spread between AAA- and A-rated fixed maturity securities to improve the quality of our fixed maturity purchases. Additionally, we began increasing the duration of our investment portfolio in 2011 to more closely match our liabilities, which have increased in conjunction with sales of our single premium whole life product. For discussion of our consolidated investment results, see the “Investments” section contained in this item.
Future policy benefits increased 32.3 percent in 2012 as compared to 2011, and 2011 increased 19.6 percent as compared to 2010. In both years, the increase was due to the increase in sales of our single premium whole life product and the demographics of our insureds.
Amortization of deferred policy acquisition costs decreased 19.9 percent in 2012 as compared to 2011 primarily as a result of a change in accounting guidance that limits the deferral of policy acquisition costs, effective January 1, 2012. As previously described for our property and casualty insurance segment, we prospectively adopted this change and as a result the amount of underwriting expenses eligible for deferral has decreased $1.6 million.
Underwriting expenses increased 41.7 percent in 2012 as compared to 2011 due to a $2.3 million increase in commissions related to the increase in premiums and the previously mentioned decrease in deferrals.
Net premiums earned increased 23.7 percent in 2012 as compared to 2011, and is 33.6 percent higher than 2010, primarily due to increased sales of single premium whole life products.
Deferred annuity deposits decreased 24.8 percent in 2012, as compared to 2011. We believe it is prudent to lower the credited rate offered during the low investment return environment, thus affecting current deposits. Sales of single premium deferred annuities also decreased in regard to overall portfolio production, due to increased sales of traditional life products. Deferred annuity deposits increased 33.7 percent in 2011 as compared to 2010 as consumers sought products with a consistent rate of return as the equity markets remained volatile and interest rates low.
Net cash outflow related to the Company's annuity business was $42.3 million in 2012, compared to a net cash inflow of $17.6 million and $0.4 million in 2011 and 2010, respectively. This result is attributed to the activity described previously.
As of December 31, 2012, we have a net operating loss (“NOL”) carryforward of $11.0 million, $1.6 million of which is due to the net operating loss generated in 2011 and $9.4 million of which is due to our purchase of American Indemnity Financial Corporation in 1999. No NOLs will expire in 2013.
Due to our determination that we may not be able to fully realize the benefits of the NOLs acquired in the purchase of American Indemnity Financial Corporation, which are only available to offset the future taxable income of our property and casualty insurance operations, we have recorded a valuation allowance against these NOLs that totaled $2.9 million at December 31, 2012. 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. If NOLs expire during the year, the decrease in the valuation allowance is offset with a corresponding decrease to the deferred income tax asset. The valuation allowance was reduced by $0.5 million in 2012 due to the realization of $1.6 million in NOLs.
The weighted average effective duration of our portfolio of fixed maturity securities, at December 31, 2012 is 4.0 years compared to 3.4 years at December 31, 2011.
The amortized cost and fair value of held-to-maturity, available-for-sale and trading fixed maturity securities at December 31, 2012, by contractual maturity, are shown in the following table. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Asset-backed securities, mortgage-backed securities and collateralized mortgage obligations may be subject to prepayment risk and are therefore not categorized by contractual maturity.
We invest the premiums received from our policyholders and annuitants in order to generate investment income, which is an important component of our revenues and profitability. The amount of investment income that we are able to generate is affected by many factors, some of which are beyond our control. Some of these factors are volatility in the financial markets, economic growth, inflation, changes in interest rates, world political conditions, terrorist attacks or threats of terrorism, adverse events affecting other companies in our industry or the industries in which we invest and other unpredictable national or world events. In our life insurance segment, net investment income decreased 5.3 percent in 2012, compared with the same period of 2011, due to historically low yields that reduce both our investment income and margin on earnings. We are maintaining our investment philosophy of purchasing quality investments rated investment grade or better, and we are more closely matching the duration of our investment portfolio to our liabilities.
In our property and casualty insurance segment, an increase in the value of our investments in limited liability partnerships and the inclusion of Mercer Insurance Group's results for the entire year contributed to the increase of 17.9 percent in net investment income in 2012, compared with the same period of 2011. The increases were somewhat offset by the impact of low investment yields. Our property and casualty insurance segment holds certain investments in limited liability partnerships that are recorded on the equity method of accounting, with changes in the value of these investments recorded in investment income.
In 2012, our investment income, net of investment expenses, increased $2.4 million to $111.9 million as compared to 2011. Net investment income benefited from having a full year of Mercer Insurance Group's results included in 2012 along with an increase in value of investments that are accounted for under the equity method of accounting both somewhat offset by the impact of low investment yields.
In 2012, 2011 and 2010, we reported net realized investment gains of $5.5 million, $6.4 million and $8.5 million, respectively. The following table summarizes the components of our realized investment gains or losses:
As of December 31, 2012, net unrealized investment gains, after tax, totaled $144.1 million, compared to $124.4 million and $102.6 million as of December 31, 2011 and 2010, respectively. The increase in unrealized gains in 2012 resulted from an increase in fair value of both the fixed maturity and equity portfolios. In 2011, our acquisition of Mercer Insurance Group increased our holdings of fixed maturity securities that, in connection with a decrease in market interest rates, led to an increase in our net unrealized investment gains. We have and will continue to closely monitor market conditions and evaluate the long-term impact of the market volatility experienced in recent years on all of our investment holdings.
Duration relates primarily to our life insurance segment because the long-term nature of these reserve liabilities increases the importance of projecting estimated cash flows over an extended time frame. At December 31, 2012, our life insurance segment had $983.6 million in deferred annuity liabilities for which investments in fixed maturity securities were specifically allocated.
The amounts set forth in the following table detail the impact of hypothetical interest rate changes on the fair value of fixed maturity securities held at December 31, 2012. The sensitivity analysis measures the change in fair values arising from immediate changes in selected interest rate scenarios. We employed hypothetical parallel shifts in the yield curve of plus or minus 100 and 200 basis points in the simulations. Additionally, based upon the yield curve shifts, we employ estimates of prepayment speeds for mortgage-related products and the likelihood of call or put options being exercised within the simulations. According to this analysis, at current levels of interest rates, the duration of the investments supporting the deferred annuity liabilities is 0.75 years longer than the projected duration of the liabilities. If interest rates increase by 100 basis points, the duration of the investments supporting the deferred annuity liabilities would be 1.80 years longer than the projected duration of the liabilities.
To the extent actual results differ from the assumptions utilized our duration and interest rate measures could be significantly affected. As a result, these calculations may not fully capture the impact of nonparallel changes in the relationship between short-term and long-term interest rates.
We base our investment decisions on the credit characteristics of individual securities; however, we have within our municipal bond portfolio a number of securities whose ratings were enhanced by third-party insurance for the payment of principal and interest in the event of an issuer default. A downgrade in the credit ratings of the insurers of these securities in 2012 and 2011 resulted in a corresponding downgrade in the ratings of the securities. Of the insured municipal securities in our investment portfolio, 95.0 percent and 93.0 percent were rated single “A” or above, and 88.9 percent and 57.9 percent were rated “AA” or above at December 31, 2012 and 2011, respectively, without the benefit of insurance. Due to the underlying financial strength of the issuers of the securities, we believe that the loss of insurance would not have a material impact on our operations, financial position, or liquidity.
Liquidity measures our ability to generate sufficient cash flows to meet our short- and long-term cash obligations. Our cash inflows are primarily a result of the receipt of premiums, annuity deposits, reinsurance recoveries, sales or maturities of investments, and investment income. Cash provided from these sources is used primarily to fund the payment of losses and loss settlement expenses, policyholder benefits under life insurance contracts, annuity withdrawals, purchase of investments, operating expenses, dividends, pension plan contributions, and in recent years, common stock repurchases.
Cash outflows may be variable because of the uncertainty regarding settlement dates for losses. In addition, the timing and amount of individual catastrophe losses are inherently unpredictable and could increase our liquidity
requirements. The timing and amount of reinsurance recoveries may be affected by reinsurer solvency and reinsurance coverage disputes.
The following table displays a summary of cash sources and uses in 2012, 2011 and 2010:
Net cash flows provided by operating activities totaled $172.1 million, $74.4 million and $71.2 million in 2012, 2011 and 2010, respectively. Operating cash flows in 2012 reflect a higher level of property and casualty premiums collected, and a lower level of property and casualty loss payments from the prior year.
Operating cash flows in 2011 reflected a higher level of loss and loss settlement expense payments, and a lower level of investment income received compared to prior year.
We invest funds required for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. At December 31, 2012, our cash and cash equivalents included $45.6 million related to these money market accounts, compared to $62.9 million at December 31, 2011.
Net cash flows provided by (used in) financing activities totaled $(97.8) million, $65.2 million and $12.7 million in 2012, 2011 and 2010, respectively. In the first quarter of 2011, we borrowed $79.9 million to partially finance the purchase of Mercer Insurance Group. In 2012, we repaid the remaining balance of $45.0 million outstanding on our credit facility and we also fully repaid the $15.6 million of trust preferred securities previously issued by Mercer Insurance Group.
Dividends paid to stockholders totaled $15.3 million, $15.5 million and $15.8 million in 2012, 2011 and 2010, respectively. Our practice has been to pay quarterly cash dividends, which we have paid every quarter since March 1968.
As a holding company with no independent operations of its own, United Fire Group, Inc. relies on dividends received from its insurance operating subsidiaries in order to pay dividends to its common stockholders. Dividends payable by our insurance subsidiaries are governed by the laws in the states in which they are domiciled. In all cases, these state laws permit the payment of dividends only from earned surplus arising from business operations. Furthermore, under state law our insurance operating subsidiaries may pay dividends only if after giving effect to the payment they are able to pay their debts as they become due in the normal course of business or their total assets would be equal to or greater than the sum of their total liabilities. Based on these restrictions, at December 31, 2012, our insurance operating subsidiaries are able to make a maximum of $31.6 million in dividend payments without prior regulatory approval. These restrictions will not have a material impact in meeting our cash obligations.
The credit agreement contains customary representations, covenants and events of default, including certain covenants that limit or restrict our ability to engage in certain activities. Subject to certain exceptions, these activities include restricting our ability to sell or transfer assets or enter into a merger or consolidate with another company, grant certain types of security interests, incur certain types of liens, impose restrictions on subsidiary dividends, enter into leaseback transactions, or incur certain indebtedness. The credit agreement contains certain financial covenants including covenants that require us to maintain a minimum consolidated net worth, a debt to capitalization ratio and minimum stockholders' equity. As of December 31, 2012, we have not been in default and were in compliance with all covenants of the credit agreement.
The amounts presented for future payments to be made to policyholders and beneficiaries must be actuarially estimated and are not determinable from the contract. The projected payments are based on our current assumptions for mortality, morbidity and policy lapse, but are not discounted with respect to interest. Additionally, the projected payments are based on the assumption that the holders of our annuities and life insurance policies will withdraw their account balances upon the expiration of their contracts. Policies must remain in force for the policyholder or beneficiary to receive the benefit under the policy. Depending on the terms of a particular policy, future premiums from the policyholder may be required for the policy to remain in force. In contrast, the future policy benefit
Critical accounting policies are defined as those that are representative of significant judgments and uncertainties and that may potentially 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 policies are as follows.
fixed maturity securities, trading securities and equity securities at fair value. Other long-term investments consist primarily of our interests in limited liability partnerships that are recorded on the equity method of accounting. We record mortgage loans at their unpaid principal balance and policy loans at the outstanding loan amount due from policyholders.
We validate the prices obtained from independent pricing services and brokers prior to their use for reporting purposes by evaluating their reasonableness on a monthly basis. Our validation process includes a review for unusual fluctuations. In our opinion, the pricing obtained at December 31, 2012, was reasonable.
For further discussion on fair value measurements and disclosures refer to Note 3 “Fair Value of Financial Instruments” contained in Part II, Item 8, “Financial Statements and Supplementary Data.”
The following table summarizes the activity related to our DAC asset for December 31, 2012 and 2011:
The DAC asset was impacted by a change in accounting guidance that limits the amount of underwriting expenses eligible for deferral. We prospectively adopted the new accounting guidance effective January 1, 2012. As a result, the amount of underwriting expenses eligible for deferral has decreased which resulted in the recognition of $8.7
million of additional expense in 2012 in our property and casualty insurance segment than would have been had the guidance remained the same. In compliance with the new accounting guidance we calculate the amount of underwriting compensation expense eligible for deferral based on time studies and a ratio of success in policy placement.
The following table illustrates the hypothetical impact on the premium deficiency charge recorded for the quarter ended December 31, 2012, of reasonably likely changes in the assumed loss and loss settlement expense ratios utilized for purposes of this calculation. The entire impact of these changes would be recognized through income as other underwriting expenses. The following table illustrates the impact of potential changes in the expected loss and loss settlement expense ratios for all line of business on the premium deficiency charge. The base amount indicated below is the actual premium deficiency charge recorded as an offset against the DAC asset established as of December 31, 2012 for the quarter then ended:
Costs that vary with and relate to the acquisition of life insurance and annuity business are deferred. Such costs consist principally of commissions and related variable underwriting, agency and policy issue expenses.
As discussed in the Property and Casualty Segment, the DAC asset was impacted by a change in accounting guidance that limits the amount of underwriting expenses eligible for deferral. We prospectively adopted the new accounting guidance effective January 1, 2012 that resulted in the recognition of $1.6 million of additional expense in 2012 in our life insurance segment.
We periodically review estimates of expected profitability and evaluate the need to “unlock” or revise the assumptions for the amortization of the DAC asset. The primary assumptions utilized when estimating future profitability relate to interest rate spread, mortality experience and policy lapse experience. The table below illustrates the impact that a reasonably likely change in our assumptions used to estimate expected gross profits would have on the DAC asset for our non-traditional business recorded as of December 31, 2012. The entire impact of the changes illustrated would be recognized through income as an increase or decrease to amortization expense:
A material change in these assumptions could have a significant negative or positive effect on our reported DAC asset, earnings and stockholders’ equity.
The DAC asset recorded in connection with our non-traditional business is also adjusted with respect to estimated expected gross profits as a result of changes in the net unrealized gains or losses on available-for-sale fixed maturity securities allocated to support the block of fixed annuities and universal life policies. That is, because we carry
Most of our insurance policies are written on an occurrence basis that provides coverage if a loss occurs during the policy period, even if the insured reports the loss many years later. For example, some liability claims for construction defect coverage are reported 10 years or more after the policy period, and the workers’ compensation coverage provided by our policies pays unlimited medical benefits for the duration of the claimant’s injury up to the lifetime of the claimant. In addition, final settlement of certain claims can be delayed for years due to litigation or other reasons. Reserves for these claims require us to estimate future costs, including the effect of judicial actions, litigation trends and medical cost inflation, among others. Reserve development can occur over time as conditions and circumstances change in years after the policy was issued and/or the loss occurred.
what is deemed most appropriate for a particular line of business and year. In general, results of several methods are averaged together to provide a final point estimate. IBNR estimates are derived by subtracting reported loss (or LAE) from projected ultimate loss (or LAE).
Our key assumptions are subject to change as actual claims occur and as we gain additional information about the variables that underlie our assumptions. Accordingly, management reviews and updates these assumptions
As an example, if our loss and loss settlement expense reserves of $971.9 million as of December 31, 2012, is 10.0 percent inadequate, we would experience a reduction in future pre-tax earnings of up to $97.2 million. This reduction could be recorded in one year or multiple years, depending on when we identify the deficiency. The deficiency would also affect our financial position in that our equity would be reduced by an amount equivalent to the reduction in net income. Any deficiency that would be recognized in our loss and loss settlement expense reserves usually does not have a material effect on our liquidity because the claims have not been paid. Conversely, if our estimates of ultimate unpaid loss and loss settlement expense reserves prove to be redundant, our future earnings and financial position would be improved. We believe our reserving philosophy, coupled with what we believe to be aggressive and successful claims management and loss settlement practices, has resulted in year-to-year redundancies in reserves. Our approach is consistent year-to-year and produces a reasonable range of reserves that is better than experiencing year-to-year uncertainty as to the adequacy of our reserves.
We are unable to reasonably quantify the impact of changes in our key assumptions utilized to establish individual case-basis reserves on our total reported reserve because the impact of these changes would be unique to each specific case-basis reserve established. However, based on historical experience, we believe that aggregate case-basis reserve volatility levels of 5.0 percent and 10.0 percent can be attributed to the ultimate development of our net case-basis reserves. The impact to pre-tax earnings would be a decrease if the reserves were to be adjusted upwards and an increase if the reserves were to be adjusted downwards. The table below details the impact of this development volatility on our reported net case-basis reserves at December 31, 2012:
Our reserve for other liability claims at December 31, 2012, is $522.7 million and consists of 5,331 claims, compared with $506.0 million, consisting of 5,358 claims at December 31, 2011. Of the $522.7 million total reserve for other liability claims, $81.3 million is identified as defense costs and $14.4 million is identified as general overhead required in the settlement of claims.
Included in the other liability line of business are gross reserves for construction defect losses and loss settlement expenses. Construction defect is a liability allegation relating to defective work performed in the construction of structures such as commercial buildings, apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. These claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. At December 31, 2012, we had $34.0 million in construction defect loss and loss settlement expense reserves, excluding IBNR reserves that are calculated at the overall other liability commercial line, which consisted of 1,839 claims. At December 31, 2011, our reserves, excluding IBNR reserves, totaled $42.3 million, which consisted of 1,861 claims. The acquisition of Mercer Insurance Group contributed $24.9 million in construction defect loss and loss settlement expense reserves at December 31, 2011, representing 1,535 claims. The reporting of such claims can be delayed, as the statute of limitations can be up to 10 years. Also, court decisions in recent years have expanded insurers’ exposure to construction defect claims. As a result, claims may be reported more than 10 years after a project has been completed, as litigation can proceed for several years before an insurance company is identified as a potential contributor. Claims have also emerged from parties claiming additional insured status on policies issued to other parties, such as contractors seeking coverage from a subcontractor’s policy.
Included in the other liability and assumed reinsurance lines of business are reserves for asbestos and other environmental losses and loss settlement expenses. At December 31, 2012 and 2011, we had $1.7 million and $1.8 million, respectively, in direct and assumed asbestos and environmental loss reserves. In addition, we had ceded asbestos and environmental loss reserves of $0.4 million and $0.3 million at December 31, 2012 and 2011, respectively. The estimation of loss reserves for environmental claims and claims related to long-term exposure to asbestos and other substances is one of the most difficult aspects of establishing reserves, especially given the inherent uncertainties surrounding such claims. Although we record our best estimate of loss and loss settlement expense reserves, the ultimate amounts paid upon settlement of such claims may be more or less than the amount of the reserves, because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved for many years.
Like the other liability line of business, workers’ compensation losses and loss settlement expense reserves are based upon variables that create imprecision in estimating the ultimate reserve. Estimates for workers’ compensation are particularly sensitive to assumptions about medical cost inflation, which has been steadily increasing over the past few years. Other variables that we consider and that contribute to the uncertainty in establishing reserves for workers’ compensation claims include: state legislative and regulatory environments; trends in jury awards; and mortality rates. Because of these variables, the process of reserving for the ultimate loss and loss settlement expense to be incurred requires the use of informed judgment and is inherently uncertain. Consequently, actual loss and loss settlement expense reserves may deviate from our estimates. Such deviations may be significant. Our reserve for workers’ compensation claims at December 31, 2012, is $162.3 million and consists of 2,117 claims, compared with $157.5 million, consisting of 2,015 claims, at December 31, 2011.
In 2012, 2011 and 2010, we recognized a favorable development in our net reserves for prior accident years totaling $73.4 million, $61.1 million and $45.9 million, respectively. The addition of Mercer Insurance Group contributed to the favorable development in our net reserves.
Generally, we base reserves for each claim on the estimated ultimate exposure for that claim, determined from a pessimistic point of view. We believe that it is appropriate and reasonable to establish a best estimate for reserves within a range of reasonable estimates, especially when we are reserving for claims for bodily injury, disabilities and similar claims, for which settlements and verdicts can vary widely. Our reserving philosophy may result in favorable development in future years that will decrease losses and loss settlement expenses for prior year claims in the year of adjustment. While we realize that this philosophy, coupled with what we believe to be aggressive and successful claims management and loss settlement practices, has resulted in year-to-year redundancies in reserves, our approach is better than experiencing year-to-year uncertainty as to the adequacy of our reserves. We believe our approach produces recorded reserves that are reasonably consistent as to their relative position within a range of reasonable reserves from year-to-year.
Based upon our comparison of carried reserves to actual claims experience over the last several years, we believe that using company historical premium and claims data to establish reserves for losses and loss settlement expenses results in adequate and reasonable reserves. Reserve development is discussed in detail under the heading “Reserve Development” in the “Property and Casualty Insurance Segment” of the “Results of Operations” section in this item.
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. On an annual basis, we compare our estimate of total reserves to point estimates prepared by Regnier by line of business to ensure that our estimates are within the actuary’s acceptable range. Regnier performs a 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. In 2012 and 2011, after considering the actuary’s range of reasonable estimates, management believed that carried reserves were reasonable and therefore did not adjust the recorded amount.
We establish reserves for amounts that are payable under traditional insurance policies, including traditional life products, disability income and income annuities. Reserves are calculated as the present value of future benefits expected to be paid, reduced by the present value of future expected premiums. Our estimates use methods and underlying assumptions that are in accordance with GAAP and applicable actuarial standards. The key assumptions that we utilize in establishing reserves are mortality, morbidity, policy lapse, renewal, retirement, investment returns, inflation and expenses. Future investment return assumptions are determined based upon prevailing investment yields as well as estimated reinvestment yields. Mortality, morbidity and policy lapse assumptions are based on our experience. Expense assumptions include the estimated effects of inflation and expenses to be incurred beyond the premium-paying period. These assumptions are established at the time the policy is issued, are consistent with the assumptions for determining DAC amortization for these contracts, and are generally not changed during the policy coverage period. However, if actual experience emerges in a manner that is significantly adverse relative to the original assumptions, adjustments to reserves (or DAC) may be required resulting in a charge to earnings which could have a material adverse effect on our operating results and financial condition.
We engage an independent actuarial firm to render an opinion 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 2012 and 2011, 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 2013.
A 100 basis point decrease in our estimated long-term rate of return on pension plan assets would increase the benefit expense for the year ended December 31, 2012, by $0.7 million, while a 100 basis point increase in the rate would decrease benefit expense by $0.7 million, for the same period.
For the postretirement benefit plan, an increase in our estimated medical trend rate would increase the benefit expense for the year ended December 31, 2012, by $1.1 million, while a 100 basis point decrease in the rate would decrease benefit expense by $0.9 million, for the same period.
On March 28, 2011, we acquired 100 percent of the outstanding common stock of Mercer Insurance Group, Inc. for $191,475. The acquisition was funded through a combination of cash and $79,900 of short-term debt. Accordingly, the results of operations for Mercer Insurance Group, Inc. have been included in the accompanying consolidated financial statements from that date forward. The acquisition allowed us to diversify our exposure to weather and other catastrophe risks across our geographic markets. In connection with the acquisition transaction, we incurred $8,318 of transaction costs, which included $5,540 of expense related to change in control payments made to the former executive officers of Mercer Insurance Group, Inc.
On February 1, 2012, United Fire & Casualty Company completed a corporate reorganization ("the Reorganization") that resulted in the creation of United Fire Group, Inc., an Iowa corporation, as the holding company and sole owner of United Fire & Casualty Company. In connection with the Reorganization, each share of United Fire & Casualty Company common stock (par value $3.33 1/3 per share) that was issued and outstanding immediately prior to the effective date was automatically converted into a share of United Fire Group, Inc. common stock (par value $0.001 per share). In addition, each outstanding option to purchase or other right to acquire shares of United Fire & Casualty Company common stock was automatically converted into an option to purchase or right to acquire, upon the same terms and conditions, an identical number of shares of United Fire Group, Inc. common stock. United Fire Group, Inc. became the publicly held corporation upon completion of the Reorganization.
The accompanying Consolidated Financial Statements include United Fire and its wholly owned subsidiaries: United Fire & Casualty Company, United Life Insurance Company (“United Life”), Addison Insurance Company, American Indemnity Financial Corporation, Lafayette Insurance Company, United Fire & Indemnity Company, Texas General Indemnity Company (currently in run-off) and Mercer Insurance Group, Inc., which includes BICUS Services Corporation, Financial Pacific Insurance Agency (currently inactive), Financial Pacific Insurance Company, Financial Pacific Insurance Group, Inc., Franklin Insurance Company, Mercer Insurance Company, and Mercer Insurance Company of New Jersey, Inc. (collectively, "Mercer Insurance Group").
In the preparation of the accompanying Consolidated Financial Statements, we have evaluated all material subsequent events or transactions that occurred after the balance sheet date through the date on which the financial statements were issued for potential recognition or disclosure.
We record our best estimate of reserves for claim litigation that arises in the ordinary course of business. We consider all of our pending litigation as of December 31, 2012 to be ordinary, routine and incidental to our business.
Premiums earned and losses and loss settlement expenses incurred are reported net of reinsurance ceded. Ceded insurance business is accounted for on a basis consistent with the original policies issued and the terms of the reinsurance contracts. Refer to Note 4 “Reinsurance” for a discussion of our reinsurance operations.
Other long-term investments consist primarily of our interests in limited liability partnerships that are recorded on the equity method of accounting. Mortgage loans are recorded at their unpaid principal balance. Policy loans are recorded at the outstanding loan amount due from policyholders. Included in investments at December 31, 2012 and 2011, are securities on deposit with, or available to, various regulatory authorities as required by law, with fair values of $1,736,466 and $1,682,525, respectively.
Certain costs associated with underwriting new business (primarily commissions, premium taxes and variable underwriting and policy issue expenses associated with successful acquisition efforts) are deferred. The following table is a summary of the components of DAC that are reported in the accompanying Consolidated Financial Statements:
Property and casualty policy acquisition costs deferred are amortized as premium revenue is recognized. The method followed in computing DAC limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, losses and loss settlement expenses to be incurred and certain other costs expected to be incurred as the premium is earned.
The effect on DAC that results from the assumed realization of unrealized gains (losses) on investments allocated to non-traditional business is recognized with an offset, or "shadow" DAC, to net unrealized investment appreciation as of the balance sheet date. The "shadow" DAC adjustment decreased the DAC asset by $38,695 and $33,874 at December 31, 2012 and 2011, respectively.
In October 2010, the Financial Accounting Standards Board ("FASB") issued updated accounting guidance to address the diversity in practice for the accounting for costs associated with acquiring or renewing insurance contracts. This guidance modifies the definition of acquisition costs to specify that a cost must be incremental and directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. Acquisition costs that are not eligible for deferral are to be charged to expense in the period incurred.
Property and equipment is presented at cost less accumulated depreciation. Expenditures for maintenance and repairs are generally expensed as incurred. We periodically review these assets for impairment whenever events or changes in business circumstances indicate that the carrying value of the underlying asset may not be recoverable. A loss would be recognized if the estimated fair value of the asset were less than its carrying value.
Depreciation expense totaled $5,440, $3,661 and $2,812 for 2012, 2011 and 2010, respectively.
Goodwill and other intangible assets arise as a result of business combinations and consist of the excess of the fair value of consideration paid over the tangible assets acquired and liabilities assumed. We evaluate goodwill and other intangible assets for impairment at least on an annual basis or whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill and other intangible assets may exceed its implied fair value. Goodwill is evaluated at the reporting unit level. Any impairment is charged to operations in the
period that the impairment is identified. In 2012 and 2011, we performed a qualitative assessment of our goodwill. As a result of this assessment, we did not recognize an impairment charge on our goodwill in 2012 or 2011.
We file a consolidated federal income tax return. We also file income tax returns in various state jurisdictions. We are no longer subject to federal or state income tax examination for years before 2009.
We utilize the Black-Scholes option pricing method to establish the fair value of non-qualified stock options granted under our equity compensation plans. Our determination of the fair value of stock options 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 term of the award, the expected dividends to be paid over the term of the award and the expected risk-free interest rate. Any changes in these assumptions may materially affect the estimated fair value of the award. For our restricted and unrestricted stock awards, we utilize the fair value of our common stock on the date of grant to establish the fair value of the award. Refer to Note 9 “Stock-Based Compensation” for further discussion.
In May 2011, the FASB issued updated accounting guidance (ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards ("IFRS")) that changed the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between GAAP and International Financial Reporting Standards. The guidance also requires additional disclosures for fair value measurements that are estimated using significant unobservable (i.e., Level 3) inputs. The Company adopted the updated guidance on a prospective basis effective January 1, 2012, and has provided the additional disclosures required in "Note 3 Fair Value of Financial Instruments". The adoption of the new guidance did not have any impact on the Company's financial position or results of operations.
Net realized gains (losses) on disposition of investments are computed using the specific identification method and are included in the computation of net income. A summary of net realized investment gains (losses) for 2012, 2011 and 2010, is as follows:
Our investment portfolio includes trading securities with embedded derivatives. These securities, which are primarily convertible redeemable preferred debt securities, are recorded at fair value. Income or loss, including the change in the fair value of these trading securities, is recognized currently in earnings as a component of net realized
investment gains and losses. Our portfolio of trading securities had a fair value of $15,371 and $15,222 at December 31, 2012 and 2011, respectively.
We believe the unrealized depreciation in value of securities in our fixed maturity portfolio is primarily attributable to changes in market interest rates and not the credit quality of the issuer. We have no intent to sell and it is more likely than not that we will not be required to sell these securities until the fair value recovers to at least equal our cost basis or the securities mature.
The fair value of our debt approximates carrying value due to the variable interest rates and short-term nature of the outstanding amounts.
with whom we have had several years experience and who have demonstrated knowledge of the subject security. We request and utilize one broker quote per security.
In order to determine the proper classification in the fair value hierarchy for each security where the price is obtained from an independent pricing service, we obtain and evaluate the vendors’ pricing procedures and inputs used to price the security, which include unadjusted quoted market prices for identical securities, such as a New York Stock Exchange closing price, and quoted prices for identical securities in markets that are not active. For fixed maturity securities, an evaluation of interest rates and yield curves observable at commonly quoted intervals, volatility, prepayment speeds, credit risks and default rates may also be performed. We have determined that these processes and inputs result in fair values and classifications consistent with the applicable accounting guidance on fair value measurements.
The following tables present the categorization for our financial instruments measured at fair value on a recurring basis in our Consolidated Balance Sheets at December 31, 2012 and 2011:
(1) Realized gains (losses) are recorded as a component of earnings whereas unrealized gains (losses) are recorded as a component of comprehensive income.
In 2011, we renewed our participation in all of our assumed programs, while increasing the participation level on one contract, that generated the growth of our assumed premiums written and earned. Loss and loss settlement expenses increased significantly in 2011 due to several natural disasters, primarily in New Zealand and Japan, that impacted our assumed program.
The benefit reported for loss and loss settlement expenses incurred from assumed business in 2010 was the result of our process to evaluate the overall reserve adequacy of our property and casualty insurance segment. This re-estimation of reserve adequacy of our assumed business did not have a direct impact on the net income reported for our property and casualty insurance segment in 2010.
Refer to Note 5 “Reserves for Loss and Loss Settlement Expenses” for an analysis of changes in our overall property and casualty insurance reserves.
We have several programs that provide reinsurance coverage. This reinsurance coverage limits the risk of loss that we retain by reinsuring direct risks in excess of our retention limits. The following table provides a summary of our primary reinsurance programs, for 2012 and 2011. Retention amounts reflect the accumulated retentions and co-participation of all layers within a program.
(1) On August 1, 2011, Mercer Insurance Group's reinsurance retention and limits were changed to match those of the Company.
(2) On January 1, 2012, Mercer Insurance Group's catastrophe reinsurance programs were changed to match those of the Company.
United Life purchases reinsurance to limit the dollar amount of any one risk of loss. Beginning in 2011, our retention on standard individual life cases is $300. Our accidental death benefit rider on an individual policy is reinsured at 100 percent, up to a maximum benefit of $250. Our group coverage, both life and accidental death and dismemberment, is reinsured at 50.0 percent. Catastrophe excess reinsurance coverage applies when three or more insureds die in a catastrophic accident. For catastrophe excess claims, we retain the first $1,000 of ultimate net loss and the reinsurer agrees to indemnify us for the excess up to a maximum of $5,000. We supplement this coverage when appropriate with “known concentration” coverage. Known concentration coverage is typically tied to a specific event and time period, with a threshold of a minimum number of lives involved in the event, minimum event deductible (stated retention limit) and a maximum payout.
The ceding of insurance does not legally discharge United Life from primary liability under its policies. United Life must pay the loss if the reinsurer fails to meet its obligations. We periodically monitor the financial condition of our reinsurers to confirm that they are financially stable. We believe that all of our reinsurers are in an acceptable financial condition. Approximately 99.0 percent of ceded life insurance in force as of December 31, 2012, has been ceded to five reinsurers.
Because property and casualty insurance reserves are estimates of the unpaid portions of incurred losses that have been reported to us, as well as losses that have been incurred but not reported ("IBNR"), the establishment of appropriate reserves, including reserves for catastrophes, is an inherently uncertain and complex process. The ultimate cost of losses and related loss settlement expenses may vary materially from recorded amounts, which are based on management’s best estimates. We regularly update our reserve estimates as new information becomes available and as events unfold that may affect the resolution of unsettled claims. Changes in prior year reserve estimates, which may be material, are reported as a component of losses and loss settlement expenses incurred in the period such changes are determined.
The favorable development in 2011 and 2010 on claims that occurred in prior years, resulted from a re-estimation of loss reserves recorded at December 31 of the prior year. This re-estimation is primarily attributable to both the payment of claims in amounts less than the amounts reserved and changes in loss reserves mainly in the other liability and commercial automobile lines due to additional information on claims that we received after the reserves for those claims had been established. Another factor contributing to the redundancy recognized is the development of reserves for IBNR loss and loss settlement expenses at a level less than anticipated at December 31 of the prior year. We attribute the favorable development to the fact that we have experienced overall lower levels of claims severity during recent years.
Our property and casualty and life insurance subsidiaries are required to prepare and file statutory-basis financial statements in conformity with the National Association of Insurance Commissioner’s (“NAIC”) Accounting Practices and Procedures Manual, subject to any deviations prescribed or permitted by the applicable insurance commissioner and/or director. 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 material permitted accounting practices were used to prepare our statutory-basis financial statements during 2012, 2011 and 2010. Statutory accounting practices primarily differ from GAAP in that policy acquisition and certain sales inducement costs are charged to expense as incurred, goodwill is amortized, certain fair value adjustments related to the acquisition of Mercer Insurance Group are recorded for GAAP and not recorded for statutory accounting, life insurance reserves are established based on different actuarial assumptions and the values reported for investments, pension obligations and deferred taxes are established on a different basis.
We are directed by the state insurance departments’ solvency regulations to calculate a required minimum level of statutory capital and surplus based on insurance risk factors. The risk-based capital results are used by the NAIC and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. Both United Life and United Fire & Casualty Company and its property and casualty insurance subsidiaries and affiliate had statutory capital and surplus in regards to policyholders well in excess of their required levels at December 31, 2012.
As a holding company with no independent operations of its own, United Fire Group, Inc. relies on dividends received from its insurance operating subsidiaries in order to pay dividends to its common stockholders. Dividends payable by our insurance subsidiaries are governed by the laws in the states in which they are domiciled. Based on these restrictions, at December 31, 2012, our insurance operating subsidiaries are able to make a maximum of $31,649 in dividend payments without prior approval. These restrictions will not have a material impact in meeting our cash obligations. We paid dividends of $15,269, $15,507 and $15,774 in 2012, 2011 and 2010, respectively. In 2012, United Fire & Casualty Company paid dividends to United Fire Group, Inc. totaling $26,950. In 2012, United Fire & Casualty Company received dividends from American Indemnity Financial Corporation, United Fire & Indemnity Company, United Fire Lloyds and United Life Insurance for $1,750, $1,500, $500 and $16,000, respectively. In 2011, United Fire & Casualty Company received dividends from Addison Insurance Company, American Indemnity Financial Corporation, and Lafayette Insurance Company for $3,000, $1,700 and $6,750, respectively. In 2010, United Fire & Casualty Company received a dividend from United Life for $15,000. These intercompany dividend payments are eliminated for reporting in our Consolidated Financial Statements.
The significant components of our net deferred tax liability at December 31, 2012 and 2011, are as follows:
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 to fund the pension plan on a current basis to not less than the minimum amounts required by the Employee Retirement Income Security Act of 1974, as amended, and the Internal Revenue Code of 1986, as amended, is to assure that plan assets will be adequate to provide retirement benefits. We estimate that we will contribute approximately $7,000 to the pension plan in 2013.
Equity securities, which may include various types of stock, such as large-cap, mid-cap and small-cap stocks, and international stocks.
An arbitrage fund, which is a fund that takes advantage of price discrepancies, primarily equity securities, for the same asset in different markets.
A group annuity contract that is administered by United Life, a subsidiary of United Fire.
pension plan, 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. We use an external actuarial firm to verify that the expected long-term rate of return is reasonable.
The availability of assets held in cash and cash equivalents enables the pension plan to mitigate market risk that is associated with other types of investments and allows the pension plan to maintain liquidity both for the purpose of making future benefit payments to participants and their beneficiaries and for future investment opportunities.
The investment in United Fire common stock was stated at fair value based upon the closing sales price (or bid price if no sales) reported on a recognized securities exchange on the last business day of the year. On December 18, 2012, the investment in United Fire common stock was sold to diversify the assets held by the pension plan.
We have an employee stock ownership plan (the “ESOP”) for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the ESOP upon completion of one year of service, meeting the hourly employment requirements and attaining 21 years of age. Contributions to the ESOP are made at our discretion. When made, these contributions are based upon a percentage of total payroll and are allocated to participants on the basis of compensation. We can make contributions in stock or cash, which the trustee uses to acquire shares of our stock to allocate to participants’ accounts. As of December 31, 2012, 2011 and 2010, the ESOP owned 224,041, 226,375, and 234,107 shares of United Fire common stock, respectively. Shares owned by the ESOP are included in shares issued and outstanding for purposes of calculating earnings per share, and dividends paid on the shares are charged to retained earnings. We made contributions to the ESOP of $100 in 2012, $175 in 2011, and $100 in 2010.
to 1,900,000 shares of United Fire common stock to employees, with 568,746 authorized shares available for future issuance at December 31, 2012. The 2008 Stock Plan is administered by the Board of Directors, which determines those employees who will receive awards, when awards will be granted, and the terms and conditions of the awards. The Board of Directors may also take any action it deems necessary and appropriate for the administration of the 2008 Stock Plan. Pursuant to the 2008 Stock Plan, the Board of Directors may, at its sole discretion, grant awards to our employees who are in positions of substantial responsibility with United Fire.
The analysis below details the award activity for 2012 and the awards outstanding at December 31, 2012, for both of our plans and ad hoc options, which were granted prior to the adoption of the other plans:
Intrinsic value is the difference between our share price on the last day of trading (i.e., December 31, 2012) and the price of the options when granted and represents the value that would have been received by option holders had they exercised their options on that date. These values change based on the fair market value of our shares. The intrinsic value of options exercised totaled $229, $35 and $27 in 2012, 2011 and 2010, respectively.
The following table summarizes information regarding the stock options outstanding and exercisable at December 31, 2012:
We write both commercial and personal lines of property and casualty insurance. We focus on our commercial lines, which represented 90.0 percent of our property and casualty insurance premiums earned for 2012. Our personal lines represented 10.0 percent of our property and casualty insurance premiums earned for 2012.
have a disciplined approach to underwriting and risk management that emphasizes profitable growth rather than premium volume or market share. Our insurance subsidiaries are subject to state laws and regulations regarding rate and policy form approvals. The applicable state laws and regulations establish standards in certain lines of business to ensure that rates are not excessive, inadequate, unfairly discriminatory, or used to engage in unfair price competition. Our ability to increase rates and the relative timing of the process are dependent upon each respective state's requirements, as well as the competitive market environment.
Life insurance in force, before ceded reinsurance, totaled $5,206,087 and $4,916,875 as of December 31, 2012 and 2011, respectively. Traditional life insurance products represented 65.4 percent and 65.5 percent of our insurance in-force at December 31, 2012 and 2011, respectively. Universal life insurance represented 29.8 percent and 31.8 percent of insurance in force at December 31, 2012 and 2011, respectively.
We determine the dilutive effect of our outstanding stock options using the “treasury stock” method. Under this method, we assume the exercise of all of the outstanding stock options whose exercise price is less than the weighted-average market value of our common stock during the reporting period. This method also assumes that the proceeds from the hypothetical stock option exercises are used to repurchase shares of our common stock at the weighted-average market value of the stock during the reporting period. The net of the assumed stock options exercised and assumed common shares repurchased represents the number of dilutive common shares, which we add to the denominator of the earnings per share calculation.
At December 31, 2012, we were obligated under noncancelable operating lease agreements for office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $6,017, $5,232 and $4,506 for 2012, 2011 and 2010, respectively. Our most significant lease arrangement is for office space for our regional office in Galveston, Texas. This lease expires in December 2014. The annual lease payments for this office space total approximately $2,105.
At December 31, 2012, our future minimum rental payments are as follows:
There was no outstanding balance on the credit facility at December 31, 2012. We incurred $780 in interest expense related to this credit facility in 2012. We were in compliance with all covenants of the credit agreement at December 31, 2012.
In connection with our acquisition of Mercer Insurance Group, we acquired three statutory trusts with outstanding issuances of trust preferred securities balances as of the acquisition date of $15,614. We redeemed each of the trusts and related issuances in full in 2012. We incurred $509 and $1,055 of interest expense related to these trust preferred securities for 2012 and 2011, respectively.