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 components.
Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions and marine coverages. We also offer select personal lines policies, including homeowners’ coverages. Our crop, property reinsurance and recreational vehicle products are in runoff after we discontinued our crop relationship at the end of 2015 and began curtailing reinsurance and recreational vehicle offerings at the end of 2015 and 2016, respectively. Property insurance 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 wind storms to commercial properties throughout the Gulf and East Coast, as well as to homes we insure in Hawaii. We limit our net
The combined ratio, which is derived from components of underwriting income, is a common industry performance measure of profitability for underwriting operations and is calculated in two components. First, the loss ratio is losses and settlement expenses divided by net premiums earned. The second component, the expense ratio, reflects the sum of policy acquisition costs and insurance operating expenses divided by net premiums earned. All items included in these components of the combined ratio are presented in our GAAP consolidated financial statements. The sum of the loss and expense ratios is the combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of underwriting income or loss. For example, a combined ratio of 85 implies that for every $100 of premium we earn, we record $15 of underwriting income.
Within a reasonable period of time after a claim is reported, our claim department completes an initial investigation and establishes a case reserve. This case-specific reserve is an estimate of the ultimate amount we will have to pay for the claim, including related legal expenses and other costs associated with resolving and settling it. The estimate reflects all of the current information available regarding the claim, the informed judgment of our professional claim personnel regarding the nature and value of the specific type of claim and our reserving practices. During the life cycle of a particular claim, as more information becomes available, we may revise the estimate of the ultimate value of the claim either upward or downward. We may determine that it is appropriate to pay portions of the reserve to the claimant or related settlement expenses before final resolution of the claim. The amount of the individual claim reserve will be adjusted accordingly and is based on the most recent information available.
Our best estimate of ultimate loss and LAE reserves are proposed by our lead reserving actuary and approved by our Loss Reserve Committee (LRC). The LRC is made up of various members of the management team including the lead reserving actuary, chief executive officer, chief operating officer, chief financial officer, general counsel and other selected executives. We do not use discounting (recognition of the time value of money) in reporting our estimated reserves for losses and settlement expenses. Based on current assumptions used in calculating reserves, we believe that our reserve levels at December 31, 2017, make a reasonable provision to meet our future obligations.
Assumed reinsurance businesses where there is an extended reporting lag and/or a heavier utilization of ceding company data and claims and product expertise,
Our estimates of ultimate loss and LAE reserves are subject to change as additional data emerges. This could occur as a result of change in loss development patterns, a revision in expected loss ratios, the emergence of exceptional loss activity, a change in weightings between actuarial methods, the addition of new actuarial methodologies, new information that merits inclusion or the emergence of internal variables or external factors that would alter our view.
Actuarial methods attempt to quantify future outcomes. However, insurance companies are subject to unique exposures that are difficult to foresee at the point coverage is initiated and, often, many years subsequent. Judicial and regulatory bodies involved in interpretation of insurance contracts have increasingly found opportunities to expand coverage beyond that which was intended or contemplated at the time the policy was issued. Many of these policies are issued on an “all risk” and occurrence basis. Aggressive plaintiff attorneys have often sought coverage beyond the insurer’s original intent. Some examples would be the industry’s ongoing asbestos and environmental litigation and court interpretations of exclusionary language for mold and construction defect.
We classify our investments in securities into one of three categories: trading, held-to-maturity or available-for-sale. We do not hold any securities classified as trading or held-to-maturity. Available-for-sale securities are carried at fair value with unrealized gains and losses recorded as a component of comprehensive earnings and shareholders’ equity, net of deferred income taxes.
The probability that we will recover the entire amortized cost basis of our fixed income securities prior to maturity or
Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, rather than being netted with the related liabilities, since reinsurance does not relieve us of our liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and settlement expenses impact the estimates for the ceded portion of such liabilities. We continually monitor the financial condition of our reinsurers. As part of our monitoring efforts, we review their annual financial statements, Securities and Exchange Commission (SEC) filings for those reinsurers that are publicly traded, A.M. Best and S&P rating developments and insurance industry developments that may impact the financial condition of our reinsurers. In addition, we subject our reinsurance recoverables to detailed recoverability tests, including one based on average default by S&P rating. Based upon our review and testing, 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.
Consolidated revenue, as displayed in the table that follows, totaled $797.2 million for 2017, compared to $816.3 million for 2016 and $794.6 million in 2015.
for 2017 and 2016 included $3.4 million and $7.2 million, respectively, of non-cash realized losses on goodwill and definite-lived intangible asset impairments, while 2015 reflects a $6.7 million gain related to the sale of RLI Indemnity Company.
Equity in earnings of unconsolidated investees totaled $17.2 million in 2017. Maui Jim contributed $14.4 million, up from $9.7 million and $9.9 million in 2016 and 2015, respectively. The remaining $2.8 million of equity in earnings of
unconsolidated investees relates to our equity investment in Prime, up from $1.1 million and $1.0 million in 2016 and 2015, respectively.
While overall pricing in our portfolio remained flat in 2017, we achieved top line growth of 1 percent during the year. New product initiatives within our casualty segment, coupled with modest rate increases on some casualty lines, more than offset the negative impact to premium from transportation re-underwriting, depressed pricing for catastrophe exposed business and product exits in recent years. These exits included RV and treaty reinsurance in 2016. Excluding the impact of these exits, gross premiums written for 2017 increased 4 percent.
Gross premiums written from the casualty segment totaled $585.4 million, up 4 percent in 2017, following increases of 8 percent in 2016 and 2015. The segment was able to grow its top line during 2017 despite a 13 percent decline from transportation, which occurred as a result of ongoing re-underwriting efforts during much of the year. Re-underwriting actions began during the fourth quarter of 2016 in response to higher commercial auto loss trends, and resulted in a combination of rate increases on retained accounts and exits from certain underperforming classes of business. Transportation re-underwriting was completed during the latter part of 2017 with price increases obtained across all classes, in particular for commercial auto. While down on a full year basis, an increase in gross premiums written was posted by transportation in the fourth quarter of 2017. This business posted growth of 16 percent and 27 percent, respectively, in the two previous years.
Notwithstanding transportation, all products within the segment posted top line growth. Growth was led by other casualty, most notably our assumed reinsurance business with Prime and recently launched general binding authority (GBA) business. Gross premiums written have more than doubled for Prime, up $16.2 million during 2017, while GBA contributed $5.8 million. The growth from Prime follows 18 percent and 11 percent increases in 2016 and 2015, respectively, due to expansion into new classes of business. Exposure growth from both mature and newer products led to premium increases within our executive products and general liability lines. Gross premiums written were up 8 percent in 2017 for executive products, driven by growth from newer products such as cyber liability. This growth more than offset a continued trend of lower prices for executive products offerings, as low single digit rate declines have been experienced in each of the past three years. General liability growth was 4 percent and 5 percent in 2017 and 2016, respectively, due to exposure growth from new product initiatives such as energy casualty and mortgage reinsurance that were launched in 2016. Growth from general liability was achieved despite pricing that has continued to trend slightly lower in recent years. Umbrella also posted a modest top line increase, up 2 percent, as both commercial and personal accounts contributed to growth during 2017. This result reflects slightly improved pricing for all coverages, as well as exposure growth attributable to our new energy casualty offering. Except
for a small decline in commercial umbrella rates during 2015, pricing has been flat to slightly up for each of the past three years across our umbrella businesses, and has contributed to continued growth in gross premiums over these periods.
Other products contributing to growth included small commercial and medical professional liability. Small commercial posted premium growth of 4 percent for 2017, after increasing 7 percent and 14 percent in 2016 and 2015, respectively. The growth in each of these years was exposure driven as prices for these coverages have been flat to down slightly over this timeframe. Medical professional liability premiums increased modestly during 2017, due to exposure growth from health care liability coverages within the group, which more than offset ongoing price declines and competitive pressures in other coverages. Premiums were flat for our professional services group during 2017, following modest growth achieved in 2016 and 2015. Professional services continued to benefit from improved pricing, in particular for our architects and engineers lines, consistent with trends seen in these lines over the two previous years.
The market for our E&S property coverages continued to be challenging in 2017. While the losses from Hurricanes Harvey, Irma and Maria have had a positive impact on prices for wind-exposed catastrophe coverages, the overall market remains flush with capital, which may limit the duration and magnitude of further price strengthening. Following the spike in hurricane activity, renewal rates on catastrophe coverages improved, with wind-exposed accounts showing mid-single digit increases during the fourth quarter of 2017. Although rate change on wind and earthquake exposed catastrophe coverages remained negative on a year-to-date basis, the rate of decline was slower than that of recent years. By comparison, low double digit rate decreases were experienced throughout 2016 and 2015. In total, our commercial property business was able to achieve a flat top line in 2017, as modest exposure growth served to offset rate declines from the catastrophe exposed coverages. This result follows declines of 9 percent in 2016 and 2015. Marine contributed significantly to growth during the year, up 13 percent due to a combination of exposure growth and modestly higher prices for inland marine. Premiums from marine were down 2 percent in 2016 after increasing slightly in 2015, with results for each of those periods reflecting slightly improved pricing.
Specialty personal lines include property coverage for Hawaii homeowners, which posted a 7 percent increase in gross premiums written during 2017, after increasing 8 percent in 2016 and flat in 2015. Growth from this line has been primarily exposure driven as rates have been relatively flat over this timeframe. Specialty personal offerings also included our RV product, which we exited at the end of 2016 due to under performance. RV accounted for less than $1.0 million in gross premiums written in 2017, compared to $10.4 million and $13.4 million during 2016 and 2015, respectively. From an underwriting income standpoint, the exit from RV is expected to benefit property segment results, as this product sustained underwriting losses in each year of operation. Other property, which includes reinsurance premiums, has also declined in 2017 due to recent product exits. Premiums in 2016 related specifically to our treaty reinsurance business, while the results prior to 2016 included both treaty and facultative reinsurance. Facultative reinsurance was discontinued in 2015. In the latter part of 2016, we also discontinued our treaty reinsurance offering, due to a combination of lack of scale, increased loss activity and unfavorable market conditions.
Gross premiums written from our surety segment declined 3 percent in 2017, following modest growth of 2 percent and 6 percent in 2016 and 2015, respectively. The decline in the current year resulted from decreases within each of our surety products. Miscellaneous surety was down 4 percent, largely due to targeted reductions to select programs during the year. This product posted steady increases in the two preceding years, with both new and existing programs contributing to the growth in those periods. Contract surety was also down 4 percent in 2017, as certain accounts which no longer met our underwriting appetite were non-renewed. Contract surety was up 5 percent in 2016 due largely to growth from bonds targeted to smaller contractors, following a period of slight decline in the year prior. Commercial surety was down slightly in 2017 as efforts to selectively trim the portfolio continued. These efforts to upgrade the portfolio in favor of retaining higher quality, lower risk accounts began in 2016, and also led to a decline in that period. Commercial surety was up 7 percent in 2015. For energy surety, similar efforts to upgrade the portfolio have taken place over the past year. These activities, combined with the impact
of continued lower energy prices and soft market conditions, contributed to the 6 percent decline in 2017. Gross premiums written from energy surety for 2016 were up slightly, following an 8 percent increase achieved in 2015 as we capitalized on opportunities provided by energy industry consolidation.
Underwriting income for the casualty segment was $3.9 million in 2017, which translates into a combined ratio of 99.2. The current accident year combined ratio in 2017 was higher than prior years, primarily due to higher loss ratio selections on transportation and other auto-related exposures. Changes in mix of business, due in part to growth from more recent product launches, has also served to increase the current accident year loss ratio since we take a conservative approach to loss ratio selection for new products. Slightly higher catastrophe losses also impacted results in 2017, as hurricane losses were sustained during the year on certain casualty-oriented products that include ancillary property exposures.
Comparatively, overall results for the casualty segment in 2016 included favorable development of $32.4 million, with the bulk of the development attributable to general liability, executive products, small commercial and umbrella across accident years 2009 through 2015. For 2015, results included favorable development of $45.7 million, with the bulk of the development related to accident years 2006 through 2014. Most product lines within the segment experienced favorable development, with general liability, umbrella and small commercial representing the majority of the release.
The segment’s loss ratio was 63.9 in 2017, compared to 57.1 in 2016 and 53.0 in 2015. The loss ratio increased in 2017 due in part to the lower benefit from favorable development on prior years’ reserves. A higher current accident year loss ratio also contributed to the increase during 2017, due to shifts in product mix, higher loss ratio selections and modest amount of catastrophe losses mentioned above. From a current accident year standpoint, 2016 and 2015 reflected positive underwriting performance. The expense ratio for the casualty segment was 35.3 in 2017, compared to 34.9 in 2016 and 35.8 in 2015. An additional $3.9 million of incentive and profit-sharing expenses was recognized in connection with tax reform benefits during 2017, accounting for nearly 1 point of the expense ratio. Adjusting for this one-time impact, the expense ratio has trended lower in the past three years, as the increase in premiums has allowed for improved leveraging of our expense base.
Partially offsetting the catastrophe losses described above, favorable development in prior years’ reserves benefited underwriting results in each of the past three years. Results for 2017 included $12.1 million of favorable development in prior years’ reserves, largely from marine and commercial property, compared to $4.8 million and $11.8 million in 2016 and 2015, respectively. Marine and other property reinsurance were drivers of the favorable development during 2016 and 2015, with each year partially offset by adverse development from RV.
The segment’s loss ratio was 61.5 in 2017 compared to 46.9 in 2016 and 40.9 in 2015. The record catastrophe losses in 2017 added nearly 28 points to the loss ratio, compared to 10 points and 7 points of impact from catastrophe losses in 2016 and 2015, respectively. Higher current accident year losses from our fire business also contributed to the loss ratio increase in 2017. These items were partially offset by approximately 7 points of favorable development on prior years’ reserves in 2017, compared to 1 point and 6 points of benefit in the two previous years. Results for 2015 reflected the improved current accident year loss ratio performance resulting from marine re-underwriting efforts. The expense ratio for the property segment was 47.1 in 2017 compared to 44.7 in 2016 and 42.2 in 2015. An additional $1.8 million of incentive and profit-sharing expenses was recognized in connection with tax reform benefits during 2017, which added approximately 1 point to the expense ratio. Beyond this one-time impact in 2017, the expense ratio has trended higher in the past three years, driven largely by the overall decline in earned premium and the relative fixed nature of certain expenses.
Underwriting income totaled $34.8 million in 2017, which translates into a combined ratio of 71.2. Underwriting performance for each of the past three years reflects a combination of positive current accident year results and favorable development in prior accident years’ loss reserves. From a current accident year standpoint this segment has continued to deliver strong performance, with each product line contributing underwriting profit. The current accident year combined ratio result in each of the past three years has been in the low 80s, though the result for 2016 was slightly higher due to increased current accident year losses from energy surety and contract surety. While all years benefited from favorable development in prior years’ reserves, the amount of favorable development was higher during 2017. Results for 2017 included $9.3 million of favorable development in prior years’ reserves, compared to $4.8 million and $7.9 million in 2016 and 2015, respectively.
The after-tax yield reflects the different tax rates applicable to each category of investment. Our taxable fixed income securities are subject to our corporate tax rate of 35.0 percent, our tax-exempt municipal securities are subject to a tax rate of 5.3 percent and our dividend income is generally subject to a tax rate of 14.2 percent. During 2017, the average after-tax yield on the taxable fixed income portfolio was 2.1 percent, the same as the prior year, while the average after-tax yield on the tax-exempt portfolio decreased to 2.4 percent.
Despite bond prices falling during the final quarter of the year, the fixed income portfolio increased by $67.0 million during the year as the majority of operating cash flows were used for fixed income purchases. The tax-adjusted total return on a mark-to-market basis was 4.4 percent. Due to strong equity market returns in 2017, our equity portfolio increased by $31.3 million to $400.5 million. The total return for the year on the equity portfolio was 15.8 percent.
We realized a total of $4.4 million in net gains in 2017. Included in this number is $10.3 million in net realized gains in the equity portfolio, $1.7 million in net realized losses in the fixed income portfolio and $4.2 million in other net realized losses, $3.4 million of which related to a non-cash impairment charge on goodwill and definite-lived intangibles. In 2016, we realized $34.6 million in net gains. Included in this number is $38.7 million in net realized gains in the equity portfolio, $4.2 million in net realized gains in the fixed income portfolio and $8.3 million in other net realized losses, $7.2 million of which related to a non-cash impairment charge on goodwill. In 2015, we realized $39.8 million in net gains. Included in this number is $22.1 million in net realized gains in the equity portfolio, $10.8 million in net realized gains in the fixed income portfolio and $6.9 million in other net realized gains related to the sale of RIC.
As of December 31, 2017, our investment portfolio had the following asset allocation breakdown:
Fixed income represented 78 percent of our total 2017 portfolio, down 1 percent from 2016. As of December 31, 2017, the fair value of our fixed income portfolio consisted of 38 percent AAA-rated securities, 28 percent AA-rated securities, 17 percent A-rated securities, 11 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities. This compares to 35 percent AAA-rated securities, 30 percent AA-rated securities, 18 percent A-rated securities, 11 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities in 2016.
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, 2017, our fixed income portfolio’s duration was 5.0 years.
Our equity portfolio had a fair value of $400.5 million at December 31, 2017, entirely classified as available-for-sale. Equities comprised 19 percent of our total 2017 portfolio, up 1 percent over 2016. Securities within the equity portfolio are well diversified and are primarily invested in large-cap issues with a focus on dividend income. Our strategy is value oriented and security selection takes precedence over market timing. Likewise, low turnover throughout our long investment horizon minimizes transaction costs and taxes.
As of December 31, 2017, our fixed income portfolio had the following rating distributions:
When making investments in MBS/ABS/CMBS, we evaluate the quality of the underlying collateral, the structure of the transaction (which dictates how any losses in the underlying collateral will be distributed) and prepayment risks. All of our collateralized securities carry the highest credit rating by one or more major rating agencies and continue to pay according to contractual terms. We had $4.4 million in unrealized losses in these asset classes as of December 31, 2017.
As of December 31, 2017, municipal bonds totaled $636.2 million (38 percent) of our fixed income portfolio, compared to $627.3 million (39 percent) as of December 31, 2016. 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, 2017, approximately 43 percent of the municipal fixed income securities in the investment portfolio were GO and the remaining 57 percent were revenue based. Eighty-eight percent of our municipal fixed income securities were rated AA or better, while 99 percent were rated A or better.
The following table illustrates our corporate debt exposure to the financial and non-financial sectors as of December 31, 2017, including fair value, cost basis and unrealized gains and losses:
We believe corporate debt investments add diversification and additional yield to our portfolio. Because corporates make up a large portion of the fixed income opportunity set, the corporate debt investments will continue to be a significant part of our investment program.
As of December 31, 2017, our equity portfolio totaled $400.5 million (19 percent) of the investment portfolio, compared to $369.2 million (18 percent) as of December 31, 2016. 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 broadly diversified, exchange traded funds (ETFs) that represent market indexes similar to the Russell 1000 Index, the S&P 500 Index, and the S&P 500 Utilities Index. No one fund makes up more than 50 percent of the ETF allocation, and the philosophy mirrors that of the actively managed equity portfolio, with a preference for dividend income and lower anticipated volatility than the market (as measured by the S&P 500). We did not recognize any impairment losses in the equity portfolio during 2017 or 2016.
required return, resulting in the accrual of executive bonuses. Increased levels of comprehensive earnings in 2017 resulted in higher variable compensation earned. In addition, other general corporate expenses were up due to certain non-recurring expenses.
Except for the following two aspects, we have completed the accounting for the tax effects of the enactment of the TCJA as of December 31, 2017. First, we provisionally recorded $2.3 million in deferred tax expense for an expected disallowance of deductions related to certain performance based compensation, including bonuses and stock options. As there is a lack of clarity on whether some amounts could be grandfathered in as deductible, we were unable to complete our analysis. Once the IRS provides more guidance on the deductibility of certain compensation classes, we will finalize the tax expense adjustments for this aspect of the TCJA changes. Second, the IRS has not yet published the factors for us to calculate the discount on loss reserves under the basis required by the TCJA. Although there is currently no net impact from the tax law changes, the gross deferred tax assets will likely increase as the discounting factors are expected to delay the deductibility of loss reserves. Once the revised discount factors are obtained, we can implement the new discounting methodology related to this aspect of the TCJA changes and will recognize the adjustment ratably over the allowed eight-year period beginning in 2018.
Our net earnings include equity in earnings of unconsolidated investees, Maui Jim and Prime. The investees do not have a policy or pattern of paying dividends. As a result, we record a deferred tax liability on the earnings at the recently revised corporate capital gains rate of 21 percent in anticipation of recovering our investments through means other than through the receipt of dividends, such as a sale. In the fourth quarter of 2017, Maui Jim gave notification that a $9.9 million dividend would be paid in January 2018. Even though no dividend was received in 2017, we were aware that the lower tax rate applicable to affiliated dividends (7.35 percent in 2018) would be applied when the dividend was paid in 2018 and we therefore recorded a $1.4 million tax benefit in 2017. We received a $9.9 million dividend from Maui Jim in the fourth quarter of 2016 and recognized a $2.8 million tax benefit from applying the lower tax rate applicable to affiliated dividends (7 percent in 2016), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. No dividends were received from unconsolidated investees in 2015. Standing alone, the dividend resulted in a 1.6 percent and 1.8 percent reduction to the 2017 and 2016 effective tax rates, respectively.
In addition, our pretax earnings in 2017 included $25.4 million of investment income that is partially exempt from federal income tax, compared to $24.9 million and $25.1 million in 2016 and 2015, respectively.
Loss and settlement expense reserves represent our best estimate of the ultimate cost of settling reported and unreported claims and related expenses. As discussed previously, the estimation of loss and loss expense reserves is based on various complex and subjective judgments. Actual losses and settlement expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the payments due by periods are based on our historical claims payment experience. Due to the uncertainty inherent in the process of estimating the timing of such payments, there is a risk that the amounts paid in any period can be significantly different than the amounts disclosed above. Amounts disclosed above are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable on unpaid loss and settlement reserves are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not discharge us of our liability to policyholders. Reinsurance balances recoverable on unpaid loss and settlement reserves totaled $302.0 million at December 31, 2017, compared to $288.2 million in 2016.
Additionally, two of our insurance companies, RLI Ins. and Mt. Hawley, are members of the Federal Home Loan Bank of Chicago (FHLBC). Membership in the Federal Home Loan Bank system provides both companies access to an additional source of liquidity via a secured lending facility. Based on qualifying assets at year end, aggregate borrowing capacity is
We believe that cash generated by operations, cash generated by investments and cash available from financing activities will provide sufficient sources of liquidity to meet our anticipated needs over the next 12 to 24 months. We have consistently generated positive operating cash flow. The primary factor in our ability to generate positive operating cash flow is underwriting profitability, which we have achieved for 22 consecutive years.
Our 167th consecutive dividend payment was declared in February 2018 and will be paid on March 20, 2018, in the amount of $0.21 per share. Since the inception of cash dividends in 1976, we have increased our annual dividend every year.
reserve releases were smaller and the industry continued to experience an increase in loss cost inflation across several casualty lines.
As 2017 progressed, we saw a strengthening economy which increased underlying exposures and demand for insurance. We expect the recently passed tax reform to add further fuel to economic expansion, in addition to benefitting our bottom line in 2017 and beyond. This, coupled with the potential additional investments in the country’s infrastructure, could positively impact the construction industry, which a third of our insurance and surety businesses protect.
Our portfolio exhibited strong total return results again in 2017 as tighter credit spreads in fixed income insulated the portfolio from the uplift in short term Treasury yields. We were pleased to establish a positive net investment income result over several quarters and expect that profile to be supported by our invested asset base and overall market yields. The equity portfolio finished the year with double digit returns, however, conservatism and positioning in our strategy left us behind the S&P 500 for the calendar year.
Capital markets volatility was markedly muted during 2017, while returns were fairly robust. On the heels of a presidential election cycle, markets moved in one cohesive uptrend for most of the last twelve months based on optimism for fiscal stimulus, the potential for growth and the possibility of lower levels of Federal regulation. Throughout the year, gross domestic product shifted to levels above recent averages and the unemployment rate steadily declined. In this relatively robust macroeconomic setting, the U.S. central bank found enough rationale to raise short term rates on three occasions in 2017. Confidence in annual growth for the new year will likely perpetuate a trend of Federal Reserve tightening despite few signs of inflation. With short term interest rates reacting to monetary policy, two-year Treasury yields increased by nearly 0.7 percent during the year and the differential between short term and long term rates compressed significantly. Unless inflation expectations move higher, this ‘flat’ yield curve condition should persist in 2018. Any expectations that prices and wages accelerate, will be met with higher long term yields.
A delicate transition from monetary policy stimulus to one centered in fiscal policies has begun and market expectations are high for a smooth hand-off. Although, corporate fundamentals will be the standard bearer for the efficacy of tax reform in 2018, the second order impacts on consumer spending and medium-term growth have significant potential. Regardless of outcome, our strategy will continue to support insurance operations through investment income and sponsor long-term growth in book value through surplus-assigned strategies.
ASU 2016-09 was issued to simplify the accounting for share-based payment awards. The guidance requires that, prospectively, all tax effects related to share-based payments be made through the income statement at the time of settlement as opposed to excess tax benefits being recognized in additional paid-in capital under the previous guidance. The ASU also removes the requirement to delay recognition of a tax benefit until it reduces current taxes payable. This change is required to be applied on a modified retrospective basis, with a cumulative-effect adjustment to opening retained earnings. Additionally, all tax related cash flows resulting from share-based payments are to be reported as operating activities on the statement of cash flows, a change from the previous requirement to present tax benefits as an inflow from financing activities and an outflow from operating activities. Finally, entities will be allowed to withhold an amount up to the employees’ maximum individual tax rate (as opposed to the minimum statutory tax rate) in the relevant jurisdiction without resulting in liability classification of the award. The change in withholding requirements will be applied on a modified retrospective approach.
As most of our assets and liabilities associated with a reporting unit are measured at fair value, the impact of measuring the impairment at the reporting unit level rather than at the goodwill asset level was believed to be minimal.
This ASU was issued to improve the recognition and measurement of financial instruments. The new guidance makes targeted improvements to GAAP as follows:
Simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment;
Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet;
Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes;
This ASU is effective for annual and interim reporting periods beginning after December 15, 2019. Early adoption is permitted beginning after December 15, 2018. Upon adoption, the update will be applied using the modified-retrospective approach, by which a cumulative-effect adjustment will be made to retained earnings as of the beginning of the first reporting period presented. We do not have any assets measured at amortized cost that would be impacted by this update. Additionally, as our fixed income portfolio is weighted towards higher rated bonds (83 percent rated A or better and 66 percent rated AA or better at December 31, 2017) and we purchase reinsurance from financially strong reinsurers, we do not expect that our credit losses will be material.
ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments
ASU 2016-15 was issued to reduce the diversity in practice of how certain cash receipts and payments, for which current guidance is silent, are classified in the statement of cash flows. The update addresses eight specific issues, including contingent consideration payments made after a business combination, distributions received from equity method investees and the classification of cash receipts and payments that have aspects of more than one class of cash flows. This ASU is effective for annual and interim reporting periods beginning after December 15, 2017. Upon adoption, the update will be applied using the retrospective transition method. We do not expect a material impact on our statement of cash flows.
This ASU is effective for annual and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. As the adoption of ASU 2016-01 in 2018 will result in the reclassification of the entire unrealized balance on equity securities from AOCI into retained earnings, only the stranded tax effects on the unrealized balances of our fixed income securities and equity method investees will be impacted. Upon adoption of ASU 2018-02, a $4.1 million reclassification of the remaining stranded tax effects will be applied in the period of adoption or retrospectively to each period in which the effects of the TCJA changes are recognized. As there is no income statement impact and the balance sheet effect is limited to a reclassification within the equity section, there will not be a material impact to our financial statements.
Debt and equity securities purchased for short-term resale are classified as trading securities. These securities are reported at fair value with unrealized gains and losses included in earnings. We do not hold any debt securities classified as trading.
Approximately $66.3 million of undistributed earnings from Maui Jim are included in our retained earnings as of December 31, 2017. In 2016, we received dividends of $9.9 million from Maui Jim. No dividends were received in 2017 or 2015.
The definite-lived intangible assets are amortized against future operating results based on their estimated useful lives. Amortization of intangible assets was $0.7 million, $0.9 million and $0.9 million for 2017, 2016 and 2015, respectively. We anticipate we will recognize amortization expense of $0.5 million in 2018, 2019 and 2020, $0.2 million in 2021 and $0.1 million in 2022. In addition to the aforementioned $1.8 million reduction due to the medical professional liability impairment, the asset sale of an agency in 2017 also reduced the definite-lived intangibles by $1.0 million.
We file a consolidated federal income tax return. Federal income taxes are accounted for using the asset and liability method under which deferred income taxes are recognized for the tax consequences of temporary differences by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities, operating losses and tax credit carry forwards. The effect on deferred taxes for a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some of the deferred tax assets will not be realized.
Our comprehensive earnings include net earnings plus unrealized gains/losses on our available-for-sale investment securities, net of tax. In reporting the components of comprehensive earnings, we used a 35 percent tax rate. Other comprehensive income (loss), as shown in the consolidated statements of earnings and comprehensive earnings, is net of tax expense (benefit) of $19.0 million, $(0.6) million and $(25.3) million for 2017, 2016 and 2015, respectively.
The following table illustrates the changes in the balance of each component of accumulated other comprehensive earnings for each period presented in the consolidated financial statements:
The sale or other-than-temporary impairment of an available-for-sale security results in amounts being reclassified from accumulated other comprehensive earnings to current period net earnings. The effects of reclassifications out of accumulated other comprehensive earnings by the respective line items of net earnings are presented in the following table:
Corporate, Agencies, Government and Municipal Bonds: The pricing vendor employs a multi-dimensional model which uses standard inputs including (listed in approximate order of priority for use) benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, market bids/offers and other reference data. The pricing vendor also monitors market indicators, as well as industry and economic events. All bonds valued using these techniques are classified as Level 2. All Corporate, Agencies, Government and Municipal securities are deemed Level 2.
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, pre-payment 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.
environments. If the actual amount of insured losses is greater than the amount we have reserved for these losses, our profitability could suffer.
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 2017, for this coverage, we had reinsurance protection of $300 million in excess of $25 million first-dollar retention for earthquakes in California and $325 million in excess of a $25 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 retentions. Our second largest catastrophe exposure is to losses caused by wind storms to commercial properties throughout the Gulf and East Coasts, as well as to homes we insure in Hawaii. In 2017, these coverages were supported by $225 million in excess of a $25 million first-dollar retention in traditional catastrophe reinsurance protection, subject to certain co-participations by us in the excess layers. In addition, we have incidental exposure to international catastrophic events.
Our catastrophe reinsurance treaty renewed on January 1, 2018. We purchased the same limits over the same first-dollar retention amounts outlined above, subject to certain retentions by us in the excess layers. We actively manage our catastrophe program to keep our net retention in line with risk tolerances and to optimize the risk/return trade off.
We made loss and settlement expense payments on environmental liability claims and have loss and settlement expense reserves for others. We include this historical environmental loss experience with the remaining loss experience in the applicable line of business to project ultimate incurred losses and settlement expenses as well as related incurred but not reported (IBNR) loss and settlement expense reserves.
Assets measured at fair value on a recurring basis as of December 31, 2016, 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, 2017 and 2016. Additionally, there were no securities transferred in or out of levels 1 or 2 during 2017 or 2016.
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, 2017 and 2016:
Gross unrealized losses in the corporate bond portfolio decreased to $1.7 million in 2017 from $5.7 million at the end of 2016 as credit spreads remained at historically tight levels during the year. The corporate bond portfolio has an overall rating of BBB+.
As of December 31, 2017, municipal bonds totaled $636.2 million with gross unrealized losses of $1.3 million. Unrealized losses decreased during the year due to strong investor demand for the sector. As of December 31, 2017, approximately 43 percent of the municipal fixed income securities in the investment portfolio were general obligations of state and local governments and the remaining 57 percent were revenue based. Eighty-eight percent of our municipal fixed income securities were rated AA or better while 99 percent were rated A or better.
As of December 31, 2017, outstanding debt balances totaled $148.9 million, net of unamortized discount and debt issuance costs, 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 was $160.3 million as of December 31, 2017. The fair value of our long-term debt is based on the limited observable prices that reflect thinly traded securities and is therefore classified as a level 2 liability within the fair value hierarchy.
We incurred $7.4 million of interest expense on our senior notes in each of the last three years. The average rate on debt was 4.91 percent in 2017, 2016 and 2015.
We maintain a revolving line of credit with JP Morgan Chase Bank N.A., which permits us to borrow up to an aggregate principal amount of $40.0 million. This facility was entered into during the second quarter of 2014 and replaced the previous $25.0 million facility which expired on May 31, 2014. Under certain conditions, the line may be increased up to an aggregate principal amount of $65.0 million. This facility has a four-year term that expires on May 28, 2018. As of and during the years ended December 31, 2017, 2016 and 2015, no amounts were outstanding on these facilities.
addition, we subject our reinsurance recoverables to detailed recoverability tests, including a segment based analysis using the average default rating percentage by S&P rating, which assists us in assessing the sufficiency of the existing allowance. Additionally, we perform an in-depth reinsurer financial condition analysis prior to the renewal of our reinsurance placements.
The differences from our initial reserve estimates emerged as changes in our ultimate loss expectations as we performed 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.
A discussion of significant components of reserve development for the three most recent calendar years follows:
2017. We experienced favorable emergence relative to prior years’ reserve estimates in all of our segments during 2017. The casualty segment contributed $17.5 million in favorable development, inclusive of unallocated loss and adjustment expenses (ULAE). Accident years 2014, 2015 and 2016 contributed significantly to the favorable development. This was predominantly caused by favorable frequency and severity trends that continued to be better 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. Within the primary occurrence grouping, the general liability product contributed $4.6 million to our favorable development with all coverages contributing to the favorable development in 2017. Small commercial products were the second largest contributor with $3.2 million in favorable development. Within the excess occurrence grouping, personal and commercial umbrella were favorable by $1.1 million and $9.9 million, respectively. Within the claims made grouping, our executive products had favorable contributions of $4.4 million, while medical professional liability was adverse $3.7 million. Transportation was adverse $7.4 million for the year, but posted favorable experience during the last three quarters of the year.
2016. We experienced favorable emergence relative to prior years’ reserve estimates in all of our segments during 2016. The casualty segment contributed $32.4 million in favorable development, inclusive of ULAE, which is excluded from the incurred loss and loss adjustment expense tables above. Accident year 2015 contributed significantly to the favorable development, with accident years 2010 to 2014 also continuing to develop favorably. The favorable development in 2016 was smaller than 2015 but continued to reflect favorable frequency and severity trends. In addition, the risk selection by our underwriters continued to provide better results than estimated in our reserving process. Within the primary occurrence grouping, the general liability product contributed $17.6 million to our favorable development. Small commercial products were favorable by $6.2 million. Within the excess occurrence grouping, commercial umbrella was favorable by $13.8 million which was offset by adverse development in our personal umbrella product of $4.9 million. Within the claims made grouping, executive products contributed $14.7 million in favorable development and miscellaneous professional liability had $0.8 million of favorable development. Transportation experienced unfavorable development of $15.4 million as adverse commercial loss trends resulted in an increase in case reserves for accident years 2013 through 2015.
Marine contributed $2.1 million of the $4.8 million total favorable property development, inclusive of ULAE. Accident years 2013 through 2015 contributed to the marine products’ favorable development. Assumed property contributed $2.5 million of favorable development offsetting the unfavorable development of $0.2 million in other direct property products.
million, respectively. Miscellaneous surety had favorable development of $1.1 million and contract surety had favorable development of $0.1 million.
Our effective tax rates were -24.2 percent, 26.8 percent and 30.1 percent for 2017, 2016 and 2015, respectively. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate was significantly lower in 2017, primarily as the result of recent tax reform. Additionally, catastrophic losses incurred in the third quarter resulted in significantly lower pretax earnings and the change in accounting for excess tax benefits on share-based compensation further decreased the effective tax rate.
The Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law on December 22, 2017. Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. As a result, we revalued deferred tax items as of year-end 2017 to reflect the lower rate. The revaluation reduced our net deferred tax liability and income tax expense by $32.8 million and decreased the effective tax rate by 38.8 percent.
We have recorded our deferred tax assets and liabilities using the statutory federal tax rate of 21 percent. We believe it is more likely than not that all deferred tax assets will be recovered, given the carry back availability as well as the results of future operations, which will generate sufficient taxable income to realize the deferred tax asset. In addition, we believe when these deferred items reverse in future years, our taxable income will be taxed at an effective rate of 21 percent.
Although we are not currently under audit by the Internal Revenue Service (IRS), tax years 2014 through 2017 remain open and are subject to examination.
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 $12.5 million, $11.7 million and $11.6 million, for 2017, 2016 and 2015, respectively.
Annual awards are provided to executives, managers and associates through our incentive plans, provided certain financial and operational goals are met. Annual expenses for these incentive plans totaled $19.7 million, $19.2 million and $20.4 million for 2017, 2016 and 2015, respectively.
In 2017, the trusts purchased 7,464 shares of our common stock on the open market at an average price of $58.66 ($0.4 million). In 2016, the trusts purchased 6,702 shares of our common stock on the open market at an average price of $61.61 ($0.4 million). In 2015, the trusts purchased 9,348 shares of our common stock on the open market at an average price of $53.15 ($0.5 million). At December 31, 2017, the trusts’ assets were valued at $33.2 million.
In 2010, our shareholders approved the RLI Corp. Long-Term Incentive Plan (2010 LTIP), which provides for equity-based compensation and replaced the omnibus plan. In conjunction with the adoption of the 2010 LTIP, effective May 6, 2010, options were no longer granted under the omnibus plan. The 2010 LTIP provided for equity-based compensation, including stock options, up to a maximum of 4,000,000 shares of common stock (subject to adjustment for changes in our capitalization and other events). Between 2010 and 2015, we granted 2,878,000 stock options under the 2010 LTIP. The 2010 LTIP was replaced in 2015.
In 2015, our shareholders approved the 2015 RLI Corp. Long-Term Incentive Plan (2015 LTIP), which provides for equity-based compensation and replaced the 2010 LTIP. In conjunction with the adoption of the 2015 LTIP, effective May 7, 2015, options were no longer granted under the 2010 LTIP. Awards under the 2015 LTIP may be in the form of restricted stock, stock options (non-qualified only), stock appreciation rights, performance units as well as other stock-based awards. Eligibility under the 2015 LTIP is limited to employees and directors of the company or any affiliate. The granting of awards under the 2015 LTIP is solely at the discretion of the board of directors. The maximum number of shares of common stock available for distribution under the 2015 LTIP is 4,000,000 shares (subject to adjustment for changes in our capitalization and other events). Since the plan’s approval in 2015, we have granted 1,448,575 awards under the 2015 LTIP, including 497,825 in 2017.
Under the 2015 LTIP, as under the 2010 LTIP and omnibus plan, we grant stock options for shares with an exercise price equal to the fair market value of the shares at the date of grant (subject to adjustments for changes in our capitalization, including special dividends and other events as set forth in such plans). Options generally vest and become exercisable ratably over a five-year period and expire eight years after grant.
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 at the time 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 2016 and 2015, the aggregate intrinsic value of options exercised was $31.3 million and $32.1 million, respectively. 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 2016 and 2015 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 2017 as the intrinsic value of the options exercised was not as significant ($12.8 million). Therefore, the exercise of options in 2017 resulted in an increase to paid-in-capital. Prior to the adoption of FASB ASU 2016-09 in 2017, shareholders’ equity was also impacted by corporate tax deductions allowed as a result of option exercises. This tax benefit offset our current tax liability and was recorded as an increase to paid-in-capital. Beginning in 2017, all tax effects related to share-based payments are required to be recorded in net earnings and will directly impact our effective tax rate. See note 7 for the impact in 2017. For 2016 and 2015, refer to our consolidated statements of shareholders’ equity for the impact to paid-in capital from this tax benefit in those years.
On November 9, 2017, the board of directors declared a $1.75 per share special cash dividend to be paid on December 27, 2017, to shareholders of record at the close of business on November 30, 2017. Similarly, on November 10, 2016, the board of directors declared a $2.00 per share special cash dividend to be paid on December 23, 2016, to shareholders of record at the close of business on November 30, 2016. On November 12, 2015, the board of directors declared a $2.00 per share special cash dividend to be paid on December 22, 2015, to shareholders of record at the close of business on November 30, 2015. To preserve the intrinsic value of the options, the board also approved, pursuant to the terms of our various stock option plans, a proportional adjustment to the exercise price (equivalent to the special dividend) for all outstanding non-qualified options in relation to the 2015 special dividend. This adjustment 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 were approximately equal immediately before and after the adjustments. No adjustments were made in 2017 or 2016.
In 2017, 482,375 options were granted with an average exercise price of $57.12 and an average fair value of $8.00. Of these grants, 384,750 were granted at the board meeting in May with a calculated fair value of $7.91. We recognized $4.4 million of expense during 2017 related to options vesting. Since options granted under our plan are non-qualified, we recorded a deferred tax benefit of $1.5 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $5.7 million, which will be recognized over the remainder of the vesting period.
In 2016, 440,750 options were granted with an average exercise price of $63.54 and an average fair value of $11.38. Of these grants, 345,750 were granted at the board meeting in May with a calculated fair value of $11.42. We recognized $4.1 million of expense during 2016 related to options vesting. Since options granted under our plan are non-qualified, we recorded a deferred tax benefit of $1.4 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $6.2 million, which will be recognized over the remainder of the vesting period.
In 2015, 563,500 options were granted with an average exercise price of $49.01 and an average fair value of $9.25. Of these grants, 412,000 were granted at the board meeting in May with a calculated fair value of $8.94. We recognized $4.1 million of expense during 2015 related to options vesting. Since options granted under our plan are non-qualified, we recorded a deferred tax benefit of $1.4 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $5.7 million, which will be recognized over the remainder of the vesting period.
The risk-free rate was determined based on U.S. treasury yields that most closely approximated the option’s expected life. The dividend yield for 2017 was determined based on the average annualized quarterly dividends paid during the most recent
five-year period and incorporated a consideration for special dividends paid in recent history. The dividend yield in 2016 and 2015 was calculated based on the average annualized dividends paid during the most recent five-year period, exclusive of consideration for special dividends. The expected volatility was calculated based on the median of the rolling volatilities for the expected life of the options. The expected option life was determined based on historical exercise behavior and the assumption that all outstanding options will be exercised at the midpoint of the current date and remaining contractual term, adjusted for the demographics of the current year’s grant.
In addition to stock options, restricted stock units (RSUs) were granted for the first time in May 2017. RSUs have a grant date value equal to the closing stock price of the Company’s stock on the dates the shares are granted. Generally, these units have a three-year cliff vesting. For participants who become retirement eligible, defined by the plan as those individuals whose age and years of service equals 75, the units become fully vested. In addition, the RSUs have dividend participation which accrues and is settled in additional shares with all granted stock units at the end of the three-year period.
As discussed in note 1.A., our three insurance companies are subsidiaries of RLI Corp, with RLI Ins. as the first-level, or principal, insurance subsidiary. 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, 2017, our holding company had $853.6 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 unrestricted portion of holding company net assets is comprised primarily of
investments and cash, including $23.5 million in liquid assets, which approximates half of our annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and ordinary 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 access to capital markets.
Ordinary dividends, which may be paid by our principal insurance subsidiary without prior regulatory approval, are subject to certain limitations based upon statutory income, surplus and earned surplus. The maximum ordinary dividend distribution from our principal insurance subsidiary in a rolling 12-month period is limited by Illinois law to the greater of 10 percent of RLI Ins. policyholder surplus, as of December 31 of the preceding year, or the net income of RLI Ins. for the 12-month period ending December 31 of the preceding year. Ordinary dividends are further restricted by the requirement that they be paid from earned surplus. In 2017, 2016 and 2015, our principal insurance subsidiary paid ordinary dividends totaling $107.0 million, $123.6 million and $125.0 million, respectively, to RLI Corp. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the IDOI. No extraordinary dividends were paid in 2017, 2016 or 2015. Given the amount of dividends paid during the prior rolling 12-month period, the net assets of our principal insurance subsidiary are restricted until the end of the third quarter of 2018 and cannot be distributed to RLI Corp. without prior approval of the IDOI. However, in addition to the unrestricted liquid net assets that RLI Corp. had on hand as of December 31, 2017, RLI Corp. has other anticipated cash inflows and access to lines of credit that would cover normal annual holding company expenditures as they are incurred and become payable.
As of December 31, 2017, we also had $17.7 million of unfunded commitments related to our investment in a business development company, $7.2 million of unfunded commitments related to an investment in a global credit fund that specializes in consumer loans and $3.1 million of unfunded commitments related to our low income housing tax credit investments. See note 2 for more information on these investments.
segment is also subject to inflation risk and may be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses.
We have audited the accompanying consolidated balance sheets of RLI Corp. and subsidiaries (the “Company”) as of December 31, 2017 and 2016, the related consolidated statements of earnings and comprehensive earnings, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2017, and the related notes and financial statement schedules I to VI (collectively, the “consolidated financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report on Controls and Procedures. Our responsibility is to express an opinion on the Company’s consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.