We own five commercial buildings totaling 171,000 square feet on our 23-acre campus that serves as our corporate headquarters in Peoria, Illinois. All of our branch offices and other company operations lease office space throughout the country. Management considers our office facilities suitable and adequate for our current levels of operations.
On January 15, 2014, our stock split on a 2-for-1 basis. All share and per share data has been retroactively stated to reflect this split.
The foundation of our overall business strategy is to underwrite for profit in all market conditions and we achieved this for the 21st consecutive year in 2016, averaging an 87.4 combined ratio over that period of time. This drives our ability to provide shareholder returns in three different ways: the underwriting income itself, net investment income from our investment portfolio and long-term appreciation in our equity portfolio. Our investment strategy is based on preservation of capital as the first priority, with a secondary focus on generating total return. The fixed income portfolio consists primarily of highly-rated, diversified, liquid, investment-grade securities. Consistent underwriting income allows a portion of our investment portfolio to be invested in equity securities and other risk asset classes. Our equity portfolio consists of a core stock portfolio weighted toward dividend-paying stocks, as well as exchange traded funds (ETFs). Our minority equity ownership interests in Maui Jim, Inc. (Maui Jim), a manufacturer of high-quality sunglasses, and Prime Holdings Insurance Services, Inc. (Prime), a specialty E&S insurance company, has also enhanced returns. We have a diversified investment portfolio and closely monitor our investment risks. Despite periodic fluctuations in market value, our equity portfolio is part of a long-term asset allocation strategy and has contributed significantly to our historic growth in book value.
The casualty portion of our business consists largely of commercial umbrella, personal umbrella, general liability, transportation and executive products coverages, as well as package business and other specialty coverages, such as professional liability and workers’ compensation for office-based professionals. We also offer fidelity and crime coverage for commercial insureds and select financial institutions and medical and healthcare professional liability coverage in the excess and surplus market. The casualty business is subject to the risk of estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty 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.
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. We discontinued our crop and facultative reinsurance in 2015 as a result of challenging market conditions and began curtailing recreational vehicle and treaty reinsurance offerings at the end of 2016. 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 aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and maintaining policy terms and
conditions throughout market cycles. We also use computer-assisted modeling techniques to provide estimates that help us carefully manage the concentration of risks exposed to catastrophic events.
On February 5, 2014, we invested $5.3 million for a 20 percent equity ownership interest in Prime Holdings Insurance Services, Inc. (Prime). On March 4, 2015, we invested an additional $1.7 million, increasing our total equity ownership to 27 percent. Prime writes business through two Illinois domiciled insurance carriers, Prime Insurance Company, an excess and surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company.
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.
Unpaid losses and settlement expenses, as shown in the liabilities section of our balance sheets, represents the total obligations to claimants for both estimates of known claims and estimates for incurred but not reported (IBNR) claims. The related asset item, reinsurance balances recoverable on unpaid losses and settlement expense, is the estimate of known claims and estimates of IBNR that we expect to recover from reinsurers. The net of these two items is generally referred to as net unpaid loss and settlement expenses and is commonly used in our disclosures regarding the process of establishing these various estimated amounts.
In preparing the consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.
The amount by which estimated losses differ from those originally reported for a period is known as “development.” Development is unfavorable when the losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable developments of loss reserves in the results of operations in the period the estimates are changed.
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, 2016, make a reasonable provision to meet our future obligations.
Three times a year, estimates of the expected value of the unpaid loss and LAE are derived using standard actuarial methodologies. In addition, an emergence analysis is completed quarterly to determine if further adjustments are necessary. These estimates are then compared to the carried loss reserves to determine the appropriateness of the current reserve balance.
Given the substantial impact of the reserve estimates on our financial statements, we subject the reserving process to significant diagnostic testing and reasonability checks. In addition, there are data validity checks and balances in our front-end processes. Data anomalies are researched and explained to reach a comfort level with the data and results. Leading indicators such as actual versus expected emergence and other diagnostics are also incorporated into the reserving processes.
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, court interpretations of exclusionary language for mold and construction defect and debates over wind versus flood as the cause of loss from major hurricane events.
Fair value is defined as the price in the principal market that would be received for an asset to facilitate an orderly transaction between market participants on the measurement date.
We record deferred tax assets to the extent that temporary differences representing future deductible items exceed future taxable items. A significant amount of our deferred tax assets relate to expected future tax deductions arising from claim reserves and future taxable income related to changes in our unearned premium.
Consolidated revenue, as displayed in the table that follows, totaled $816.3 million for 2016, compared to $794.6 million for 2015 and $775.2 million in 2014.
Bonus and profit-sharing amounts earned by executives, managers and associates are predominately influenced by corporate performance including operating earnings, combined ratio and return on capital. Operating earnings refers to net earnings excluding after-tax net realized gains. Return on capital measures components of comprehensive earnings against a minimum required return on capital. Return on capital is the primary measure of executive bonus achievement and a significant component of manager and associate bonus targets. Bonus and profit sharing-related expenses attributable to the favorable reserve developments totaled $6.6 million, $11.0 million and $10.6 million for 2016, 2015 and 2014, respectively. These performance-related expenses impact policy acquisition, insurance operating and general corporate expenses line items in the financial statements. Partially offsetting the 2016, 2015 and 2014 increases were $2.6 million, $1.9 million and $1.1 million, respectively, in reductions to bonus and profit-sharing earned due to losses associated with natural catastrophe activity.
Equity in earnings of unconsolidated investees totaled $10.8 million in 2016, Maui Jim contributed $9.7 million, down slightly from the prior year. The remaining $1.1 million of equity in earnings of unconsolidated investees relates to our equity
investment in Prime which was consistent with 2015 results. Further discussion of the investment in Prime can be found in note 13 to the consolidated financial statements within Item 8, Financial Statement and Supplementary Data.
Despite these challenging market conditions, we were able to deliver solid results again in 2016. While overall pricing within our portfolio was flat during the year, we achieved top line growth of 2 percent. Certain products within our casualty book grew rate by low to mid single digits. In contrast, catastrophe exposed coverages in our property segment again experienced low double digit declines. While flat or declining primary market pricing has presented a challenge to gross premium production, we have benefitted from softer pricing in the reinsurance market. In each of the past three years, we have realized cost savings during our annual reinsurance renewals, while also expanding some coverage. The benefits realized were greater in 2015 and 2014, and as a result, net premiums written growth outpaced gross premiums written growth in each of those years.
Gross premiums written from the casualty segment totaled $560.3 million, up 8 percent in 2016, following increases of 8 percent and 6 percent in 2015 and 2014, respectively. The majority of products within the segment posted top line growth, driven by a combination of rate and exposure changes. Growth was led by transportation as favorable pricing has continued to contribute to improved top line performance. Rates for most transportation coverages have increased modestly in each of the past three years. Our medical professional liability business group also made significant contributions to overall growth in 2016, driven entirely by our healthcare liability offerings, which was launched in late 2014. The growth from healthcare liability more than offset an 8 percent decline in 2016 from our other medical professional liability lines, as falling prices continued to adversely impact results from those coverages. Small commercial posted premium growth in 2016, up 7 percent for the year, after achieving double digit growth in both 2015 and 2014. This growth was exposure driven as prices for these coverages have been flat in each of the past two years. For general liability, gross premiums written increased 5 percent, driven by new product initiatives in energy and high retention casualty, which were launched during 2016. Premiums from these new offerings served to more than offset overall price changes within general liability, which have continued to trend slightly lower in recent years.
premiums from executive products were down slightly in both 2015 and 2014, as well, as the market for these coverages, particularly for excess coverage, remained extremely competitive. New product offerings for cyber liability and transactional representations and warranty coverages were launched in the past two years, and served to partially offset the overall decline.
While the bulk of property segment business relates to commercial property and marine coverages, the segment also includes specialty personal lines and other property reinsurance programs. Specialty personal offerings include coverage for Hawaii homeowners, which posted an 8 percent increase in gross premiums written during the year, and our recreational vehicles (RV) product which we began phasing out at the end of 2016 due to poor performance. From a revenue standpoint, the exit will be relatively insignificant, as RV accounted for only $10.4 million, $13.4 million, and $16.1 million of gross premiums written during 2016, 2015 and 2014, respectively. From an underwriting income standpoint, the exit from RV is expected to benefit our property segment results, as this product has sustained underwriting losses in each of the past three years. Property reinsurance premiums in 2016 related specifically to our treaty reinsurance business, while the results prior to 2016 included both treaty and facultative reinsurance. As referenced above and disclosed in prior SEC filings, facultative reinsurance was discontinued in 2015. In the latter part of 2016, we also began the curtailment of our treaty reinsurance offering. The treaty product has struggled to achieve the scale necessary to generate profit, and the combination of increased loss activity and unfavorable market conditions has driven our decision to shrink this business.
The segment’s loss ratio was 57.1 in 2016, compared to 53.0 in 2015 and 52.1 in 2014. The loss ratio increased in 2016 due to the lower benefit from favorable development on prior years’ reserves. Excluding the impact of prior years’ reserve development, the loss ratio has been steady over the past three years. From a current accident year standpoint, both 2016 and 2015 reflected positive underwriting performance. The expense ratio for the casualty segment was 34.9 in 2016, improved from 35.8 in 2015 and 35.9 in 2014. While investments in expansion and new products have increased in recent years, the related increase in premiums has allowed for improved expense leverage and a lower trending expense ratio.
Underwriting income totaled $27.0 million in 2016, which translates into a combined ratio of 77.8. 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, though results for 2016 include higher current accident year losses from energy surety and contract surety. Despite the relatively higher losses sustained in 2016, the current accident year combined ratio result for each of the past three years has been in the low 80s.
During 2016, net investment income decreased by 3 percent. The decrease was primarily due to the lower average yield environment seen during 2016 compared to the previous year. Additionally, credit spreads declined across most fixed income sectors during the year, putting further pressure on reinvestment rates. The average annual yields on our investments were as follows for 2016, 2015 and 2014:
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 2016, the average after-tax yield on the taxable fixed income portfolio declined to 2.1 percent from 2.2 percent in 2015, while the average after-tax yield on the tax-exempt portfolio decreased 0.1 percent to 2.5 percent.
We regularly evaluate the quality of our investment portfolio. When we determine that a specific security has suffered an other-than-temporary decline in value, the investment’s value is adjusted by reclassifying the decline from unrealized to realized losses. This has no impact on shareholders’ equity. During 2016, we recognized $0.1 million in impairment losses. All losses were taken during the third quarter on fixed income securities we no longer had the intent to hold until recovery. We did not recognize any OTTI losses during 2015 or 2014.
As of December 31, 2016, we held four securities in our equity portfolio that were in unrealized loss positions. The total unrealized loss on these securities was $1.3 million. With respect to both the significance and duration of the unrealized loss positions, we have no equity securities in an unrealized loss position of greater than 20 percent for more than six consecutive months.
Fixed income represented 79 percent of our total 2016 portfolio, the same as in 2015. As of December 31, 2016, the fair value of our fixed income portfolio consisted of 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. This compares to 34 percent AAA-rated securities, 31 percent AA-rated securities, 17 percent A-rated securities, 12 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities in 2015.
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, 2016, our fixed income portfolio’s duration was 4.8 years.
Our equity portfolio had a fair value of $369.2 million at December 31, 2016, entirely classified as available-for-sale. Equities comprised 18 percent of our total 2016 portfolio, down from 19 percent in 2015. 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.
Our allocation to agency mortgage-backed securities totaled $284.1 million as of December 31, 2016. MBS represented 18 percent of the fixed income portfolio compared to $254.9 million or 17 percent of that portfolio as of December 31, 2015.
Variability in the average life of principal repayment is an inherent risk of owning mortgage-related securities. However, we reduce our portfolio’s exposure to prepayment risk by seeking characteristics that tighten the probable scenarios for expected cash flows. As of December 31, 2016, the MBS portfolio contained 76 percent of pure pass-throughs compared to 69 percent as of December 31, 2015. An additional 14 percent of the MBS portfolio was invested in planned amortization class CMOs (PACs), down from 17 percent in 2015.
An asset-backed security (ABS) or commercial mortgage-backed security (CMBS) is a securitization collateralized by the cash flows from a specific pool of underlying assets. These asset pools can include items such as credit card payments, auto loans and residential or commercial mortgages. As of December 31, 2016, ABS/CMBS investments were $93.9 million (6 percent) of the fixed income portfolio, compared to $91.9 million (6 percent) as of December 31, 2015. All of the securities in the ABS/CMBS portfolio were rated AAA as of December 31, 2016. We believe that ABS/CMBS investments add diversification and additional yield to the portfolio while often adding superior cash flow stability over mortgage pass-throughs or CMOs.
As of December 31, 2016, municipal bonds totaled $627.3 million (39 percent) of our fixed income portfolio, compared to $610.4 million (40 percent) as of December 31, 2015. 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, 2016, approximately 45 percent of the municipal fixed income securities in the investment portfolio were GO and the remaining 55 percent were revenue based. Eighty-seven percent of our municipal fixed income securities were rated AA or better, while 98 percent were rated A or better.
The amortized cost and fair value of fixed income securities at December 31, 2016, by contractual maturity, are shown as follows:
As of December 31, 2016, our equity portfolio totaled $369.2 million (18 percent) of the investment portfolio, compared to $375.4 million (19 percent) as of December 31, 2015. 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 2016 or 2015.
The following table illustrates the distribution by sector of our equity portfolio as of December 31, 2016, including fair value, cost basis and unrealized gains and losses:
In 2016 and 2014, we received dividends from Maui Jim. Dividends from Maui Jim have been irregular in nature and while they provide added liquidity when received, we do not rely on those dividends to meet our liquidity needs. While these
dividends do not flow through the investee earnings line, they do result in the recognition of a tax benefit, which is discussed in the income tax section that follows.
On February 5, 2014, we invested $5.3 million for a 20 percent equity ownership interest in Prime Holdings Insurance Services, Inc. (Prime). On March 4, 2015, we invested an additional $1.7 million, increasing our total equity ownership to 27 percent. Prime writes business through two Illinois domiciled insurance carriers, Prime Insurance Company, an excess and surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company. As a minority shareholder, we are subject to the decisions of the controlling shareholder, which may impact the value of our investment. In 2016, we recorded $1.1 million in investee earnings from this investment compared to $1.0 million in 2015 and $0.3 million in 2014. Additionally, we entered into a 25 percent quota share reinsurance treaty with Prime, effective January 1, 2014, which contributed to $13.4 million of gross premiums written and $11.4 million of net premiums earned during 2016 compared to $11.3 million of gross premiums written and $10.9 million of net premiums earned during 2015 and $10.2 million of gross premiums written and $5.3 million of net premiums earned during 2014.
Dividends paid to our Employee Stock Ownership Plan (ESOP) also result in a tax deduction. Special dividends paid to the ESOP in 2016, 2015 and 2014 resulted in tax benefits of $2.4 million, $2.5 million and $3.6 million, respectively. These tax benefits reduced the effective tax rate for 2016, 2015 and 2014 by 1.5 percent, 1.2 percent and 1.9 percent, respectively.
In addition, our pretax earnings in 2016 included $24.9 million of investment income that is partially exempt from federal income tax, compared to $25.1 million and $25.3 million in 2015 and 2014, respectively.
Gross reserves (liability) and the reinsurance balances recoverable (asset) are generally subject to the same influences that affect net reserves, though changes to our reinsurance agreements can cause reinsurance balances recoverable to behave differently. Total gross loss and LAE reserves increased to $1.14 billion at December 31, 2016 from $1.10 billion at December 31, 2015 while ceded loss and LAE reserves decreased to $288.2 million from $297.8 million over the same period.
We have posted positive operating cash flow in each of the last three years. Variations in operating cash flow between periods are largely driven by the volume and timing of premium receipt, claim payments, reinsurance and taxes. In addition, fluctuations in insurance operating expenses impact operating cash flow. During 2016, the majority of cash flows were used in financing activities, due largely to the payment of special dividends. Financing cash flows noted in the above table include special dividends totaling $87.9 million, $87.1 million and $129.3 million for 2016, 2015 and 2014, 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 $288.2 million at December 31, 2016, compared to $297.8 million in 2015.
We maintain a diversified investment portfolio representing policyholder funds that have not yet been paid out as claims, as well as the capital we hold for our shareholders. As of December 31, 2016, our portfolio had a carrying value of $2.0 billion. Portfolio assets at December 31, 2016, increased by $70.3 million, or 4 percent, from December 31, 2015.
Our overall investment philosophy is designed to first protect policyholders by maintaining sufficient funds to meet corporate and policyholder obligations and then generate long-term growth in shareholders’ equity. Because our existing and projected liabilities are sufficiently funded by the fixed income portfolio, we can improve returns by investing a portion of the surplus (within limits) in a risk assets portfolio largely made up of equities. As of December 31, 2016, 45 percent of our shareholders’ equity was invested in equities, compared to 46 percent at December 31, 2015 and 49 percent at December 31, 2014.
Our capital structure is comprised of equity and debt obligations. As of December 31, 2016, our capital structure consisted of $148.7 million in 10-year maturity senior notes (long-term debt) and $823.6 million of shareholders’ equity. Debt outstanding comprised 15 percent of total capital as of December 31, 2016.
be paid from earned surplus. In 2016, 2015 and 2014, our principal insurance subsidiary paid ordinary dividends totaling $123.6 million, $125.0 million and $185.0 million, respectively, to RLI Corp. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the Illinois Department of Insurance (IDOI). No extraordinary dividends were paid in 2016, 2015 or 2014. Given the amount of dividends paid during the prior rolling 12-month period, the net assets of our principal insurance subsidiary are restricted through the second quarter of 2017 and cannot be distributed to RLI Corp. without prior approval of the IDOI. However, as of December 31, 2016, RLI Corp. had the approximate amount of unrestricted liquid net assets on hand that would be necessary to cover normal annual holding company expenditures.
While underwriting profit may remain under pressure from the competitive forces mentioned, we expect to post positive underwriting income overall, barring any significant catastrophe events. We will continue to prudently reserve for the ultimate claims we expect to pay over the life of our coverages. Our expense ratio has been impacted by the costs associated with new products over the last few years and we are actively looking for ways to gain scale in those products to better leverage our investments, as well as pruning those products which no longer show promise. Specific details regarding our insurance segments follows.
The casualty segment continues to be an area of opportunity. Premium rates are anticipated to remain relatively flat for most products with the exception of commercial auto. Because the industry has failed to increase pricing at the same pace as loss trends, we expect rate improvement to continue for these coverages during 2017. We recorded notable growth in our commercial transportation business in 2016 through rate increases and by providing excellent service to our producers and insureds. Some of the expansion was in certain geographies and classes that proved unprofitable. As we re-underwrite sub-segments of the book, it will be more challenging to show top line growth in transportation in 2017. We will continue to grow our small commercial businesses, which includes the previously acquired CBIC business and our packages that supplement professional services liability coverages for design, miscellaneous and technology professionals. We also expect growth in several new lines of E&S business that were launched in the last two years, including general and excess liability coverage in the energy, healthcare and large retention products. Finally, growth is probable from adjacent coverages provided by our executive products group, comprised of cyber liability and representations and warranties coverage. As with all of our newer businesses, while we expect some growth, we are careful to maintain the right underwriting approach. Legacy lines such as our general liability, umbrella and traditional executive products will be challenged to remain flat due to competitive market conditions. The casualty segment will likely be a larger portion of our product portfolio in 2017.
The property market is the most competitive of our three segments. Despite increased catastrophe activity in 2016, losses have not been material enough to impact excessive capital levels and stabilize rates. Underwriting margins have decreased to the point where any loss activity is pronounced. We expect marginal growth in the marine and homeowners businesses. Property’s top line is expected to decline in 2017 with our phase out of the recreational vehicle and assumed specialty treaty reinsurance business. The combination of phasing out these products will result in the reduction of approximately $20 million of gross written premium in 2017. While premium will decline, we do not anticipate a corresponding decline in underwriting income as these products have produced underwriting losses in recent years. We expect to report underwriting income in this segment overall, barring significant catastrophic events. Property will be a smaller segment of our product portfolio in 2017.
Competition is plentiful in the surety segment as well. This segment is dependent on both regulations and the economy, making its prospects uncertain during this political transition. Our energy business has been under pressure due to the prolonged decline in oil prices, while the contract business is reliant on construction investments which have been stable over the last few years. We believe both of these sub-segments will have some opportunity for growth and our underwriters remain focused on the bottom line. We have made additional investments in our miscellaneous and other transactional surety products. Technology, faster processing and ease of doing business are imperative for these products and these investments should begin to pay off in the coming years. Energy and commercial surety’s losses are infrequent but can be sizeable when they occur. In late 2016, we recognized some loss activity in these areas and expect underlying trends may impact our competitors as well. We will continue to carefully evaluate our accounts in these lines. We expect to produce underwriting income in this segment and anticipate that it will remain a similar portion of our overall product portfolio in 2017.
RLI Corp., an insurance holding company, is an Illinois corporation that was organized in 1965. We underwrite select property and casualty insurance coverages through major subsidiaries collectively known as RLI Insurance Group (the Group). We conduct operations principally through three insurance companies. RLI Insurance Company (RLI Ins.), a subsidiary of RLI Corp. and our principal insurance subsidiary, writes multiple lines of insurance on an admitted basis in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. Mt. Hawley Insurance Company (Mt. Hawley), a subsidiary of RLI Ins., writes surplus lines insurance on a non-admitted basis in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. Contractors Bonding and Insurance Company (CBIC), a subsidiary of RLI Ins., writes multiple lines of insurance on an admitted basis in all 50 states and the District of Columbia.
ASU 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs
For each accident year presented, quantitative information about claim frequency accompanied by a qualitative description of methodologies used for determining claim frequency information; and
Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; and
ASU 2016-13 was issued to provide more decision-useful information about the expected credit losses on financial instruments. Current GAAP delays the recognition of credit losses until it is probable a loss has been incurred. The update will require a financial asset measured at amortized cost to be presented at the net amount expected to be collected by means of an allowance for credit losses that runs through net income. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses. However, the amendments would limit the amount of the allowance to the amount by which fair value is below amortized cost. The measurement of credit losses on available-for-sale securities is similar under current GAAP, but the update requires the use of the allowance account through which amounts can be reversed, rather than through an irreversible write-down.
ASU 2017-04 was issued to simplify the subsequent measurement of goodwill. This update changes the impairment test by requiring an entity to compare the fair value of a reporting unit with its carrying amount as opposed to comparing the carrying amount of goodwill with its implied fair value. This ASU is effective for annual and interim reporting periods beginning after December 15, 2019. Early adoption is permitted. We have not yet completed the analysis of how adopting this ASU will affect our financial statements.
Cash consists of uninvested balances in bank accounts. Short-term investments consist of investments with original maturities of 90 days or less, primarily AAA-rated prime and government money market funds. Short-term investments are carried at cost. We have not experienced losses on these instruments. Other invested assets includes an investment in three low income housing tax credit partnerships (LIHTC), carried at amortized cost, membership in the Federal Home Loan Bank of Chicago (FHLBC), carried at cost, and an investment in a real estate fund, carried at cost. Due to the nature of cash, short-term investments, the LIHTC and our membership in the FHLBC, their carrying amounts approximate fair value.
written and $10.9 million of net premiums earned during 2015 and $10.2 million of gross premiums written and $5.3 million of net premiums earned during 2014.
In accordance with GAAP guidelines, the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or earlier if there is reason to suspect that their values may have been diminished or impaired. Goodwill and intangibles totaled $64.4 million at December 31, 2016 as detailed in the following table.
* The 2016 medical professional liability goodwill balance reflects a $7.2 million non-cash impairment charge recorded in 2016.
The liability for unpaid losses and settlement expenses represents estimates of amounts needed to pay reported and unreported claims and related expenses. The estimates are based on certain actuarial and other assumptions related to the ultimate cost to settle such claims. Such assumptions are subject to occasional changes due to evolving economic, social and political conditions. All estimates are periodically reviewed and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments are reflected in the results of operations in the period in which they are determined. Due to the inherent uncertainty in estimating reserves for losses and settlement expenses, there can be no assurance that the ultimate liability will not exceed recorded amounts. If actual liabilities do exceed recorded amounts, there will be an adverse effect. Furthermore, we may determine that recorded reserves are more than adequate to cover expected losses, which would lead to a reduction in our reserves.
Due to the relatively short-term nature of cash, short-term investments, accounts receivable and accounts payable, their carrying amounts are reasonable estimates of fair value. The fair value of our long-term debt is discussed further in note 4.
We compete with a large number of other companies in our selected lines of business. During periods of intense competition for premium, we are vulnerable to the actions of other companies who may seek to write business without the appropriate regard for ultimate profitability. The insurance industry is currently operating under highly competitive conditions and, as a result, margins in the industry are under pressure. During these times, it is very difficult to grow or maintain premium volume without sacrificing underwriting discipline and income. Our profitability can be affected significantly by the ability of our underwriters to accurately select and price risk and our claim personnel to appropriately deliver fair outcomes. We attempt to mitigate this risk by incentivizing our underwriters to maximize underwriting profit and remain disciplined in pricing and selecting risks. If we are unable to compete effectively in the markets in which we operate or expand our operations into new markets, our underwriting revenues may decline, as well as overall business results.
We are subject to environmental claims and exposures primarily through our commercial umbrella, general liability and discontinued assumed casualty reinsurance lines of business. Although exposure to environmental claims exists in these lines of business, we seek to mitigate or control the extent of this exposure on the vast majority of this business through the following methods: (1) our policies include pollution exclusions that have been continually updated to further strengthen them, (2) our policies primarily cover moderate hazard risks and (3) we began writing this business after the insurance industry became aware of the potential pollution liability exposure and implemented changes to limit its exposure to this hazard.
In 2009, as an extension of our excess and surplus lines general liability product, we expanded our offerings into low to moderate environmental liability exposures for small contractors and asbestos and mold remediation specialists. The business unit also provides limited coverage for individually underwritten underground storage tanks. We mitigate the overall exposure by focusing on smaller risks with low to moderate exposures. We avoid risks that have large-scale exposures including petrochemical, chemical, mining, manufacturers and other risks that might be exposed to superfund sites. This business is covered under our casualty ceded reinsurance treaties. Since 2009, we have written a total of $21.2 million of premium from this product extension with $4.3 million written in 2016.
fund assessments for various programs designed to ensure policyholder indemnification. We generally accrue an assessment during the period in which it becomes probable that a liability has been incurred from an insolvency and the amount of the related assessment can be reasonably estimated.
Pretax net realized investment gains (losses) and net changes in unrealized gains (losses) on investments for the years ended December 31 are summarized as follows:
During 2016, we recorded $34.6 million in net realized gains, $7.2 million of which related to a non-cash goodwill impairment charge, along with a change in net unrealized losses of $1.8 million. The majority of our net realized gains were due to sales of equity securities while the change in unrealized losses was due to an increase in interest rates at the end of the year. For 2016, the net realized gains (losses) and changes in unrealized gains (losses) on investments totaled $32.9 million.
The amortized cost and estimated fair value of fixed income securities at December 31, 2016, by contractual maturity, are shown as follows:
Gross unrealized losses in the collateralized securities bond portfolio increased to $4.1 million in 2016 as interest rates increased during the second half of the year. 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.
For all fixed income securities at an unrealized loss at December 31, 2016, we believe it is probable that we will receive all contractual payments in the form of principal and interest. In addition, we are not required to, nor do we intend to sell these investments prior to recovering the entire amortized cost basis of each security, which may be at maturity. We do not consider these investments to be other-than-temporarily impaired at December 31, 2016.
Gross unrealized losses in the corporate bond portfolio decreased to $5.7 million in 2016 from $14.8 million at the end of 2015 as credit spreads tightened during the year. The corporate bond portfolio has an overall rating of BBB+.
The following table is also used as part of our impairment analysis and displays the total value of securities that were in an unrealized loss position as of December 31, 2016, and December 31, 2015. The table segregates the securities based on type, noting the fair value, cost (or amortized cost) and unrealized loss on each category of investment as well as in total. The table further classifies the securities based on the length of time they have been in an unrealized loss position.
As of December 31, 2016, we held four equity securities that were in unrealized loss positions. The total unrealized loss on these securities was $1.3 million. In considering both the significance and duration of the unrealized loss position, we have no equity securities in an unrealized loss position of greater than 20 percent for more than six consecutive months.
The fixed income portfolio contained 377 securities in an unrealized loss position as of December 31, 2016. Of these 377 securities, 44 have been in an unrealized loss position for 12 consecutive months or longer and represent $3.3 million in unrealized losses. All fixed income securities in the investment portfolio continue to pay the expected coupon payments under the contractual terms of the securities. Credit-related impairments on fixed income securities that we do not plan to sell, and for which we are not more likely than not to be required to sell, are recognized in net earnings. Any non-credit related impairment is recognized in comprehensive earnings. Based on our analysis, our fixed income portfolio is of a high credit quality and we believe we will recover the amortized cost basis of our fixed income securities. We continually monitor the credit quality of our fixed income investments to assess if it is probable that we will receive our contractual or estimated cash flows in the form of principal and interest. There were no OTTI losses recognized in other comprehensive earnings in the periods presented. Key factors that we consider in the evaluation of credit quality include:
Based on our analysis, we concluded that the securities in an unrealized loss position were not other-than-temporarily impaired at December 31, 2016 and 2015. There were $0.1 million in losses associated with OTTI of securities in 2016. We did not recognize any impairment losses during 2015 or 2014.
Other invested assets shown on the balance sheet as of December 31, 2016 include investments in low income housing tax credit (LIHTC) partnerships, membership stock in the Federal Home Loan Bank of Chicago (FHLBC) and an investment in a real estate fund. During 2016, we recorded an additional $5.0 million interest in a low income housing tax credit partnership. Our LIHTC interests had a balance of $17.5 million at December 31, 2016 compared to $14.0 million at December 31, 2015 and recognized a total tax benefit of $1.9 million during 2016 compared to $1.1 million during 2015 and $0.2 million during 2014. Our investment in FHLBC stock totaled $1.6 million at the end of 2016 and 2015. Our investment in the real estate fund was carried at and had a fair value of $5.0 million at December 31, 2016, the same as the previous year.
As of December 31, 2016, outstanding debt balances totaled $148.7 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 is $157.4 million. The fair value of our long-term debt is estimated based on the limited observable prices that reflect thinly traded securities.
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, 2016, 2015 and 2014, no amounts were outstanding on these facilities.
In the ordinary course of business, our insurance subsidiaries assume and cede premiums and selected insured risks with other insurance companies, known as reinsurance. A large portion of the reinsurance is put into effect under contracts known as treaties and, in some instances, by negotiation on each individual risk (known as facultative reinsurance). In addition, there are several types of treaties including quota share, excess of loss and catastrophe reinsurance contracts that protect against losses over stipulated amounts arising from any one occurrence or event. The arrangements allow us to pursue greater diversification of business and serve to limit the maximum net loss to a single event, such as a catastrophe. Through the quantification of exposed policy limits in each region and the extensive use of computer-assisted modeling techniques, we monitor the concentration of risks exposed to catastrophic events.
Through the purchase of reinsurance, we also generally limit our net loss on any individual risk to a maximum of $3.0 million, although retentions can range from $1.0 million to $11.0 million.
Our policy is to charge to earnings, in the form of an allowance, an estimate of unrecoverable amounts from reinsurers. This allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover. Once regulatory action (such as receivership, finding of insolvency, order of conservation or order of liquidation) is taken against a reinsurer, the paid and unpaid recoverable for the reinsurer are specifically identified and written off through the use of our allowance for estimated unrecoverable amounts from reinsurers. When we write-off such a balance, it is done in full. We then re-evaluate the remaining allowance and determine whether the balance is sufficient as detailed above and if needed, an additional allowance is recognized and income charged. The amounts of allowances for uncollectible amounts on paid and unpaid recoverables were $15.2 million and $10.7 million, respectively, at December 31, 2016. At December 31, 2015, the amounts were $14.0 million and $11.9 million, respectively. We have no receivables with a due date that extends beyond one year that are not included in our allowance for uncollectible amounts.
The following is information about incurred and paid loss development as of December 31, 2016, net of reinsurance, as well as cumulative claim frequency, the total of IBNR liabilities included within the net incurred loss amounts and average historical claims duration as of December 31, 2016. The loss information has been disaggregated so that only losses that are expected to develop in a similar manner are grouped together. This has resulted in the presentation of loss information for our property and surety segments at the segment level, while information for our casualty segment has been separated in four groupings: primary occurrence, excess occurrence, claims made and transportation. Primary occurrence includes select lines within the professional services product along with general liability, small commercial and other casualty products. Excess occurrence encompasses commercial and personal umbrella, while claims made includes select lines within the professional services product and medical professional liability and executive products. Reported claim counts represent claim events on a specified policy rather than individual claimants and includes claims that did not or are not expected to result in an incurred loss. The information about incurred and paid claims development for the years ended December 31, 2007 to 2015 is presented as unaudited required supplementary information.
The following is a reconciliation of the net incurred and paid loss development tables to the liability for unpaid losses and settlement expenses in the consolidated balance sheet.
Three times a year, actuaries perform a ground-up, reserve study of the expected value of the unpaid loss and LAE derived using multiple standard actuarial methodologies. Each method produces an estimate of ultimate loss by accident year. We review all of these various estimates and assign weights to each based on the characteristics of the product being reviewed. These estimates are then compared to the carried loss reserves to determine the appropriateness of the current reserve balance. In addition, an emergence analysis is completed quarterly to determine if further adjustments are necessary.
Upon completion of our loss and LAE estimation analysis, a review of the resulting variance between the indicated reserves and the carried reserves takes place. Our actuaries make a recommendation to management in regards to booked reserves that reflect their analytical assessment and view of estimation risk. After discussion of these analyses and all relevant
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 unallocated loss and adjustment expenses (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 $16.4 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.
2015. We experienced favorable emergence relative to prior years’ reserve estimates in all of our segments during 2015. Development from the casualty segment totaled $45.7 million, inclusive of ULAE. The largest amounts of favorable development came from accident years 2010 through 2014. We continued to experience emergence that was generally better than previously estimated, but to a lesser degree in 2015 than in the previous year. Frequency and severity trends have been favorable relative to initial estimates and we believe this is largely due to risk selection by our underwriters, which has been effective in offsetting loss cost trends and a competitive pricing environment. Within the primary occurrence grouping, our general liability and small commercial products experienced favorable development of $14.7 million and $6.6 million, respectively. Although the habitational classes within general liability produced adverse development, it was more than offset by favorable development from the construction classes. However, the professional services product, experienced adverse development totaling $3.2 million in 2015. Within the excess occurrence grouping, our commercial umbrella product experienced $10.7 million of favorable development while the casualty runoff business experienced $5.4 million of adverse development, primarily on the 1983 accident year. The claims made and transportation groupings had favorable contributions of $3.9 million and $5.4 million, respectively.
Our marine product was the predominant driver of the favorable development in the property segment, accounting for $9.2 million of the $11.8 million total favorable development for the segment, inclusive of ULAE. The accident years making the largest contributions were 2010 through 2014. The inland marine and cargo coverages were responsible for the majority of the favorable loss experience. Our assumed property products contributed $4.9 million of favorable development with the majority of
that coming from loss reductions on previous hurricanes and storms. Development on direct property products business was also favorable overall. Our recreational vehicle product experienced $1.3 million of adverse development, mostly due to auto physical damage coverages.
2014. We experienced favorable emergence relative to prior years’ reserve estimates in all of our segments during 2014. The casualty segment contributed $52.8 million in favorable development, inclusive of ULAE. Accident years 2012 and 2013 contributed significantly to the favorable development, with accident years 2007 to 2011 also continuing to develop favorably. The favorable development in 2014 was smaller than 2013. 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 $28.1 million to our favorable development with all coverages contributing to the favorable development in 2014. Small commercial products were the second largest contributor with $9.4 million in favorable development mostly from accident years 2011, 2012 and 2013. Within the excess occurrence grouping, personal and commercial umbrella were favorable by $0.8 million and $4.4 million, respectively. Claims made and transportation also had favorable contributions of $4.6 million and $1.2 million, respectively. Run-off business had favorable development of $0.9 million due mostly to favorable development in the discontinued restaurant-bar-tavern business.
The surety segment experienced favorable development of $10.9 million, inclusive of ULAE. The majority of the favorable development was from accident year 2013. Contract and commercial surety products were the main contributors with favorable development of $4.6 million and $4.3 million, respectively. Energy surety had favorable development of $1.2 million and miscellaneous surety had favorable development of $0.9 million.
The following table represents paid and unpaid environmental, asbestos and mass tort claims data (including incurred but not reported losses) as of December 31, 2016, 2015 and 2014:
While our environmental exposure is limited, the ultimate liability for this exposure is difficult to assess because of the extensive and complicated litigation involved in the settlement of claims and evolving legislation on issues such as joint and several liability, retroactive liability and standards of cleanup. Additionally, we participate primarily in the excess layers of coverage, where accurate estimates of ultimate loss are more difficult to derive than for primary coverage.
Income tax expense attributable to income from operations for the years ended December 31, 2016, 2015 and 2014, differed from the amounts computed by applying the U.S. federal tax rate of 35 percent to pretax income from continuing operations as demonstrated in the following table:
Our effective tax rates were 26.8 percent, 30.1 percent and 28.5 percent for 2016, 2015 and 2014, respectively. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate was lower in 2016 due to a decline in underwriting income along with increased tax benefits associated with dividends received from unconsolidated investees.
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 corporate capital gains rate of 35 percent. We received a $9.9 million and $6.6 million dividend from Maui Jim in the fourth quarters of 2016 and 2014, respectively. No dividend was received from any unconsolidated investee in 2015. In accordance with GAAP guidelines on income taxes, we recognized a $2.8 million and $1.8 million tax benefit for 2016 and 2014, respectively. The tax benefit is generated from applying the lower tax rate applicable to affiliated dividends (7 percent), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. Standing alone, the dividend resulted in a 1.8 percent and 1.0 percent reduction to the 2016 and 2014 effective tax rates, respectively. In determining the appropriate tax rate to apply, we anticipate recovering our investments through means other than the receipt of dividends, such as a sale.
Dividends paid to our ESOP also result in a tax deduction. Dividends paid to the ESOP in 2016, 2015 and 2014 resulted in tax benefits of $3.3 million, $3.4 million and $4.5 million, respectively. These tax benefits reduced the effective tax rate for 2016, 2015 and 2014 by 2.1 percent, 1.7 percent and 2.4 percent, respectively.
Federal and state income taxes paid in 2016, 2015 and 2014, amounted to $26.9 million, $44.2 million and $48.5 million, respectively.
Although we are not currently under audit by the Internal Revenue Service (IRS), tax years 2013 through 2016 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 $11.7 million, $11.6 million and $14.1 million, for 2016, 2015 and 2014, respectively.
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 plans approval in 2015, we have granted 950,750 stock options under the 2015 LTIP, including 440,750 in 2016.
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 and other events as set forth in such plans). Options generally vest and become exercisable ratably over a five-year period.
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 2014 as the intrinsic value of the options exercised was not as significant ($6.2 million). Therefore, the exercise of options in 2014 resulted in an increase to paid-in-capital. In addition to settlement of the exercise, shareholders’ equity is impacted by corporate tax deductions allowed as a result of option exercises. The amount of the deduction is largely driven by the level of intrinsic value associated with exercises during the period. This tax benefit offsets our current tax liability and is recorded as an increase to paid-in-capital. As shown in the consolidated
statements of shareholders’ equity, the increase to paid-in-capital from this tax benefit is larger in periods when options are exercised with significant intrinsic value, as happened in 2016 and 2015.
The following tables summarize option activity in 2016, 2015 and 2014:
In 2014, each director received $10,000 worth of restricted common shares as part of annual director compensation. The shares were issued from the 2010 LTIP during the first quarter. The shares were directly owned by each director on the date of
issuance and included a one-year restriction on the sale or transfer of such shares. In the first quarter of 2014, we issued a total of 2,097 restricted shares and recognized $0.1 million of compensation expense. This restricted share program was terminated in 2014.
Year-end statutory surplus for 2016 presented in the table below includes $104.4 million of RLI stock (cost basis of $64.6 million) held by Mt. Hawley Insurance Company, compared to $117.5 million and $86.1 million in 2015 and 2014, respectively. The Securities Valuation Office provides specific guidance for valuing this investment, which is eliminated in our GAAP consolidated financial statements.
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, 2016, our holding company had $823.6 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 $45.9 million in liquid assets, which approximates annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and 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 issuances of common stock and debt.
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 2016, 2015 and 2014, our principal insurance subsidiary paid ordinary dividends totaling $123.6 million, $125.0 million and $185.0 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 2016, 2015 or 2014. Given the amount of dividends paid during the prior rolling 12-month period, the net assets of our principal insurance subsidiary are restricted through the second quarter of 2017 and cannot be distributed to RLI Corp. without
Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions and marine. We also offer select personal lines policies, including homeowners’ coverages. We discontinued our crop and facultative reinsurance in 2015 as a result of challenging market conditions and began curtailing recreational vehicle and treaty reinsurance offerings at the end of 2016. Facultative and treaty reinsurance operations generated $11.2 million, $12.8 million and $13.1 million of gross written premium in 2016, 2015 and 2014, respectively, while recreational vehicle operations generated $10.4 million, $13.4 million and $16.1 million of gross written premium over the same time period. 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 aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and maintaining policy terms and conditions throughout market cycles. We also use computer-assisted modeling techniques to provide estimates that help us carefully manage the concentration of risks exposed to catastrophic events.
Net investment income is the by-product of the interest and dividend income streams from our investments in fixed income and equity securities. Interest and general corporate expenses include the cost of debt and other director and shareholder relations costs incurred for the benefit of the corporation, but not attributable to the operations of our insurance segments. Investee earnings represent our share in Maui Jim and Prime earnings. We own 40 percent of Maui Jim, a privately held company which operates in the sunglass and optical goods industries, and 27 percent of Prime Holdings Insurance Services, Inc., a privately-held insurance company which specializes in hard-to-place risks in the excess and surplus market and has recently expanded into certain coverages in the admitted market. Our investment in Maui Jim, which is carried at the holding company, is unrelated to our core insurance operations.
On November 3, 2015, RLI Corp completed the sale of its subsidiary RLI Indemnity Company (RIC) to Clear Blue Financial Holdings, LLC for net sale proceeds of $7.5 million that were primarily generated from the transfer of insurance licenses. RIC was sold as a “shell,” with all business and cash flows from the company being retained by RLI Insurance Group. At the time of the sale, RIC had minimal assets and written premium and was transferring all premium and loss cash flows to RLI Ins. through a 100 percent quota share reinsurance agreement. RLI Ins. will continue to reinsure all RIC bond and insurance liabilities that existed at the date of sale, adjust claims and service the remaining in-force polices and bonds until they terminate or are moved into RLI Ins.