Property and casualty reserves may be affected by both internal and external events, such as changes in claims handling procedures, judicial or legislative actions, inflation, and catastrophes. In 2011, our acquisition of Mercer Insurance Group and a significant level of catastrophes were factors in the change in our reserves. In prior years, the fluctuations in our reserves primarily related to losses incurred from Hurricanes Ike and Gustav, which occurred in 2008, and the adverse claims litigation that has resulted from Hurricane Katrina, which occurred in 2005. For further discussion of our acquisition of Mercer Insurance Group, refer to Note 16, “Business Combinations” contained in Part II, Item 8, “Financial Statements and Supplementary Data.”
markets resulted in a significant decrease to our net unrealized gains in 2008, while in subsequent years our net unrealized gains returned to levels similar to years prior to 2008. In addition, our 2011 net unrealized gains were impacted by our acquisition of the investment portfolio of Mercer Insurance Group.
In 2011, our stockholders' equity decreased as a result of stockholder dividends, stock repurchases and an increase in the underfunded status of our employee benefit plans. The decrease was somewhat offset by an increase in net unrealized gains. In 2010, our stockholders' equity improved due to an increase in net unrealized gains and a significant improvement in our earnings. In 2008 and 2009, our stockholders’ equity was impacted by the overall state of the economy and the volatility in the financial markets, which impaired our ability to generate an underwriting profit and reduced our net investment income and net unrealized investment gains.
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Results of Operations for the Years Ended December 31, 2011, 2010, and 2009
Founded in 1946, United Fire & Casualty Company and its subsidiaries provide insurance protection for individuals and businesses through several regional companies. We are represented nationally by 1,302 independent property and casualty insurance agencies and predominantly in the Midwest by 950 independent life insurance agencies.
For 2011, property and casualty business accounted for approximately 90.0 percent of our net premiums earned, of which 89.6 percent was generated from commercial insurance. Life insurance business made up approximately 10.0 percent of our net premiums earned, of which over 61.0 percent was generated from traditional life insurance products.
We evaluate segment profit or loss based upon operating and investment results. Segment profit or loss described in the following sections of Management’s Discussion and Analysis is reported on a pre-tax basis. Additional segment information is presented in Part II, Item 8, Note 10 “Segment Information” to the Consolidated Financial Statements.
Our primary sources of revenue are premiums and investment income. Major categories of expenses include losses and loss settlement expenses, changes in reserves for future policy benefits, operating (i.e., underwriting) expenses and interest on policyholders’ accounts.
To manage these risks and uncertainties, we seek to achieve consistent profitability through strong agency relationships, exceptional customer service, fair and prompt claims handling, disciplined underwriting, superior loss control services, and effective and efficient use of technology.
Our consolidated financial statements are prepared on the basis of GAAP. We also prepare financial statements for each of our insurance subsidiaries based on statutory accounting principles; these statements are filed with insurance regulatory authorities in the states where they do business.
Management evaluates our operations by monitoring key measures of growth and profitability. The following provides further explanation of the key measures management uses to evaluate the results:
Premiums written is a statutory measure of our overall business volume. Premiums written is an important measure of business production for the period under review. Net premiums written comprise direct and assumed premiums written, less ceded premiums written. Direct premiums written is the amount of premiums charged for policies issued during the period. For the property and casualty insurance segment there are no differences between direct statutory premiums written and direct premiums written under GAAP. However, for the life insurance segment, deferred annuity deposits (i.e., sales) are included in direct statutory premiums written, whereas they are excluded for GAAP.
Combined ratio is a commonly used statutory financial measure of property and casualty underwriting performance. A combined ratio below 100.0 percent generally indicates a profitable book of business. The combined ratio is the sum of two separately calculated ratios, the loss and loss settlement expense ratio (the “net loss ratio”) and the underwriting expense ratio (the “expense ratio”). If the combined ratio is at or above 100.0 percent, an insurance company is not underwriting profitably and may not be profitable unless investment income is sufficient to offset underwriting losses.
When prepared in accordance with GAAP, the net loss ratio is calculated as the ratio of losses and loss settlement expenses incurred to net premiums earned and measures the underwriting profitability of a company’s insurance business. We use the net loss ratio as a measure of the overall underwriting profitability of the insurance business we write and to assess the adequacy of our pricing. Our net loss ratio is meaningful in evaluating our financial results as reported in our Consolidated Financial Statements.
When prepared in accordance with GAAP, the underwriting expense ratio is calculated as the ratio of amortization of deferred policy acquisition costs and nondeferred underwriting expenses to net premiums earned. The underwriting expense ratio measures a company’s operational efficiency in producing, underwriting and administering its insurance business.
remain on schedule to convert the West Coast business to our systems in 2012. We also began the initial planning for integration of the East Coast business. In addition, we consolidated Mercer Insurance Group's core and catastrophe reinsurance programs into our programs, resulting in increased coverage and reduction in Mercer Insurance Group's historical costs. We expect to realize cost savings of approximately $1.5 million in 2012 from the consolidation of these programs.
In 2011, our life insurance subsidiary received approval to operate in New Jersey, North Carolina, Pennsylvania,Virginia and West Virginia, continuing to leverage the Mercer Insurance Group acquisition by expanding the life insurance segment's geographical footprint. Our life management team continues to improve service to our agents by increasing marketing support and automating life product processes.
At a special meeting held on January 24, 2012, our stockholders approved our reorganization into a new holding company structure. United Fire Group, Inc. has replaced United Fire & Casualty Company as the publicly held corporation, and United Fire & Casualty Company is now a wholly owned subsidiary of United Fire Group, Inc. In addition to creating a more streamlined corporate structure, the new holding company's organizational documents enhanced our stockholder rights by reducing the percentage of stockholders required to amend our Articles of Incorporation, approve the merger or sale of substantially all company assets, and call a special meeting. This new structure will potentially provide us with more flexibility to operate and finance our businesses, particularly if we should need to raise capital in the future.
Net premiums written comprise direct and assumed premiums written, less ceded premiums written. Direct premiums written are the total policy premiums, net of cancellations, associated with policies issued and underwritten by our property and casualty insurance segment. Assumed premiums written are the total premiums associated with the insurance risk transferred to us by other insurance and reinsurance companies pursuant to reinsurance contracts. Ceded premiums written is the portion of direct premiums written that we cede to our reinsurers under our reinsurance contracts. Net premiums earned are recognized over the life of a policy and differ from net premiums written, which are recognized on the effective date of the policy.
Direct premiums written decreased in 2010 as a slow recovery continued to affect the economy and potential commercial lines policyholders. Cancellations due to non-payment and/or companies going out of business contributed to the decline, while ongoing competition in a soft insurance market also continued to have an impact on our business. In the fourth quarter of 2010, we slightly reduced our commercial lines renewal pricing levels in order to retain quality accounts, keeping approximately 80.0 percent of our accounts, which is in line with our retention goals. However, new business pricing remained unchanged.
In 2011, we increased our participation on one active contract, while renewing all other active contracts. Our increased participation and pricing increases in recent years led to the increase in assumed premiums written in both
A new version of a third-party catastrophe modeling tool that we and others in the insurance industry utilize for estimating potential losses from natural catastrophes was released in 2011. Overall, the model is indicating higher risk estimates for our exposure to hurricanes in the United States, but the impact of the new model on our book of business varies significantly among the regions that we model for hurricanes. Based on our analysis, and the indications of other catastrophe models, we have begun to implement more targeted underwriting and rate initiatives in some regions. We will continue to take underwriting actions and/or purchase additional reinsurance to reduce our exposure as we believe is warranted.
In 2011, we developed earthquake underwriting guidelines to significantly decrease our earthquake exposure in the New Madrid fault area of the Midwest. The guidelines were implemented with most agents in the New Madrid fault area in July 2011. The reduction in exposure has occurred through business being non-renewed, moved by the agent, the use of sublimits rather than using full earthquake limits, and a waiver signed by the insured rejecting earthquake coverage. As of December 31, 2011, our earthquake exposure has been reduced by $111.2 million, with an ultimate reduction goal of $405.4 million to be accomplished by the end of 2013.
We use many reinsurers, both domestic and foreign, which helps us to avoid concentrations of credit risk associated with our reinsurance. All reinsurers we do business with must meet the following minimum criteria: capital and surplus of at least $250.0 million and an A.M. Best rating or an S&P rating of at least “A-.” If a reinsurer is rated by both rating agencies, then both ratings must be at least an “A-.”
The following table represents the primary reinsurers we utilize and their financial strength ratings as of December 31, 2011:
The Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”) was signed into law on December 27, 2007. TRIPRA coverage includes most direct commercial lines of business, including coverage for losses from nuclear, biological and chemical exposures if coverage was afforded by an insurer, with exclusions for commercial automobile insurance, burglary and theft insurance, surety, professional liability insurance and farm owners multiple peril insurance. Under TRIPRA, each insurer has a deductible amount, which is 20.0 percent of the prior year’s direct commercial lines earned premiums for the applicable lines of business, and retention of 15.0 percent above the deductible. No insurer that has met its deductible shall be liable for the payment of any portion of that amount that exceeds the annual $100.0 trillion aggregate loss cap specified in TRIPRA. TRIPRA provides marketplace stability. As a result, coverage for terrorist events in both the insurance and reinsurance markets is often available. The amount of aggregate losses necessary for an act of terrorism to be certified by the U.S. Secretary of Treasury, the Secretary of State and the Attorney General was $100.0 million for 2011 and remains the same for 2012. Our TRIPRA deductible was $55.9 million for 2011 and our TRIPRA deductible will be $78.2 million for 2012. Our catastrophe and non-catastrophe reinsurance programs provide limited coverage for terrorism exposure excluding nuclear, biological and chemical-related claims.
We experienced favorable development in all lines of business with the exception of fire and allied lines, which experienced a slight deficiency, primarily due to Hurricane Katrina. Our workers’ compensation line had a significant decrease in losses as a result of a reduction in frequency as well as favorable reserve development on resolved cases. Additionally, we experienced an overall decrease in claims severity accompanied by a slight decrease in claims frequency, which contributed to the improvement.
The following table illustrates the major components of the net redundancy (deficiency) we experienced in our reserves for 2011, 2010 and 2009:
Salvage is the sale of damaged goods, for which the insured has been indemnified and for which the insured has transferred title to the insurance company. Salvage reduces the cost incurred for property losses. Subrogation also reduces the costs incurred for a loss by seeking payment from other parties involved in the loss and/or from the other parties’ insurance company. Alternative dispute resolution facilitates settlements and reduces defense and legal costs through processes such as mediation and arbitration. Workers’ compensation medical bill review is a system designed to detect duplicate billings, unrelated and unauthorized charges, and coding discrepancies. It also ensures that we are billed for medical services according to the fee schedule designated by each state in which we have claims.
The following table depicts our net loss ratio for 2011, 2010 and 2009:
Commercial fire and allied lines include fire, allied lines, commercial multiple peril and inland marine. The insurance covers losses to an insured’s property, including its contents, from weather, fire, theft or other causes. We provide this coverage through a variety of business policies. The net loss ratio for our commercial fire and allied lines was 104.8 percent in 2011, 79.2 percent in 2010, and 98.2 percent in 2009.
In 2011, premiums earned in these lines increased to $117.8 million, of which $19.2 million was related to our acquisition of Mercer Insurance Group. Without Mercer Insurance Group, the premiums earned in this line were flat.
In 2010 premiums earned in these lines decreased to $98.7 million as our premium writings were affected by ongoing competition in a soft commercial lines market. Also contributing to the reduction in direct premiums written was the nonrenewal of accounts in 2009 that no longer met our underwriting or pricing guidelines. As pricing in the industry continued to decrease, we avoided accounts that became too underpriced for the risk.
Other liability is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured’s premises and products manufactured or sold. We reported a net loss ratio in this line of 47.2 percent in 2011, 83.3 percent in 2010 and 99.7 percent in 2009.
In 2011, better underwriting results and improvement in the economy contributed to the decrease in frequency. In 2010, the increase in frequency was due to continued deterioration of the economy with an associated increase in new claims submitted, primarily bodily injury claims.
Our commercial automobile insurance covers physical damage to an insured’s vehicle, as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by the insured, uninsured or underinsured motorists and the legal costs of defending the insured against lawsuits. Generally, our policy is to write standard automobile insurance. Our net loss ratio in the
commercial automobile was 73.1 percent in 2011, 71.9 percent in 2010 and 76.7 percent in 2009.
Our net loss ratio in the workers’ compensation line of business was 86.7 percent in 2011, 60.3 percent in 2010 and 79.4 percent in 2009. We consider our workers’ compensation business to be a companion product; we rarely write stand-alone workers’ compensation policies. Our workers’ compensation insurance covers primarily small- to mid-size accounts.
The deterioration in this line for 2011 was due to an increase in severity and frequency as a result of several large losses that occurred during the year and development in 2011 on claims that occurred in 2010. Generally changes in experience year-over-year in this line are considered normal fluctuations that generally occurs in the workers' compensation line of business.
In 2010 and 2009, both the nonrenewal of accounts that no longer met our underwriting or pricing guidelines and avoiding accounts that had become too underpriced for the risk contributed to the reduction in premiums earned in this line. Also in 2010, cancellations due to non-payment and/or companies going out of business contributed to the decline in our premium writings.
The improvement in loss and loss settlement expenses in 2010 was the result of a reduction in frequency as well as favorable reserve development on resolved cases.
Our surety products guarantee performance and payment by our bonded principals. Our contract bonds protect owners from failure to perform on the part of our principals. In addition, our surety bonds protect material suppliers and subcontractors from nonpayment by our contractors. When surety losses occur, our loss is determined by estimating the cost to complete the remaining work and to pay the contractor’s unpaid bills, offset by contract funds due to the contractor, reinsurance, and the value of any collateral to which we may have access. The net loss ratio in this line was 8.1 percent in 2011, 16.4 percent in 2010 and 8.6 percent in 2009.
In 2011, we experienced an improvement in our net loss ratio, that is the result of continued underwriting discipline and some favorable development on losses incurred in prior years. The improvement in our loss and loss settlement expense for 2011 was also the result of a slight decrease in claims frequency.
Our personal lines consist primarily of fire and allied lines (including homeowners) and automobile lines. The net loss ratio was 93.1 percent in 2011, 64.4 percent in 2010 and 66.2 percent in 2009.
The deterioration in 2011 was due to the significant increase in catastrophe activity during the year as compared to 2010. Personal lines pricing continued to improve during 2011, continuing a trend that began over two years ago. Policy retention rates remained strong, with approximately 82.0 percent of our policies renewing.
In late 2009, we averaged low- to mid-single-digit percentage increases in premium rates for our homeowner and personal auto lines of business and experienced an increase in the policy counts for homeowners, automobile and umbrella lines.
Our assumed reinsurance line of business had a net loss ratio of 186.9 percent, a negative net loss ratio of 72.1 percent and a net loss ratio of 67.1 percent in 2011, 2010 and 2009, respectively. The net loss ratio experienced in 2011 was the result of significant losses from natural disasters, including catastrophes impacting New Zealand and Japan.
In 2010, our other underwriting expense ratio decreased slightly primarily as the result of a higher level of deferrable underwriting expenses in 2010 as compared to 2009. Included in this line for 2010 are transaction costs totaling $1.2 million that were incurred during the fourth quarter related to our acquisition of Mercer Insurance Group.
The Measurement of Results section of this report defines data prepared in accordance with statutory accounting practices, which is a comprehensive basis of accounting other than U.S. GAAP.
The improvement in our 2010 results, as compared to 2009, is attributable to the reduction in other-than-temporary-
Net investment income in 2011 was lower than in 2010 and 2009. This was driven by the continuing low interest rate environment. In the fourth quarter of 2011, we began taking advantage of the decreasing spread between AAA- and A-rated fixed maturity securities to improve the quality of our fixed maturity purchases. Additionally, in 2011 we began increasing the duration of our investment portfolio to more closely match our liabilities, which have increased in conjunction with sales of our single premium whole life product. For discussion of our consolidated investment results, see the “Investments” section contained in this item.
Due to our determination that we may not be able to fully realize the benefits of the NOLs acquired in the purchase of American Indemnity Financial Corporation, which are only available to offset the future taxable income of our property and casualty insurance operations, we have recorded a valuation allowance against the NOLs that totaled $3.5 million at December 31,2011. Based on a yearly review, we determine whether the benefit of the NOLs can be realized, and, if so, the decrease in the valuation allowance is recorded as a reduction to current federal income tax expense. If NOLs expire during the year, the decrease in the valuation allowance is offset with a corresponding decrease to the deferred income tax asset. The valuation allowance was reduced by $.5 million in 2011 due to the expiration of $1.6 million in NOLs.
In 2011, volatility across investment classes was at the highest level since the financial crisis of 2008 and 2009. Credit rating downgrades of major economies (including the U.S.), natural disasters, and extraordinary political events dominated investor sentiment and the investment landscape. Fixed maturity security yields are at or near historic lows, due in part to a combination of investors wanting safety and the massive amount of monetary and fiscal stimulus in the world's financial system. We continue to carefully monitor global markets and remain disciplined in our approach to managing the risks and maximizing returns in the investment portfolio. We believe our investment strategy is prudent during this period of heightened uncertainty.
The composition of our investment portfolio at December 31, 2011, is presented in the following table:
The following table is a breakdown of the composition of fixed maturity securities held in our available-for-sale, held-to-maturity and trading security portfolios, by credit rating, at December 31, 2011 and 2010, respectively. Information contained in the table is based upon issue credit ratings provided by Moody’s unless the rating is unavailable, and then it is obtained from Standard & Poor’s:
Our investment portfolio is comprised primarily of fixed maturity securities whose fair value is susceptible to market risk, specifically interest rate changes. Duration is a measurement used to quantify our inherent interest rate risk and analyze our ability to match our invested assets to our claim liabilities. If our invested assets and claim liabilities have similar durations, then any change in interest rates will have an equal and opposite effect on these account balances. Mismatches in the duration of assets and liabilities can cause significant fluctuations in our results of operations. The primary purpose for matching invested assets and claim liabilities is liquidity. With appropriate matching, our investments will mature when cash is needed, preventing the need to liquidate other assets prematurely.
For our property and casualty insurance segment, the weighted average effective duration of our holdings of fixed maturity securities, at December 31, 2011, is 4.0 years compared to 5.3 years at December 31, 2010.
For our life insurance segment, weighted average effective duration of our holdings of fixed maturity securities, at December 31, 2011, is 3.4 years compared to 2.8 years at December 31, 2010.
We invest the premiums received from our policyholders and annuitants in order to generate investment income, which is an important component of our revenues and profitability. The amount of investment income that we are able to generate is affected by many factors, some of which are beyond our control. These factors include: volatility in the financial markets, economic growth, inflation, interest rates, world political conditions, terrorism attacks or threats, adverse events affecting other companies in our industry or the industries in which we invest and other unpredictable national or world events.
In 2011, our investment income, net of investment expenses, decreased $2.2 million to $109.5 million as compared to 2010. This decrease is attributable to ongoing low investment yields in 2011 and interest expense paid in 2011 in connection with our purchases of Mercer Insurance Group. We are preparing for an extended period of low interest rates by increasing our purchases of long-term fixed maturity securities and a small number of equity securities.
Represents the change in value of our holdings in limited liability partnership funds, which are accounted for under the equity method of accounting.
In 2011, 92.8 percent of our gross investment income originated from interest on fixed maturities, compared to 92.9 percent and 94.4 percent in 2010 and 2009, respectively.
In 2011 and 2010, we reported realized investment gains of $6.4 million and $8.5 million, respectively, compared to losses of $13.2 million in 2009. The following table summarizes the components of our realized investment gains or losses:
Our Consolidated Balance Sheets include financial instruments whose fair values are subject to market risk. The active management of market risk is integral to our operations. Market risk is the potential for loss due to a decrease in the fair value of securities resulting from uncontrollable fluctuations such as: interest rate risk, equity price risk, foreign exchange risk, credit risk, inflation, or world political conditions. Our primary market risk exposure is to changes in interest rates. We also have limited exposure to equity price risk and foreign exchange risk.
We analyze potential changes in the value of our investment portfolio due to the market risk factors noted above within the overall context of asset and liability management. A technique we use in the management of our investment portfolio and reserve liabilities is the calculation of duration. Our actuaries estimate the payout pattern of our reserve liabilities to determine their duration, which is the present value of the weighted average payments expressed in years. We then establish a target duration for our investment portfolio so that at any given time the estimated cash generated by the investment portfolio will match the estimated cash required for the payment of the
The duration of the life insurance segment's investment portfolio must take into consideration interest rate risk. This is accomplished through the use of sensitivity analysis, which measures the price sensitivity of the fixed maturities to changes in interest rates. The alternative valuations of the investment portfolio, given the various hypothetical interest rate changes utilized by the sensitivity analysis, allow management to revalue the potential cash flow from the investment portfolio under varying market interest rate scenarios. Duration can then be recalculated at the differing levels of projected cash flows.
The following table details the effect on the fair value of our investments in equity securities for a positive and negative 10 percent price change at December 31, 2011 and 2010:
We base our investment decisions on the credit characteristics of individual securities; however, we have within our municipal bond portfolio a number of securities whose ratings were enhanced by third-party insurance for the payment of principal and interest in the event of an issuer default. A downgrade in the credit ratings of the insurers of these securities in 2011 and 2010 resulted in a corresponding downgrade in the ratings of the securities. Of the insured municipal securities in our investment portfolio, 93.0 percent and 88.4 percent were rated single “A” or above, and 57.9 percent and 65.4 percent were rated “AA” or above at December 31, 2011 and 2010, respectively, without the benefit of insurance. Due to the underlying financial strength of the issuers of the securities, we believe that the loss of insurance would not have a material impact on our operations, financial position, or liquidity.
Liquidity measures our ability to generate sufficient cash flows to meet our short- and long-term cash obligations. Our cash inflows are primarily a result of collection of premiums, annuity deposits, reinsurance recoveries, sales or maturities of investments, and investment income. Cash provided from these sources is used primarily to fund loss and loss settlement expenses, payment of policyholder benefits under life insurance contracts, annuity withdrawals, stockholder dividends, pension plan contributions, commissions, premium taxes, income taxes, operating expenses, and, in recent years, common stock repurchases. Insurance premiums generally are received before losses are paid under the policies purchased with those premiums. Over the past three years, cash receipts from premiums along with investment income, have been more than sufficient to pay claims and operating expenses. Capital resources consist of stockholders' equity and debt, representing our overall financial strength to support writing and growth in our insurance businesses.
Net cash flows provided by operating activities totaled $74.4 million in 2011, compared to $71.2 million in 2010 and $100.4 million in 2009, respectively. Operating cash flows in 2011 reflected a higher level of loss and loss settlement expense payments, and a lower level of investment income received from the prior year.
Operating cash flows in 2010 reflected a lower level of loss and loss settlement expense payments, a lower level of operating expenses paid and an increased level of investment income received from the prior year. Negatively impacting operating cash flows was a lower level of property and casualty insurance premiums collected. The 2009 operating cash flows include a reduction in other assets of $29.0 million for the conclusion of certain litigation related to Hurricane Katrina; and a reduction in reinsurance recoveries due to the collection of payments during the year and an improvement in our catastrophe experience.
Our cash flows from operations were sufficient to meet our liquidity needs in 2011, 2010 and 2009.
Cash in excess of operating requirements is generally invested in fixed maturity securities and equity securities. Fixed maturities provide regular interest payments and allow us to match the duration of our liabilities. Equity securities provide potential dividend income, potential dividend income growth or reduction and potential appreciation or depreciation. For further discussion of our investments, including our philosophy and portfolio, see the “Investments” section contained in this item.
In addition to investment income, sales of investments and proceeds from calls or maturities of fixed maturity securities can also provide liquidity. During the next five years, $1.3 billion, or 49.1 percent, of our fixed maturity portfolio will mature.
Net cash flows used in investment activities totaled $175.2 million in 2011, compared to $94.7 million in 2010 and $130.1 million in 2009. In 2011, we had cash inflows from scheduled and unscheduled investment maturities, redemptions, prepayments, and sales of investments that totaled $610.0 million compared to $482.5 million and $399.6 million for the same period in 2010 and 2009, respectively. The increasing cash inflows over the last three years primarily relates to redemptions of fixed maturity securities that are reissued at lower interest rates as interest rates have been declining during this period.
Our cash outflows for investment purchases totaled $598.5 million in 2011, compared to $575.2 million and $519.1 million for the same period in 2010 and 2009, respectively. We also had a net cash outflow in 2011 of $172.6 million related to our acquisition of Mercer Insurance Group.
In 2010, net cash from financing activities decreased due to a lower volume of annuity deposits. Net cash flows from financing activities in 2009 were primarily due to deposits from annuity and universal life contracts exceeding withdrawals. In 2009, we experienced the largest reduction of withdrawals since 2005, which was indicative of the change in economic conditions and the inclination of consumers to choose products with less risk and guaranteed returns.
Payments of any future dividends and the amounts of such dividends, however, will depend upon factors such as net income, financial condition, capital requirements, and general business conditions. We will only pay dividends if declared by our Board of Directors, out of funds legally available, and subject to any other restrictions that may be applicable to us.
During 2011, 2010 and 2009, pursuant to authorization by our Board of Directors, we repurchased 702,947; 343,328; and 92,721 shares of our common stock respectively, which used cash totaling $12.4 million in 2011, $6.3 million in 2010 and $1.5 million in 2009. At December 31, 2011, we were authorized to purchase an additional 469,879 shares of our common stock under our share repurchase program, which expires in August 2013.
In the fourth quarter of 2011, United Fire & Casualty Company entered into a credit agreement with a syndicate of financial institutions as lenders party thereto, KeyBank National Association as administrative agent, lead arranger, sole book runner, swingline lender, and letter of credit issuer, and Bankers Trust Company as syndication agent. The four-year credit agreement provides for a $100.0 million unsecured revolving credit facility that includes a $20.0 million letter of credit subfacility and a swing line subfacility in the amount of up to $5.0 million.
During the term of this credit facility, we have the right to increase the total facility from $100.0 million up to $125.0 million, provided that no event of default has occurred or is continuing and certain other conditions are satisfied. The credit facility is available for general corporate purposes, including working capital, acquisitions and liquidity purposes. Principal of the credit facility is due in full at maturity, on December 22, 2015. The interest rate is based on our monthly choice of either the London Interbank Offered Rate (“LIBOR”) or a base rate plus, in each case, a calculated margin amount. A commitment fee on each lender's unused commitment under the credit facility is also payable quarterly. The credit facility replaced a $50.0 million revolving credit facility with Bankers Trust Company, which was repaid and terminated in connection with entering into the new credit agreement.
The credit agreement contains customary representations, covenants and events of default, including certain covenants that limit or restrict our ability to engage in certain activities. Subject to certain exceptions, these activities include restricting our ability to sell or transfer assets or enter into a merger or consolidate with another company,
grant certain types of security interests, incur certain types of liens, impose restrictions on subsidiary dividends, enter into leaseback transactions, or incur certain indebtedness. The credit agreement contains certain financial covenants including covenants that require us to maintain a minimum consolidated net worth, a debt to capitalization ratio and minimum stockholders' equity. The credit agreement contains terms that allow the agreement to continue after the formation of our holding company, United Fire Group, Inc., which occurred on February 1, 2012.
As of December 31, 2011, we were in compliance with the covenants for the credit agreement.
On March 28, 2011, we acquired 100 percent of the outstanding common stock of Mercer Insurance Group for $191.5 million. The acquisition was funded through a combination of cash and $79.9 million of short-term debt. Accordingly, the results of operations for Mercer Insurance Group are included in our Consolidated Financial Statements from that date forward. After the acquisition, we market our products through over 1,300 independent property and casualty agencies. In addition, the acquisition allows us to diversify our exposure to weather and other catastrophe risks across our geographic markets.
This transaction was accounted for under the acquisition method using Mercer Insurance Group historical financial information and applying fair value estimates to the acquired assets, liabilities and commitments as of the acquisition date. Refer to Part II, Item 8, Note 16 “Business Combinations” for additional information related to this acquisition.
In connection with this acquisition, we incurred $8.3 million of transactions costs, which included $5.5 million of expense in the first quarter of 2011 related to change in control payments made to the former executive officers of Mercer Insurance Group.
For a discussion of our credit facility, refer to Part II, Item 8, Note 17 “Debt.”
Our operating lease obligations are for the rental of office space, vehicles, computer equipment and office equipment. For further discussion of our operating leases, refer to Part II, Item 8, Note 14 “Lease Commitments.”
Our interest expense is primarily related to our three Trust Preferred Securities, as discussed in Part II, Item 8, Note 18 “Trust Preferred Securities.” The remaining interest expense is related to our credit facility, as discussed in Part II, Item 8, Note 17 “Debt.”
Pursuant to an agreement with one of our limited liability partnership funds, we are contractually committed to make capital contributions up to $15.0 million, upon request by the partnership, through December 31, 2017. Our remaining potential contractual obligation was $9.2 million at December 31, 2011.
Critical accounting estimates are defined as those that are representative of significant judgments and uncertainties and that may potentially result in materially different results under different assumptions and conditions. We base our discussion and analysis of our results of operations and financial condition on the amounts reported in our Consolidated Financial Statements, which we have prepared in accordance with GAAP. As we prepare these Consolidated Financial Statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities; and the disclosure of contingent assets and liabilities at the date of the financial statements; and the reported amounts of revenues and expenses for the reporting period. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. We believe that our most critical accounting estimates are as follows.
Upon acquisition, we classify investments in marketable securities as held-to-maturity, available-for-sale, or trading. We record investments in held-to-maturity fixed maturities at amortized cost. We record available-for-sale fixed maturity securities, trading securities and equity securities at fair value. Other long-term investments consist primarily of our interests in limited liability partnerships or joint ventures and are recorded on the equity method of accounting. We record mortgage loans at their unpaid principal balance and policy loans at the outstanding loan amount due from policyholders.
In general, investment securities are exposed to various risks, such as interest rate risk, credit risk, and overall market volatility risk. Therefore, it is reasonably possible that changes in the fair value of our investment securities, reported at fair value, will occur in the near term and such changes could materially affect the amounts reported in the Consolidated Financial Statements. Also, it is reasonably possible that changes in the value of our investments in limited liability partnerships could occur in the future and such changes could materially affect our results of operations as reported in our Consolidated Financial Statements.
Securities that may be categorized as Level 3 include holdings in certain private placement fixed maturity and equity securities and certain other securities that were determined to be other-than-temporarily impaired in a prior period and for which an active market does not currently exist.
The $5.4 million reported as “disposals” included $1.9 million of corporate bonds that were called as a result of debt restructuring by the issuer and $2.0 million of corporate bonds that matured. Of the $1.9 million, $.3 million were short-term investments that were transferred to corporate bonds as a result of the restructuring of debt by the issuer. The remaining $1.5 million in disposals relates to the receipt of principal on calls or sinking fund bonds, in accordance with the indentures.
The following table presents the composition of our Level 3 securities at December 31, 2010:
As of December 31, 2011 and 2010, we had a number of securities where fair value was less than our cost. The total unrealized depreciation on these securities was $7.5 million at December 31, 2011, compared with $8.8 million at December 31, 2010. At December 31, 2011, the largest pre-tax unrealized loss on an individual equity security was $0.2 million. Our rationale for not recording OTTI charges on these securities is discussed in Part II, Item 8, Note 2 “Summary of Investments.”
We record an asset for certain costs of underwriting new business, such as commissions, premium taxes and other variable costs that have been deferred.
To calculate the premium deficiency charge by line of business, we estimate expected losses and loss settlement expenses by using an expected loss and loss settlement expense ratio which is based on an analysis of actual experience of the line of business in recent years. This calculation is performed on a quarterly basis. This is the only assumption process we utilize in our calculation. Changes in these assumptions can have a significant impact on the amount of premium deficiency charge calculated for a line of business.
We defer policy acquisition costs related to non-traditional business and amortize these costs in proportion to the ratio of the expected annual gross profits to the expected total gross profits. The components of expected gross profits include investment spread, mortality and expense margins and surrender charges. Of these factors, we anticipate that investment returns, expenses and persistency are reasonably likely to significantly impact the rate of DAC amortization.
We periodically review estimates of expected profitability and evaluate the need to “unlock” or revise the amortization of the DAC asset. The primary assumptions utilized when estimating future profitability relate to interest rate spread, mortality experience and policy lapse experience. The table below illustrates the impact that a reasonably likely change in our assumptions used to estimate expected gross profits would have on the DAC asset for our non-traditional business recorded as of December 31, 2011. The entire impact of the changes illustrated would be recognized through operations as an increase or decrease to amortization expense.
available-for-sale fixed maturity securities at fair value, we make an adjustment to the DAC asset equal to the change in amortization that would have been recorded if we had sold such securities at their stated fair value and reinvested the proceeds at current yields. We include this adjustment, which is called “shadow” DAC, net of tax, as a component of accumulated other comprehensive income. At December 31, 2011 and 2010, the “shadow” DAC adjustment decreased our DAC asset by $33.9 million and $37.3 million, respectively.
Most of our insurance policies are written on an occurrence basis that provides coverage if a loss occurs in the policy period, even if the insured reports the loss many years later. For example, some liability claims are reported
10 years or more after the policy period, and the workers’ compensation coverage provided by our policies pays unlimited medical benefits for the duration of the claimant’s injury up to the lifetime of the claimant. In addition, final settlement of certain claims can be delayed for years due to litigation or other reasons. Reserves for these claims require us to estimate future costs, including the effect of judicial actions, litigation trends and medical cost inflation, among others. Reserve development can occur over time as conditions and circumstances change in years after the policy was issued.
For both our short-tail and long-tail lines of business, we establish our IBNR reserves by applying a factor to our current pool of in-force premium, as well as evaluating our exposure units. This factor has been developed through a
Loss settlement expense reserves include amounts ultimately allocable to individual claims, as well as amounts required for the general overhead of the claims handling operation that are not specifically allocable to individual claims. We do not establish loss settlement expense reserves on a claim-by-claim basis. Instead, on a quarterly basis, our actuary performs a detailed statistical analysis (using historical data) to estimate the required reserve for unpaid loss settlement expenses. On a monthly basis, the required reserve estimate is adjusted to reflect additional earned exposure and expense payments that have occurred subsequent to completion of the quarterly analysis.
In establishing an estimate of loss and loss settlement expense reserves, management uses a number of key assumptions, which are as follows:
The Company’s historical ratio of loss settlement expenses paid to losses paid is consistent and will continue to be consistent.
We are unable to reasonably quantify the impact of changes in our key assumptions utilized to establish individual case-basis reserves on our total reported reserve because the impact of these changes would be unique to each specific case-basis reserve established. However, based on historical experience, we believe that aggregate case-basis reserve volatility levels of 5.0 percent and 10.0 percent can be attributed to the ultimate development of our net case-basis reserves. The table below details the impact of this development volatility on our reported net case-basis reserves. The impact to pre-tax earnings would be a decrease if the reserves were to be adjusted upwards and an increase if the reserves were to be adjusted downwards.
Factors that can cause reserve uncertainty in estimating reserves in this line include:
Whether such claims were reasonably foreseeable and intended to be covered at the time the contracts were written (i.e., coverage disputes); and
In addition to these issues, other variables also contribute to a high degree of uncertainty in establishing reserves for construction defect claims. These variables include: whether coverage exists; when losses occur; the size of each loss; expectations for future interpretive rulings concerning contract provisions; and the extent to which the assertion of these claims will expand geographically. In recent years, we have implemented various underwriting measures
Like the other liability line of business, workers’ compensation losses and loss settlement expense reserves are based upon variables that create imprecision in estimating the ultimate reserve. Estimates for workers’ compensation are particularly sensitive to assumptions about medical cost inflation, which has been steadily increasing over the past few years. Other variables that we consider and that contribute to the uncertainty in establishing reserves for workers’ compensation claims include: state legislative and regulatory environments; trends in jury awards; and mortality rates. Because of these variables, the process of reserving for the ultimate loss and loss settlement expense to be incurred requires the use of informed judgment and is inherently uncertain. Consequently, actual loss and loss settlement expense reserves may deviate from our estimates. Such deviations may be significant. Our reserve for workers’ compensation claims at December 31, 2011, is $157.5 million and consists of 2,015 claims, compared with $128.5 million, consisting of 1,967 claims, at December 31, 2010.
In 2011 and 2010, our development resulted in a redundancy in our net reserves for prior accident years totaling $61.1 million and $45.9 million, respectively, which is consistent with our historical development, excluding the impact of Hurricane Katrina. In 2009, our development resulted in deficiencies in our net reserves for prior accident years totaling $26.2 million. Our development in these years was negatively impacted by adverse development from Hurricane Katrina claims and related litigation totaling $6.5 million, $8.6 million and $38.0 million in 2011, 2010 and 2009, respectively. Also contributing to our development in 2009 was the deterioration in our other liability lines of business which includes claims for construction defects.
claims management and loss settlement practices, has resulted in year-to-year redundancies in reserves, we believe our approach is better than experiencing year-to-year uncertainty as to the adequacy of our reserves.
Using programs and services to help prevent fraud and to assist in favorably resolving cases.
Based upon our comparison of carried reserves to actual claims experience over the last several years, we believe that using company historical premium and claims data to establish reserves for losses and loss settlement expenses results in adequate and reasonable reserves. Based upon this comparison, we believe that our total established reserves at December 31, 2011, are unlikely to vary by more than 10 percent of the recorded amounts, either positively or negatively. Reserve development is discussed in detail under the heading “Reserve Development” in the “Property and Casualty Insurance Segment” of the “Results of Operations” section in this item.
point estimates prepared by Regnier by line of business to ensure that our estimates are within the actuary’s acceptable range. Regnier performs an extensive review of loss and loss settlement expense reserves at each year end using generally accepted actuarial guidelines to ensure that the recorded reserves appear reasonable. If the carried reserves were deemed unreasonable, we would adjust reserves. In 2011 and 2010, after considering the actuary’s range of reasonable estimates, management believed that carried reserves were reasonable and therefore did not adjust the recorded amount.
The actuarial analysis performed by Regnier indicated a reasonable range for our net reserves of $705.3 million to $887.3 million at December 31, 2011. Our net reserves for losses and loss settlement expenses as of December 31, 2011 were $824.7 million.
We engage an independent actuarial firm to render opinions as to the reasonableness of the statutory reserves we establish. Statutory reserves are established using considerably more conservative assumptions regarding future investment earnings and contractual benefit payments than are used for GAAP reserves. During 2011 and 2010, we engaged the services of Griffith, Ballard and Company as our independent actuarial firm for the life insurance segment. We anticipate that this engagement will continue in 2012.
Goodwill and other intangible assets arise as a result of business combinations and consist of the excess of the fair value of consideration paid over the tangible assets acquired and liabilities assumed.We evaluate goodwill and other intangible assets for impairment at least on an annual basis or whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill and other intangible assets may exceed the implied fair value. Goodwill is evaluated at the reporting unit level. Any impairment is charged to operations in the period that the impairment was recognized. We did not recognize an impairment charge on our goodwill in 2011.
The process of estimating our pension and postretirement benefit obligations and related benefit expense is inherently uncertain, and the actual cost of benefits may vary materially from the estimates recorded. These liabilities are particularly volatile due to their long-term nature and are based on several assumptions. The main assumptions used in the valuation of our benefit obligations are:
A change in any one or more of these assumptions is likely to result in an ultimate liability different from the original actuarial estimate. Such changes in estimates may be material. For example, a 100 basis point decrease in our estimated discount rate would increase the pension and postretirement benefit obligation at December 31, 2011, by $19.9 million and $7.1 million, respectively, while a 100 basis point increase in the rate would decrease the benefit obligation at December 31, 2011, by $15.8 million and $5.6 million, respectively.
The recognition of the underfunded status of employee benefit plans is net of income taxes.
The accompanying Consolidated Financial Statements include United Fire Group, Inc. and its wholly owned subsidiaries: United Fire & Casualty Company, United Life Insurance Company (“United Life”), Addison Insurance Company, American Indemnity Financial Corporation, Lafayette Insurance Company, United Fire & Indemnity Company, Texas General Indemnity Company and Mercer Insurance Group, Inc. which includes BICUS Services Corporation, Financial Pacific Insurance Agency (currently inactive), Financial Pacific Insurance Company, Financial Pacific Insurance Group, Inc., Franklin Insurance Company, Mercer Insurance Company, and Mercer Insurance Company of New Jersey, Inc. (collectively, "Mercer Insurance Group").
United Fire Lloyds, an affiliate of United Fire & Indemnity Company, is organized as a Texas Lloyds plan, which is an aggregation of underwriters who, under a common name, engage in the business of insurance through a corporate attorney-in-fact. United Fire Lloyds is financially and operationally controlled by United Fire & Indemnity
United Fire Lloyds and three statutory trusts affiliated with Financial Pacific Insurance Group, Inc., have also been included in consolidation. Refer to Note 18 “Trust Preferred Securities” for a discussion of the nature and purpose of the trusts. All intercompany balances have been eliminated in consolidation.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The financial statement categories that are most dependent on management estimates and assumptions include: investments; deferred policy acquisition costs; reinsurance receivables and recoverables (for net realizable value); goodwill and intangible assets (for recoverability); and future policy benefits and losses, claims and loss settlement expenses.
The costs of acquiring new life business, principally commissions and certain variable underwriting, agency and policy issue expenses, have been deferred. These costs are amortized to income over the premium-paying period of the related traditional policies in proportion to the ratio of the expected annual premium revenue to the expected total premium revenue and over the anticipated terms of non-traditional policies in proportion to the ratio of the expected annual gross profits to the expected total gross profits. Policy acquisition costs deferred in 2011, 2010 and 2009 totaled $8,965,000, $8,807,000 and $13,612,000, respectively. Amortization of DAC in 2011, 2010 and 2009 totaled $9,224,000, $10,735,000 and $9,287,000, respectively. The expected premium revenue and gross profits are based upon the same mortality and withdrawal assumptions used in determining future policy benefits. For non-traditional policies, changes in the amount or timing of expected gross profits result in adjustments to the cumulative amortization of these costs. The effect on the amortization of DAC for revisions to estimated gross profits is reported in earnings in the period such estimated gross profits are revised.
Other long-term investments consist primarily of our interests in limited liability partnerships or joint ventures and are recorded on the equity method of accounting. Mortgage loans are recorded at their unpaid principal balance. Policy loans are recorded at the outstanding loan amount due from policyholders. Included in investments at December 31, 2011 and 2010, are securities on deposit with, or available to, various regulatory authorities as required by law, with fair values of $1,682,525,000 and $1,563,821,000, respectively.
In 2011, 2010 and 2009, we recorded a pre-tax realized loss of $395,000, $459,000 and $18,307,000, respectively, as a result of the recognition of other-than-temporary impairment (“OTTI”) charges on certain holdings in our investment portfolio. None of the OTTI charges were considered to have a noncredit related loss component. We review all of our investment holdings for appropriate valuation on an ongoing basis. Refer to Note 2 “Summary of Investments” for a discussion of our accounting policy for impairment recognition.
We made payments for income taxes of $570,000, $14,124,000 and $4,324,000 during 2011, 2010 and 2009, respectively. In addition, we received refunds totaling $13,491,000 and $10,256,000 in 2010 and 2009, respectively, due to the overpayment of prior year tax and carryback of operating losses. In 2011, we received no refunds. We made payments of interest totaling $1,926,000 during 2011, which does not include payments to policyholders' accounts related to non-traditional life insurance business. In 2010 and 2009, there were no significant payments of interest, other than payments to policyholders’ accounts.
Deferred tax assets and liabilities are established based on differences between the financial statement bases of assets and liabilities and the tax basis of those same assets and liabilities, using the currently enacted statutory tax rates. Deferred income tax expense is measured by the year-to-year change in the net deferred tax asset or liability, except for certain changes in deferred tax amounts that affect stockholders' equity and do not impact federal income tax expense.
We have recognized no liability for unrecognized tax benefits at December 31, 2011 or 2010 or at any time during 2011 or 2010. In addition, we have not accrued for interest and penalties related to unrecognized tax benefits. However, if interest and penalties would need to be accrued related to unrecognized tax benefits, such amounts would be recognized as a component of federal income tax expense.
We file a consolidated federal income tax return. We also file income tax returns in various state jurisdictions. We are no longer subject to federal or state income tax examination for years before 2006. There are ongoing examinations of income tax returns by the Internal Revenue Service of the 2008 tax year and by the State of Florida for the 2008 through 2010 tax years.
In May 2011, the FASB issued updated accounting guidance that changes the wording used to describe many of the requirements in GAAP for measuring fair value and for disclosing information about fair value measurements to ensure consistency between GAAP and International Financial Reporting Standards. The guidance also expands the disclosures for fair value measurements that are estimated using significant unobservable (i.e., Level 3) inputs. The updated guidance is to be applied prospectively for public companies for interim and annual reporting periods beginning after December 15, 2011. We will adopt this guidance effective January 1, 2012 and anticipate no impact
The amortized cost and fair value of held-to-maturity, available-for-sale and trading securities at December 31, 2011, by contractual maturity, are shown in the following table. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities and collateralized mortgage obligations may be subject to prepayment risk and are therefore not categorized by contractual maturity.
The proceeds and gross realized gains (losses) on the sale of available-for-sale securities for 2011, 2010 and 2009, were as follows:
A summary of changes in net unrealized investment appreciation is as follows:
The tables on the following pages summarize our fixed maturity and equity securities that were in an unrealized loss position at December 31, 2011 and 2010. The securities are presented by the length of time they have been continuously in an unrealized loss position. It is possible that we could recognize OTTI charges in future periods on securities held at December 31, 2011, if future events or information cause us to determine that a decline in fair value is other-than-temporary.
In most cases, we use quoted market prices to determine the fair value of fixed maturities, equity securities, trading securities and short-term investments. When quoted market prices do not exist, we estimate fair value based on pricing or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement of the financial instrument. Such inputs may reflect management’s own assumptions about the assumptions a market participant would use in pricing the financial instrument.
We estimate the fair value of mortgage loans based on discounted cash flows, utilizing the market rate of interest for similar loans in effect at the valuation date.
We calculate the fair value of the liabilities for all of our annuity products based upon the estimated value of the business, using current market rates and forecast assumptions and risk-adjusted discount rates, when relevant observable market data does not exist.
Annuity accumulations represent deferred annuity contracts that are currently earning interest.
We validate the prices obtained from pricing services and brokers prior to their use for reporting purposes by evaluating their reasonableness on a monthly basis. Our validation process includes a review for unusual fluctuations. In our opinion, the pricing obtained at December 31, 2011 was reasonable.
The fair value of our Level 3 impaired securities was determined primarily based upon management’s assumptions regarding the timing and amount of future cash inflows. If a security has been written down or the issuer is in bankruptcy, management relies in part on outside opinions from rating agencies, our lien position on the security, general economic conditions and management’s expertise to determine fair value. We have the ability and the
positive intent to hold securities until such time that we are able to recover all or a portion of our original investment. If a security does not have a market at the balance sheet date, management will estimate the security’s fair value based on other securities in the market. Management will continue to monitor securities after the balance sheet date to confirm that their estimated fair value is reasonable.
The following table provides a summary of the changes in fair value of our Level 3 securities for 2011:
The securities reported as “transfers in” relate to securities transferred from either Level 1 or 2 to Level 3 because an updated market value was not available. The securities reported as “transfers out” relate to securities transferred from Level 3 to either Level 1 or 2 because an updated market value was available.
The $5,439,000 reported as “disposals” included $1,930,000 of corporate bonds that were called as a result of debt restructuring by the issuer and $2,000,000 of corporate bonds that matured. Of the $1,930,000, $254,000 were short-term investments that were transferred to corporate bonds as a result of the restructuring. The remaining $1,509,000
in disposals relates to the receipt of principal on calls or sinking fund bonds, in accordance with the indentures.
The ceding of insurance does not legally discharge United Life from primary liability under its policies. United Life must pay the loss if the reinsurer fails to meet its obligations. We periodically monitor the financial condition of our reinsurers to confirm that they are financially stable. We believe that all of our reinsurers are in an acceptable financial condition. Approximately 99.0 percent of ceded life insurance in force as of December 31, 2011, has been ceded to five reinsurers.
The favorable development in 2011 and 2010 on claims that occurred in prior years, resulted from a re-estimation of loss reserves recorded at December 31 of the prior year. This re-estimation is primarily attributable to both the payment of claims in amounts less than the amounts reserved and changes in loss reserves mainly in the other liability and commercial automobile lines due to additional information on individual claims that we received after the reserves for those claims had been established. Another factor contributing to the redundancy recognized is the development of reserves for IBNR loss and loss settlement expenses at a level significantly less than anticipated at December 31 of the prior year. We attribute the favorable development to the fact that we have experienced overall lower levels of claims severity during recent years.
The unfavorable development in 2009 was attributable to an increase we made in our prior accident year loss reserves due to additional development from Hurricane Katrina, which included a federal court ruling and subsequent judgment of $28,868,000, which we paid in 2009. We also experienced deterioration in our other liability lines of business, which includes claims for construction defects.
We did not alter our reserving process during 2011. However, conditions and trends that have affected the reserve development for a given year may change. Therefore, such development cannot be used to project future reserve redundancies or deficiencies.
Statutory capital and surplus in regards to policyholders at December 31, 2011, 2010 and 2009 and statutory net income (loss) for the years then ended are as follows:
Our property and casualty and life insurance subsidiaries are required to file financial statements with state regulatory authorities. The accounting principles used to prepare these statutory-basis financial statements follow prescribed or permitted accounting practices that differ from GAAP. Prescribed statutory accounting principles include state laws, regulations and general administrative rules issued by the state of domicile, as well as a variety of publications and manuals of the NAIC. Permitted accounting practices encompass all accounting practices not prescribed, but allowed by the state of domicile. No permitted accounting practices were used to prepare our statutory-basis financial statements during 2011, 2010 and 2009.
We are directed by the state insurance departments’ solvency regulations to calculate a required minimum level of statutory capital and surplus based on insurance risk factors. The risk-based capital results are used by the NAIC and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. Both United Life and United Fire & Casualty Company and its property and casualty insurance subsidiaries and affiliate had statutory capital and surplus in regards to policyholders well in excess of their required levels at December 31, 2011.
The State of Iowa Insurance Department governs the amount of dividends that we may pay to stockholders without prior approval by the department. Based on these restrictions, we are allowed to make a maximum of $56,584,000 in dividend distributions to stockholders in 2012 without prior approval. We paid dividends of $15,507,000, $15,774,000 and $15,951,000 in 2011, 2010 and 2009, respectively. Dividend payments by the insurance subsidiaries to United Fire Group, Inc. are subject to similar restrictions in the states in which they are domiciled. In 2011, United Fire & Casualty Company received dividends from Addison Insurance Company, American Indemnity Financial Corporation, and Lafayette Insurance Company for $3,000,000, $1,700,000 and $6,750,000, respectively. In 2010 and 2009, United Fire & Casualty Company received a dividend from United Life of $15,000,000 and $4,000,000, respectively. These intercompany dividend payments are eliminated in our Consolidated Financial Statements.
The significant components of the net deferred tax liability at December 31, 2011 and 2010, are as follows:
Due to our determination that we may not be able to fully realize the benefits of the net operating losses ("NOLs") acquired in the purchase of American Indemnity Financial Corporation, which are only available to offset the future taxable income of our property and casualty insurance operations, we have recorded a valuation allowance against the NOLs that totaled $3,456,000 at December 31, 2011. Based on a yearly review, we determine whether the benefit of the NOLs can be realized, and, if so, the decrease in the valuation allowance is recorded as a reduction to current federal income tax expense. If NOLs expire during the year, the decrease in the valuation allowance is offset with a corresponding decrease to the deferred income tax asset. The valuation allowance was reduced by $548,000 in 2011 due to the expiration of $1,643,000 in NOLs. No portion of the NOLs will expire in 2012.
As of December 31, 2011, we had six external investment managers that are allowed to exercise investment discretion, subject to limitations, if any, established by the investment/retirement committee. We utilize multiple investment managers in order to maximize the pension plan’s investment return while minimizing risk. None of our investment managers uses leverage in managing the pension plan. Annually, the investment/retirement committee meets with each investment manager to review the investment manager’s goals, objectives and the performance of the assets they manage. The decision to establish or terminate a relationship with an investment manager is at the discretion of our investment/retirement committee.
an external actuarial firm to verify that the expected long-term rate of return is reasonable.
The following is a summary of the pension plan’s actual and target asset allocations at December 31, 2011 and 2010, by asset category:
The investment in United Fire Group, Inc. common stock is stated at fair value based upon the closing sales price reported on a recognized securities exchange on the last business day of the year or, when no sales are reported, the bid price on that date. Our common stock is actively traded.
Assumed health care cost trend rates have a significant effect on the amounts reported for the postretirement benefit plan. A 1.0 percent change in assumed health care cost trend rates would have the following effects:
The following table displays the effect that the unrecognized prior service cost and unrecognized actuarial loss of our plans had on accumulated other comprehensive income (“AOCI”), as reported in the accompanying Consolidated Balance Sheets:
The unrecognized prior service cost is being amortized on a straight-line basis over an average period of approximately 10 years. We anticipate amortization of prior service costs and net actuarial losses for our pension plan in 2012 to be $8,000 and $4,450,000, respectively. We anticipate amortization of our prior service costs and net actuarial losses for our postretirement benefit plan in 2012 to be $(6,000) and $726,000, respectively.
The following table summarizes the expected benefits to be paid from our plans over the next 10 years:
We have a profit-sharing plan in which employees who meet service requirements are eligible to participate. The amount of our contribution is discretionary and is determined annually, but cannot exceed the amount deductible for federal income tax purposes. Our contribution to the profit-sharing plan for 2011, 2010 and 2009, was $1,092,000, $2,074,000 and $927,000, respectively.
For 2011, 2010 and 2009, we recognized stock-based compensation expense of $1,829,000, $1,787,000, and $2,084,000, respectively.
At December 31, 2011, we had 50,206 restricted stock awards outstanding, of which 19,464, were granted in May 2008 at a fair market value of $33.43 per share and 30,742 were granted in February 2011 at a fair market value of $20.54, which resulted in compensation expense that is recognized over a five-year vesting period from the date of grant. In 2011, we recognized $245,000 in compensation expense related to these awards. In each of 2010 and 2009, we recognized $127,000 in compensation expense. At December 31, 2011, we had $662,000 in compensation expense that has yet to be recognized through our results of operations related to these awards. The intrinsic value of the unvested restricted stock awards outstanding totaled $1,013,000 and $434,000 at December 31, 2011 and 2010, respectively.
We have two reportable business segments in our operations: property and casualty insurance and life insurance. The property and casualty insurance segment has six domestic locations from which it conducts its business. The life insurance segment operates from our home office. The accounting policies of the segments are the same as those described in Note 1 to our Consolidated Financial Statements. We analyze results based on profitability (i.e., loss ratios), expenses and return on equity. Because all of our insurance is sold domestically, we have no revenues allocable to foreign operations.
We write both commercial and personal lines of property and casualty insurance. We focus on our commercial lines, which represented 89.6 percent of our property and casualty insurance premiums earned for 2011. Our personal lines represented 10.4 percent of our property and casualty insurance premiums earned for 2011.
Our primary commercial policies are tailored business packages that include the following coverages: fire and allied
Life insurance in force, before ceded reinsurance, totaled $4,916,875,000 and $4,804,167,000 as of December 31, 2011 and 2010, respectively. Traditional life insurance products represented 65.5 percent and 64.1 percent of our insurance in-force at December 31, 2011 and 2010, respectively. Universal life insurance represented 31.8 percent and 33.2 percent of insurance in force at December 31, 2011 and 2010, respectively.
The following table sets forth certain data for each of our business segments and is reconciled to our Consolidated Financial Statements. Depreciation expense and property and equipment acquisitions for 2011, 2010 and 2009, are reported in the property and casualty insurance segment.
Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted-average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share gives effect to all dilutive common shares outstanding during the reporting period. The dilutive shares we consider in our diluted earnings (loss) per share calculation relate to our outstanding stock options and restricted stock awards.
(1) Outstanding awards were excluded from the diluted earnings per share calculation because the effect of including them would have been anti-dilutive.
The following table sets forth the components of our comprehensive income and the related tax effects for 2011, 2010 and 2009:
At December 31, 2011, we were obligated under noncancelable operating lease agreements for office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $5,232,000, $4,506,000 and $4,209,000 for 2011, 2010 and 2009, respectively. Our most significant lease arrangement is for office space for our regional office in Galveston, Texas. This lease expires in December 2014. The annual lease payments for this office space total approximately $2,100,000.
We intend to continue to defend the cases related to losses incurred as a consequence of Hurricane Katrina. There are approximately 49 individual policyholder cases pending as of December 31, 2011. Our evaluation of these claims and the adequacy of recorded reserves may change if we encounter adverse developments in the further defense of these claims. For the years ended December 31, 2011, 2010, and 2009, we incurred $6,528,000,$8,576,000, and $37,976,000, respectively, of loss and loss settlement expenses from Hurricane Katrina claims and related litigation.
The excess of the purchase price over the estimated fair value of the tangible assets acquired and liabilities assumed at the acquisition date has been allocated to goodwill and intangible assets of our property and casualty insurance segment. The following is a summary of the fair value of the tangible and intangible assets acquired and liabilities assumed of Mercer Insurance Group at the date of acquisition:
from the acquisition date in proportion to the timing of the estimated underwriting profit associated with the in-force business. The amortization pattern for the VOBA asset will be greater in the initial months subsequent to the acquisition date in correlation to the remaining term of the policies that were underwritten by Mercer Insurance Group. We recorded amortization expense of $25,763,000 in 2011. The VOBA asset was $1,673,000 at December 31, 2011, which will be fully amortized in the first quarter of 2012.
The fair value of the intangible asset for licenses was estimated by assigning values to state insurance licenses to determine the value of the company if it were sold as a “shell company” (i.e., no policies in force but with the license to write business in certain states). Value is derived from the states having limited the number of insurers licensed or from the significant expense of obtaining a new license from the state.
The following is a summary of our unaudited pro forma historical results as if Mercer Insurance Group had been acquired on January 1, 2010:
(1) The year ended December 31, 2011, excludes transaction related expenses incurred that reduced net income by $11.9 million.
In the fourth quarter of 2011, United Fire & Casualty Company entered into a credit agreement with a syndicate of financial institutions as lenders party thereto, KeyBank National Association as administrative agent, lead arranger, sole book runner, swingline lender, and letter of credit issuer, and Bankers Trust Company as syndication agent. The four-year credit agreement provides for a $100,000,000 unsecured revolving credit facility that includes a $20,000,000 letter of credit subfacility and a swing line subfacility in the amount of up to $5,000,000.
During the term of this credit facility, we have the right to increase the total facility from $100,000,000 up to $125,000,000, provided that no event of default has occurred and is continuing and certain other conditions are satisfied. The credit facility is available for general corporate purposes, including working capital, acquisitions and liquidity purposes. Principal of the credit facility is due in full at maturity, on December 22, 2015. The interest rate is based on our monthly choice of either the London Interbank Offered Rate (“LIBOR”) or a base rate plus, in each case, a calculated margin amount. A commitment fee on each lender's unused commitment under the credit facility is also payable quarterly. The credit facility replaced a $50,000,000 revolving credit facility with Bankers Trust Company, which was repaid and terminated in connection with entering into the new credit agreement.
The credit agreement contains customary representations, covenants and events of default, including certain covenants that limit or restrict our ability to engage in certain activities. Subject to certain exceptions, these activities include restricting our ability to sell or transfer assets or enter into a merger or consolidate with another company, grant certain types of security interests, incur certain types of liens, impose restrictions on subsidiary dividends, enter into leaseback transactions, or incur certain indebtedness. The credit agreement contains certain financial covenants including covenants that require us to maintain a minimum consolidated net worth, a debt to capitalization ratio and minimum stockholders equity. The credit agreement contains terms that allowed the agreement to continue after the formation of the holding company, United Fire Group, Inc., which was completed on February 1, 2012.
Financial Pacific Statutory Trust II (“Trust II”) is a Connecticut statutory business trust. Trust II issued 3,000,000 shares of the Trust Preferred Securities at a price of $1 per share for $3,000,000 and purchased $3,093,000 in junior subordinated debentures from Mercer Insurance Group that mature on May 15, 2033. The annual effective rate of interest at December 31, 2011 is 4.557 percent.
Financial Pacific Trust III (“Trust III”) is a Delaware statutory business trust. Trust III issued 7,500,000 shares of the Trust Preferred Securities at a price of $1 per share for $7,500,000 and purchased $7,740,000 in junior subordinated debentures from Mercer Insurance Group that mature on September 30, 2033. The annual effective rate of interest at December 31, 2011 is 4.419 percent.
We have the right, at any time, so long as there are no continuing events of default, to defer payments of interest on the junior subordinated debentures for a period not exceeding 20 consecutive quarters, but not beyond the stated maturity of the junior subordinated debentures. To date no interest has been deferred. Total interest expense for the year ended December 31, 2011 was $1,055,000.
The Trust Preferred Securities are subject to mandatory redemption, in whole or in part, upon repayment of the junior subordinated debentures at maturity or their earlier redemption. We have the right to redeem the junior subordinated debentures after December 4, 2007 for Trust I, after May 15, 2008 for Trust II and after September 30, 2008 for Trust III. Mercer Insurance Group has not exercised these rights as of December 31, 2011.
Trust II was redeemed along with the corresponding junior subordinated debentures on February 15, 2012 for $3,129,000 and Trust I was redeemed along with the corresponding junior subordinated debentures on March 5, 2012 for $5,214,000.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire Group, Inc. at December 31, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), United Fire’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report, dated March 15, 2012, expressed an unqualified opinion thereon.