Our regional locations in Westminster, Colorado, and Galveston, Texas, and our claims office in Metairie, Louisiana, conduct operations in leased office space. While our employees were displaced from our Galveston, Texas office due to Hurricane Ike, which occurred in September 2008, we temporarily leased office space in a suburb of Houston, Texas for our Gulf Coast Regional Office to conduct business. This lease expired on September 30, 2009.
The adequacy of our loss and loss settlement reserves established for Hurricane Katrina, which are based on management estimates.
We begin Management’s Discussion and Analysis with an overview of our company and our financial highlights and then follow with detailed discussions on our results of operations; investments; liquidity; capital resources; enterprise risk management; and critical accounting estimates. When we provide information on a statutory basis, we label it as such; otherwise all other data is presented in accordance with GAAP.
Our premium written is cyclical in nature and is influenced by many factors, including price competition, economic conditions, interest rates, weather-related events and other catastrophes including natural disasters (e.g., hurricanes and tornados) and man-made disasters, state regulations, court decisions and changes in the law.
Over the past three years, our commercial lines of business have accounted for over 90.0 percent of premium revenue. We anticipate that our current composition of commercial lines and personal lines business will not change materially during the coming year.
Net income declined from $111.4 million in 2007 to net losses of $13.1 million in 2008 and $10.4 million in 2009, as a result of (i) year over year reductions in net premiums earned due to continued competition and the weak economy and (ii) an increase in loss and loss settlement expenses that stemmed from an increase in our case reserves on prior year losses, which was partially due to an increase in late reported claims and an increase in IBNR reserves.
Annuity deposits increased to $176.2 million for 2009, from $161.1 million and $161.5 in 2008 and 2007, respectively. Annuity deposits are not recorded as a component of net premiums written or net premiums earned; however, they do generate investment income.
Adverse development from Hurricane Katrina resulted in losses of $38.0 million in 2009 compared to $26.6 million (including a $10.8 million judgment, net of reinsurance) for 2008 and $6.3 million for 2007. We appealed this judgment in 2008, which we lost in 2009.
Our financial strength continued, as our stockholders’ equity increased in 2009 to $672.7 million from $641.7 million in 2008. Our equity in 2007 was $751.5 million, which was primarily the result of record earnings in that year.
The weak economy has significantly affected our business in 2009 and 2008 as follows:
Investment income has been impacted by lower market interest rates, a decline in the value of our other long-term investments, and the reduction or discontinuation of dividend payments by some of our equity securities that previously had paid regular dividends.
Other-than-temporary impairment (“OTTI”) charges totaled $18.3 million for 2009 compared to $9.9 million and $.1 million in 2008 and 2007, respectively.
It is widely believed that the economic downtown we faced in recent years appears to be over, however the economic indicators illustrate that the recovery will be a long, slow process. We are encouraged that as the economy improves, the market may be more conducive to better premium rate levels as well as more opportunities to write good business, but may or may not affect the trend in claims, specifically in our other liability line of business. As the economy recovers, it is also possible that interest rates may increase, which will increase net investment income, but could result in lower values of our fixed maturity securities. A combination of these trends may affect our net income going forward, but we cannot predict the timing or related impact, if any.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007
Direct premiums written decreased in 2009 due to continued competition and the weak economy, as explained in the previous section. Also contributing to the reduction in direct premiums written in 2009, was the nonrenewal of accounts that no longer meet our underwriting or pricing guidelines. As pricing in the industry continues to decrease, we avoid accounts that have become too underpriced for the risk.
Our policy retention rate in both the personal and commercial lines of business was approximately 80.0 percent in 2009, which was a slight decrease from 2008, as our underwriters continue to focus on writing good business at an adequate price, preferring quality to volume. Despite continued competition, particularly on medium and large commercial accounts, we were able to renew a select number of accounts at a higher rate/premium level in 2009 as compared to 2008.
In 2008, we continued to experience the effects of soft market conditions within the insurance industry. These conditions led to downward pressure on premium rates, particularly for mid-size to large commercial accounts. At the same time, we experienced an unexpected increase in loss severity during 2008 compared to prior years, while frequency of reported losses remained relatively stable between years, particularly in accounts under $100,000.
We experienced a decrease in assumed premiums written in 2009, as we terminated one of our assumed reinsurance contracts and lowered participation on another contract. In 2008, the decrease in assumed premiums written was due to the lower level of active assumed contracts we had as compared to prior years. Also contributing to the decline in premiums written for 2009, 2008 and 2007 was some of our assumed business that had been in run-off since late 2006, which concluded in early 2009. In 2010, we entered into three new assumed contracts, which we anticipate will increase our assumed premiums written.
Direct and assumed premiums written are reduced by the ceded premiums that we pay to reinsurers. Pricing of ceded reinsurance did not increase materially in 2009, 2008 or 2007. The reduction in ceded premiums written in 2009, 2008 and 2007 was due to the lower level of direct premiums written in each of those years as well as our reduced exposure in Southern Louisiana, which also had an effect on the premiums we pay for our property catastrophe reinsurance treaty.
Catastrophes losses are inherent risks of the property and casualty insurance business. These catastrophic events and natural disasters include, without limitation, hurricanes, tornadoes, earthquakes, hailstorms, wildfires, high winds and winter storms. Such events result in insured losses that may be a material factor in our results of operations and consolidated financial position. Additionally, since the level of insured losses that may occur in any one year cannot be accurately predicted, these losses contribute to fluctuations in our year-to-year results of operations and consolidated financial position. Some types of catastrophes are more likely to occur at certain times within the year than others, which adds an element of seasonality to our property and casualty insurance claims. The occurrence and severity of catastrophic events are difficult to accurately predict in any year. However, some geographic locations are more susceptible to these events than others. We have endeavored to control our direct insurance exposures in certain regions that are prone to naturally occurring catastrophic events through a combination of geographic diversification, restrictions on the amount and location of new business production in such regions, and reinsurance. The process of estimating and establishing reserves for catastrophe losses is inherently uncertain and the actual ultimate cost of a claim, net of reinsurance recoveries, may vary materially from the estimated amount reserved.
In 2008 and 2007, adverse development from Hurricane Katrina resulted in losses of $26.6 million (including a $10.8 million judgment, net of reinsurance, that was under appeal in 2008, which we lost on appeal in 2009) and $6.3 million, respectively.
In 2009, our pre-tax catastrophe losses without adverse development from Hurricane Katrina were $22.4 million. In comparison our 2008 and 2007 pre-tax catastrophe losses were $76.1 million and $14.1 million, respectively. In 2008 and 2007, the portion of these losses attributable to adverse development from Hurricane Katrina was $15.8 million (which excludes the $10.8 million judgment, net of reinsurance) for 2008 and $6.3 million, respectively. Our 2009 losses were the result of 26 new catastrophes, with our largest single loss coming from a Midwest storm that caused wind and hail damage and resulted in pre-tax losses totaling $3.6 million. In 2008, we experienced our second highest year for catastrophe losses in the past decade, with losses from 34 new catastrophe events. Our largest losses during 2008 were related to Hurricane Ike ($20.2 million) and Hurricane Gustav ($15.8 million).
Our 2009 core and catastrophe reinsurance programs remained relatively unchanged from our 2008 programs. Neither terms and conditions nor pricing were materially different. In 2009, we did not utilize our property catastrophe excess of loss treaty. In 2008, we exceeded our catastrophe retention of $20.0 million with Hurricane Ike, and recorded $2.4 million in ceded losses recoverable from that catastrophe.
In evaluating our catastrophe reinsurance coverage for 2005, we utilized two industry accepted models to estimate our exposure, and then purchased catastrophe reinsurance coverage that exceeded the estimated level. Hurricane Katrina resulted in a level of damage that the models, the industry, and we could not foresee. Consequently, we did not give consideration for such an event, which resulted in a level of reinsurance coverage that did not adequately protect us from the devastation of Hurricane Katrina. In addition to strengthening our underwriting guidelines and reducing our exposure in Southern Louisiana after Hurricane Katrina, we also evaluated and modified our catastrophe reinsurance coverage to lessen the impact of future catastrophes by increasing our property catastrophe reinsurance limits from $125.0 million in 2005 to $200.0 million beginning in 2007.
Primary insurers participating on the property and casualty excess of loss programs.
Late in 2008, we began a corporate-wide audit of our reported large claim losses to analyze the increase in severity that we experienced in 2008. While we were satisfied with the results of the audit, our review resulted in the modification of certain underwriting guidelines. Examples of such modifications include an increase in the number of commercial accounts serviced by our loss control unit, the development of a new safety class for insureds, a decline in certain classes of commercial business that are no longer profitable and the introduction of some pricing increases.
Other changes in loss development included prior year reserve redundancies in the following lines of business: commercial auto liability ($3.2 million), workers’ compensation ($7.2 million) and assumed reinsurance ($5.2 million).
In 2007, we incurred losses and loss settlement expenses of $245.8 million, of which $291.0 million were from claims that occurred in 2007. We had favorable development from prior years’ claims of $45.2 million. The redundancy was realized in each of our lines of business, with the exception of homeowners, which was attributable to adverse development from Hurricane Katrina.
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.
Our profitability in the commercial lines of business has been impacted by competition, in each of the three years. In 2009 we experienced a modest decrease in premium level, reflecting the continuation of a trend of gradual decreases in premium level for some lines of business dating back to the third quarter of 2004.
An additional factor in the deterioration of our 2008 loss ratio was the significant impact catastrophe losses had on the commercial lines of business. The pre-tax impact totaled $54.5 million, which was an increase of $41.8 million over 2007 catastrophes. In 2008, we experienced our second highest year for catastrophe losses in the past decade. A portion of these losses was attributable to a $10.8 million judgment, net of reinsurance, for Hurricane Katrina litigation that was under appeal in 2008, which we lost on appeal in 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 98.2 percent in 2009, 122.7 percent in 2008 and 56.0 percent in 2007. The improvement in these lines for 2009 as compared to 2008 was primarily due to a decrease in loss and loss settlement expenses in this line due to lower catastrophe losses and a leveling off of severity. Without considering catastrophe losses, frequency has not changed significantly over the past three years.
We continue to take measures to address our increase in incurred losses in the commercial fire and allied lines of business by implementing a number of underwriting initiatives that we anticipate will improve our loss experience. Our 2009 underwriting initiatives included:
Continued expansion of the loss control function in our Gulf Coast and Denver regions. Our service account program, which provides at least annual loss control visits, was implemented for larger and/or more complex accounts.
Change in our underwriting guidelines to address issues noted in large loss audits.
Implementation of CATography Underwriter, a new property underwriting tool that integrates hazard data for many perils, catastrophe modeling, interactive color-coded exposure mapping, and aerial photography into an intuitive dashboard screen, providing a complete overview of the risk landscape at a geocode or street address level.
In addition, since the occurrence of Hurricane Katrina in 2005, we have focused on reducing our risk exposure in Southern Louisiana by, among other things, decreasing the number of insured properties and raising rates, which has lead to a decline in premiums earned over the past three years.
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 99.7 percent in 2009, 69.2 percent in 2008 and 40.5 percent in 2007.
The other liability line experienced a lower level of premiums earned in 2009, as compared to 2008, due to the effect competition and the weak economy had on residential and commercial construction. Our other liability losses and loss settlement expenses incurred increased to $119.2 million in 2009, compared to $93.0 million in 2008 and $55.4 million in 2007. For 2009, the deterioration was attributable to an increase in IBNR reserves and a slight increase in severity from trends such as larger jury awards and increases in construction defect claims and loss settlement expenses. Incurred losses from construction defect claims totaled $6.0 million in 2009 as compared to $11.0 million and $5.4 million in 2008 and 2007, respectively.
Within our other liability lines of business (other than construction defect), frequency increased slightly in 2009 as compared to 2008, with losses incurred on 4,936 claims in 2009 compared to 4,817 in 2008 and 4,523 in 2007. In 2009, our average direct losses incurred per other liability claim (other than construction defect) were $23,699 per claim compared to $28,727 per claim in 2008 and $16,444 per claim in 2007.
Our net loss ratio in the workers’ compensation line of business was 79.4 percent in 2009, 78.5 percent in 2008 and 67.0 percent in 2007. 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.
In 2009, both the nonrenewal of accounts that no longer meet our underwriting or pricing guidelines and avoiding accounts that have become too underpriced for the risk have contributed to the reduction in premiums earned in this line. In 2008 and 2007, we wrote more workers’ compensation business, as we worked to retain business with current policyholders that required workers’ compensation insurance coverage.
We believe that our underwriting expertise, loss control service and medical review programs will enable us to be profitable in the workers’ compensation line of business. The challenges faced by workers’ compensation insurance providers to attain profitability include the regulatory climates in some states that make it difficult to obtain appropriate premium rate increases and inflationary medical costs. Despite these pricing issues, we continue to believe that we can improve profitability in the workers’ compensation line of business. Consequently, we have introduced predictive modeling analytics into our workers’ compensation underwriting process. In addition, we are going to increase our utilization of our loss control unit in the analysis of current risks, with the intent of increasing the quality of our workers’ compensation book of business.
The deterioration in the loss and loss settlement expenses in 2009 and 2008 is reflective of the increased premium writings we undertook in recent years and the risk associated with this long-tail line. The improvement in results in 2007 was due to lower severity, a slight decrease in our frequency and improvements in our medical review programs.
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 8.6 percent in 2009, 18.5 percent in 2008 and 9.7 percent in 2007.
Beginning in 2008, a downturn in general economic conditions decreased demand for our surety products, as construction activity declined. This contributed to flat growth in premiums earned in 2008 and the slight decline in 2009.
Our personal lines consist primarily of fire and allied lines (including homeowners) and automobile lines. The net loss ratio was 66.2 percent in 2009, 135.3 percent in 2008 and 60.7 percent in 2007.
In late 2009, we averaged low- to mid-single-digit percentage increases in premium level for our homeowner and personal auto lines of business. In 2008 and 2007, premium pricing decreased only in our personal auto line of business. In 2009, policy counts for homeowners, automobile and umbrella increased, as compared to 2008 where policy counts decreased in fire and allied lines (including homeowners) and automobile. In 2008, the premium reduction we experienced in the homeowners lines of business due to loss of business was more than offset by the significant increases in premium pricing in hurricane-exposed regions.
Our underwriting expense ratios, which are a percentage of other underwriting expenses over premiums earned, were 31.3 percent, 29.4 percent and 29.3 percent for 2009, 2008 and 2007, respectively. In 2009 we were unable to defer underwriting expenses (primarily agent commissions and employee salaries) at the same level as we were able to in 2008, due to lower premium writings resulting from continued competition and the weak economy, thus leading to the increase in our expense ratio.
Net premiums earned increased in 2009 as compared to 2008 as well as in 2008 as compared to 2007. The increase in net premium earned in both 2009 and 2008 is attributable to increased sales of single premium whole life products and to our increased marketing efforts.
Net investment income in both 2009 and 2008 was lower than in 2007, which is a reflection of lower market interest rates. Consolidated investment results are discussed in more detail later in this section under the caption “Investments.”
Our annuity deposits increased 9.4 percent in 2009 compared to a decrease of 0.2 percent in 2008 and an increase of 11.1 percent in 2007. Annuity deposit levels increased from 2008 to 2009, primarily due to consumers choosing products with less risk and guaranteed returns.
The decrease in amortization of DAC in 2009 was due to modest changes in amortization schedules implemented for the universal life and deferred annuity lines, as compared to more significant changes in 2008. The 2008 changes were implemented because of lower than expected investment returns, reflecting large realized capital losses, as well as an adjustment in anticipated lapse rates, based upon recent experience. The impact of the changes each year resulted in a decrease of $3.1 million in DAC amortization charges in 2009 as compared to 2008. Offsetting this decrease was an increase in regular amortization charges in the traditional life line due to the growth of the business, increasing amortization charges by $.8 million in 2009 as compared to 2008.
We reported a federal income tax benefit of $18.3 million and $20.1 million in 2009 and 2008, respectively, resulting from a taxable loss in our property and casualty insurance operations. Our effective federal income tax rate was 30.1 percent for 2007. Our effective federal tax rate varied from the generally applicable federal income tax expense rate of 35.0 percent, due primarily to our portfolio of tax-exempt securities.
As of December 31, 2009, we have a net operating loss (“NOL”) carryforward of $17.2 million, all of which is due to our purchase of American Indemnity Financial Corporation in 1999. Such net operating losses are currently available to offset future taxable income of our property and casualty companies. NOLs totaling $.8 million and $5.5 million expire in 2010 and 2011, respectively.
During both 2009 and 2008, we saw extraordinary volatility and deterioration in the financial markets. This deterioration impacted our investment income results for 2009. It is widely believed that the economic downtown we faced in recent years appears to be over, however the economic indicators illustrate that the recovery will be a long, slow process. We will carefully watch the national and global economies and financial markets and monitor and modify our investment portfolio to reflect changes in market conditions in order to match our liabilities and maximize our investment return.
We comply with state insurance laws that prescribe the kind, quality and concentration of investments that may be made by insurance companies. We determine the mix of our investment portfolio based upon these state laws, our liquidity needs, our tax position and general market conditions. We also consider the timing of our obligations, so we have cash available to pay our obligations when they become due. We make any necessary modifications to our investment portfolio as changing conditions warrant. We manage all but a small portion of our investment portfolio internally.
Our invested assets at December 31, 2009 totaled $2.352 billion, compared to $2.095 billion at December 31, 2008. At December 31, 2009, fixed maturity securities comprised 92.3 percent of our investment portfolio, while equity securities accounted for 5.6 percent of the value of our portfolio. Because the primary purpose of the investment portfolio is to fund future claims payments, we utilize a conservative investment philosophy, investing in a diversified portfolio of high quality, intermediate-term taxable corporate bonds, taxable U.S. government bonds and tax-exempt U.S. municipal bonds.
The composition of our investment portfolio at December 31, 2009, is presented in the following table.
At December 31, 2009, $2,158.4 million, or 99.6 percent, of our fixed maturities were classified as available-for-sale, compared with $1,898.6 million, or 99.2 percent, at December 31, 2008. We classify our remaining fixed maturities as held-to-maturity or trading. We record held-to-maturity securities at amortized cost. We record trading securities, primarily convertible redeemable preferred debt securities, at fair value, with any changes in fair value recognized in earnings.
Our total carrying value of “AAA” rated fixed maturity securities decreased in 2009 as compared to 2008 because “AAA” agency bonds that we owned were called during 2009. Both our “AA” and “Baa/BBB” fixed maturity securities increased due to purchases in 2009, as we sought a higher yield in our fixed maturity portfolio. Downgrades in corporate bonds and other securities during 2009 also shifted the composition of our investment portfolio, increasing our “A” and “Other/Not Rated” fixed maturity securities and contributing to the increase of our “Baa/BBB” fixed maturity securities.
For our property and casualty insurance segment, the weighted average duration of our fixed maturity available-for-sale, held-to-maturity and trading portfolios, at December 31, 2009 is 7.3 years compared to 7.7 years at December 31, 2008.
Also contributing to the decline were changes in the value of certain investments in limited liability partnerships, which we account for under the equity method of accounting. Our largest investment is in a partnership fund that invests in U.S. subregional banks. We continue to hold our investments in limited liability partnerships, as it is anticipated that the performance of these holdings will improve as the industry recovers.
In 2009, 94.4 percent of our gross investment income originated from interest on fixed maturities, compared to 89.7 and 81.8 percent in 2008 and 2007, respectively.
The realized investment losses in 2009 and 2008 were primarily due to pre-tax OTTI charges on our fixed maturity securities and equity securities. We recorded $18.3 million in investment write-downs in 2009 compared to $9.9 million and $.1 million in 2008 and 2007, respectively. The write-downs that occurred in 2009 and 2008 represent 0.8 percent and 0.5 percent of our investment portfolio, respectively. In 2007, our realized investment gains were due primarily to cash received as a result of transactions that impacted companies whose securities we held.
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 premiums, annuity deposits, reinsurance recoveries, sales or maturities of investments, and investment income. Historically, we have generated substantial cash inflows from operations. It is our policy to invest the cash generated from operations in securities with maturities that correlate to the anticipated timing of payments for losses and loss settlement expenses of the underlying insurance policies. The majority of our assets are invested in available-for-sale fixed maturity securities.
Our cash outflows are a result of losses and loss settlement expenses for property and casualty claims; payment of policyholder benefits under life insurance contracts; annuity withdrawals; payment of commissions, premium taxes, income taxes, operating expenses, dividends; and investment purchases. Cash outflows may be variable because of the uncertainty regarding settlement dates for losses. In addition, the timing and amount of individual catastrophe losses are inherently unpredictable and could increase our liquidity requirements.
In the insurance industry there generally is a time delay between when premiums are collected and when insurance claims or policyholder benefits are paid. During periods of positive operating cash flows, we are able to invest a portion of our operating cash flows to fund future insurance claims and policyholder benefit payments. During periods of negative operating cash flows, such as during a decline in premium revenues, we may need to sell investments to fund payments to claimants and policyholders. Additionally, if we experience several significant catastrophes over a relatively short period of time, or if we experience an extraordinary catastrophe, it is possible that investments may have to be sold before their maturity dates to fund payments, which could either result in investment gains or losses.
The following table displays a summary of cash sources and uses in 2009, 2008 and 2007.
In 2009, we continued to purchase a higher level of corporate fixed maturities rather than other investment vehicles such as short-term investments, which were less profitable due to the lower market interest rates. In 2008, we substantially increased our purchases of corporate fixed maturity securities, as the interest rates on these securities increased during 2008.
The following table shows our contractual obligations and commitments, including our estimated payments due by period, at December 31, 2009.
This projection of our obligation for future policy benefits considers only actual future cash outflows. The future policy benefit reserves presented on the consolidated balance sheet is the net present value of the benefits to be paid, less the net present value of future net premiums.
Future payments to be made to policyholders and beneficiaries must be actuarially estimated and are not determinable from the contract. The projected payments are based on our current assumptions for mortality, morbidity and policy lapse, but are not discounted with respect to interest. Additionally, the projected payments are based on the assumption that the holders of our annuities and life insurance policies will withdraw their account balances from our company upon the expiration of their contracts. Policies must remain in-force for the policyholder or beneficiary to receive the benefit under the policy. Depending on the terms of a particular policy, future premiums from the policyholder may be required for the policy to remain in-force. The future policy benefit reserves for the life insurance segment reported on the Consolidated Balance Sheets are generally based on the historical assumptions for mortality and policy lapse rates and are on a discounted basis. Accordingly, the amounts presented above for future policy benefit reserves significantly exceeds the amount of future policy benefit reserves reported on our Consolidated Balance Sheets at December 31, 2009.
The amounts presented are estimates of the dollar amounts and time periods in which we expect to pay out our gross loss and loss settlement expense reserves. These amounts are estimates based upon historical payment patterns and may not represent actual future payments because the timing of future payments may vary from the stated contractual obligation. Refer to “Critical Accounting Estimates: Loss and Loss Settlement Expenses - Property and Casualty Insurance Segment” in this section for further discussion.
We employ a multi-disciplinary approach to risk identification and evaluation - from claims to underwriting to financial to investments. Members of our ERM committee include our Chief Executive Officer, Chief Financial Officer, Executive Vice President, Vice President of Claims, Vice President of Corporate Underwriting, Chief Investment Officer and Vice President/Chief Operating Officer of our life insurance subsidiary (United Life Insurance Company), as well as United Life Insurance Company’s independent actuary. During 2009, this committee met on a quarterly basis with two members of our Board of Directors to oversee our risk management process and to implement risk management strategies. At the November 2009 meeting of our Board of Directors, the directors established a Risk Management Committee consisting of four directors. Going forward, this committee will meet on a quarterly basis and will continue meeting jointly with the ERM committee.
During its meetings, the ERM committee discusses the risks that our company faces, as well as the controls that are in place to mitigate those risks. These are not new ideas - management has actively and successfully managed risks throughout our company’s history. Collectively, the committee has identified two broad categories of risk faced by our company - insurance risk and operational risk. Types of insurance risks generally include, but are not limited to, those risks associated with catastrophes, geographical concentrations of property insured, business mix, underwriting practices, loss reserving practices, policy pricing, and the actions of our competitors. Types of operational risks we face generally include, but are not limited to, those risks associated with business continuity planning, information technology, executive succession planning, regulatory and legal compliance, diversification and quality of investments and the application of accounting policies and procedures.
ERM issues are discussed both during our quarterly meetings of the Board of Directors and at our semi-annual managers meetings. At these meetings, directors and managers are updated on ERM issues and the ongoing efforts of the ERM committee. The work of our ERM committee has led to the development of new tools designed to aid in the evaluation and mitigation of underwriting risks.
In 2009, we established a Business Continuity group that enables us to be better prepared in the event of another disaster similar to the floods we experienced in 2008. The Business Continuity group evaluated our risks that are specific to natural perils such as flooding, while our ERM Committee evaluated other risks we have such as cyber events, and directors and officers liability.
One of the most significant risks in our business is our exposure to catastrophic events. Although catastrophes are inherently unpredictable, we use various analyses and methods, including computer modeling techniques, to analyze catastrophic events and the risks associated with them. We use these analyses and methods to make underwriting and reinsurance decisions designed to manage our exposure to losses associated with catastrophic events.
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 carrying values of our limited liability partnerships could occur in the future and such changes could materially affect our results of operations and financial condition on the amounts reported in our Consolidated Financial Statements.
The securities categorized as Level 3 include holdings in certain private placement fixed maturity and equity securities and certain impaired securities for which there is not an active market. 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.
The following table presents the composition of our Level 3 securities at December 31, 2009:
For further discussion on fair value measurements and disclosures refer to Note 3. “Fair Value of Financial Instruments” contained in Part II, Item 8, “Financial Statements and Supplementary Data.”
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires OTTI charges to be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in fair value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which fair value has been less than cost; the financial condition and near-term prospects of the issuer; our intention to hold the investment; and the likelihood that we will be required to sell the investment. As of December 31, 2009, we had a number of securities where fair value was less than our cost. The total unrealized depreciation on these securities totaled $14.7 million at December 31, 2009, compared with $82.6 million at December 31, 2008. At December 31, 2009, the largest unrealized loss, after tax, on any single fixed maturity or equity security was $1.7 million. Our rationale for not recording OTTI charges on these securities is discussed in Part II, Item 8, Note 2, “Summary of Investments.”
This asset is amortized over the life of the policies written, generally one year. We assess the recoverability of DAC on a quarterly basis by line of business. This assessment is performed by comparing recorded unearned premium to the sum of unamortized DAC and estimates of expected losses and loss settlement expenses. If the sum of these costs exceeds the amount of recorded unearned premium, (i.e., the line of business is expected to generate an operating loss) the excess is recognized as an offset against the asset established for DAC. This offset is referred to as a premium deficiency charge. If the amount of the premium deficiency charge is greater than the unamortized deferred policy acquisition cost asset, a liability will be recorded for the excess.
The following table illustrates the hypothetical impact on the premium deficiency charge recorded at December 31, 2009 of reasonably likely changes in the assumed loss and loss settlement expense ratio utilized for purposes of this calculation. The entire impact of these changes would be recognized through income as other underwriting expenses. The base amount indicated below is the actual premium deficiency charge recorded as of December 31, 2009.
Actual future results could differ materially from our current estimates, requiring adjustments to the recorded deferred policy acquisition cost asset. Such adjustments are recorded through operations in the period the adjustments are identified. Due to changes in the estimated recoverability of DAC, the premium deficiency charge calculated at December 31, 2009 increased $1.8 million from the premium deficiency charge calculated at December 31, 2008 and $1.2 million from the charge calculated at December 31, 2007. An increase in the premium deficiency charge results in the deferral of comparatively less underwriting costs period over period, resulting in a relatively smaller deferred acquisition cost asset. The changes in the estimated recoverability of DAC are attributable to deterioration in our underwriting experience in the past two years.
The following table summarizes DAC for December 31, 2009 and 2008. The majority of the DAC asset relates to our universal life and annuity contracts, hereafter referred to as non-traditional business.
We periodically review estimates of expected profitability and evaluate the need to “unlock” or revise the amortization of the deferred policy acquisition cost 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 deferred policy acquisition cost asset for our non-traditional business recorded as of December 31, 2009. The entire impact of the changes illustrated would be recognized through operations as an increase or decrease to amortization expense.
The DAC in connection with our non-traditional business are adjusted with respect to estimated expected gross profits as a result of changes in the net unrealized gains or losses on available-for-sale fixed maturity securities allocated to support the block of fixed annuities and universal life policies. That is, because we carry available-for-sale fixed maturity securities at fair value, we make an adjustment to DAC 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 the change in this adjustment, which is called “shadow” DAC, net of tax, as a component of accumulated other comprehensive income. At December 31, 2009, “shadow” DAC decreased our DAC asset by $35.1 million, compared with “shadow” DAC that increased our DAC asset by $28.3 million at December 31, 2008.
For both our short-tail and long-tail lines of business, we establish our reserves for IBNR claims by applying a factor to our current pool of in-force premium, as well as evaluating our IBNR to exposure units. This factor has been developed through a historical analysis of company experience as to what level of IBNR reserve should be established to achieve an adequate IBNR reserve relative to our existing loss exposure base. Unique circumstances or trends which are evident as of the end of a given period may require us to refine our IBNR reserve calculation. This methodology for establishing our IBNR reserve has consistently resulted in aggregate reserve levels that management believes are reasonable in comparison to the reserve estimates prepared by Regnier Consulting Group, Inc., an independent actuary which we utilize in our reserving process.
Our key assumptions are subject to change as actual claims occur and as we gain additional information about the variables that underlie our assumptions. Accordingly, management reviews and updates these assumptions periodically to ensure that the assumptions continue to be valid. If necessary, management makes changes not only in the estimates derived from the use of these assumptions, but also in the assumptions themselves. Due to the inherent uncertainty in the loss reserving process, management believes that there is a reasonable chance that modification to key assumptions could individually, or in aggregate, result in reserve levels that are misstated either above or below the actual amount for which the related claims will eventually settle.
Due to the formula-based nature of our IBNR and loss settlement expense reserve calculations, changes in the key assumptions utilized to generate these reserves can result in a quantifiable impact on our reported results. It is not possible to isolate and measure the potential impact of just one of these factors, and future loss trends could be partially impacted by all factors concurrently. Nevertheless, it is meaningful to view the sensitivity of the reserves to potential changes in these variables. To demonstrate the sensitivity of reserves to changes in significant assumptions, the following example is presented. The amounts reflect the pre-tax impact on earnings from a hypothetical percentage change in the calculation of IBNR and loss settlement expense reserves. The impact to pre-tax earnings would be a decrease if the reserves were to be adjusted upwards. The impact to pre-tax earnings would be an increase if the reserves were to be adjusted downwards. We believe that the changes presented are reasonably likely based upon an analysis of our historical IBNR and loss settlement expense reserve experience.
In 2009, we did not change the key assumptions on which we based our reserving calculations. In estimating our 2009 loss and loss settlement expense reserves, we did not anticipate future events or conditions that were inconsistent with past development patterns.
Included in the other liability and assumed reinsurance lines of business are gross reserves for asbestos and other environmental losses and loss settlement expenses. At December 31, 2009 and 2008, we had $3.8 million in direct and assumed asbestos and environmental loss reserves. In addition, we had ceded asbestos and environmental loss reserves of $.5 million and $.6 million at December 31, 2009 and 2008, respectively. The estimation of loss reserves for environmental claims and claims related to long-term exposure to asbestos and other substances is one of the most difficult aspects of establishing reserves, especially given the inherent uncertainties surrounding such claims. Although we record our best estimate of loss and loss settlement expense reserves, the ultimate amounts paid upon settlement of such claims may be more or less than the amount of the reserves, because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved for many years.
In two of the past ten years, our development has resulted in deficiencies in our net reserves for prior accident years totaling $26.2 million and $.5 million for 2009 and 2008, respectively. In 2007, our development resulted in a redundancy of $45.2 million. Our reserves have been negatively impacted by an increase in our prior accident year loss reserves due to adverse development from Hurricane Katrina claims and litigation totaling $38.0 million, $26.6 million and $8.7 million in 2009, 2008 and 2007, respectively. Also contributing to our deficiency in 2009 and 2008 was the deterioration in our other liability lines of business which includes claims for construction defects.
It is management’s policy to utilize staff adjusters to develop our estimate of case-basis loss reserves. IBNR and loss settlement expense reserves are established through various formulae that utilize pertinent, recent company historical data. The calculations are supplemented with knowledge of current trends and events that could result in adjustments to the level of IBNR and loss settlement expense reserves. In addition, management consults with Regnier Consulting Group, Inc. throughout the year as deemed necessary. Management annually compares our estimate of total reserves to point estimates prepared by Regnier Consulting Group, Inc. by line of business to ensure that our estimates are within the actuary’s acceptable range. Regnier Consulting Group, Inc. 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 2009 and 2008, after considering the actuary’s range of reasonable point estimates, management believed that carried reserves were reasonable and therefore did not adjust the recorded amount.
Regnier Consulting Group, Inc. uses four projection methods in their actuarial analysis of our loss reserves and uses the paid-to-paid projection method in their analysis of our loss settlement expense reserves. Based on the results of the projection methods, the actuaries select an actuarial central estimate of the reserves. They then compare their estimate to our carried reserves to evaluate the reasonableness of the carried reserves. The four methods utilized by Regnier Consulting Group, Inc. are: paid loss development; reported loss development; expected loss emergence based on paid losses; and expected loss emergence based on reported losses.
Based on the results of the projection methods, a reasonable range of net reserves from $500.9 million to $615.1 million has been calculated. Our net reserves for losses and loss settlement expenses as of December 31, 2009 were $572.3 million.
We do not view the result of a single projection method as superior over the results of a combination of projection methods. That is, our actuary has not selected one method to determine the reserves. The results of Regnier Consulting Group, Inc.’s use of various methods, in conjunction with their actuarial judgment, leads to the actuarially-determined estimate of the reserves. The impact of reasonably likely changes in the reserving variables is implicitly considered in Regnier Consulting Group, Inc.’s use of several reserving methods.
Our reserves for universal life and deferred annuity contracts are based upon the policyholders’ current account value. Acquisition expenses are amortized in relation to expected gross profits forecast based upon current best estimates of anticipated premium income, investment earnings, benefits and expenses.
United Fire and its subsidiaries are required to file financial statements based on statutory accounting principles in each of the states where our insurance companies are domiciled and licensed to conduct business.
Management analyzes financial data and statements that are required to be reconciled to data prepared in accordance with statutory accounting principles, and those reconciliations are presented as required.
Premiums written is a measure of our overall business volume. 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. Assumed premiums written is consideration or payment we receive in exchange for insurance we provide to other insurance companies. We report these premiums as revenue as they are earned over the underlying policy period. Ceded premiums written is the portion of direct premiums written that we cede to our reinsurers under our reinsurance contracts. Premiums written is an important measure of business production for the period under review.
Combined ratio is a commonly used financial measure of underwriting performance. A combined ratio below 100 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 (referred to as the “net loss ratio”) and the underwriting expense ratio (the “expense ratio”).
This number reflects the reserves established for Hurricane Katrina litigation and does not include other Hurricane Katrina loss development.
The Notes to Consolidated Financial Statements are an integral part of these statements.
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, 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, DAC and future policy benefits and losses, claims and loss settlement expenses.
We are engaged in the business of writing property and casualty insurance and life insurance and selling annuities.
United Fire & Indemnity Company provides all of the statutory capital necessary for the formation of the Lloyds plan by contributing capital to each of the trustees. The trust agreements require the trustees to become underwriters of the Lloyds plan, to contribute the capital to the Lloyds plan, to sign the articles of agreement and to appoint the attorney-in-fact. The trust agreements also require the trustees to pay to United Fire & Indemnity Company all of the profits and benefits received by the trustees as underwriters of the Lloyds plan, which means that United Fire & Indemnity Company has the right to receive 100 percent of the gains and profits from the Lloyds plan. The trustees serve at the pleasure of United Fire & Indemnity Company, which may remove a trustee and replace that trustee at any time. Termination of a trustee must be accompanied by the resignation of the trustee as an underwriter, so that the trustee can obtain the capital contribution from the Lloyds plan to reimburse United Fire & Indemnity Company. By retaining the ability to terminate trustees, United Fire & Indemnity Company possesses the ability to name and remove the underwriters.
Our whole life and term insurance (traditional business) premiums are reported as earned when due and benefits and expenses are associated with premium income in order to result in the recognition of profits over the lives of the related contracts. On universal life and annuity policies (non-traditional business), income and expenses are reported when charged and credited to policyholder account balances in order to result in the recognition of profits over the lives of the related contracts. We accomplish this by means of a provision for future policy benefits and the deferral and subsequent amortization of policy acquisition costs.
The costs of acquiring new life business, principally commissions, 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 2009, 2008 and 2007 were $13,612,000, $10,620,000 and $10,511,000, respectively. Amortization of DAC in 2009, 2008 and 2007 totaled $9,287,000, $11,568,000 and $13,385,000, 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.
The effect on DAC that results from the assumed realization of unrealized gains (losses) is recognized with an offset to unrealized investment appreciation (depreciation) as of the balance sheet dates. In 2009, pre-tax adjustments decreased DAC by $63,425,000. In 2008, pre-tax adjustments increased DAC by $36,284,000.
In 2009, 2008 and 2007, we wrote-down certain holdings in our investment portfolio as a result of other-than-temporary impairment (“OTTI”) charges and recorded a pre-tax realized loss of $18,307,000, $9,904,000 and $105,000, respectively. None of the OTTI charges were considered to have a noncredit related loss component. We continue to 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.
Premiums earned and losses and loss settlement expenses incurred are reported net of reinsurance ceded. Ceded insurance business is accounted for on a basis consistent with the original policies issued and the terms of the reinsurance contracts. Refer to Note 5 “Reinsurance” for a discussion of our reinsurance operations.
Property and equipment is carried at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the underlying assets. Depreciation expense totaled $3,473,000, $3,556,000 and $3,513,000 for 2009, 2008 and 2007, respectively.
We have recognized no liability for unrecognized tax benefits at December 31, 2009 or 2008 or at any time during 2009 or 2008. 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 have been named as a defendant in various lawsuits, including actions seeking certification from the court to proceed as a class action suit and actions filed by individual policyholders, relating to disputes arising from damages that occurred as a result of Hurricane Katrina in 2005. As of December 31, 2009, there were approximately 215 individual policyholder cases pending, and an additional seven class action cases pending. These cases have been filed in Louisiana state courts and federal district courts and involve, among other claims, disputes as to the amount of reimbursable claims in particular cases, as well as the scope of insurance coverage under homeowners and commercial property policies due to flooding, civil authority actions, loss of use and business interruption. Certain of these cases also claim a breach of duty of good faith or violations of Louisiana insurance claims-handling laws or regulations and involve claims for punitive or exemplary damages. Other cases claim that under Louisiana’s so-called “Valued Policy Law,” the insurers must pay the total insured value of a home that is totally destroyed if any portion of such damage was caused by a covered peril, even if the principal cause of the loss was an excluded peril. Other cases challenge the scope or enforceability of the water damage exclusion in the policies.
In light of an April 2008 Louisiana Supreme Court decision finding that flood damage was clearly excluded from coverage, state and federal courts have been reviewing the pending lawsuits seeking class certification and other pending lawsuits in order to expedite pre-trial discovery and to move the cases towards trial. In the twelve months ended December 31, 2009 we resolved approximately 200 of the lawsuits, which were pending at December 31, 2008.
In July 2008, Lafayette Insurance Company participated in a hearing in St Bernard Parish, Louisiana after which the court entered an order certifying a class defined as all Lafayette Insurance Company personal lines policyholders within an eight parish area in and around New Orleans who sustained wind damage as a result of Hurricane Katrina and whose claim were at least partially denied or allegedly misadjusted. We appealed this order as we feel it was not supported by the evidence. On October 14, 2009, we were notified that our appeal to the Louisiana Fourth Circuit Court of Appeals was denied. We are seeking review of this decision at the Louisiana Supreme Court. Our petition for review remains pending at December 31, 2009. We have reserved each case based on the estimated exposure attributable to our policy. However, in the event that our request for relief is denied, we may increase reserves.
We consider all of our other litigation pending as of December 31, 2009 to be ordinary, routine, and incidental to our business.
We participate in a securities lending program administered by The Northern Trust Company (“Northern Trust”), which generates investment income and provides discounts on other investment fees we are charged by Northern Trust. Pursuant to the lending agreement, certain of our fixed maturity securities are loaned to other institutions for short periods of time. Borrowers of these securities must deposit collateral, which is generally in the form of cash, with Northern Trust, as our agent, that is equal to at least 102% of the market value of the loaned securities plus accrued interest. The value of the loaned securities is marked to market daily by Northern Trust at an aggregate level per borrower. As the market value of the loaned securities fluctuates, the borrower either deposits additional collateral or Northern Trust refunds collateral to the borrower in order to maintain the collateral level at 102%. We retain the right to terminate the loan at any time, whereupon the borrower must return the loaned securities to Northern Trust. If the borrower defaults and does not return the securities, Northern Trust will use the deposited collateral to purchase equivalent securities for us. However, we would receive the deposited collateral in place of the borrowed securities if Northern Trust is unable to purchase equivalent securities. Our participation in the securities lending program generated investment income of $139,000 in 2009 and $89,000 in 2008. There were no securities on loan under the program at December 31, 2009 and 2008. We resumed our participation in the securities lending program in January 2010.
In December 2008, the FASB issued accounting guidance that requires an employer to provide certain disclosures about the assets held by its defined benefit pension or other postretirement benefit plans. The required disclosures include the investment policies and strategies of the plans, the fair value of the major categories of plan assets, the inputs and valuation techniques used to develop fair value measurements and a description of significant concentrations of risk in plan assets. The guidance is effective for fiscal years ending after December 15, 2009. The adoption of the guidance did not have any impact on our consolidated financial position or results of operations.
The amortized cost and fair value of held-to-maturity, available-for-sale and trading securities at December 31, 2009, 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 and losses on the sale of available-for-sale securities for the years ended December 31, 2009, 2008 and 2007 were as follows:
The realized gains (losses) attributable to the change in fair value of trading securities still held at December 31, 2009, 2008 and 2007 were $1,547,000, $(1,528,000) and $(480,000), respectively.
Pursuant to an agreement with one of our limited liability partnership holdings, we are contractually committed to make capital contributions up to $15.0 million, upon request by the partnership, through December 31, 2017. As of December 31, 2009, our remaining potential contractual obligation was $13.1 million.
We believe the unrealized depreciation in value of our fixed maturity portfolio is primarily attributable to changes in market interest rates and not the credit quality of the issuer. We have no intent to sell and it is more likely than not that we will not be required to sell the securities until such time as the value recovers or the securities mature.
We have evaluated the unrealized losses reported for all of our equity securities at December 31, 2009, and have concluded that the duration and severity of these losses do not warrant the recognition of an OTTI charge at December 31, 2009. Specifically, the unrealized losses reported for individual securities that have been in an unrealized loss position for greater than twelve months has fluctuated significantly during 2009. Our largest unrealized loss greater than twelve months on an individual equity security at December 31, 2009 was $180,000. We have no intention to sell any of these securities prior to a recovery in value, but will continue to monitor the fair value reported for these securities as part of our overall process to evaluate investments for OTTI recognition.
We estimate the fair value of our financial instruments based on relevant market information or by discounting estimated future cash flows at estimated current market discount rates appropriate to the particular asset or liability shown.
Our other long-term investments consist primarily of holdings in limited liability partnership funds that are valued by the various fund managers and are recorded on the equity method of accounting. In management’s opinion, these values represent fair value at December 31, 2009 and 2008.
A summary of the carrying value and estimated fair value of our financial instruments at December 31, 2009 and 2008 is as follows:
FASB guidance on fair value measurements includes the application of a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Our financial instruments are categorized into a three level hierarchy, which is based upon the priority of the inputs to the valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the financial instrument.
Level 3: Valuations are 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 maintain a $50,000,000 bank line of credit. Under the terms of the agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate minus 1.0 percent. No outstanding loan balances existed at December 31, 2009 and 2008, and we did not borrow against this line of credit in 2009, 2008 or 2007.
We have several programs that provide reinsurance coverage. This reinsurance coverage limits the risk of loss that we retain by reinsuring direct risks in excess of our retention limits. The following table provides a summary of our primary reinsurance treaties, which remained the same for both 2009 and 2008. Retention amounts reflect the accumulated retentions and co-participation of all layers within a treaty. For 2010, our umbrella excess of loss treaty will be included in the casualty excess of loss treaty and will no longer be a separate treaty.
In the event that we incur catastrophe losses and loss settlement expenses that exceed the coverage limits of our reinsurance program, our property catastrophe treaty provides one guaranteed reinstatement. In such an instance, we are required to pay the reinsurers a reinstatement premium at 100 percent of the original premium, which will reinstate the full amount of reinsurance available under the property catastrophe treaty.
NOTE 7. STATUTORY REPORTING, CAPITAL REQUIREMENTS AND DIVIDENDS AND RETAINED EARNINGS RESTRICTIONS
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. At December 31, 2009, both United Life Insurance Company and United Fire and its property and casualty subsidiaries and affiliate had statutory capital and surplus in regards to policyholders well in excess of their required levels.
As of December 31, 2009, we have a gross deferred tax asset for net operating loss carryforwards totaling $17,215,000, all of which was acquired as part of our purchase of American Indemnity Financial Corporation. Net operating loss carryforwards totaling $769,000 and $5,491,000 expire in 2010 and 2011, respectively, and can only be used to offset future income of our property and casualty insurance segment. We are required to establish a valuation allowance for any portion of the gross deferred tax asset that we believe may not be realized. At December 31, 2009, we recorded a valuation allowance of $5,647,000. As we determine that the benefit of these net operating losses can be realized, the related reduction in the deferred tax asset valuation allowance will be recorded as a reduction to our federal income tax expense in the period of such determination.
We offer a noncontributory defined benefit pension plan (“pension plan”) in which all of our employees are eligible to participate after they have completed one year of service, attained 21 years of age and have met the hourly service requirements. Retirement benefits under our pension plan are based on the number of years of service and level of compensation. Our policy is to fund the pension plan on a current basis to the extent that the contribution is deductible under existing tax regulations. We estimate that we will contribute approximately $3,045,000 to the pension plan in 2010.
The annuity is held by our subsidiary United Life Insurance Company.
We have an internal investment/retirement committee, which includes our Chief Executive Officer, Chief Investment Officer, and Executive Vice President, all of whom receive monthly information on the value of the pension plan assets and their performance. Quarterly, the committee meets to review and discuss the performance of the pension plan’s investments as well as the allocation of investments within the pension plan.
We determine our expected long-term rate of return, which is an assumption as to the average rate of earnings expected on the pension plan funds invested, or to be invested, to provide for the settlement of benefits included in the projected pension benefit obligation. Investment securities, in general, are exposed to various risks, such as fluctuating interest rates, credit standing of the issuer of the security and overall market volatility. In addition, we consider historical experience for comparable investments and the target allocations we have established for the various asset categories. Annually, we perform an analysis of expected long-term rates of return based on the composition and allocation of our pension plan assets and recent economic conditions. We make use of an external actuarial firm to verify that our expected long-term rate of return is reasonable.
The investment return expectations for the pension plan are used to develop the asset allocation based on the specific needs of the pension plan. Accordingly, fixed maturity and equity securities comprise the largest portion of the pension plan assets, as they yield the highest rate of return. The pension plan’s annuity, which is the second largest category of pension plan assets and was originally written by our life insurance subsidiary in 1976, provides a guaranteed rate of return. The interest rate on the annuity is determined annually.
The availability of the pension plan assets held in cash and cash equivalents enables the pension plan to mitigate market risk that is associated with other types of investments and allows the pension plan to maintain liquidity both for the purpose of making future pension payments to participants and their beneficiaries and for future investment opportunities.
The pension plan’s investment in United Fire common stock, accounted for 6.7 percent or $3,684,000 of its assets at December 31, 2009 and 13.0 percent or $6,278,000 of the pension plan assets at December 31, 2008. We believe that even though market fluctuations impact the fair value of this investment, the target allocation is reasonable and historically has generated investment income, through dividend payments, for the pension plan.
The investment in United Fire 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. Dividends on shares of United Fire common stock totaled $121,000 in both 2009 and 2008 and $109,000 in 2007.
The preparation of financial statements in conformity with GAAP requires us to make various estimates and assumptions that affect the reporting of net periodic benefit cost, plan assets for all plans and plan obligations for all plans at the date of the financial statements. Actual results could differ from these estimates. One significant estimate relates to the calculation of plan obligations for all plans. We annually establish the discount rate, which is an estimate of the interest rate at which plan benefits for all plans could be effectively settled, that is used to determine the present value of the respective plan’s benefit obligations as of December 31. In estimating the discount rate, we look to rates of return on high-quality, fixed-income investments currently available and expected to be available during the period to maturity of the respective plan’s benefit obligations.
We have an employee stock ownership plan (“ESOP plan”) for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the ESOP plan upon completion of one year of service, meeting the hourly requirements with United Fire and attaining 21 years of age. Contributions to the ESOP plan are made at our discretion. These contributions are based upon a percentage of the total payroll and are allocated to participants on the basis of compensation. We make contributions in stock or cash, which the trustee uses to acquire shares of United Fire stock to allocate to participants’ accounts. As of December 31, 2009, 2008 and 2007, the ESOP plan owned 241,741, 241,796 and 244,386 shares of United Fire common stock, respectively. Shares owned by the ESOP plan are included in shares issued and outstanding for purposes of calculating earnings per share and dividends paid on the shares are charged to retained earnings. We made contributions to the ESOP plan of $150,000 in both 2009 and 2008 and $275,000 in 2007.
We have a nonemployee director stock option and restricted stock plan that authorizes United Fire to grant restricted stock and nonqualified stock options to purchase 150,000 shares of United Fire’s common stock, with 70,003 options available for future issuance at December 31, 2009. The Board of Directors has the authority to determine which nonemployee directors receive awards under the plan, when options and restricted stock shall be granted, the option price, the option expiration date, the date of grant, the vesting schedule of options or whether the options shall be immediately vested, the terms and conditions of options and restricted stock (other than those terms and conditions set forth in the plan) and the number of shares of common stock to be issued pursuant to an option agreement or restricted stock agreement. The Board of Directors may also take any action it deems necessary and appropriate for the administration of the plan.
The analysis below details the activity of both of our stock option plans and the ad hoc options, which were granted prior to the adoption of the other plans, for 2009. Information on options outstanding at December 31, 2009, is also presented.
Intrinsic value is the difference between our share price on the last day of trading (December 31, 2009) and the price of the options when granted and represents the value that would have been received by option holders had they exercised their options on December 31, 2009. These values change based on the fair market value of our shares. The intrinsic value of options exercised totaled $4,000, $125,000 and $774,000 in 2009, 2008 and 2007, respectively.
At December 31, 2009 we had 19,464 restricted stock awards outstanding, all of which were granted in May 2008 at a fair value of $33.43 per share, which resulted in $634,000 of compensation expense to be recognized over the next five years during the vesting period. The intrinsic value of the restricted stock awards outstanding totaled $355,000 for 2009.
The following table summarizes information regarding the stock options outstanding and exercisable at December 31, 2009:
We have two reportable business segments in our operations: property and casualty insurance and life insurance. The property and casualty insurance segment has three domestic locations from which it conducts its business. All offices target a similar customer base, market the same products and use the same marketing strategies and are therefore aggregated. 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.
The following table set forth our net premiums earned by segment before intersegment eliminations.
Total revenue by segment includes sales to external customers and intersegment sales that are eliminated to arrive at the total revenues as reported in the accompanying Consolidated Statements of Income. We account for intersegment sales on the same basis as sales to external customers. 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 2009, 2008 and 2007, are reported in the property and casualty insurance segment.
Outstanding awards were excluded from the diluted earnings per share calculation because the effect of including them would have been anti-dilutive.
At December 31, 2009, our future minimum rental payments are as follows:
The management of United Fire & Casualty Company is responsible for establishing and maintaining adequate internal control over financial reporting. United Fire & Casualty Company’s internal control over financial reporting is a process designed under the supervision of its Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of its Consolidated Financial Statements for external purposes in accordance with U.S. generally accepted accounting principles.
We have audited the internal control over financial reporting of United Fire & Casualty Company (United Fire) as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). United Fire’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on United Fire’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balances sheets of United Fire & Casualty Company as of December 31, 2009 and 2008 and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009 and our report dated March 1, 2010 expressed an unqualified opinion thereon.