(1) See note 1.P to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
(6) The GAAP and statutory combined ratios are impacted by favorable development on prior accident years’ loss reserves. For further discussion, see note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
The foundation of our overall business strategy is to underwrite for profit in all market conditions and we achieved this for the 18th consecutive year in 2013, averaging an 87.6 combined ratio over that period of time. This foundation drives our ability to provide shareholder returns in three different ways: the underwriting income itself, net investment income from our investment portfolio and long-term appreciation in our equity portfolio. Our investment strategy is based on preservation of capital as the first priority with a secondary focus on generating total return. The fixed income portfolio consists primarily of highly-rated, diversified, liquid investment-grade securities. Consistent underwriting income allows a portion of our shareholders’ equity to be invested in equity securities. Our equity portfolio consists of a core stock portfolio weighted toward dividend-paying stocks, as well as exchange traded funds (ETFs). Our minority equity ownership in Maui Jim, Inc. (Maui Jim), a manufacturer of high-quality sunglasses, has also enhanced overall returns. We have a diversified investment portfolio and closely monitor our investment risks. Despite periodic fluctuations in market value, our equity portfolio is part of a long-term asset allocation strategy and has contributed significantly to our historic growth in book value.
The casualty portion of our business consists largely of general liability, personal umbrella, transportation, executive products, commercial umbrella, package business and other specialty coverages, such as our professional liability for design professionals. We also offer fidelity and crime coverage for commercial insureds and select financial institutions and recently expanded our casualty offerings to include medical professional liability coverage in the excess and surplus market. The casualty business is subject to the risk of estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty segment is also subject to inflation risk and may be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses.
Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions, marine, facultative and treaty reinsurance including crop and select personal lines policies, such as recreational vehicle and Hawaii homeowners coverages. While our marine and facultative reinsurance coverages are predominantly domestic risks, these portfolios do contain a relatively small portion of foreign risks. Property insurance and reinsurance results are subject to the variability introduced by perils such as earthquakes, fires and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. Our second largest catastrophe exposure is to losses caused by hurricanes to commercial properties throughout the Gulf and East Coast, as well as to homes we insure in Hawaii. We limit our net aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and through extensive use of computer-assisted modeling techniques. These techniques provide estimates that help us carefully manage the concentration of risks exposed to catastrophic events. Our assumed multi-peril crop and hail treaty reinsurance business covers revenue shortfalls or production losses due to natural causes such as drought, excessive moisture, hail, wind, frost, insects and disease. Significant aggregation of these losses is mitigated by the U.S. Federal Government reinsurance program that provides stop loss protection inuring to our benefit.
Modest rate improvements, which began on most coverages in 2012, have continued through 2013. The insurance marketplace, however, continues to be intensely competitive in many segments with new entrants and less disciplined markets broadening policy terms and reducing prices. Nevertheless, we believe that our business model is geared to create underwriting income by focusing on sound risk selection and discipline. Our primary focus will continue to be on underwriting profitability, with a secondary focus on premium growth where we believe underwriting profit exists, as opposed to general premium growth or market share measurements.
On April 28, 2011, we acquired CBIC through an acquisition of its holding company, Data and Staff Service Co., for $135.9 million in cash. CBIC is a Seattle-based insurance company specializing in surety bonds and related niche property and casualty insurance products. CBIC is a leading writer of contractor license bonds in the Northwest.
Loss and loss adjustment expense (LAE) reserves represent our best estimate of ultimate payments for losses and related settlement expenses from claims that have been reported but not paid and those losses that have occurred but have
The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables. These variables can be affected by both internal and external events, such as changes in claims handling procedures, claim personnel, economic inflation, legal trends and legislative changes, among others. The impact of many of these items on ultimate costs for loss and LAE is difficult to estimate. Loss reserve estimations also differ significantly by coverage due to differences in claim complexity, the volume of claims, the policy limits written, the terms and conditions of the underlying policies, the potential severity of individual claims, the determination of occurrence date for a claim and reporting lags (the time between the occurrence of the policyholder event and when it is actually reported to the insurer). Informed judgment is applied throughout the process. We continually refine our loss reserve estimates as historical loss experience develops and additional claims are reported and settled. We rigorously attempt to consider all significant facts and circumstances known at the time loss reserves are established.
We record two categories of loss and LAE reserves - case-specific reserves and IBNR reserves.
LAE represents the cost involved in adjusting and administering losses from policies we issued. The LAE reserves are frequently separated into two components: allocated and unallocated. Allocated loss adjustment expense (ALAE) reserves represent an estimate of claims settlement expenses that can be identified with a specific claim or case. Examples of ALAE would be the hiring of an outside adjuster to investigate a claim or an outside attorney to defend our insured. The claim professional typically estimates this cost separately from the loss component in the case reserve. Unallocated loss adjustment expense (ULAE) reserves represent an estimate of claims settlement expenses that cannot be identified with a
All decisions regarding our best estimate of ultimate loss and LAE reserves are made by our Loss Reserve Committee (LRC). The LRC is made up of various members of the management team including the chief executive officer, chief operating officer, chief financial officer, chief actuary, general counsel and other selected executives. We do not use discounting (recognition of the time value of money) in reporting our estimated reserves for losses and settlement expenses. Based on current assumptions used in calculating reserves, we believe that our overall reserve levels at December 31, 2013, make a reasonable provision to meet our future obligations.
For most property products, we use an alternative method of determining an appropriate provision for initial IBNR. Since this segment is characterized by a shorter period of time between claim occurrence and claim settlement, the IBNR reserves are determined by IBNR percentages applied to premium earned. The percentages are determined based on historical reporting patterns and are updated periodically. In addition, for assumed property reinsurance, consideration is given to data compiled for a sizable sample of reinsurers. No deductions for paid or case reserves are made. This alternative method of determining initial IBNR allows incurred losses and ALAE to react more rapidly to the actual emergence and is more appropriate for our property products where final claim resolution occurs over a shorter period of time.
· A new business or one experiencing significant growth and/or high turnover,
· Assumed reinsurance businesses where there is an extended reporting lag and/or a heavier utilization of ceding company data and claims and product expertise,
· High sensitivity to significant swings in loss trends, economic change or judicial change.
The LRC makes all final decisions regarding changes in the initial loss and ALAE ratios.
The process of estimating ultimate payment for claims and claim expenses begins with the collection and analysis of current and historical claim data. Data on individual reported claims, including paid amounts and individual claim adjuster estimates, are grouped by common characteristics. There is judgment involved in this grouping. Considerations when grouping data include the volume of the data available, the credibility of the data available, the homogeneity of the risks in each cohort and both settlement and payment pattern consistency. We use this data to determine historical claim reporting and payment patterns, which are used in the analysis of ultimate claim liabilities. For portions of the business without sufficiently large numbers of policies or that have not accumulated sufficient historical statistics, our own data is supplemented with external or industry average data as available and when appropriate. For our newer products such as crop reinsurance, as well as for executive products, professional services and marine, we utilize external data extensively.
Our actuaries engage in discussions with senior management, underwriting and the claim department on a regular basis to ascertain any substantial changes in operations or other assumptions that are necessary to consider in the reserving analysis.
A considerable degree of judgment in the evaluation of all these factors is involved in the analysis of reserves. The
We believe that because of the inherent variation and the likelihood that there are unforeseen and under-quantified liabilities absent from the actuarial estimate, it is prudent to carry loss reserves above the actuarial central estimate. Most of our variance between the carried reserve and the actuarial central estimate is in the most recent accident years for our casualty segment, where the most significant estimation risks reside. These estimation risks are considered when setting the initial loss ratios. In the cases where these risks fail to materialize, favorable loss development will likely occur over subsequent accounting periods. It is also possible that the risks materialize above the amount we considered when booking our initial loss reserves. In this case, unfavorable loss development is likely to occur over subsequent accounting periods.
Loss reserve estimates are subject to a high degree of variability due to the inherent uncertainty of ultimate settlement
· The length of time and the extent to which the fair value has been less than cost,
· Changes in technology that may impair the earnings potential of the investment,
· Specific concerns related to the issuer’s industry or geographic area of operation,
We defer commissions, premium taxes and certain other costs that are incrementally or directly related to the successful acquisition of new or renewal insurance contracts. Acquisition-related costs may be deemed ineligible for deferral when they are based on contingent or performance criteria beyond the basic acquisition of the insurance contract, or when efforts to obtain or renew the insurance contract are unsuccessful. All eligible costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premiums to be earned and anticipated losses and settlement expenses, as well as certain other costs expected to be incurred as the premiums are earned. Judgments as to the ultimate recoverability of such deferred costs are reviewed on a segment basis and are highly dependent upon estimated future loss costs associated with the premiums written. This deferral methodology applies to both gross and ceded premiums and acquisition costs.
We record net deferred tax assets to the extent that temporary differences representing future deductible items exceed future taxable items. A significant amount of our deferred tax assets relate to expected future tax deductions arising from claim reserves and future taxable income related to changes in our unearned premium.
offsetting valuation allowance is recorded, thereby reducing net earnings and the deferred tax asset in that period. In addition, management must make estimates of the tax rates expected to apply in the periods in which future taxable items are realized. Such estimates include determinations and judgments as to the expected manner in which certain temporary differences, including deferred amounts related to our equity method investment, will be recovered. These estimates enter into the determination of the applicable tax rates and are subject to change based on the circumstances.
Net earnings increased in 2013, after declining in 2012 and 2011. Results for 2013 benefited from a benign catastrophe season and reflected an absence of hurricane activity. Also impacting results was an increase in favorable loss reserve development on prior accident years and improved current accident year results from our casualty segment. Catastrophe losses in 2013 related to spring storm activity and reduced underwriting income by $10.0 million. By comparison, 2012 included a much greater impact from catastrophes, as losses related to Hurricane Sandy, Hurricane Isaac and spring storms reduced underwriting results by $35.0 million. For 2011, results included $13.0 million in spring storm losses and $4.5 million in losses from Hurricane Irene. In total, underwriting income was $106.8 million in 2013, compared to $63.6 million in 2012 and $110.2 million in 2011. These results were the product of both disciplined underwriting in the current accident year and favorable development on prior accident years’ reserves. Also fundamental to our approach is a focus on investing in new product initiatives and geographic expansion, in order to position ourselves for future growth. We have experienced revenue growth in recent years as a result of these expansion efforts. In addition, our continued underwriting income, which has again outperformed industry results, is a testament to our underwriters’ discipline throughout the insurance cycle. We believe our underwriting discipline can differentiate us from the broader insurance market by ensuring appropriate risk selection and pricing of both new and renewal business and can serve to slow the pace of deterioration in underwriting results. Since our products must be priced before the ultimate loss costs are known, it may take several years to know if pricing was adequate or inadequate. Inadequate pricing may lead to adverse loss development in future periods. In 2013, we experienced $72.5 million in favorable development on prior accident years’ reserves, compared to favorable development of $64.6 million in 2012 and $110.1 million in 2011. Further discussion of reserve development can be found in note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Over the past several years, we invested in our capacity to produce premium. We expanded our geographic footprint of existing products by adding underwriters and entering new markets. We hired teams of underwriters to start new products, and in 2011, added to our product offerings through the acquisition of CBIC. Over the past two years, approximately one-fourth of our gross premiums written were due to these initiatives. Expansion efforts, including the addition of CBIC, resulted in growth in our surety segment, which carries higher acquisition costs than other segments. In addition, new product offerings result in investments in systems, and in some instances, like CBIC, acquisition activities result in added costs of integration, including severance. On a consolidated basis, our policy acquisition costs, which include the expenses associated with expansion, represent an increased percentage of net premiums earned. Policy acquisition costs as a percentage of net premiums earned totaled 33 percent in 2013 and 34 percent in 2012 and 2011. We believe these investments have positioned us well to capitalize on future market opportunities.
Equity in earnings of unconsolidated investee (Maui Jim) increased for the second consecutive year in 2013, after declining in 2011. Maui Jim posted increased sales volume in each of the last three years, as a result of continued investments in marketing and advertising efforts. The increased sales, coupled with decreased cost of goods sold and improved foreign exchange results, have resulted in an increase in earnings in 2013.
On an overall basis, net premium growth outpaced the growth achieved in gross premiums written. In 2013, net premiums written advanced $78.4 million (28 percent) while gross premiums advanced $65.3 million (17 percent). The increase in net retained premium is due largely to increased retentions at our 2013 casualty reinsurance renewal. Given improved pricing on business we underwrite and overall volume growth, particularly in umbrella, we increased retentions on certain casualty products in 2013.
The segment’s loss ratio was 45.9 in 2013, compared to 53.8 in 2012 and 36.0 in 2011. While each year benefited from varying degrees of favorable reserve development on prior accident years, the results for 2013 and 2012 reflect lower loss ratios on the current accident year. Modest rate increases, relatively benign loss cost inflation and an improved mix of business, particularly with respect to general liability, resulted in a reduction to the 2013 accident year loss ratio of over 3 points. This result follows a 1 point improvement in 2012, which was also driven by an improved rate environment and a shift in mix of business toward lower loss producing products. The expense ratio for the casualty segment was 36.9 in 2013 compared to 36.7 in 2012 and 38.0 in 2011. Higher underwriting income in 2013 and 2011 resulted in increased bonus and profit-sharing expenses for those periods. During all three years, we continued to invest in expansion and new product initiatives. In 2013 and 2012, however, increased revenue from these investments has resulted in improved expense leverage and a lower trending expense ratio.
Gross premiums written in the property segment decreased by 3 percent in 2013 after increasing 4 percent in 2012 and 15 percent in 2011. While expansion efforts resulted in gross premiums increasing for crop reinsurance and recreational vehicles in 2013, most other coverages declined due to competitive pressures or re-underwriting efforts. In 2010, we initiated a crop reinsurance program in which we began assuming multi-peril crop insurance (MPCI) and crop hail exposure under a quota share agreement. In 2012, we reduced our participation in the first treaty but added a second treaty with coverages concentrated in the Midwest states. In 2013, we increased our participation in the treaty with coverages concentrated in the Midwest. The crop reinsurance program produced $53.4 million, $35.5 million and $34.9 million of gross premiums written in 2013, 2012 and 2011, respectively. On a net basis, however, premium growth was less dramatic as two-thirds of premium assumed under the second treaty was ceded to another reinsurance partner. In late 2012, we began offering recreational vehicle coverages. During 2013, gross premiums written associated with this new coverage totaled $11.5 million. Given the start-up nature of this venture, however, less than half of the premium written has been earned as revenue as of year-end 2013. Offsetting these improvements, gross premiums written for commercial property, marine and other property reinsurance declined in 2013. Commercial property declined 3 percent in 2013 after increasing 4 percent in 2012. The result for 2013 is due to a modest decline in catastrophe wind rates coupled with re-underwriting of our habitational book of business in non-coastal states. Gross premiums written for marine declined 7 percent in 2013 after increasing 2 percent in 2012. The decline in marine is due to re-underwriting efforts on the cargo and inland marine books, where additional rate was needed to improve underwriting results. On an overall basis, marine achieved a 9 percent rate
increase in 2013. While rate increases were achieved in aggregate, re-underwriting efforts also included exiting certain underperforming accounts, which resulted in the decline in gross premium writings. For other property reinsurance, excluding crop, gross premiums declined to $16.1 million in 2013 from $37.8 million in 2012. A majority of business assumed in our other property reinsurance program is catastrophe exposed and is viewed as complementary and diversifying for our catastrophe strategy employed within our commercial property product. Where experience is adverse or pricing is deemed inadequate, as occurred in 2013, underperforming or underpriced accounts are non-renewed. In addition, our exit from pet insurance in late 2012 negatively impacted premium in 2013. In total, pet insurance added $5.0 million in gross premiums written in 2012, after adding $5.8 million in 2011.
Underwriting income was $27.6 million in 2013, compared to income of $11.7 million in 2012 and $30.3 million in 2011. The segment’s results translated into combined ratios of 86.2, 94.3 and 85.1 for 2013, 2012 and 2011, respectively. While all three periods were impacted by spring storm losses, the result for 2013 and 2011 benefited from light hurricane activity. Results for 2013 included $9.9 million in losses from spring storms but were devoid of hurricane losses. In addition, results for 2013 were negatively impacted by increased loss activity on marine property coverages, specifically cargo and inland marine. Underwriting actions were taken to increase rates across both coverages, as well as exiting certain underperforming accounts. Partially offsetting these adverse impacts, commercial fire losses remained low and favorable development on prior accident years added $7.3 million to underwriting income. Approximately half of this benefit related to reductions in prior years’ hurricane reserves. The remainder related to continued positive emergence on marine liability and protection & indemnity coverages, where previous underwriting action was taken. For 2012, underwriting results included elevated natural catastrophe and weather-related losses that impacted our commercial property, marine, crop and other reinsurance coverages. Incurred losses from spring storms totaled $15.9 million in 2012, while losses and reinstatement premiums from Hurricanes Sandy and Isaac served to reduce income by an additional $18.1 million. In addition, widespread drought conditions across the United States resulted in our crop coverages posting $2.0 million in increased underwriting loss on the 2012 reinsurance contracts, when compared to the 2013 and 2011 reinsurance contracts. Partially offsetting these adverse impacts was $16.8 million in favorable development on prior accident years’ reserves. This benefit was due to $12.1 million in positive emergence on marine liability and protection & indemnity coverages. Reserves related to prior year hurricane and storm losses within commercial property and crop coverages also developed favorably in 2012 and accounted for the balance of favorable development within this segment. In contrast, results for 2011 included $17.0 million in losses from natural catastrophes and storms, which was offset by $18.5 million in favorable development on prior accident years. Prior years’ loss reserves have developed favorably in recent years for marine coverages, while commercial property posted favorable development on the 1994 accident year due to the settlement of the final claim from the Northridge earthquake. Spring storm losses in 2011 totaled $13.0 million, while Hurricane Irene added approximately $4.0 million in incurred loss.
Underwriting income totaled $23.6 million in 2013, compared to $26.5 million in 2012 and $18.5 million in 2011. The segment’s results translated into combined ratios of 77.9, 75.1 and 81.3 for 2013, 2012 and 2011, respectively. The segment’s loss ratio was 13.8 in 2013, compared to 11.1 in 2012 and 13.2 in 2011. While all three years benefited from favorable development on prior accident years’ loss reserves, the benefit in 2013 was $3.9 million lower than in 2012. This decline resulted in the increased loss ratio in 2013. For 2011, underwriting results were adversely impacted by loss experience on contract surety in the current accident year. The expense ratio for the surety segment was 64.1 in 2013, compared to 64.0 in 2012 and 68.1 in 2011. The increase in 2011 is reflective of costs associated with the acquisition and
During 2013, net investment income decreased by 10 percent as reinvestment rates remained below the portfolio’s average yield, despite an increase in market yields during the year. The average annual yields on our investments were as follows for 2013, 2012 and 2011:
The after-tax yield reflects the different tax rates applicable to each category of investment. Our taxable fixed income securities are subject to our corporate tax rate of 35.0 percent, our tax-exempt municipal securities are subject to a tax rate of 5.3 percent and our dividend income is generally subject to a tax rate of 14.2 percent. During 2013, the average after-tax yield on the fixed income portfolio declined to 2.4 percent from 2.6 percent in 2012. During the year, we focused on purchasing high-quality fixed income investments, primarily municipal securities and corporate bonds in the 5 to 15 year maturity range.
Despite a decrease in unrealized gains due to rising interest rates, the fixed income portfolio increased by $50.4 million during the year as operating cash flow contributed to net purchases. During 2013, the portfolio experienced net realized gains of $1.3 million and ended 2013 with net unrealized gains of $9.0 million. The tax-adjusted total return on a mark-to-market basis was -1.6 percent. During 2013, our equity portfolio increased by $42.9 million to $418.7 million due to the strong performance of the equity market during the year. During 2013, our equity portfolio experienced net realized gains of $21.5 million and ended 2013 with net unrealized gains of $199.8 million. The total return for the year on the equity portfolio was 27.4 percent.
(1) Average amounts at beginning and end of year (inclusive of cash and short-term investments).
We regularly evaluate the quality of our investment portfolio. When we determine that a specific security has suffered an other-than-temporary decline in value, the investment’s value is adjusted by reclassifying the decline from unrealized to realized losses. This has no impact on shareholders’ equity. We did not recognize any OTTI losses during 2013. During 2012, we recognized $1.2 million in impairment losses. All losses were taken during the second quarter on equity securities we no longer had the intent to hold. There were $0.3 million in losses associated with the OTTI of securities in 2011. All losses were in our equity portfolio.
As of December 31, 2013, we held one security in our equity portfolio that was in an unrealized loss position. The total unrealized loss on this security was $0.3 million. With respect to both the significance and duration of the unrealized loss positions, we have no equity securities in an unrealized loss position of greater than 20 percent for more than six consecutive months.
Fixed income represented 75 percent of our total 2013 portfolio compared to 76 percent in 2012. As of December 31, 2013, the fair value of our fixed income portfolio consisted of 17 percent AAA-rated securities, 46 percent AA-rated securities, 25 percent A-rated securities, 11 percent BBB-rated securities and 1 percent BB-rated securities. This compares to 16 percent AAA-rated securities, 46 percent AA-rated securities, 29 percent A-rated securities and 9 percent BBB-rated securities in 2012.
Our equity portfolio had a fair value of $418.7 million at December 31, 2013, entirely classified as available-for-sale. Equities comprised 22 percent of our total 2013 portfolio, up from 20 percent in 2012. Securities within the equity portfolio are well diversified and are primarily invested in large-cap issues with a focus on dividend income. Our strategy is value
We believe MBS investments add diversification, liquidity, credit quality and additional yield to our portfolio. Our objective for the MBS portfolio is to provide reasonable cash flow stability where we are compensated for the call risk associated with residential refinancing. The MBS portfolio includes mortgage-backed pass-through securities and collateralized mortgage obligations (CMO). A mortgage pass-through is a security consisting of a pool of residential mortgage loans which returns principal and interest cash flows to investors each month. A CMO has a more finite payment structure and can reduce the risks associated with prepayment. CMO securities are divided into maturity classes that are paid off under certain expected interest rate conditions. Our MBS portfolio does not include interest-only securities or principal-only securities. As of December 31, 2013, all of the securities in our MBS portfolio were rated AA+ and issued by Government Sponsored Enterprises (GSEs) such as the Governmental National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC).
Variability in the average life of principal repayment is an inherent risk of owning mortgage-related securities. However, we reduce our portfolio’s exposure to prepayment risk by seeking characteristics that tighten the probable scenarios for expected cash flows. As of December 31, 2013, the MBS portfolio contained 78 percent of pure pass-throughs compared to 89 percent as of December 31, 2012. An additional 16 percent of the MBS portfolio was invested in planned amortization class CMOs (PACs), compared to 8 percent as of December 31, 2012. CMO PACs are securities whose cash flows are designed to remain constant in a variety of mortgage prepayment environments.
As of December 31, 2013, approximately 55 percent of the municipal fixed income securities in the investment portfolio were GO and the remaining 45 percent were revenue based. Ninety-one percent of our municipal fixed income securities were rated AA or better while 99 percent were rated A or better.
The following table illustrates our corporate debt exposure to the financial and non-financial sectors as of December 31, 2013, including fair value, cost basis and unrealized gains and losses:
Our net earnings include equity in earnings of unconsolidated investee, Maui Jim. This investee does not have a policy or pattern of paying dividends. As a result, we record a deferred tax liability on the earnings at the corporate capital gains rate of 35 percent. In the fourth quarters of 2013 and 2012, we received a $13.2 and $6.6 million dividend, respectively. In accordance with GAAP guidelines on income taxes, we recognized a $3.7 million tax benefit for 2013 and a $1.8 million tax benefit for 2012 from applying the lower tax rate applicable to affiliated dividends (7 percent), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. Standing alone, the dividend resulted in a 2.1 and 1.3 percent reduction to the 2013 and 2012 effective tax rate, respectively. In determining the appropriate tax rate to apply, we anticipate recovering our investment through means other than the receipt of dividends, such as a sale.
In addition, our pretax earnings in 2013 included $24.5 million of investment income that is partially exempt from federal income tax, compared to $22.7 million and $17.6 million in 2012 and 2011, respectively. During 2013, we increased our exposure in tax-exempt municipal bonds with high quality state and local municipalities.
The primary liability on our balance sheet relates to unpaid losses and settlement expenses, which represents our estimated liability for losses and related settlement expenses before considering offsetting reinsurance balances recoverable. The largest asset on our balance sheet, outside of investments, is the reinsurance balances recoverable on unpaid losses and settlement expenses, which serves to offset this liability.
Prior to 2011, our balance sheet did not reflect any cash balance because all of our funds were invested in short-term investments, primarily highly-rated money market instruments. During 2011, we began holding a cash balance in our operating accounts. For further details, see note 1.F to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
We have entered into certain contractual obligations that require us to make recurring payments. The following table summarizes our contractual obligations as of December 31, 2013.
Loss and settlement expense reserves represent our best estimate of the ultimate cost of settling reported and unreported claims and related expenses. As discussed previously, the estimation of loss and loss expense reserves is based on various complex and subjective judgments. Actual losses and settlement expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the payments due by periods are based on our historical claims payment experience. Due to the uncertainty inherent in the process of estimating the timing of such payments, there is a risk that the amounts paid in any period can be significantly different than the amounts disclosed above. Amounts disclosed above are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable on unpaid loss and settlement reserves are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not discharge us of our liability to policyholders. Reinsurance balances recoverable on unpaid loss and settlement reserves totaled $354.9 million at December 31, 2013, compared to $359.9 million in 2012.
and commission, of $148.6 million. We are not party to any off-balance sheet arrangements.
At December 31, 2013, we had cash, short-term investments and other investments maturing within one year of approximately $74.8 million and an additional $170.5 million of investments maturing between 1 to 5 years. We maintain a revolving line of credit with JP Morgan Chase, which permits us to borrow up to an aggregate principal amount of $25.0 million. Under certain conditions, the line may be increased up to an aggregate principal amount of $50.0 million. The facility has a three-year term that expires on May 31, 2014. As of and during the year ended December 31, 2013, no amounts were outstanding on the revolving line of credit. We believe that cash generated by operations, cash generated by investments and cash available from financing activities will provide sufficient sources of liquidity to meet our anticipated needs over the next 12 to 24 months. We have generated positive operating cash flow for more than 20 consecutive years. The primary factor in our ability to generate positive operating cash flow is underwriting profitability, which we have achieved for 18 consecutive years.
We maintain a diversified investment portfolio representing policyholder funds that have not yet been paid out as claims, as well as the capital we hold for our shareholders. As of December 31, 2013, our portfolio had a carrying value of $1.9 billion. Invested assets at December 31, 2013, increased by $81.2 million, or 4 percent, from December 31, 2012.
Our overall investment philosophy is designed to first protect policyholders by maintaining sufficient funds to meet corporate and policyholder obligations and then generate long-term growth in shareholders’ equity. Because our existing and projected liabilities are sufficiently funded by the fixed income portfolio, we can improve returns by investing a portion of the surplus (within limits) in an equity portfolio. As of December 31, 2013, 51 percent of our shareholders’ equity was invested in equities, compared to 47 percent at December 31, 2012 and 47 percent at December 31, 2011.
Ordinary dividends, which may be paid by our principal insurance subsidiary without prior regulatory approval, are
subject to certain limitations based upon statutory income, surplus and earned surplus. The maximum ordinary dividend distribution from our principal insurance subsidiary in a rolling 12-month period is limited by Illinois law to the greater of 10 percent of RLI Ins. policyholder surplus, as of December 31 of the preceding year, or the net income of RLI Ins. for the 12-month period ending December 31 of the preceding year. Ordinary dividends are further restricted by the requirement that they be paid from earned surplus. In 2013 and 2012, our principal insurance subsidiary paid ordinary dividends totaling $40.0 million and $13.0 million, respectively, to RLI Corp. No ordinary dividends were paid in 2011. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the Illinois Department of Insurance. While no extraordinary dividends were paid in 2013, our principal insurance subsidiary sought and received regulatory approval in 2012 and 2011, prior to the payment of extraordinary dividends totaling $125.0 million and $150.0 million, respectively. As of December 31, 2013, $92.7 million of the net assets of our principal insurance subsidiary are not restricted and could be distributed to RLI Corp. as ordinary dividends. As of December 31, 2012 and 2011, as a result of extraordinary dividends distributed, the net assets of our principal insurance subsidiary were restricted and prior approval from the Illinois Department of Insurance was required for all dividends to RLI Corp. Because the limitations are based upon a rolling 12-month period, the presence, amount and impact of these restrictions vary over time.
We will maintain our underwriting focus and look to broaden our production sources and product offerings as a means of holding our market position in this segment. We expect moderate growth in this segment from both mature products and newer products in 2014. Newer products including professional liability for medical and non-medical professionals, multi-peril package products for professional service firms and CBIC packages all remain on a growth trajectory. In addition, we expect to see some growth from a small quota share reinsurance opportunity. We also expect to realize net premium growth from ceding less through our primary casualty reinsurance treaty. In January 2014, we were able to realize more than a 10 percent ($5.0 million) reduction in ceded reinsurance costs while leaving retentions relatively unchanged.
We expect primary rate levels to begin moderating as a result of the competitive reinsurance environment, but do not anticipate a rapid decline in market pricing. We continue to invest heavily in this segment, expanding our footprint in preparation for a market turn. However, the lack of significant price increases, a sluggish economy driving weaker demand and our heavy investment in developing new products will make it increasingly difficult to improve our underwriting
margins in this segment. We look to exercise our traditional underwriting discipline and select quality risks to continue to differentiate ourselves from the marketplace.
The investment landscape has been largely dominated by monetary policy over the last twelve months as the Federal Reserve publicly debated the need for ongoing accommodation in the form of quantitative easing. Despite the Federal Reserve’s effort to stimulate the economy, the U.S. remained in a slow but steady growth environment that realized approximately 2 percent in GDP growth, a 1.2 percent decline in unemployment and support from a stable albeit less than robust consumer. Inflation remains well contained, contributing to predictable input prices for manufacturers and helpful in an economy with little wage growth. Anticipation of the end of monetary policy stimulus around mid-year contributed to a sell-off in bond markets and a rise in yields from historic lows. As market participants began rotating out of fixed income for the first time in several years, credit spreads were under pressure across most sectors. With little income cushion to counteract a decline in bond prices, most fixed income indices posted a negative total return for the year. Other investment sectors with sensitivity to rates were not immune as emerging market stocks and bonds, along with income-focused equities, were held back by a rising rate backdrop. Although the market may experience some volatility around the transition to a more normal monetary policy stance from the Federal Reserve in 2014, our portfolio remains well positioned to support operations through current income and to contribute to long-term growth in book value via our low beta equity strategy. With bond yields rising from lows experienced in early 2013, there is a less significant drag on investment income as we invest incremental capital; however, turning the tide of decline is a slow multi-year process. Looking forward, we expect a flat year over year income comparison to 2013, which has some upside risk should portfolio growth be more than anticipated.
B. PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION: The accompanying consolidated financial statements were prepared in conformity with generally accepted accounting principles in the United States of America (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities. The consolidated financial statements include the accounts of our holding company and our subsidiaries. All significant intercompany balances and transactions have been eliminated. On January 15, 2014, RLI Corp. executed a two-for-one split of its common stock. All share and per share data throughout this report reflect the stock split and certain related reclassifications were made to prior years’ financial statements to conform to classifications used in the current year.
We adopted ASU 2012-02 on January 1, 2013. The adoption did not have a material effect on our financial statements. There have been no triggering events that would suggest possible impairment or that it is more likely than not that the fair values of indefinite-lived intangible assets are less than their carrying amounts.
There are no prospective accounting standards which would have a material impact on our financial statements as of December 31, 2013.
F. CASH AND SHORT-TERM INVESTMENTS: Cash consists of uninvested balances in bank accounts. Short-term investments consist of investments with original maturities of 90 days or less, primarily AAA-rated prime and government money market funds. Short-term investments are carried at cost, which approximates fair value. We have not
G. REINSURANCE: Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not relieve us of our legal liability to our policyholders.
J. INVESTMENT IN UNCONSOLIDATED INVESTEE: We maintain a 40 percent interest in the earnings of Maui Jim, Inc. (Maui Jim), a manufacturer of high-quality polarized sunglasses, which is accounted for by the equity method. We also maintain a similar minority representation on their board of directors. Maui Jim’s chief executive officer owns a controlling majority of the outstanding shares of Maui Jim. We carry this investment at the holding company, RLI Corp., level as it is not core to our insurance operations. Our investment in Maui Jim was $49.8 million in 2013 and $52.1 million in 2012. In 2013, we recorded $10.9 million in investee earnings, compared to $8.9 million in 2012 and $6.5 million in 2011. Maui Jim recorded net income of $26.1 million in 2013, $22.6 million in 2012 and $16.1 million in 2011. Additional summarized financial information for Maui Jim for 2013 and 2012 is outlined in the following table:
Approximately $36.7 million of undistributed earnings from Maui Jim are included in our retained earnings as of December 31, 2013. In 2013 and 2012, we received dividends of $13.2 million and $6.6 million, respectively, from Maui Jim.
K. INTANGIBLE ASSETS: In accordance with GAAP guidelines, the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or earlier if there is reason to suspect that their values may have been diminished or impaired. Goodwill and intangibles totaled $74.9 million at December 31, 2013. These assets relate to acquisition activity
The remaining $16.2 million of goodwill and intangibles relates to our purchase of Rockbridge in November 2012. Of this amount, $12.4 million is recorded as goodwill attributable to our casualty segment. The remaining $3.8 million relates to definite-lived intangible assets, net of amortization, as of December 31, 2013. We completed our evaluation of the acquisition under ASC Topic 805, Business Combinations in January 2013, which resulted in no adjustments from amounts recorded at December 31, 2012. Annual impairment testing was performed on this goodwill in the fourth quarter of 2013. Based upon this review, the asset was not impaired. In addition, as of December 31, 2013, there were no triggering events that occurred that would suggest an updated review was necessary.
L. UNPAID LOSSES AND SETTLEMENT EXPENSES: The liability for unpaid losses and settlement expenses represents estimates of amounts needed to pay reported and unreported claims and related expenses. The estimates are based on certain actuarial and other assumptions related to the ultimate cost to settle such claims. Such assumptions are subject to occasional changes due to evolving economic, social and political conditions. All estimates are periodically reviewed and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments are reflected in the results of operations in the period in which they are determined. Due to the inherent uncertainty in estimating reserves for losses and settlement expenses, there can be no assurance that the ultimate liability will not exceed recorded amounts. If actual liabilities do exceed recorded amounts, there will be an adverse effect. Furthermore, we may determine that recorded reserves are more than adequate to cover expected losses, as happened during 2010 through 2013, when favorable experience primarily on casualty business led us to reduce our reserves. Based on the current assumptions used in estimating reserves, we believe that our overall reserve levels at December 31, 2013, make a reasonable provision to meet our future obligations. See note 6 for a further discussion of unpaid losses and settlement expenses.
N. INCOME TAXES: We file a consolidated federal income tax return. Federal income taxes are accounted for using the asset and liability method under which deferred income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities, operating losses and tax credit carry forwards. The effect on deferred taxes for a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance if it is more likely than not all or some of the deferred tax assets will not be realized.
During 2013, the Internal Revenue Service (IRS) completed an examination of the income tax returns for the years 2010 and 2011, which produced no material change to net earnings. Although 2010 and 2011 have been examined by the IRS, tax years 2010 through 2013 remain open and are subject to examination or re-examination.
O. EARNINGS PER SHARE: Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the dilution that could occur if securities or other contracts to issue common stock or common stock equivalents were exercised or converted into common stock. When inclusion of common stock equivalents increases the earnings per share or reduces the loss per share, the effect on earnings is anti-dilutive. Under these circumstances, the diluted net earnings or net loss per share is computed excluding the common stock equivalents.
The following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the consolidated financial statements. As discussed in note 1.B. above, all share and per share data reflect the two-for-one stock split executed on January 15, 2014.
P. COMPREHENSIVE EARNINGS: Our comprehensive earnings include net earnings plus unrealized gains/losses on our available-for-sale investment securities, net of tax. In reporting the components of comprehensive earnings on a net basis in the statement of earnings, we used a 35 percent tax rate. Other comprehensive income (loss), as shown in the consolidated statements of earnings and comprehensive earnings, is net of tax expense (benefit) of $(3.8) million, $13.9 million and $11.5 million for 2013, 2012 and 2011, respectively.
Q. FAIR VALUE DISCLOSURES: Fair value is defined as the price in the principal market that would be received for an asset to facilitate an orderly transaction between market participants on the measurement date. We determined the fair value of certain financial instruments based on their underlying characteristics and relevant transactions in the marketplace. GAAP guidance requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance also describes three levels of inputs that may be used to measure fair value.
Common Stock: Exchange traded equities have readily observable price levels and are classified as Level 1 (fair value based on quoted market prices). All of our common stock holdings are deemed Level 1.
R. STOCK-BASED COMPENSATION: We expense the estimated fair value of employee stock options and similar awards. Guidance requires entities to measure compensation cost for awards of equity instruments to employees based on the grant-date fair value of those awards and recognize compensation expense over the service period that the awards are expected to vest.
S. RISKS AND UNCERTAINTIES: Certain risks and uncertainties are inherent to our day-to-day operations and to the process of preparing our consolidated financial statements. The more significant risks and uncertainties, as well as our attempt to mitigate, quantify and minimize such risks, are presented below and throughout the notes to the consolidated financial statements.
Our catastrophe reinsurance treaty renewed on January 1, 2014. We purchased the same limits over the same retention amounts outlined above for earthquakes in California. For earthquakes outside of California, we purchased $325 million excess of a $25 million first-dollar retention, subject to certain retentions by us in the excess layers. For other CAT events such as hurricanes, we purchased $225 million excess of a $25 million first-dollar retention, subject to certain retentions by us in the excess layers. We actively manage our catastrophe program to keep our net retention in line with risk tolerances and to optimize the risk/return trade off.
We are subject to environmental claims and exposures primarily through our commercial umbrella, general liability and discontinued assumed casualty reinsurance lines of business. Although exposure to environmental claims exists in these lines of business, we sought to mitigate or control the extent of this exposure on the vast majority of this business through the following methods: (1) our policies include pollution exclusions that have been continually updated to further strengthen them, (2) our policies primarily cover moderate hazard risks and (3) we began writing this business after the insurance industry became aware of the potential pollution liability exposure and implemented changes to limit its exposure to this hazard.
Our investment portfolio is subject to market, credit and interest rate risks. The equity portfolio will fluctuate with movements in the overall stock market. While the equity portfolio has been constructed to have lower downside risk than the market, the portfolio is sensitive to movements in the market. The bond portfolio is affected by interest rate changes and movement in credit spreads. We attempt to mitigate our interest rate and credit risks by constructing a well-diversified portfolio with high-quality securities with varied maturities. Downturns in the financial markets could have a negative effect on our portfolio. However, we attempt to manage this risk through asset allocation and security selection.
The preparation of the accompanying consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities and reported amounts of revenues and expenses. The most significant of these amounts is the liability for unpaid losses and settlement expenses. Other estimates include investment valuation and OTTIs, the collectability of reinsurance balances, recoverability of deferred tax assets and deferred policy acquisition costs. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. Although recorded estimates are supported by actuarial computations and other supportive data, the estimates are ultimately based on our expectations of future events. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in those estimates resulting from continuing changes in the economic environment will be reflected in the consolidated financial statements in future periods.
Our insurance subsidiaries are highly regulated by the states in which they are incorporated and by the states in which they do business. Such regulations, among other things, limit the amount of dividends, impose restrictions on the amount and types of investments and regulate rates insurers may charge for various coverages. We are also subject to insolvency and guarantee fund assessments for various programs designed to ensure policyholder indemnification. We generally accrue an assessment during the period in which it becomes probable that a liability has been incurred from an insolvency and the amount of the related assessment can be reasonably estimated.
The following is a summary of the disposition of fixed maturities and equities for the years ended December 31, with separate presentations for sales and calls/maturities.
Expected maturities may differ from contractual maturities due to call provisions on some existing securities. At December 31, 2013, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $208.8 million pretax. At December 31, 2012, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $219.7 million pretax.
Unrealized losses in the corporate bond portfolio increased to $8.0 million in 2013 from $0.2 million at the end of 2012 as interest rates increased during the year. These unrealized losses are not due to credit-specific issues. The corporate bond portfolio has an overall rating of A.
Unrealized losses in the collateralized securities bond portfolio increased to $7.7 million in 2013 due to the increase in interest rates during the year. Ninety-nine percent of our collateralized securities carry the highest credit rating by one or more major rating agency and continue to pay according to contractual terms.
For all fixed income securities at a loss at December 31, 2013, we believe it is probable that we will receive all contractual payments in the form of principal and interest. In addition, we are not required to, nor do we intend to sell these investments prior to recovering the entire amortized cost basis of each security, which may be maturity. We do not consider these investments to be other-than-temporarily impaired at December 31, 2013.
Our equity portfolio consists of common stocks and exchange traded funds (ETF). Unrealized losses in the equity portfolio decreased $0.6 million in 2013. Given our intent to hold and expectation of recovery to cost within a reasonable period of time, we do not consider any of our equities to be other-than-temporarily impaired.
Under current accounting standards, an OTTI write-down of debt securities, where fair value is below amortized cost, is triggered by circumstances where (1) an entity has the intent to sell a security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis or (3) the entity does not expect to recover the entire amortized cost basis of the security. If an entity intends to sell a security or if it is more likely than not the entity will be required to sell the security before recovery, an OTTI write-down is recognized in earnings equal to the difference between the security’s amortized cost and its fair value. If an entity does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income.
The fixed income portfolio contained 337 securities at an unrealized loss as of December 31, 2013. Of these 337 securities, two have been in an unrealized loss position for 12 consecutive months or longer and represent $0.2 million in unrealized losses. The majority of fixed income unrealized losses can be attributed to the increases in interest rates during the final three quarters of the year and are not credit related. All fixed income securities in the investment portfolio continue to pay the expected coupon payments under the contractual terms of the securities. Any credit-related impairment related to fixed income securities we do not plan to sell and for which we are not more likely than not to be required to sell is recognized in net earnings, with the non-credit related impairment recognized in comprehensive earnings. Based on our analysis, our fixed income portfolio is of a high credit quality and we believe we will recover the amortized cost basis of our fixed income securities. We continually monitor the credit quality of our fixed income investments to assess if it is probable that we will receive our contractual or estimated cash flows in the form of principal and interest. There were no OTTI losses recognized in other comprehensive earnings in the periods presented. Key factors that we consider in the evaluation of credit quality include:
· The discontinuance of a segment of business that may affect future earnings potential,
Based on our analysis, we concluded that the securities in an unrealized loss position were not other-than-temporarily impaired at December 31, 2013, and 2012.
During 2013, we did not recognize any impairment losses. There were $1.2 million in losses associated with OTTI of securities in 2012 and $0.3 million in losses associated with OTTI of securities in 2011.
We maintain a revolving line of credit with JP Morgan Chase, which permits us to borrow up to an aggregate principal amount of $25.0 million. Under certain conditions, the line may be increased up to an aggregate principal amount of $50.0 million. This facility was renewed under similar terms for a three-year term that expires on May 31, 2014. As of and during the years ended December 31, 2013, 2012 and 2011, no amounts were outstanding on this facility.
In the ordinary course of business, the insurance subsidiaries assume and cede premiums and selected insured risks with other insurance companies, known as reinsurance. A large portion of the reinsurance is put into effect under contracts known as treaties and, in some instances, by negotiation on each individual risk (known as facultative reinsurance). In addition, there are several types of treaties including quota share, excess of loss and catastrophe reinsurance contracts that
protect against losses over stipulated amounts arising from any one occurrence or event. The arrangements allow us to pursue greater diversification of business and serve to limit the maximum net loss to a single event, such as a catastrophe. Through the quantification of exposed policy limits in each region and the extensive use of computer-assisted modeling techniques, we monitor the concentration of risks exposed to catastrophic events.
The following table summarizes our prior accident years’ loss reserve development by segment for 2013, 2012 and 2011:
2013. We experienced favorable emergence relative to prior years’ reserve estimate in all our segments during 2013. The casualty segment contributed $61.8 million in favorable development. Accident year 2012 contributed significantly to the favorable development, with accident years 2008 to 2011 also continuing to develop favorably. The favorable development in 2013 is larger than 2012 and reflects the continuing favorable frequency and severity trends. In addition, the risk selection by our underwriters continued to provide results better than estimated in our reserving process. The general liability product contributed $28.5 million to our favorable development with all coverages, including habitational contributing to the favorable development in 2013. Executive products were the second largest contributor with $8.9 million in favorable development mostly from accident year 2011. Personal and commercial umbrella were favorable by $7.5 million and $6.0 million respectively. P&C package products were favorable by $8.1 million. Our run-off program business was favorable by $2.0 million mostly from the discontinued restaurant-bar-tavern business. Transportation and miscellaneous professional liability were the only products unfavorable at $3.5 million and $0.5 million, respectively.
The marine product was the primary driver of the favorable development in the property segment. Marine contributed $5.9 million of the $7.3 million total favorable property development. Accident year 2009 to 2012 contributed to the marine products’ favorable development. The marine protection & indemnity and liability coverages accounted for the majority of the favorable development. Other direct property products contributed $3.5 million favorable development offsetting the unfavorable development of $1.4 million in the assumed property.
2012. We experienced favorable emergence relative to prior years’ reserve estimates in all of our segments during 2012. Development from the casualty segment totaled $40.4 million with the largest amounts coming from accident years 2007 through 2010. We continue to experience emergence that is generally better than previously estimated, but to a lesser degree in 2012 than in the previous two years. Frequency and severity trends have been favorable relative to initial estimates and we believe this is largely due to risk selection by our underwriters, which has been effective in offsetting loss cost trends and a competitive pricing environment. Our general liability product was the largest single contributor to this favorable development at $14.2 million. Although the habitational classes within this product produced adverse development, it was more than offset by favorable development from the construction classes. The second largest contributor was our personal umbrella product at $11.5 million and we also had a favorable contribution of $4.9 million from our commercial umbrella products. In addition, our active program business combined for $9.2 million of favorable development, coming mostly from the CBIC products that were added in 2011. Our run-off program business contributed $4.6 million of favorable development coming mostly from the discontinued restaurant-bar-tavern class. Two business units experienced adverse development in 2012. Transportation and executive products were unfavorable by $3.2 million and $2.2 million, respectively.
years 2010 and 2011. The development from the commercial, miscellaneous and energy products more than offset $2.6 million of unfavorable development from the contract surety product. Last year we started seeing evidence that the cumulative effect of the economic environment was having an adverse impact on our customers and our experience, in particular for contract surety. This continued during 2012 causing us to increase our estimates for contract surety for prior accident years, in particular accident year 2011.
The following table represents paid and unpaid environmental, asbestos and mass tort claims data (including incurred but not reported losses) as of December 31, 2013, 2012 and 2011:
We have recorded our deferred tax assets and liabilities using the statutory federal tax rate of 35 percent. We believe it is more likely than not that all deferred tax assets will be recovered given the carry back availability as well as the results of future operations, which will generate sufficient taxable income to realize the deferred tax asset. In addition, we believe when these deferred items reverse in future years, our taxable income will be taxed at an effective rate of 35 percent.
Federal and state income taxes paid in 2013, 2012 and 2011, amounted to $36.8 million, $25.9 million and $50.5 million, respectively.
As discussed in note 1.B. all share and per share data throughout this report reflect the two-for-one stock split executed on January 15, 2014.
During 2013, the ESOP purchased 140,484 shares of RLI stock on the open market at an average price of $35.03 ($4.9 million) relating to the contribution for plan year 2012. Shares held by the ESOP as of December 31, 2013, totaled 3,382,944 and are treated as outstanding in computing our earnings per share. During 2012, the ESOP purchased 189,282 shares of RLI stock on the open market at an average price of $35.01 ($6.6 million) relating to the contribution for plan year 2011. During 2011, the ESOP purchased 179,566 shares of RLI stock on the open market at an average price of $28.82 ($5.2 million) relating to the contribution for plan year 2010. The above mentioned ESOP purchases relate only to our annual contributions to the plan and do not include amounts or shares resulting from the reinvestment of dividends.
Our RLI Corp. Omnibus Stock Plan (omnibus plan) was in place from 2005 to 2010. The omnibus plan provided for grants of up to 3,000,000 shares (subject to adjustment for changes in our capitalization). Since 2005, we have granted 2,457,644 stock options under this plan, including incentive stock options (ISOs), which were adjusted as part of the special dividends paid in 2013 and prior years.
eligible, defined by the plan as those individuals whose age and years of service equals 75, the requisite service period is deemed to be met and options are immediately expensed on the date of grant. For participants who will become retirement eligible during the vesting period, the requisite service period over which expense is recognized is the period between the grant date and the attainment of retirement eligibility. Shares issued upon option exercise are newly issued shares.
The following tables summarize option activity in 2013, 2012 and 2011:
The risk-free rate is determined based on U.S. treasury yields that most closely approximate the option’s expected life. The dividend yield is calculated based on the average annualized dividends paid during the most recent five-year period. It excludes the special dividends paid in 2013, 2012, 2011 and 2010. The expected volatility is calculated based on the mean reversion of RLI’s stock. The expected option life is determined based on historical exercise behavior and the assumption that all outstanding options will be exercised at the midpoint of the current date and remaining contractual term, adjusted for the demographics of the current year’s grant.
The statutory financial statements of our four insurance companies are presented on the basis of accounting practices prescribed or permitted by the insurance regulatory authority of their respective states of domicile, which are the Illinois Department of Insurance and the Washington State Office of the Insurance Commissioner. Each of those domiciliary states has adopted the NAIC statutory accounting practices as the basis of its statutory accounting practices. We do not use any permitted statutory accounting practices that differ from NAIC prescribed statutory accounting practices. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of statutory non-admitted assets and the inclusion of net unrealized holding gains or losses in shareholders’ equity relating to fixed maturities.
The NAIC has RBC requirements that require insurance companies to calculate and report information under a risk-based formula, which measures statutory capital and surplus needs based upon a regulatory definition of risk relative to the company’s balance sheet and mix of products. As of December 31, 2013, each of our insurance subsidiaries had an RBC amount in excess of the authorized control level RBC, as defined by the NAIC. RLI Insurance Company (RLI Ins.), our principal insurance company subsidiary, had an authorized control level RBC of $90.6 million, $90.4 million and $89.3
Year-end statutory surplus for 2013 presented in the table below includes $64.0 million of RLI stock (cost basis of $64.6 million) held by Mt. Hawley Insurance Company, compared to $9.1 million and $14.7 million in 2012 and 2011, respectively. The Securities Valuation Office provides specific guidance for valuing this investment, which is eliminated in our GAAP consolidated financial statements.
Ordinary dividends, which may be paid by our principal insurance subsidiary without prior regulatory approval, are subject to certain limitations based upon statutory income, surplus and earned surplus. The maximum ordinary dividend distribution from our principal insurance subsidiary in a rolling 12-month period is limited by Illinois law to the greater of 10 percent of RLI Ins. policyholder surplus, as of December 31 of the preceding year, or the net income of RLI Ins. for the 12-month period ending December 31 of the preceding year. Ordinary dividends are further restricted by the requirement that they be paid from earned surplus. In 2013 and 2012, our principal insurance subsidiary paid ordinary dividends totaling $40.0 million and $13.0 million, respectively, to RLI Corp. No ordinary dividends were paid in 2011. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the Illinois Department of Insurance. While no extraordinary dividends were paid in 2013, our principal insurance subsidiary sought and received regulatory approval in 2012 and 2011, prior to the payment of extraordinary dividends totaling $125.0 million and $150.0 million, respectively. As of December 31, 2013, $92.7 million of the net assets of our principal insurance subsidiary are not restricted and could be distributed to RLI Corp. as ordinary dividends. As of December 31, 2012 and 2011, as a result of extraordinary dividends distributed, the net assets of our principal insurance subsidiary were restricted and prior approval from the Illinois Department of Insurance was required for all dividends to RLI Corp. Because the limitations are based upon a rolling 12-month period, the presence, amount and impact of these restrictions vary over time.
Net investment income is the by-product of the interest and dividend income streams from our investments in fixed income and equity securities. Interest and general corporate expenses include the cost of debt and other director and shareholder relations costs incurred for the benefit of the corporation, but not attributable to the operations of our insurance segments. Investee earnings represent our share in Maui Jim earnings. We own 40 percent of Maui Jim, a privately held company which operates in the sunglass and optical goods industries. Our investment in Maui Jim, which is carried at the holding company, is unrelated to our core insurance operations.
system, the related assets are not allocated for management use and, therefore, are not included in this schedule.
The following table further summarizes net premiums earned by major product type within each segment:
On April 28, 2011, we acquired CBIC through an acquisition of its holding company, Data and Staff Service Co., for $135.9 million in cash. CBIC is a Seattle-based insurance company specializing in surety bonds and related niche property and casualty insurance products. CBIC posted $55.4 million of gross premiums written in 2013, which included $37.0 million attributable to the casualty segment and $18.4 million attributable to surety. CBIC contributed pretax earnings of $12.5 million. While these figures reflect results posted by CBIC, the full financial impact of the acquisition extends beyond CBIC and also impacts RLI Insurance Company results. Integration efforts and synergies experienced after the acquisition have transitioned certain policies which were formerly written in CBIC to RLI Insurance Company. For 2012, CBIC contributed $54.9 million of gross premiums written and pretax earnings of $14.1 million. For 2011, CBIC contributed $36.0 million of gross premiums written and pretax earnings of $2.7 million.
We have audited the accompanying consolidated balance sheets of RLI Corp. and subsidiaries as of December 31, 2013 and 2012, and the related consolidated statements of earnings and comprehensive earnings, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2013. We also have audited RLI Corp.’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). RLI Corp.’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report on Controls and Procedures. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on RLI Corp.’s internal control over financial reporting based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RLI Corp. and subsidiaries as of December 31, 2013 and 2012, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2013, in conformity with U.S. generally accepted accounting principles. Also in our opinion, RLI Corp. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The accompanying consolidated financial statements have been audited by KPMG LLP (KPMG), an independent registered public accounting firm selected by the audit committee and approved by the shareholders. Management has made available to KPMG all of the Company’s financial records and related data, including minutes of directors’ meetings. Furthermore, management believes that all representations made to KPMG during its audit were valid and appropriate.
The audit committee is comprised of four independent directors and is charged with general supervision of the audits, examinations and inspections of the books and accounts of RLI Corp. and Subsidiaries. The independent registered public accounting firm and the internal auditor have ready access to the audit committee.