We own three buildings: a five-story office building, a two-story office building and an eight-story office building in which a portion of the first floor (approximately 5.7 percent of the building’s square footage) is leased to tenants, and related parking facilities in Cedar Rapids, Iowa, that we use as our corporate headquarters. All three buildings are connected by a skywalk system. We also own a 250-space parking ramp, which is located adjacent to our corporate headquarters, for use by our employees. The parking ramp is located upon a parcel of real estate that we own and a parcel that we lease with an option to purchase.
Our regional locations in Westminster, Colorado, and Galveston, Texas, and our claims office in Metairie, Louisiana, conduct operations in leased office space.
The following table sets forth certain selected financial data derived from the Consolidated Financial Statements of United Fire and its subsidiaries and affiliate. The data should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 8, “Financial Statements and Supplementary Data.”
Property and casualty reserves may be affected by both internal and external events, such as changes in claims handling procedures, judicial or legislative actions, inflation, and catastrophes. The fluctuations in our reserves over the past five years primarily relate to losses incurred from Hurricanes Ike and Gustav, which occurred in 2008, and the adverse litigation that has resulted from Hurricane Katrina, which occurred in 2005. For further discussion of Hurricane Katrina, refer to our “Results of Operations” contained in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 16, “Contingent Liabilities” contained in Part II, Item 8, “Financial Statements and Supplementary Data.”
In 2010, our stockholders' equity improved due to an increase in net unrealized gains and a significant improvement in our earnings. In 2008 and 2009, our stockholders’ equity was impacted by the overall state of the economy and the volatility in the financial markets, which impaired our ability to generate an underwriting profit and reduced our net investment income and net unrealized investment gains. Additionally, we recognized in equity, for the five years, the net change in the underfunded status of our employee benefit plans.
Please refer to the Statutory Financial Measures section of Part II,
The adequacy of our loss and loss settlement expense reserves established for Hurricane Katrina, which are based on management’s estimates.
The frequency and severity of claims, including those related to catastrophe losses, and the impact those claims have on our loss reserve adequacy.
Developments in the domestic and global financial markets that could affect our investment portfolio and financing plans.
These are representative of the risks, uncertainties, and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report or as of the date they are
Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in Part I, Item 1A, “Risk Factors” of this document.
Results of Operations for the Years Ended December 31, 2010, 2009, and 2008
Founded in 1946, United Fire & Casualty Company provides insurance protection for individuals and businesses through several regional companies. We are represented by 796 independent property and casualty insurance agencies and 956 independent life insurance agencies throughout the country, predominantly in the Midwest, West and South.
life insurance, which includes deferred and immediate annuities, universal life products and traditional life (primarily single premium whole life insurance) products.
For 2010, more than half of our property and casualty premiums were written in Texas, Iowa, Missouri, Louisiana, and Illinois; over three-fourths of our life insurance premiums were written in Iowa, Wisconsin, Illinois, Nebraska, and Minnesota.
The following is a summary of our financial performance over the last three years and the primary factors that have affected our performance.
Our combined ratio improved to 99.9 percent for 2010, compared to 115.2 percent and 113.9 percent for 2009 and 2008, respectively. Catastrophe losses contributed 4.7 percent, 5.1 percent and 16.3 percent to our 2010, 2009 and 2008 combined ratio, respectively.
Our financial strength continued to improve, as our stockholders’ equity increased in 2010 to $716.4 million from $672.7 million in 2009 and $641.7 million in 2008. The increase in 2010 was primarily due to net income totaling $47.5 million, which was generated during the year.
Our book value per share increased by $2.00 to $27.35 in 2010 from $25.35 in 2009, primarily as a result of our significant increase in net income. Net unrealized investment gains, which was the primary factor increasing book value in 2009, were also a contributing factor in 2010. Book value per share in 2008 was $24.10.
Net premiums written decreased due to the weak economy, as growth remained depressed among current and potential commercial policyholders. In 2010, policy cancellations due to non-payment and/or companies going out of business contributed to a decline in our premium writings. However, in 2010 we successfully reduced loss and loss settlement expenses and took advantage of opportunities to grow our personal lines to offset the weaker commercial market.
Pricing in the insurance industry remained soft and very competitive in commercial lines. In the fourth quarter of 2010, we slightly reduced our commercial lines renewal pricing levels in order to retain quality accounts, although new business pricing remained unchanged. We retained approximately 80.0 percent of our commercial line accounts, in line with our goals. Personal lines retention rates reached approximately 87.0 percent for 2010 and we were successful in achieving slight price increases.
Interest rates remained a concern. While investment income has experienced gains due to increases in our bond and equity holdings in 2010, we saw some deterioration in the unrealized gains on our bond portfolio develop during the fourth quarter of 2010, due to rising interest rates.
Our property and casualty insurance segment reported pre-tax income of $38.8 million in 2010 compared to pre-tax losses of $39.9 million and $36.4 million in 2009 and 2008, respectively. While a slow economic recovery and ongoing competition continued to affect our commercial lines, we achieved slight increases in our personal lines rates. Additionally, our loss and loss settlement expenses decreased by 20.9 percent or $76.3 million from 2009 due in large part to our prior year’s claim experience. A decrease in non-catastrophe claims severity, accompanied by a slight decrease in frequency in 2010, also contributed to the reduction in losses and loss settlement expenses.
Other underwriting expenses decreased 8.3 percent in 2010, primarily as the result of a higher level of deferrable underwriting expenses in 2010 as compared to 2009. However, included in this line are transaction costs totaling $1.2 million that were incurred during the fourth quarter of 2010 related to our planned acquisition of Mercer Insurance Group, Inc. (“Mercer”). For further discussion of this planned acquisition, see the “Liquidity and Capital Resources” section contained in this item.
The following table shows our premiums written and earned for 2010, 2009 and 2008:
In 2010, we hired an outside insurance consultant to conduct a study, on our behalf, of strategic growth opportunities in the property and casualty industry that we could potentially use in the future as a means for generating additional revenue. Management has evaluated the findings from the study and are now engaged in determining if and when we will execute growth strategies.
In 2009, direct premiums written decreased due to continued competition and the weak economy. Also contributing to the reduction in direct premiums written in 2009, was the nonrenewal of accounts that no longer met our underwriting or pricing guidelines.
The insurance marketplace remained competitive in our commercial lines of business in 2009. We experienced a less than 1.0 percent decrease in our commercial lines premium level in the fourth quarter of 2009, reflecting a continuation of a trend of gradual decreases in premium level for some lines of business dating back to the third quarter of 2004. In our personal lines business, we averaged low- to mid-single-digit percentage increases in premium level for our homeowner and personal auto lines of business in late 2009.
For 2011, we have renewed our participation in all of our assumed programs, while increasing the participation level on one contract.
Direct and assumed premiums written are reduced by the ceded premiums that we pay to reinsurers. The reduction in ceded premiums written in 2010 as compared to 2009 and 2008 was due to the lower level of direct premiums written, which also affected the premiums we pay for our property catastrophe reinsurance program.
The renewal pricing for our 2010 non-catastrophe reinsurance program experienced a slight decrease due to the inclusion of umbrella coverage under the non-catastrophe program rather than maintaining it as a separate program. The renewal for our 2010 catastrophe reinsurance program also decreased as the soft market conditions impacted catastrophe reinsurance pricing.
Catastrophe losses are inherent risks of the property and casualty insurance business. Catastrophic events and natural disasters include, without limitation, hurricanes, tornadoes, earthquakes, hailstorms, wildfires, high winds, winter storms and other natural disasters. We also face man-made exposures to losses resulting from, without limitation, acts of war, acts of terrorism and political instability. Such events result in insured losses that can be, and may continue to be, a material factor in our results of operations and 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 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 frequency 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. Although we reinsure a portion of our exposure, reinsurance may prove to be inadequate if a major catastrophic event exceeds our reinsurance limits or if we experience a number of small catastrophic events that individually fall below our reinsurance retention level.
Hurricane Katrina made landfall in New Orleans, on August 29, 2005, causing an estimated $80.0 billion in damages. Over 95.0 percent of our policyholders in the New Orleans area suffered damage from Hurricane Katrina, with over 11,000 claims reported; we have concluded 97.6 percent of those claims as of December 31, 2010. Our loss and loss settlement expenses inception to date (net of reinsurance) attributable to Hurricane Katrina totaled $297.5 million as of December 31, 2010, of which $8.6 million was incurred in 2010 due to adverse claims litigation. In 2010, we continued to settle unresolved litigation related to Hurricane Katrina, concluding over 55.0 percent of the claims that were in litigation as of December 31, 2009. Our 2010 combined ratio was impacted 2.0 percent by Hurricane Katrina loss development compared to 8.7 percent and 2.3 percent for 2009 and 2008, respectively.
In January 2010, we ceased renewing policies or writing new business in the State of Louisiana through Lafayette Insurance Company and began to provide personal and commercial insurance coverage under United Fire & Casualty Company and our subsidiary, United Fire & Indemnity Company.
Our 2010 catastrophe reinsurance programs remained relatively unchanged from our 2009 programs. Neither terms and conditions nor pricing were materially different. In 2010 and 2009, we did not exceed our catastrophe retention of $20.0 million. However, 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.
Refer to Part II, Item 8, Note 5 “Reinsurance” for further discussion of our reinsurance programs.
The Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”) was signed into law on December 27, 2007. TRIPRA coverage includes most direct commercial lines of business, including coverage for losses from nuclear, biological and chemical exposures if coverage was afforded by an insurer, with exclusions for commercial automobile insurance, burglary and theft insurance, surety, professional liability insurance and farm owners multiple peril insurance. Under TRIPRA, each insurer has a deductible amount, which is 20.0 percent of the prior year’s direct commercial lines earned premiums for the applicable lines of business, and retention of 15.0 percent above the deductible. No insurer that has met its deductible shall be liable for the payment of any portion of that amount that exceeds the annual $100.0 trillion aggregate loss cap specified in TRIPRA. TRIPRA provides marketplace stability. As a result, coverage for terrorist events in both the insurance and reinsurance markets is often available. The amount of aggregate losses necessary for an act of terrorism to be certified by the U.S. Secretary of Treasury, the Secretary of State and the Attorney General was $100.0 million for 2010 and remains the same for 2011. Our TRIPRA deductible was $60.2 million for 2010 and our TRIPRA deductible will be $55.9 million for 2011. Our catastrophe and non-catastrophe reinsurance program provide limited coverage for terrorism exposure excluding nuclear, biological and chemical related claims.
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 were no longer profitable and the introduction of some pricing increases.
We also increased our case reserves on prior year’s losses, which resulted in a net deficiency of $0.5 million for 2008. The primary cause of our net deficiency in 2008 was the $26.6 million in adverse development from Hurricane Katrina. The Hurricane Katrina-related losses contributed to a deficiency in the fire and allied lines of business of $12.2 million.
Also contributing to our net deficiency in prior year reserves was an increase in general liability losses, which impacted our other and products liability lines of business. Claims for construction defect losses are included in the products liability line of business. Incurred losses from construction defect claims for prior years were $7.7 million in 2008. These losses contributed to a deficiency in the other liability and products liability lines of business totaling $5.8 million.
The following table depicts our net loss ratio for 2010, 2009 and 2008:
In 2009, the deterioration in our other liability lines was attributable to unfavorable reserve development from the re-estimation of our recorded reserves and a slight increase in severity as a result of larger jury awards and continuing construction defect claims and loss settlement expenses.
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 79.2 percent in 2010, 98.2 percent in 2009 and 122.7 percent in 2008. The improvement in 2010 was due to a reduction in adverse development from Hurricane Katrina as compared to 2009, and a decrease in severity. The improvement in 2009 as compared to 2008 was primarily the result of a decrease in loss and loss settlement expenses due to lower catastrophe losses and a leveling off of severity. Without considering catastrophe losses, frequency did not change significantly in 2009 from 2008.
In 2009, we took additional measures to address the increase in incurred losses in the commercial fire and allied lines of business, by implementing a number of underwriting initiatives that we anticipated would improve our loss experience. The following are the underwriting initiatives we undertook in 2009 and the progress we have made with them during 2010:
In 2009, we continued expansion of the use of pre-surveys, where loss control makes a visit to applicant’s property, prior to quoting larger new business accounts. The use of pre-surveys helped all of our regions in 2010 to identify quality new business that we would like to write.
In 2009, we continued to reduce our risk exposure in southern Louisiana by decreasing the number of insured properties and increasing our premium rates. Our risk exposure continued to decline in 2010 as we terminated relationships with seven agencies in the New Orleans area and did not renew accounts that no longer met our underwriting or pricing guidelines.
In 2009, we implemented 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. This tool has allowed us to identify risks with above-average exposure to weather, sinkhole, mine subsidence, storm surge, wildfire and earthquakes, on both new and renewal business. The information obtained allows us to adjust our premium levels and terms accordingly. In addition, the tool has enabled us to identify a small number of risks with favorable hazard characteristics that we otherwise might not have written.
Premiums earned in these lines have decreased from $109.2 million in 2008 to $102.3 million in 2009 to $98.7 million in 2010. Our premium writings continued to be affected by ongoing competition in a soft commerical lines market. In 2009, this led to a decline in both the residential housing market in our western states and in government-funded projects, as well as a reduction in the volume of business for the commercial and residential contractors that we insure. Also contributing to the reduction in direct premiums written for 2009 was the nonrenewal of accounts that no longer met our underwriting or pricing guidelines. As pricing in the industry continued to decrease, we avoided accounts that became too underpriced for the risk.
The other liability line experienced a decline in premiums earned in 2010 and 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 were $94.6 million in 2010, compared to $119.2 million in 2009 and $93.0 million in 2008. For 2009, the deterioration was attributable to unfavorable reserve development from the re-estimation of recorded reserves and a slight increase in severity from trends such as larger jury awards and increases in construction defect claims and loss settlement expenses.
A majority of our exposure to construction defect claims has been in Colorado and surrounding states. Historically we have insured small- to medium-sized contractors in this geographic area. In an effort to limit the number of future claims from multi-unit buildings, we have implemented new policy exclusions in recent years limiting subcontractor coverage on any building project with more than 12 units or on single family homes in any subdivision where the contractor is working on more than 15 homes. We also changed our underwriting guidelines to add a professional liability exclusion when contractors prepare their own design work or blueprints. In 2009, we implemented the multi-family exclusion and tract home building limitation form for the state of Colorado and our other western states, which we anticipate will benefit us in future years.
Within our other liability lines of business (other than construction defect), frequency increased in 2010 as compared to 2009, with losses incurred on 6,134 claims in 2010 compared to 4,936 in 2009 and 4,817 in 2008. In 2010, our average direct losses incurred per other liability claim (other than construction defect) were $15,930 per claim compared to $23,699 per claim in 2009 and $28,727 per claim in 2008.
In 2010, the increase in frequency on the other liability line of business is due to the continued deterioration of the economy with an associated increase in new claims submitted, primarily bodily injury claims.
In 2010 and 2009, our premium writings continued to be affected by the slow recovery in the economy, which resulted in a decrease in premiums earned as compared to 2008. In 2009, we also experienced a slight decrease in our policy counts, which resulted in a decrease in premiums earned, compared to 2008. Losses and loss settlement expenses were $66.9 million in 2010 compared to $75.1 million and $72.4 million in 2009 and 2008, respectively. We attribute the improvement in 2010 to a decrease in claims severity as compared to our results for 2009, when we experienced a slight increase in claims severity.
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 the results of this line of business. Consequently, we have increased the 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. And in 2011, we plan to introduce predictive modeling analytics into our workers’ compensation underwriting process.
In 2010, we continued to average low- to mid-single digit percentage increases in our personal lines premium rates, with a retention rate of approximately 87.0 percent. We will continue pursuing opportunities to grow our personal lines business in the future. We have added within our CATography™ Underwriter tool the ability to determine whether the premium we charge for an exposure is adequate in areas where hurricanes and earthquakes occur. Some initiatives that we hope to implement include predictive analytics for the homeowners and automobile lines and data prefill, which is a data accessing methodology that allows for a more complete profile of our customers at the agent’s point of sale during the quotation process.
Our assumed reinsurance line of business had a favorable loss ratio in 2010 of (72.1) percent, compared to loss ratios of 67.1 percent and 14.8 percent for 2009 and 2008, respectively. The favorable loss ratio experienced in 2010 resulted from our process to evaluate the overall adequacy of our property and casualty insurance reserves. We re-estimated our reserve requirement for this line of business as our largest assumed contract has been in run-off for many years and we believe any new claims on this contract will be minimal. In addition, our current participation level in assumed business is much lower than our historical participation level through selective renewal of the number and type of assumed contracts we have elected to continue writing. In comparison, the deterioration in 2009 was due to losses on contracts related to Hurricanes Gustav and Ike, as well as environmental and asbestos losses on run-off business.
In 2010, we increased our participation in assumed business, which led to the increase in assumed premium writings for the year. The decrease in 2009 was attributable to the termination of one of our assumed reinsurance contracts and our reduced participation level on another contract. Also contributing to the decline in 2009 was the conclusion of some of our assumed business in early 2009 that had been in run-off since late 2006.
Our underwriting expense ratios, which are a percentage of other underwriting expenses over premiums earned, were 31.0 percent, 31.3 percent and 29.4 percent for 2010, 2009 and 2008, respectively.
Our life insurance segment recorded pre-tax income of $19.5 million in 2010, compared to $11.2 million in 2009 and $3.3 million in 2008. The improvement in our 2010 results is attributable to the reduction in OTTI charges, a component of realized investment losses, as compared to the levels experienced in both 2009 and 2008. In 2010, 2009 and 2008, OTTI charges recorded totaled $0.3 million, $8.5 million and $8.9 million, respectively.
Net premiums earned increased 14.7 percent in 2010 as compared to 2009, and 13.3 percent in 2009 compared to 2008, as a result of our strategy to emphasize the marketing of our traditional life insurance products, primarily single premium whole life, to our independent life insurance agents, achieving a more balanced mix of traditional life insurance products to annuities.
United Life Insurance Company underwrites all of our life insurance business. Our principal life insurance products are deferred and immediate annuities, universal life products and traditional life (primarily single premium whole life insurance) products. We also underwrite and market other traditional products, including term life insurance and whole life insurance. Deferred and immediate annuities (66.4 percent), traditional life products (21.9 percent), universal life products (10.3 percent), and other life products (1.4 percent) comprised our 2010 life insurance premium revenues, as determined on the basis of statutory accounting practices. We do not write variable annuities or variable insurance products.
The fixed annuity deposits that we collect are not reported as net premiums earned under GAAP. Instead, we invest annuity deposits and record them as a liability against future policy benefits. The revenue that is generated from fixed annuity products consists of policy surrender charges and investment income. The difference between the yield we earn on our investment portfolio and the interest we credit on our fixed annuities is known as the investment spread. The investment spread is a major driver of the profitability for all of our annuity products.
Our deferred annuity deposits decreased 57.3 percent in 2010 compared to 2009, and increased 34.4 percent in 2009 compared to 2008. Annuity deposit levels decreased from 2009 to 2010 as historic, low interest rates continued to affect our level of deferred annuity deposits. Our deposits were driven by consumers who sought a conservative, guaranteed rate of return on their funds, while our withdrawals were driven by consumers who had a greater tolerance for risk and were seeking a potentially greater return.
Refer to “Critical Accounting Estimates” in this section for a more detailed discussion of our life segment’s deferred policy acquisition costs.
We reported a federal income tax expense of $10.9 million in 2010 and a federal income tax benefit of $18.3 million and $20.1 million in 2009 and 2008, respectively. The benefit in 2009 and 2008 resulted from a taxable loss in our property and casualty insurance operations. Our effective federal tax rate varied from the statutory federal income tax expense rate of 35.0 percent, due primarily to our portfolio of tax-exempt securities.
As of December 31, 2010, we have a net operating loss (“NOL”) carryforward of $12.5 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 insurance operations. NOLs totaling $1.6 million expire in 2011.
Due to our determination that we may not be able to fully realize the benefits of these NOLs, we have recorded a valuation allowance against the NOLs. At December 31, 2010, this valuation allowance totaled $4.0 million. Based on a yearly review we determine whether the benefit of the NOLs can be realized, and, if so, the decrease in the valuation allowance is recorded as a reduction to current federal income tax expense. The valuation allowance was reduced by $1.6 million in 2010 due to utilization of the NOLs.
We comply with state insurance laws that prescribe the quality, concentration and type 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 warranted by changing conditions in the financial markets. We manage all but a small portion of our investment portfolio internally.
Our invested assets at December 31, 2010, totaled $2.5 billion, compared to $2.4 billion at December 31, 2009. At December 31, 2010, fixed maturity securities comprised 92.5 percent of our investment portfolio, while equity securities accounted for 6.0 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 following table is a breakdown of the composition of fixed maturity securities held in our available-for-sale, held-to-maturity and trading security portfolios, by credit rating, at December 31, 2010 and 2009, respectively. Information contained in the table is based upon issue credit ratings provided by Moody’s unless the rating is unavailable, and then it is obtained from Standard & Poor’s:
Our total carrying value of our “AAA” fixed maturity securities increased in 2010 as compared to 2009 due to purchases of government agency bonds as well as an improvement in bond ratings, which caused the credit quality of our investment portfolio to shift upward. The change in ratings is also the primary reason our “AA” rated fixed maturity securities increased in 2010 as compared to 2009. Our “Baa/BBB” fixed maturity securities increased in 2010 as we chose to purchase more securities of this type in order to obtain a higher yield on our portfolio.
For our property and casualty insurance segment, the weighted average duration of our portfolio of fixed maturity securities, at December 31, 2010, is 6.5 years compared to 7.3 years at December 31, 2009.
For our life insurance segment, weighted average duration of our portfolio of fixed maturity securities, at December 31, 2010, is 3.6 years compared to 4.3 years at December 31, 2009.
The slight decline in our 2009 net investment income as compared to 2008 was due to the following factors: lower market interest rates earned on our investment portfolio, which also affected the returns on our short-term investments and cash and cash equivalents; agency bonds that were called during 2009, the proceeds of which we reinvested at lower interest rates than the called bonds carried; and the reduction or discontinuation of dividend payments by some of our equity securities that previously had paid regular dividends.
In 2010, 92.9 percent of our gross investment income originated from interest on fixed maturities, compared to 94.4 percent and 89.7 percent in 2009 and 2008, respectively.
We terminated our participation in a securities lending program effective December 31, 2010. Our participation in the securities lending program generated investment income of $100,000, $139,000 and $89,000 in 2010, 2009 and 2008, respectively.
In 2010, we reported realized investment gains of $8.5 million, compared to losses of $13.2 million and $10.4 million in 2009 and 2008, respectively. The following table summarizes the components of our realized investment gains or losses:
The improvement in our realized investment gains in 2010, as compared to the losses incurred in 2009 and 2008, was primarily due to a significant reduction in pre-tax realized losses from OTTI charges on our fixed maturity securities and equity securities. We incurred substantial OTTI charges in 2009 and 2008 as a result of the recent credit crisis that impacted the financial markets.
Changes in unrealized gains on available-for-sale securities do not affect net income (loss) and earnings (loss) per share, but do impact comprehensive income (loss), stockholders’ equity and book value per share. We believe that our unrealized losses on available-for-sale securities at December 31, 2010, are temporary based upon both our current analysis of the issuers of the securities that we hold and on current market conditions. It is possible that we could recognize impairment losses in future periods on securities that we own at December 31, 2010, if future events and information cause us to determine that a decline in value is other-than-temporary. However, we endeavor to invest in high quality assets to provide protection from future credit quality issues and corresponding impairment write-downs.The following table summarizes the change in our net unrealized gains:
Our Consolidated Balance Sheets include financial instruments whose fair values are subject to market risk. Market risk is the potential for loss due to a decrease in the fair value of securities resulting from uncontrollable fluctuations such as: interest rate risk, equity price risk, foreign exchange risk, credit risk, inflation, or world political conditions. Our primary market risk exposure is to changes in interest rates. We also have limited exposure to equity price risk and foreign exchange risk.
Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of our fixed maturity securities. Additionally, fair values of interest rate sensitive securities may be affected by the creditworthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions.
The active management of market risk is integral to our operations. We analyze potential changes in the value of our investment portfolio due to the market risk factors noted above within the overall context of asset and liability management. A technique we use in the management of our investment and reserve portfolio is the calculation of duration. Our actuaries estimate the payout pattern of our reserve liabilities to determine their duration, which is the present value of the weighted average payments expressed in years. We then establish a target duration for our investment portfolio so that at any given time the estimated cash generated by the investment portfolio will match the estimated cash flowing out of the reserve portfolio. We structure the investment portfolio to meet the target duration to achieve the required cash flow, based on liquidity and market risk factors.
The duration for the life insurance segment investment portfolio must take into consideration interest rate risk. This is accomplished through the use of sensitivity analysis, which measures the price sensitivity of the fixed maturities to changes in interest rates. The alternative valuations of the investment portfolio, given the various hypothetical interest rate changes utilized by the sensitivity analysis, allow management to revalue the potential cash flow from the investment portfolio under varying market interest rate scenarios. Duration can then be recalculated at the differing levels of projected cash flows.
To the extent actual results differ from the assumptions utilized; our duration and interest rate measures could be significantly affected. As a result, these calculations may not fully capture the impact of nonparallel changes in the relationship between short-term and long-term interest rates.
We reviewed our investment portfolio pertaining to securities guaranteed by third parties, with both direct and indirect exposure. We have no direct exposure in any of the guarantors that guarantee our investments. Our largest indirect exposure with a single guarantor totaled $134.4 million or 31.2 percent of our insured municipal securities at December 31, 2010, as compared to $129.7 million or 31.5 percent at December 31, 2009. Our five largest indirect exposures to financial guarantors accounted for 79.6 percent and 79.0 percent of our insured municipal securities at December 31, 2010 and 2009, respectively.
The following table displays a summary of cash sources and uses in 2010, 2009 and 2008:
Net cash flows provided by operating activities totaled $71.2 million in 2010, compared to $100.4 million in 2009 and $43.9 million in 2008, respectively. Cash flows in 2010 reflected a lower level of loss and loss settlement expense payments, a lower level of operating expenses paid and an increased level of investment income received. Negatively impacting operating cash flows was a lower level of property and casualty insurance premiums collected. The increase in operating cash flow for 2009 reflects an increase in loss payments; a reduction in other assets of $29.0 million for the conclusion of certain litigation related to Hurricane Katrina; and a reduction in reinsurance recoveries due to the collection of payments during the year and the improvement in our catastrophe experience in 2009 as compared to 2008.
Cash in excess of operating requirements is generally invested in fixed maturity securities and equity securities. Fixed maturities provide regular interest payments as well as the ability to match the duration of our liabilities. Equity securities provide the potential for future increases in dividend income and for appreciation. For further discussion of our investments including our philosophy and portfolio, see the “Investments” section contained in this item.
In addition to investment income, possible sales of investments and proceeds from calls or maturities of fixed maturity securities also can provide liquidity. During the next five years, $1.3 billion, or 58.4 percent, of our fixed maturity portfolio will mature.
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.
Under our share repurchase program, first announced in August 2007, we may purchase common stock from time to time on the open market or through privately negotiated transactions. The amount and timing of any purchases will be at our discretion and will depend upon a number of factors, including the share price, economic and general market conditions, and corporate and regulatory requirements. Our share repurchase program may be modified or discontinued at any time.
If our operating and investing cash flows are not sufficient to support our operations, we may also borrow up to $50.0 million on a bank line of credit. Under the current terms of our credit agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate, minus 1.0 percent, with a floor of 6.0 percent. We are currently in the process of reevaluating our line of credit options with other lenders. We did not utilize our line of credit during 2010 or 2009.
$47.5 million. Also contributing to the improvement was an increase in unrealized investment gains totaling $20.2 million, after tax, which is a 24.4 percent increase since December 31, 2009. This increase is due to an appreciation in the market value of our fixed maturity securities even as interest rates remained historically low as well as an increase in the market value of our equity securities.
These increases were somewhat offset by dividend payments; common stock repurchases; and an increase in the underfunded status of our employee benefit plans of $3.8 million, after tax. The book value per share of our common stock was $27.35 at December 31, 2010, compared with $25.35 at December 31, 2009.
The National Association of Insurance Commissioner’s (“NAIC”) adopted risk-based capital requirements, which requires us to calculate a minimum capital requirement for each of our insurance companies based on individual company insurance risk factors. These “risk-based capital” results are used by state insurance regulators to identify companies that require regulatory attention or the initiation of regulatory action. At December 31, 2010, all of our insurance companies had capital well in excess of the required levels.
On November 30, 2010, we announced our entry into a definitive agreement to acquire Mercer in a transaction valued at approximately $191.0 million. The transaction is subject to customary conditions, including approval by the stockholders of Mercer and regulatory authorities. Approval of the transaction by United Fire stockholders is not required and there is no financing condition to consummate the transaction.
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 presented 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, 2010.
The amounts presented above 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.
Our operating lease obligations are for the rental of office space, vehicles, computer equipment and office equipment.
We estimated the pension contribution for 2011 in accordance with the Pension Protection Act of 2006 (“the Act”). Contributions for future years are dependent on a number of factors, including actual performance versus actuarial assumptions made at the time of the actuarial valuations and maintaining certain funding levels relative to regulatory requirements. Contributions in 2011, and in future years, are expected to be an amount at least equal to the IRS minimum required contribution in accordance with the Act.
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. Our remaining potential contractual obligation was $11.4 million at December 31, 2010.
We validate the prices obtained from pricing services and brokers prior to their use for reporting purposes by evaluating their reasonableness on a monthly basis. Our validation process includes a review for unusual fluctuations. In our opinion, the pricing obtained at December 31, 2010, was reasonable.
In order to determine the proper classification in the fair value hierarchy for each security where the price is obtained from an independent pricing service, we obtain and evaluate the vendors’ pricing procedures and inputs used to price the security, which include unadjusted quoted market prices for identical securities, such as a New York Stock Exchange closing price and quoted prices for identical securities in markets that are not active. For fixed maturity securities, an evaluation of interest rates and yield curves observable at commonly quoted intervals, volatility, prepayment speeds, credit risks, and default rates may also be performed. We have determined that these processes and inputs result in fair values and classifications consistent with the applicable current accounting guidance on fair value measurements.
The following table presents the categorization for our financial instruments measured at fair value on a recurring basis in our Consolidated Balance Sheets at December 31, 2010 and 2009:
The $26.0 million reported as “transfers in” consisted of $22.7 million in available-for-sale fixed maturities that were primarily private placement securities that had no observable price available at December 31, 2010, and $3.3 million of available-for-sale fixed maturities that were subsequently reclassified, as a disposal, to other long-term
investments due to bankruptcy reorganization. The $4.1 million in “transfers out” resulted from available-for-sale fixed maturities and equity securities that previously had no observable market price at December 31, 2009, but for which observable prices were available at December 31, 2010.
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 established DAC asset. This offset is referred to as a premium deficiency charge. If the amount of the premium deficiency charge is greater than the unamortized DAC asset, a liability will be recorded for the excess. No such liability was recorded in 2010 or 2009.
To calculate the premium deficiency charge, we estimate expected losses and loss settlement expenses by using an assumed loss and loss settlement expense ratio which approximates that of the recent past. This is the only assumption we utilize in our calculation. Changes in this assumption can have a significant impact on the amount of premium deficiency charge calculated.
The following table illustrates the hypothetical impact on the premium deficiency charge recorded at December 31, 2010, 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 an offset against the established DAC asset as of December 31, 2010.
We defer and amortize policy acquisition costs, with interest, on traditional life insurance policies, over the anticipated premium-paying period in proportion to the present value of expected gross premium revenue. The present value of expected gross premium revenue is based upon the premium requirement of each policy and assumptions for mortality, morbidity, persistency and investment returns at policy issuance. These assumptions are not revised after policy issuance unless the recorded DAC asset is deemed to be unrecoverable from future expected profits. Absent a premium deficiency, variability in amortization after policy issuance is caused only by variability in premium volumes.
We periodically review estimates of expected profitability and evaluate the need to “unlock” or revise the amortization of the DAC asset. The primary assumptions utilized when estimating future profitability relate to interest rate spread, mortality experience and policy lapse experience. The table below illustrates the impact that a reasonably likely change in our assumptions used to estimate expected gross profits would have on the DAC asset for our non-traditional business recorded as of December 31, 2010. The entire impact of the changes illustrated would be recognized through operations as an increase or decrease to amortization expense.
A material change in these assumptions could have a negative or positive effect on our reported DAC asset, earnings and stockholders’ equity.
Reserves for losses and loss settlement expenses are reported using our best estimate of ultimate liability for claims that occurred prior to the end of any given accounting period, but have not yet been paid. Before credit for reinsurance recoverables, these reserves were $603.1 million and $606.0 million at December 31, 2010 and 2009, respectively. We purchase reinsurance to mitigate the impact of large losses and catastrophic events. Loss and loss settlement expense reserves ceded to reinsurers were $39.0 million for 2010 and $33.8 million for 2009. Our reserves, before credit for reinsurance recoverables, by line of business as of December 31, 2010, were as follows:
The amounts of the case-based reserves that we establish for claims in long-tail lines of business depends upon various factors, including individual claim facts (including type of coverage, severity of loss and underlying policy limits), company historical loss experience, changes in underwriting practice, legislative enactments, judicial decisions, legal developments in the awarding of damages, changes in political attitudes and trends in general economic conditions, including inflation. As with the short-tail lines of business, we review and make changes to long-tail case-based reserves based on our review of continually evolving facts as they become available to us during the claims settlement process. Our adjustments to case-based reserves are reported in the financial statements in the period that new information arises about the claim. Examples of facts that become known that could cause us to change our case-based reserves include, but are not limited to: evidence that loss severity is different than previously assessed; new claimants who have presented claims; and the assessment that no coverage exists.
For both our short-tail and long-tail lines of business, we establish our IBNR reserves by applying a factor to our current pool of in-force premium, as well as evaluating our exposure units. This factor has been developed through a 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 our independent actuary, Regnier Consulting Group, Inc. (“Regnier”).
The company’s historical ratio of loss settlement expenses (“LAE”) paid to losses paid is consistent and will continue to be consistent.
As an example, if our loss and loss settlement expense reserves of $603.1 million as of December 31, 2010, is 10.0 percent inadequate, we would experience a reduction in future pre-tax earnings of up to $60.3 million. This reduction could be recorded in one year or multiple years, depending on when we identify the deficiency. The deficiency would also affect our financial position in that our equity would be reduced by an amount equivalent to the reduction in net income. Any deficiency that would be recognized in our loss and loss settlement expense reserves usually does not have a material effect on our liquidity because the claims have not been paid. Conversely, if our estimates of ultimate unpaid loss and loss settlement expense reserves prove to be redundant, our future earnings and financial position would be improved.
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 and 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.
expenses covered by liability policies and can be significant, sometimes greater than the cost of the actual paid claims. For the majority of our products, defense costs are outside of the policy limit, meaning that the amounts paid for defense costs are not subtracted from the available policy limit.
Whether the “event” triggering coverage is confined to only one time period or is spread over multiple time periods;
Our reserve for other liability claims at December 31, 2010, is $282.7 million and consists of 3,419 claims, compared with $253.9 million, consisting of 5,363 claims at December 31, 2009. Of the $282.7 million total reserve for other liability claims, $85.1 million is identified as defense costs and $18.9 million is identified as general overhead required in the settlement of claims. If our established reserve is overstated or understated by 10 percent, the potential impact to our Consolidated Financial Statements would be approximately $28.3 million, before federal income taxes.
Included in the other liability and assumed reinsurance lines of business are reserves for asbestos and other environmental losses and loss settlement expenses. At December 31, 2010 and 2009, we had $3.4 million and $3.8 million in direct and assumed asbestos and environmental loss reserves. In addition, we had ceded asbestos and environmental loss reserves of $0.5 million at December 31, 2010 and 2009, 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.
Like the other liability line of business, workers’ compensation losses and loss settlement expense reserves are based upon variables that create imprecision in estimating the ultimate reserve. Estimates for workers’ compensation are particularly sensitive to assumptions about medical cost inflation, which has been steadily increasing over the past few years. Other variables that we consider and that contribute to the uncertainty in establishing reserves for workers’ compensation claims include: the state legislative and regulatory environments; trends in jury awards; and mortality rates. Because of these variables, the process of reserving for the ultimate loss and loss settlement expense to be incurred requires the use of informed judgment and is inherently uncertain. Consequently, actual loss and loss settlement expense reserves may deviate from our estimates. Such deviations may be significant. Our reserve for workers’ compensation claims at December 31, 2010, is $128.5 million and consists of 1,967 claims, compared with $131.7 million, consisting of 3,416 claims, at December 31, 2009. If our established reserve is overstated or understated by 10 percent, the potential impact to our Consolidated Financial Statements would be approximately $12.9 million, before federal income taxes.
Generally, we base reserves for each claim on the estimated ultimate exposure for that claim, determined from a pessimistic point of view. We believe that it is appropriate and reasonable to establish a best estimate for reserves within a range of reasonable estimates, especially when we are reserving for claims for bodily injury, disabilities and similar claims, for which settlements and verdicts can vary widely. Our reserving philosophy may result in favorable development in future years that will decrease losses and loss settlement expenses for prior year claims in the year of adjustment. While we realize that this philosophy, coupled with what we believe to be aggressive and successful claims management and loss settlement practices, has resulted in year-to-year redundancies in reserves, we believe our approach is better than experiencing year-to-year uncertainty as to the adequacy of our reserves.
point estimates prepared by Regnier by line of business to ensure that our estimates are within the actuary’s acceptable range. Regnier performs an extensive review of loss and loss settlement expense reserves at each year end using generally accepted actuarial guidelines to ensure that the recorded reserves appear reasonable. If the carried reserves were deemed unreasonable, we would adjust reserves. In 2010 and 2009, 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.
The actuarial analysis performed by Regnier indicated a reasonable range for our net reserves of $498.5 million to $606.8 million at December 31, 2010. Our net reserves for losses and loss settlement expenses as of December 31, 2010 were $564.1 million.
We engage an independent actuarial firm to render opinions as to the reasonableness of the statutory reserves we establish. Statutory reserves are established using considerably more conservative assumptions regarding future investment earnings and contractual benefit payments than are used for GAAP reserves. During 2010 and 2009, we engaged the services of Griffith, Ballard and Company as our independent actuarial firm for the life insurance segment. We anticipate that this engagement will continue in 2011.
Incorporated by reference from Note 1 “Significant Accounting Policies” under the heading “Pending Accounting Standards,” contained in Part II, Item 8, “Financial Statements and Supplementary Data.”
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 prepared in accordance with statutory accounting principles, as well as GAAP.
The following definitions of key statutory financial measures are provided for our readers’ convenience.
Combined ratio is a commonly used statutory financial measure of underwriting performance. A combined ratio below 100.0 percent generally indicates a profitable book of business. The combined ratio is the sum of two separately calculated ratios, the loss and loss settlement expense ratio (the “net loss ratio”) and the underwriting expense ratio (the “expense ratio”).
When prepared in accordance with statutory accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premium earned; the expense ratio is calculated by dividing underwriting expenses by net premiums written.
The accompanying Consolidated Financial Statements include United Fire and its wholly owned subsidiaries: United Life Insurance Company (“United Life”), Lafayette Insurance Company, Addison Insurance Company, American Indemnity Financial Corporation, United Fire & Indemnity Company and Texas General Indemnity Company. United Fire Lloyds, an affiliate of United Fire & Indemnity Company, has also been included in consolidation. All intercompany balances have been eliminated in consolidation.
Certain costs of underwriting new business, principally commissions, premium taxes and variable underwriting and policy issue expenses, have been deferred. Such costs are amortized as premium revenue is recognized. Policy acquisition costs deferred in 2010, 2009 and 2008 were $101,755,000, $98,946,000 and $111,521,000, respectively. Amortization of DAC in 2010, 2009 and 2008 totaled $102,636,000, $105,606,000 and $117,590,000, respectively. The method followed in computing DAC limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, losses and loss settlement expenses to be incurred and certain other costs expected to be incurred as the premium is earned.
The effect on DAC that results from the assumed realization of unrealized gains (losses) on investments allocated to non-traditional business is recognized with an offset to net unrealized investment appreciation as of the balance sheet dates. In 2010 and 2009, DAC decreased by $2,172,000 and $63,425,000, respectively, as a result of this adjustment.
Other long-term investments consist primarily of our interests in limited liability partnerships or joint ventures and are recorded on the equity method of accounting. Mortgage loans are recorded at cost. Policy loans are recorded at the outstanding loan amount due from policyholders. Included in investments at December 31, 2010 and 2009, are securities on deposit with, or available to, various regulatory authorities as required by law, with fair values of $1,563,821,000 and $1,464,406,000, respectively.
Our intangibles are composed entirely of agency relationships, which are being amortized by the straight-line method over periods of up to 10 years. We regularly review the carrying value of our intangibles for impairment in the recoverability of the underlying asset, with any impairment being charged to operations in the period that the impairment was recognized. We did not recognize an impairment charge on our intangibles in 2010, 2009 and 2008.
Deferred tax assets and liabilities are established based on differences between the financial statement bases of assets and liabilities and the tax bases of those same assets and liabilities, using the currently enacted statutory tax rates. Deferred income tax expense is measured by the year-to-year change in the net deferred tax asset or liability, except for certain changes in deferred tax amounts that affect stockholders’ equity and do not impact federal income tax expense.
We have recognized no liability for unrecognized tax benefits at December 31, 2010 or 2009 or at any time during 2010 or 2009. 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.
For our non-qualified stock options, we utilize the Black-Scholes option pricing method to establish the fair value of options granted under our stock award plans. Our determination of the fair value of stock options on the date of grant using this option-pricing model is affected by our stock price, as well as assumptions regarding a number of complex and subjective variables, which include the expected volatility in our stock price, the expected term of the award, the expected dividends to be paid over the term of the award and the expected risk-free interest rate. Any changes in these assumptions may materially affect the estimated fair value of the award.
The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for fiscal years beginning after December 15, 2010. Refer to Note 3 “Fair Value of Financial Instruments” for the information required to be disclosed upon our adoption of the guidance, effective January 1, 2010. We do not anticipate that our adoption of the guidance, effective January 1, 2011, will have any impact on our consolidated financial position or results of operations.
The proceeds and gross realized gains (losses) on the sale of available-for-sale securities for 2010, 2009 and 2008, were as follows:
Net investment income for the years ended December 31, 2010, 2009 and 2008, is comprised of the following:
Includes an adjustment for the changes in value of our holdings in limited liability partnership funds, which are accounted for under the equity method of accounting.
In most cases, we use quoted market prices to determine the fair value of fixed maturities, equity securities, trading securities and short-term investments. When quoted market prices do not exist, we base fair values 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.
The estimated fair value of policy loans is equivalent to carrying value. We do not make policy loans for amounts in excess of the cash surrender value of the related policy. In all instances, the policy loans are fully collateralized by the related liability for future policy benefits for traditional insurance policies or by the policyholders’ account balance for non-traditional policies.
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.
Annuity accumulations represent deferred annuity contracts which are currently earning interest.
For the year ended December 31, 2010, the change in our available-for-sale securities categorized as Level 1 and Level 2 is the result of investment purchases made during the period, which were made from funds held in our money market accounts, and an increase in unrealized gains on both fixed maturities and equity securities. There were no significant transfers of securities in or out of Level 1 or Level 2 during the period.
The fair value of our Level 3 private placement securities is determined by management relying on pricing received from our independent pricing services and brokers consistent with the process to estimate fair value for Level 2 securities.
The $5,439,000 reported as “disposals” included $1,930,000 of corporate bonds that were called as a result of debt restructuring by the issuer and $2,000,000 of corporate bonds that matured. Of the $1,930,000, $254,000 were short-term investments that were transferred to corporate bonds as a result of the restructuring. The remaining $1,509,000 in disposals relates to the receipt of principal on calls or sink fund bonds, in accordance with the indentures.
In 2010, we increased our participation in assumed business, which led to the increase in assumed premium writings for the year. The decrease in 2009 was attributable to the termination of one of our assumed reinsurance contracts and our reduced participation level on another contract. We also concluded some of our assumed business in early 2009 that had been in run-off since late 2006.
The benefit reported for losses incurred from assumed business in 2010 is the result of our process to evaluate the overall reserve adequacy of our property and casualty insurance segment. We re-estimated our reserve requirement for assumed business as our largest assumed reinsurance contract has been in run-off for many years and we believe any new claims on this contract will not be significant. In addition, our current participation level in assumed business is much lower than our historical participation level. The re-estimation of reserve estimates specific to the assumed reinsurance line of business did not have a direct impact on the net income reported for our property and casualty insurance segment in 2010. Refer to Note 6 “Reserves for Loss and Loss Settlement Expenses” for an analysis of changes in our overall property and casualty insurance reserves for 2010.
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 programs, which remained the same for both 2010 and 2009. Retention amounts reflect the accumulated retentions and co-participation of all layers within a program.
The unfavorable development in 2009 and 2008 was attributable to an increase we made in our prior accident year loss reserves due to additional development from Hurricane Katrina, which included a federal court ruling and subsequent judgment of $28,868,000, which we paid in 2009. We also experienced deterioration in our other liability lines of business, which includes claims for construction defects.
Statutory capital and surplus in regards to policyholders at December 31, 2010, 2009 and 2008 and statutory net income (loss) for the years then ended are as follows:
Because United Fire & Casualty Company owns United Life Insurance Company, the property and casualty statutory capital and surplus includes life, accident and health statutory capital and surplus, and therefore represents our total consolidated statutory capital and surplus.
We are directed by the state insurance departments’ solvency regulations to calculate a required minimum level of statutory capital and surplus based on insurance risk factors. The risk-based capital results are used by the NAIC and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. Both United Life and United Fire and its property and casualty subsidiaries and affiliate had statutory capital and surplus in regards to policyholders well in excess of their required levels at December 31, 2010.
and retirees (and covered dependents) who have met the service and participation requirements stipulated by the other retiree plan. The other retiree plan’s contract administrators are responsible for making medical and dental care benefit payments. Participants are required to submit claims for reimbursement or payment to the claims administrator within twelve months after the end of the calendar year in which the charges were incurred. An unfunded benefit obligation is reported for the other retiree plan in the accompanying Consolidated Balance Sheets, which relates to our postretirement benefits program.
We consider historical experience for comparable investments and the target allocations we have established for the various asset categories of the pension plan to determine the 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, by the pension plan, 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. 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 use an external actuarial firm to verify that the 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 our pension plan assets, as they yield the highest rate of return. The United Life annuity, which is the second largest asset category and was originally written by our life insurance subsidiary in 1976, provides a guaranteed rate of return. The interest rate on the group annuity contract is determined annually.
Cash and cash equivalents primarily consist of insured cash and money market funds held with various financial institutions. Interest is earned on a daily basis. The fair value of these funds approximates their cost basis due to their short-term nature.
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 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 the 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.
The following actuarial assumptions were used to determine the reported plan benefit obligations at December 31:
Our accumulated pension benefit obligation was $73,762,000 and $63,431,000 at December 31, 2010 and 2009, respectively.
The unrecognized prior service cost is being amortized on a straight-line basis over an average period of approximately 10 years. We anticipate amortization of prior service costs and net actuarial losses for our pension plan in 2011 to be $11,000 and $2,301,000, respectively. We anticipate amortization of our prior service costs and net actuarial losses for our postretirement benefit plan in 2011 to be $(32,000) and $360,000, respectively.
We have an employee stock ownership plan (the “ESOP”) for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the ESOP upon completion of one year of service, meeting the hourly requirements with United Fire and attaining 21 years of age. Contributions to the ESOP 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, 2010, 2009 and 2008, the ESOP owned 234,107; 241,741; and 241,796 shares of United Fire common stock, respectively. Shares owned by the ESOP 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 of $100,000 in 2010 and $150,000 in both 2009 and 2008.
The United Fire & Casualty Company 2008 Stock Plan (the “2008 Stock Plan”) authorizes the issuance of restricted and unrestricted stock awards, stock appreciation rights, incentive stock options, and non-qualified stock options for up to 1,900,000 shares of United Fire common stock to employees, with 833,495 authorized shares available for future issuance at December 31, 2010. The 2008 Stock Plan is administered by the Board of Directors, which determines those employees that will receive awards, when awards will be granted, and the terms and conditions of the awards. The Board of Directors may also take any action it deems necessary and appropriate for the administration of the 2008 Stock Plan. Pursuant to the 2008 Stock Plan, the Board of Directors may, at its sole discretion, grant awards to employees of United Fire or any of its affiliated companies who are in positions of substantial responsibility with United Fire.
Option awards granted pursuant to the 2008 Stock Plan are granted to buy shares of United Fire's common stock at the market value of the stock on the date of grant. All outstanding option awards vest and are exercisable in installments of 20.0 percent of the number of shares covered by the option award each year from the grant date, unless the Board of Directors authorizes the acceleration of vesting. To the extent not exercised, vested option awards accumulate and are exercisable by the awardee, in whole or in part, in any subsequent year included in the option period, but not later than 10.0 years from the grant date. Restricted and unrestricted stock awards granted pursuant to the 2008 Stock Plan are granted at the market value of our stock on the date of the grant and fully vest after 5.0 years from the date of issuance, unless accelerated upon the approval of the Board of Directors, at which time United Fire common stock will be issued to the awardee. Restricted and unrestricted stock awards are generally granted free of charge to the eligible employees of United Fire as designated by the Board of Directors.
The analysis below details the award activity for 2010 and the awards outstanding at December 31, 2010, for both of our plans and ad hoc options, which were granted prior to the adoption of the other plans:
Intrinsic value is the difference between our share price on the last day of trading (i.e., December 31, 2010) 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 that date. These values change based on the fair market value of our shares. The intrinsic value of options exercised totaled $27,000, $4,000 and $125,000 in 2010, 2009 and 2008, respectively.
At December 31, 2010, we had 19,464 restricted stock awards outstanding, all of which were granted in May 2008 at a fair market value of $33.43 per share, which resulted in $634,000 of compensation expense to be recognized over a five-year vesting period. The intrinsic value of the unvested restricted stock awards outstanding totaled $434,000 and $355,000 at December 31, 2010 and 2009, respectively.
The following table summarizes information regarding the stock options outstanding and exercisable at December 31, 2010:
We write both commercial and personal lines of property and casualty insurance. We focus on our commercial lines, which represented 90.5 percent of our property and casualty insurance premiums earned for 2010. Our personal lines represented 9.5 percent of our property and casualty insurance premiums earned for 2010.
In June 2008, our corporate headquarters was forced to close temporarily due to historic flooding in Cedar Rapids, Iowa, that caused extensive damage to the first and lower levels of our buildings. We recorded flood-related charges of $6,803,000, net of insurance, in 2008, and net insurance recoveries of $1,468,000 and $16,000 in 2009 and 2010, respectively. These charges primarily relate to costs incurred to clean up and restore our home office and contents. We have received insurance reimbursements totaling $34,000, $1,822,000 and $3,106,000, in 2010, 2009 and 2008, respectively, which offset all of the charges incurred in 2010 and 2009 and a portion of the charges incurred in 2008. There will be no further disaster charges or recoveries in 2011.
Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding during the reporting period. Diluted earnings per share gives effect to all dilutive common shares outstanding during the reporting period. The dilutive shares we consider in our diluted earnings per share calculation relate to our outstanding stock options and restricted and unrestricted stock awards.
The following table sets forth the components of our comprehensive income (loss) and the related tax effects for 2010, 2009 and 2008:
At December 31, 2010, we were obligated under noncancelable operating lease agreements for office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $4,506,000, $4,209,000 and $4,085,000 for 2010, 2009 and 2008, respectively. Our most significant lease arrangement is for office space for our regional office in Galveston, Texas. This lease expires in December 2014. The annual lease payments for this office space total approximately $2,100,000.
At December 31, 2010, our future minimum rental payments are as follows:
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, 2010, there were approximately 90 individual policyholder cases pending and four 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.
Following an April 2008 Louisiana Supreme Court decision finding that flood damage was clearly excluded from coverage, both state and federal courts have been reviewing pending lawsuits seeking class certification and other pending lawsuits in order to expedite pre-trial discovery and to move the cases towards trial. In 2010, we concluded 130 of the approximately 215 lawsuits that were pending at December 31, 2009. Five new lawsuits were filed in 2010 against us, alleging entitlement to additional insurance recovery as a result of Katrina-related damage. We have asserted that these suits were not timely filed and should be dismissed, but no court has yet addressed the viability of these recently filed suits.
We intend to continue to defend the cases related to losses incurred as a consequence of Hurricane Katrina. We have established our loss and loss settlement expense reserves on the assumption that the application of the Valued Policy
We are a defendant in two lawsuits filed in the Superior Court of New Jersey of Mercer County, Chancery Division, relating to our proposed merger with Mercer Insurance Group, Inc. Each of the lawsuits was filed as a class action on behalf of all of Mercer's stockholders and alleges, among other things, that the consideration that stockholders will receive in connection with the merger is inadequate, that Mercer's directors breached their fiduciary duties to stockholders in negotiating and approving the merger agreement, and that we aided and abetted the breach of fiduciary duty by Mercer's directors. Each of the complaints seeks various forms of relief, including injunctive relief that would, if granted, prevent the merger from closing in accordance with the agreed-upon terms. We intend to aggressively defend these cases. While we believe that the claims asserted against United Fire, Mercer, and its directors are without merit, we, along with Mercer Insurance Group, are pursuing resolution of the suits. We believe that any exposure on the part of United Fire is not material. Resolution of the litigation will remove the potential for delay in the shareholder vote which may be sought by the plaintiffs and the possibility of a consequential delay in the closing of the sale.
We consider all of our other litigation pending as of December 31, 2010, to be ordinary, routine, and incidental to our business.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire & Casualty Company at December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), United Fire’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report, dated February 28, 2011, expressed an unqualified opinion thereon.