The following is selected financial data of RLI Corp. and Subsidiaries for the five years ended December 31, 2018:
Unrealized gains and losses on equity securities were included in consolidated revenue and net earnings in 2018 and flowed through comprehensive earnings in prior years.
Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions and marine coverages. We also offer select personal lines policies, including homeowners’ coverages. Our property reinsurance and recreational vehicle (RV) products are in runoff after we began curtailing offerings at the end of 2015 and 2016, respectively. Property insurance results are subject to the variability introduced by perils such as earthquakes, fires and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. Our second largest catastrophe exposure is to losses caused by wind storms to commercial properties throughout the Gulf and East Coast, as well as to homes we insure in Hawaii. We limit our net aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and maintaining policy terms and conditions throughout market cycles. We also
Underwriting income or profit represents one measure of the pretax profitability of our insurance operations and is derived by subtracting losses and settlement expenses, policy acquisition costs and insurance operating expenses from net premiums earned, which are all GAAP financial measures. Each of these captions is presented in the statements of earnings but is not subtotaled. However, this information is available in total and by segment in note 11 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data. The nearest comparable GAAP measure is earnings before income taxes which, in addition to underwriting income, includes net investment income, net realized gains or losses, net unrealized gains or losses on equity securities in 2018, general corporate expenses, debt costs and our portion of earnings from unconsolidated investees.
In preparing the consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the
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 expected loss ratios and loss development assumptions. The loss development assumptions are typically based on historical reporting patterns but could consider alternative sources of information. The IBNR percentages are reviewed and updated periodically. 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.
The initial loss and ALAE ratios that are applied to earned premium are reviewed at least semi-annually. Prospective estimates are made based on historical loss experience adjusted for exposure mix, price change and loss cost trends. The initial loss and ALAE ratios also reflect our judgment as to estimation risk. We consider estimation risk by product and coverage within product, if applicable. A product with greater volatility and uncertainty has greater estimation risk. Products or coverages with higher estimation risk include, but are not limited to, the following characteristics:
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. In some analyses, including 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 medical professional liability and workers’ compensation, as well as for executive products, we utilize external data extensively.
Actuarial methods attempt to quantify future outcomes. However, insurance companies are subject to unique exposures that are difficult to foresee at the point coverage is initiated and, often, many years subsequent. Judicial and regulatory bodies involved in interpretation of insurance contracts have increasingly found opportunities to expand coverage beyond that which was intended or contemplated at the time the policy was issued. Many of these policies are issued on an “all risk” and occurrence basis. Aggressive plaintiff attorneys have often sought coverage beyond the insurer’s original intent including court interpretations of exclusionary language.
Loss reserve estimates are subject to a high degree of variability due to the inherent uncertainty of ultimate settlement values. Periodic adjustments to these estimates will likely occur as the actual loss emergence reveals itself over time. Our loss reserving processes reflect accepted actuarial practices and our methodologies result in a reasonable provision for reserves as of December 31, 2018.
The probability that we will recover the entire amortized cost basis of our fixed income securities prior to maturity.
We defer incremental direct costs that relate to the successful acquisition of new or renewal insurance contracts, including commissions and premium taxes. 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.
Net earnings for 2018 totaled $64.2 million, down from $105.0 million in the prior year. The components of net earnings differed significantly from prior years for two reasons. First, the inclusion of unrealized losses from equity securities in net earnings in 2018 significantly reduced pretax earnings and lowered income tax expense. Second, our effective tax rate and income tax expense were impacted by the application of a 21 percent federal corporate tax rate in 2018, compared to the historical 35 percent rate applied in prior years, as a result of tax reform legislation enacted in 2017. While current tax expense benefited from this reduction in 2018, earnings were lower because our deferred tax items were revalued to reflect the lower enacted rate in 2017. The revaluation reduced our net deferred tax liability and income tax expense by $32.8 million in 2017, which increased earnings, and decreased the effective tax rate by 38.8 percent. Additional information on income tax expense and the impact of tax reform can be found in note 7 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Incentive and profit-sharing amounts earned by executives, managers and associates are predominately influenced by corporate performance including net earnings excluding after-tax net realized and unrealized gains or losses, combined ratio and return on capital. Return on capital measures components of comprehensive earnings against a minimum required return on capital. Return on capital is the primary measure of executive bonus achievement and a significant component of manager and associate incentive targets. Incentive and profit sharing-related expenses attributable to the favorable reserve developments totaled $7.8 million, $5.9 million and $6.6 million for 2018, 2017 and 2016, respectively. An additional $7.7 million in incentive and profit-sharing-related expenses was recorded in 2017 in connection with the tax reform benefits recognized during the year, $7.0 million of which was recorded in underwriting expenses. These performance-related expenses impact policy acquisition, insurance operating and general corporate expenses line items in the financial statements. Partially offsetting the 2018, 2017 and 2016 increases were $6.1 million, $4.9 million and $2.6 million, respectively, in reductions to incentive and profit-sharing amounts earned due to losses associated with natural catastrophe activity.
Gross premiums written in the property segment increased 16 percent in 2018, after decreasing 6 percent in 2017 and 11 percent in 2016. The declines for 2017 and 2016 reflect exits from our RV, treaty reinsurance and facultative reinsurance lines. These products were discontinued due to factors such as poor underwriting performance, lack of scale or unfavorable market conditions. Production for 2016 was also impacted by our exit from crop reinsurance, which occurred due to the acquisition of the cedant company.
Our commercial property business grew 15 percent in 2018, due to a combination of exposure growth and rate increases on wind-prone business. Rates on other catastrophe coverages, such as earthquake, continued to decline, albeit at lower levels than in recent years. Our commercial property business was relatively flat in 2017, as modest exposure growth served to offset rate declines from the catastrophe exposed coverages, and followed a decline of 9 percent in 2016. Premiums from marine increased by 20 percent in 2018, as we secured new business, improved retentions and increased rates on our inland marine coverages. Marine was up 13 percent in 2017, due to a combination of exposure growth and modestly higher prices for inland marine, after declining 2 percent in 2016.
Specialty personal lines is primarily composed of homeowners’ insurance in select locations, including Hawaii, Massachusetts and North Carolina. Premiums from our Hawaii homeowners business increased 10 percent in 2018, after posting a 7 percent increase during 2017 and 8 percent in 2016. Rates have been flat for this coverage, but increased marketing efforts and recognition of our exceptional claim service following the Hawaii volcano losses have helped bring in new business. Specialty personal offerings also included our RV product, which we exited at the end of 2016 due to poor underwriting performance. RV wrote $10.4 million of specialty personal premium in 2016, but decreased to less than $1.0 million in 2017 and had almost no premium in 2018.
Gross premiums written from our surety segment increased 1 percent in 2018, following a 3 percent decline in 2017 and 2 percent growth in 2016. Miscellaneous surety was up 2 percent in 2018, as a realignment of our sales team allowed the Company to grow in a very competitive market. This product experienced a 4 percent decline in 2017, largely due to targeted reductions to select programs. Contract surety was also up 2 percent in 2018. Despite competition putting pressure on rates and terms, expansion of the commercial construction market and initiatives aimed at improving the customer experience provided an opportunity for growth with conditions and prices that met our high underwriting standards. Contract surety was down 4 percent in 2017, as certain accounts which no longer met our underwriting appetite were non-renewed, and was up 5 percent in 2016 when growth was experienced from bonds targeted to smaller contractors. Commercial surety was down slightly in 2018 and 2017, as market conditions made it difficult to compete on new account submissions. Efforts to selectively trim the portfolio in favor of retaining higher quality, lower risk accounts led to a decline in commercial surety premium in 2016. Energy surety was up 1 percent in 2018 and is combating the lower energy prices and soft market conditions that resulted in the 6 percent decline in 2017. Gross premiums written from energy surety for 2016 were up slightly.
Favorable development on prior accident years’ loss reserves benefited underwriting earnings in each of the past three years. The total benefit from favorable development on prior years’ reserves was $33.3 million for 2018, with the largest amounts of the development coming from accident years 2015 through 2017. Products which generated the majority of the favorable development include commercial excess, personal umbrella, professional services, general liability and small commercial. Increased favorable development on commercial excess, personal umbrella, general liability and professional services was responsible for a significant amount of the difference between the release in 2018 and 2017. Additionally, our transportation business experienced $0.5 million of favorable development in 2018 compared to $7.4 million of adverse development in 2017 and $15.4 million of adverse development in 2016. In response to adverse commercial auto loss trends, we began re-underwriting our transportation book in the fourth quarter 2016, with a focus on obtaining appropriate rate increases and improving risk selection. Our transportation re-underwriting efforts were completed during the second half of 2017 and have helped stabilize the business. Partially offsetting these favorable impacts was an increased level of adverse development on medical professional liability and adverse development on executive products.
Comparatively, overall results for the casualty segment in 2017 included favorable development of $17.5 million, with the bulk of the development attributable to commercial excess, personal umbrella, general liability, executive products, small commercial and professional services across accident years 2014 through 2016. For 2016, results included favorable development of $32.4 million, with the bulk of the development attributable to general liability, executive products, small commercial and commercial excess across accident years 2009 through 2015.
The segment’s loss ratio was 63.0 in 2018, compared to 63.9 in 2017 and 57.1 in 2016. The lower loss ratio in 2018 was due to the higher amounts of favorable development on prior years’ reserves, partially offset by an increased current accident year loss ratio. The expense ratio for the casualty segment was 34.9 in 2018, compared to 35.3 in 2017 and 34.9 in 2016. The decrease in expense ratio in 2018 was a result of lower incentive and profit-sharing expenses. An additional $3.9 million of incentive and profit-sharing expenses was recognized in connection with tax reform benefits during 2017, accounting for nearly 1 point of the expense ratio. Adjusting for this one-time impact, an increase in the expense ratio would have been observed in 2018, as investments were made in technology and our mix had a modest shift towards products with higher acquisition rates.
Underwriting income for the surety segment totaled $29.6 million on a 75.0 combined ratio in 2018. Underwriting performance for each of the past three years reflects a combination of positive current accident year results and favorable development in prior accident years’ loss reserves. The current accident year combined ratio in each of the past three years has been in the low 80s, with each product line contributing underwriting profit. Results for 2018 included $5.9 million of favorable development in prior years’ reserves, compared to $9.3 million and $4.8 million in 2017 and 2016, respectively.
The fixed income portfolio increased by $88.3 million during the year as the majority of operating cash flows were used for fixed income purchases. The tax-adjusted total return on a mark-to-market basis was 0.7 percent. Our equity portfolio decreased by $60.0 million to $340.5 million in 2018 as a result of the decline in equity markets in the fourth quarter, rebalancing to other asset classes and outright sales to support our special dividend. The total return for the year on the equity portfolio was -5.7 percent.
We realized a total of $63.4 million in net gains in 2018. Included in this number is $69.9 million in net realized gains in the equity portfolio, $2.2 million in net realized losses in the fixed income portfolio and $4.2 million in other net realized losses, $4.4 million of which related to a non-cash impairment charge on goodwill and definite-lived intangibles. In 2017, we realized $4.4 million in net gains. Included in this number is $10.3 million in net realized gains in the equity portfolio, $1.7 million in net realized losses in the fixed income portfolio and $4.2 million in other net realized losses, $3.4 million of which related to a non-cash impairment charge on goodwill and definite-lived intangibles. In 2016, we realized $34.6 million in net gains. Included in this number is $38.7 million in net realized gains in the equity portfolio, $4.2 million in net realized gains in the fixed income portfolio and $8.3 million in other net realized losses, $7.2 million of which related to a non-cash impairment charge on goodwill.
We regularly evaluate the quality of our investment portfolio. When we determine that a fixed income 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 recognized $0.2 million, $2.6 million and $0.1 million in impairment losses in 2018, 2017 and 2016, respectively. All losses were taken on fixed income securities we no longer had the intent to hold until recovery.
As of December 31, 2018, our investment portfolio had the following asset allocation breakdown:
Fixed income represented 80 percent of our total 2018 portfolio, up 2 percent from 2017. As of December 31, 2018, the fair value of our fixed income portfolio consisted of 48 percent AAA-rated securities, 16 percent AA-rated securities, 20 percent A-rated securities, 10 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities. This compares to 38 percent AAA-rated securities, 28 percent AA-rated securities, 17 percent A-rated securities, 11 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities in 2017.
As of December 31, 2018, our fixed income portfolio had the following rating distributions:
Our allocation to agency mortgage-backed securities totaled $395.3 million as of December 31, 2018. MBS represented 22 percent of the fixed income portfolio compared to $328.5 million or 20 percent of that portfolio as of December 31, 2017.
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, 2018, the MBS portfolio contained 66 percent of pure pass-throughs compared to 64 percent as of December 31, 2017. An additional 26 percent of the MBS portfolio was invested in sequential payer, up from 25 percent in 2017.
An asset-backed security (ABS) or commercial mortgage-backed security (CMBS) is a securitization collateralized by the cash flows from a specific pool of underlying assets. These asset pools can include items such as credit card payments, auto loans, structured bank loans in the form of collateralized loan obligations (CLOs) and residential or commercial mortgages. As of December 31, 2018, ABS/CMBS investments were $136.7 million (8 percent) of the fixed income portfolio, compared to $70.5 million (4 percent) as of December 31, 2017. All of the securities in the ABS/CMBS portfolio were rated AAA as of December 31, 2018. We believe that ABS/CMBS investments add diversification and additional yield to the portfolio while often adding superior cash flow stability over mortgage pass-throughs or CMOs.
As of December 31, 2018, municipal bonds totaled $320.1 million (18 percent) of our fixed income portfolio, compared to $636.2 million (38 percent) as of December 31, 2017. We reduced our allocation to municipal bonds during 2018 as the lower corporate tax rate from the TCJA diminished the asset class’ relative value when compared to other sectors. Despite the change, we still believe municipal fixed income securities can provide diversification and additional tax-advantaged yield to our portfolio. Our objective for the municipal fixed income portfolio is to provide reasonable cash flow stability and increased after-tax yield.
As of December 31, 2018, approximately 42 percent of the municipal fixed income securities in the investment portfolio were GO and the remaining 58 percent were revenue based. Eighty-five 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, 2018, including fair value, cost basis and unrealized gains and losses:
In 2018 and 2016, we received a dividend from Maui Jim. Dividends from Maui Jim have been irregular in nature and while they provide added liquidity when received, we do not rely on those dividends to meet our liquidity needs. While these dividends do not flow through the investee earnings line, they do result in the recognition of a tax benefit, which is discussed in the income tax section that follows.
As of December 31, 2018, we had a 23 percent interest in the equity and earnings of Prime Holdings Insurance Services, Inc. (Prime). Prime writes business through two Illinois domiciled insurance carriers, Prime Insurance Company, an excess and surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company. As a minority shareholder, we are subject to the decisions of the controlling shareholder, which may impact the value of our investment. In 2018, we recorded $3.6 million in investee earnings for Prime, compared to $2.8 million in 2017 and $1.1 million in 2016. Additionally, we maintained a 25 percent quota share reinsurance treaty with Prime, which contributed $41.1 million of gross premiums written and $34.2 million of net premiums earned during 2018, compared to $29.6 million of gross premiums written and $21.0 million of net premiums earned during 2017 and $13.4 million of gross premiums written and $11.4 million of net premiums earned during 2016. Our participation on the quota share reinsurance treaty will be reduced to 6 percent in 2019 as discussed in the Outlook for 2019 section below.
Our effective tax rates were 5.0 percent, -24.2 percent and 26.8 percent for 2018, 2017 and 2016, respectively. Effective rates are dependent upon components of pretax earnings and the related tax effects. While the effective rate was low in 2018, it was significantly lower in 2017 as a result of the impact of tax reform. Major factors contributing to the low rate in 2018 are the inclusion of unrealized losses from equity securities in pretax earnings in 2018, a reduced federal tax rate and adjustments to provisional deferred tax amounts recorded in 2017.
Except for two aspects, the accounting for the tax effects of the enactment of the TCJA were completed as of December 31, 2017. The first provisional item recorded in 2017 was related to an expected disallowance of deductions for certain performance based compensation, including bonuses and stock options. At the time of enactment, there was a lack of clarity on whether some amounts could be grandfathered in as deductible. The Internal Revenue Service (IRS) and Treasury Department provided additional guidance and we were able to finalize the accounting in 2018 by recording a $2.3 million deferred tax benefit to restore the deferred tax assets related to those performance based compensation amounts. The second provisional item related to discount factors on loss reserves that the IRS had not yet published. The IRS published the factors in the fourth quarter of 2018 and we were able to complete the accounting for the effects of the enactment of the TCJA. While there was no net impact to the deferred tax amount that was recorded at December 31, 2017, we implemented the new discounting methodology and will recognize the adjustment ratably over the allowed eight-year period beginning in 2018.
Dividends paid to our Employee Stock Ownership Plan (ESOP) also result in a tax deduction. Dividends paid to the ESOP in 2018, 2017 and 2016 resulted in tax benefits of $1.2 million $2.9 million and $3.3 million, respectively. These tax benefits reduced the effective tax rate for 2018, 2017 and 2016 by 1.8 percent, 3.4 percent and 2.1 percent, respectively.
In addition, our pretax earnings in 2018 included $21.1 million of investment income that is partially exempt from federal income tax, compared to $25.4 million and $24.9 million in 2017 and 2016, respectively.
The liability can be split into two parts: (1) case reserves representing estimates of losses and settlement expenses on known claims and (2) IBNR reserves representing estimates of losses and settlement expenses on claims that have occurred but have not yet been reported to the Company. Our gross liability for both case and IBNR reserves is reduced by reinsurance balances recoverable on unpaid losses and settlement expenses to calculate our net reserve balance. This net reserve balance increased to $1,096.3 million at December 31, 2018, from $969.5 million as of December 31, 2017. This reflects incurred losses of $428.2 million in 2018 offset by paid losses of $301.4 million compared to incurred losses of $401.6 million offset by $283.2 million paid in 2017. For more information on the changes in loss and LAE reserves by segment, see note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Gross reserves (liability) and the reinsurance balances recoverable (asset) are generally subject to the same influences that affect net reserves, though changes to our reinsurance agreements can cause reinsurance balances recoverable to behave differently. Total gross loss and LAE reserves increased to $1.5 billion at December 31, 2018 from $1.3 billion at December 31, 2017 while ceded loss and LAE reserves increased to $365.0 million from $302.0 million over the same period.
Additionally, two of our insurance companies, RLI Ins. and Mt. Hawley, are members of the Federal Home Loan Bank of Chicago (FHLBC). Membership in the Federal Home Loan Bank system provides both companies access to an additional source of liquidity via a secured lending facility. Based on qualifying assets at year-end, aggregate borrowing capacity is approximately $20 million. However, under certain circumstances, that capacity may be increased based on additional FHLBC stock purchased and available collateral. Our membership allows each insurance subsidiary to determine tenor and structure at the time of borrowing. As of and during the year ended December 31, 2018, there were no outstanding borrowings with the FHLBC.
terrorism). If we were to incur such losses, we would have to make significant claims payments in a relatively concentrated period of time.
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, 2018, our portfolio had a carrying value of $2.2 billion. Portfolio assets at December 31, 2018, increased by $53.4 million, or 2 percent, from December 31, 2017.
Our overall investment philosophy is designed to first protect policyholders by maintaining sufficient funds to meet corporate and policyholder obligations and then generate long-term growth in shareholders’ equity. Because our existing and projected liabilities are sufficiently funded by the fixed income portfolio, we can improve returns by investing a portion of the surplus (within limits) in a risk assets portfolio largely made up of equities. As of December 31, 2018, 42 percent of our shareholders’ equity was invested in equities, compared to 47 percent at December 31, 2017 and 45 percent at December 31, 2016.
The fixed income portfolio is structured to meet policyholder obligations and optimize the generation of after-tax investment income and total return.
Our capital structure is comprised of equity and debt obligations. As of December 31, 2018, our capital structure consisted of $149.1 million in 10-year maturity senior notes (long-term debt) and $806.8 million of shareholders’ equity. Debt outstanding comprised 16 percent of total capital as of December 31, 2018.
At the holding company (RLI Corp.) level, we rely largely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt, corporate expenses and dividends to RLI Corp. shareholders. As discussed further below, dividend payments to RLI Corp. from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the insurance regulatory authorities of Illinois. As a result, we may not be able to receive dividends from such subsidiary at times and in amounts necessary to pay desired dividends to RLI Corp. shareholders. On a GAAP basis, as of December 31, 2018, our holding company had $806.8 million in equity. This includes amounts related to the equity of our insurance subsidiaries, which is subject to regulatory restrictions under state insurance laws. The unrestricted portion of holding company net assets is comprised primarily of investments and cash, including $63.1 million in liquid investment assets, which more than covers our annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and regular dividend payments to our shareholders. If necessary, the holding company also has other potential sources of liquidity that could provide for additional funding to meet corporate obligations or pay shareholder dividends, which include a revolving line of credit, as well as access to the capital markets.
Our 171st consecutive dividend payment was declared in February 2019 and will be paid on March 20, 2019, in the amount of $0.22 per share. Since the inception of cash dividends in 1976, we have increased our annual dividend every year.
In 2018, the insurance industry experienced its second consecutive year of poor underwriting results due to severe catastrophe activity. Our combined ratio was impacted by catastrophe losses and rose to 94.7 and 96.4 in 2018 and 2017, respectively. Despite this elevated level of catastrophe losses, we produced an underwriting profit, exhibiting once again the benefits of our underwriting discipline and diverse product portfolio. The result for 2018 represented our 23rd consecutive year of producing an underwriting profit. We expect to produce a 24th year of underwriting profit in 2019.
The insurance industry’s return on equity has been generally poor, averaging 6.9 percent over the past five years. The industry has had a difficult time maintaining pricing discipline and significant competition continues in most of our lines of business. Broadened coverage and aggressive plaintiffs’ attorneys have also impacted loss severity trends. While we have been impacted by broader industry events, we remain a disciplined underwriting company. We outperformed the industry on both a combined ratio and return on equity basis and expect that to continue in 2019. While we have added new products in recent years that are gaining momentum, we have increased our focus on modernizing and investing in our proven, mature, profitable offerings. This focus helped produce solid premium growth in 2018, and investments made and a continued focus in these areas should provide further growth opportunities in ongoing products in 2019. We have also taken underwriting actions, including exiting certain unprofitable products, as discussed in the casualty section that follows. We believe these decisions will improve the health of our product portfolio but will challenge our ability to grow premiums on an overall basis. Our willingness to sacrifice top-line premium growth to improve profitability is a hallmark of our culture.
From a premium perspective, casualty will be under pressure in 2019, due to a decision at the end of 2018 to curtail or exit certain lines of business. We reduced our participation in our assumed reinsurance treaty with Prime from 25 percent to 6 percent. Our 23 percent minority interest remains unchanged. While Prime results have been positive, we are one step removed from both underwriting and claims handling. Given their significant premium growth and the increasing portion of our total premium they were becoming, we believed this action was necessary to reduce concentration risk. We also exited our healthcare liability business, which included primary and excess liability coverage for long-term care facilities, and our Real Estate Investment Trust business, which included liability coverage for large real estate portfolios. These actions were taken as losses had exceeded our expectations and our assessment of the competitive environment did not support a conclusion that an underwriting profit could be achieved in the near term. In combination, these decisions will reduce gross written premium by approximately $50 million, although they should result in improved underwriting results.
Our surety segment has experienced one of the most competitive environments among our product portfolio. A key driver of this competition has been continued strong profitability, although there have been several noticeable losses in this market recently. Our growth in surety has been curtailed by our underwriters’ reluctance to chase premium dollars and loosen terms and conditions, which are trends we have seen among our competitors. In addition to the competitive environment, surety’s forecast for 2019 will depend on economic activity and levels of public construction, particularly within our contract surety products. After a lengthy period of economic expansion, we are wary of the financial health of contractors and will therefore exercise caution when considering new business opportunities.
Our commercial and energy surety account-driven business will also be difficult to grow, given the competitive environment. We do expect growth in the miscellaneous surety product. In the last few years, we have re-evaluated and simplified our underwriting approach, upgraded technology and focused on ease of doing business with producers. We expect growth trends for miscellaneous surety to continue, but the overall top line for surety to remain flat given the pressure on larger accounts that make up the majority of this segment. The surety segment’s loss ratio may be under pressure, but we expect the segment to produce underwriting profit in 2019.
A confluence of headline events and a shift in market sentiment in the early fall led to a rise in market volatility in late 2018. Although the year began with significant optimism about a new tax regime and higher levels of sustained growth, it ended with tighter financial conditions, uncertainty surrounding trade policy and risk assets in decline. Unfortunately, the downdraft was enough to keep our portfolio’s total return results below zero for the year (-0.2 percent) for the first time since the financial crisis. Nevertheless, we did experience an uplift in investment income, over 13 percent for the year. While we
cannot predict the exact path of interest rates in the new year, we would expect a larger invested asset base and wider credit spreads to be supportive of tempered increases in investment income.
We would expect a modest uplift in treasury yields over a portion of the new year, albeit capped by a more shallow growth trajectory, nascent inflation expectations and a demographically-driven demand for interest rate sensitive sectors. Should wage pressure accelerate, we may experience pass through pricing pressure and / or corporate margin compression, both of which would be a headwind. The differential in long-term versus short-term yields will likely remain very narrow over the course of 2019, which will allow an opportunity to adjust yield curve exposure without a degradation of potential income.
We underwrite select property and casualty insurance coverages through major subsidiaries collectively known as RLI Insurance Group. We conduct operations principally through three insurance companies. RLI Insurance Company (RLI Ins.), a subsidiary of RLI Corp. and our principal insurance subsidiary, writes multiple lines of insurance on an admitted basis in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. Mt. Hawley Insurance Company (Mt. Hawley), a subsidiary of RLI Ins., writes surplus lines insurance on a non-admitted basis in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. Contractors Bonding and Insurance Company (CBIC), a subsidiary of RLI Ins., writes multiple lines of insurance on an admitted basis in all 50 states and the District of Columbia.
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. Certain reclassifications were made to 2017 and 2016 to conform to the classifications used in the current year. The Company has evaluated subsequent events through the date these consolidated financial statements were issued. There were no subsequent events requiring adjustment to the financial statements or disclosure.
are not impacted in 2018. We expect that revenue generated by both of our equity method investees will either be outside the scope of this update or largely unaffected by the changes.
c.Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet,
f.Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements and
ASU 2016-02 was issued to improve the financial reporting of leasing transactions. Under current guidance for lessees, leases are only included on the balance sheet if certain criteria, classifying the agreement as a capital lease, are met. This update will require the recognition of a right-of-use asset and a corresponding lease liability, discounted to the present value, for all leases that extend beyond 12 months. For operating leases, the asset and liability will be amortized over the lease term on a straight-line basis, with all cash flows included in the operating section of the statement of cash flows. For finance leases, interest on the lease liability will be recognized separately from the amortization of the right-of-use asset in the statement of comprehensive income and the repayment of the principal portion of the lease liability will be classified as a financing activity while the interest component will be included in the operating section of the statement of cash flows.
This ASU is effective for annual and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. ASU 2018-10, Codification Improvements to Topic 842, Leases was issued to clarify certain aspects of ASU 2016-02 and the two updates will be adopted concurrently. ASU 2016-02 requires leases to be recognized and measured at the beginning of the earliest period presented using a modified retrospective approach upon adoption. However, ASU 2018-11, Leases (Topic 842): Targeted Improvements provides an alternative transition method by which leases are recognized at the date of adoption and a cumulative-effect adjustment to the opening balance of retained earnings is recognized in the period of adoption. We plan to adopt using this alternative. It is expected that total assets and total liabilities will increase by approximately $25 million to $30 million upon implementation and the adoption of this update will not have a material impact on net earnings.
ASU 2018-07 was issued to simplify the accounting for share-based transactions by expanding the scope of Topic 718 from only being applicable to share-based payments to employees to also include share-based payment transactions for acquiring goods and services from nonemployees. As a result, nonemployee share-based transactions will be measured by estimating the fair value of the equity instruments at the grant date, taking into consideration the probability of satisfying performance conditions. This ASU is effective for annual and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. Our long-term incentive plan limits the awards of share-based payments to employees and directors of the Company or any affiliate. The share-based compensation expense to nonemployee directors was $0.3 million in 2018. Costs associated with such payments are not expected to materially increase and we do not expect this update to have a material impact on our financial statements.
This ASU is effective for annual and interim reporting periods beginning after December 15, 2019. As the amendments are only disclosure-related and we do not currently have any assets or liabilities that are measured based on Level 3 inputs, our financial statements will not be materially impacted by this update.
Equity securities are carried at fair value with unrealized gains and losses recorded within net earnings in 2018. Prior to 2018, unrealized gains and losses on equity securities were recognized through other comprehensive earnings. We classify our investments in fixed income securities into one of three categories: trading, held-to-maturity or available-for-sale.
Debt securities not included as held-to-maturity or trading are classified as available-for-sale and reported at fair value. Unrealized gains and losses on these securities are excluded from net earnings but are recorded as a separate component of
comprehensive earnings and shareholders’ equity, net of deferred income taxes. All of our debt securities are classified as available-for-sale.
We continuously monitor the financial condition of our reinsurers. As part of our monitoring efforts, we review their annual financial statements, quarterly disclosures and Securities and Exchange Commission (SEC) filings for reinsurers that are publicly traded. We also review insurance industry developments that may impact the financial condition of our reinsurers. We analyze the credit risk associated with our reinsurance balances recoverable by monitoring the A.M. Best and Standard & Poor’s (S&P) ratings of our reinsurers. In addition, we subject our reinsurance recoverables to detailed recoverable tests, including one based on average default by S&P rating. Based upon our review and testing, our policy is to charge to earnings, in the form of an allowance, an estimate of unrecoverable amounts from reinsurers. This allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover.
Approximately $68.9 million of undistributed earnings from Maui Jim are included in our retained earnings as of December 31, 2018. We received dividends of $9.9 million from Maui Jim in 2018 and 2016. No dividends were received in 2017.
Goodwill and intangibles totaled $54.5 million and $59.3 million at December 31, 2018 and 2017, respectively, as detailed in the following table.
As the amortization of goodwill and indefinite-lived intangible assets is not permitted, the assets 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. Annual impairment testing was performed on each of our goodwill and indefinite-lived intangible assets during 2018. Based upon these reviews, our energy surety goodwill, miscellaneous and contract surety goodwill, small commercial goodwill and state insurance license indefinite-lived intangible asset were not impaired. In addition, as of December 31, 2018, there were no triggering events on the above-mentioned goodwill and intangible assets that would suggest an updated review was necessary.
Our comprehensive earnings include net earnings plus after-tax unrealized gains and losses on our available-for-sale fixed income portfolio in 2018. In 2017 and 2016, after-tax unrealized gains and losses on our equity portfolio were also included. With the adoption of ASU 2016-01 on January 1, 2018, we began recognizing unrealized gains and losses on the equity portfolio through net income. See note 1.C for more information. In reporting the components of comprehensive earnings, we used the federal statutory tax rate of 21 percent in 2018 and 35 percent in 2017 and 2016. Other comprehensive income (loss), as shown in the consolidated statements of earnings and comprehensive earnings, is net of tax expense (benefit) of $(9.0) million, $19.0 million and $(0.6) million for 2018, 2017 and 2016, respectively.
The sale or other-than-temporary impairment of an available-for-sale security results in amounts being reclassified from accumulated other comprehensive earnings to current period net earnings. The effects of reclassifications out of accumulated other comprehensive earnings by the respective line items of net earnings are presented in the following table. As previously mentioned, 2018 activity is reflective of activity on fixed income securities classified as available-for-sale, while 2017 and 2016 also includes activity from the equity portfolio.
Common Stock: All but one of our common stock holdings are traded on an exchange. Exchange traded equities have readily observable price levels and are classified as Level 1 (fair value based on quoted market prices). Pricing for the equity security not traded on an exchange is provided by a third-party pricing source and is classified as Level 2.
The tax effects related to share-based payments were made through net earnings in 2018 and 2017. In 2016, the tax effects of share-based compensation were recognized in additional paid-in capital under the alternative transition method. The alternative transition method used simplified methods to determine the impact on the additional paid-in capital pool and consolidated statements of cash flows.
We compete with a large number of other companies in our selected lines of business. During periods of intense competition for premium, we are vulnerable to the actions of other companies who may seek to write business without the appropriate regard for risk and profitability. The insurance industry is currently operating under highly competitive conditions and, as a result, margins in the industry are under pressure. During these times, it is very difficult to grow or maintain premium volume without sacrificing underwriting discipline and income. Our profitability can be affected significantly by the ability of our underwriters to accurately select and price risk and our claim personnel to appropriately deliver fair outcomes. We attempt to mitigate this risk by incentivizing our underwriters to maximize underwriting profit and remain disciplined in pricing and selecting risks. If we are unable to compete effectively in the markets in which we operate or expand our operations into new markets, our underwriting revenues may decline, as well as overall business results.
Our insurance coverages include exposure to catastrophic events. We monitor all catastrophe exposures by quantifying our exposed policy limits in each region and by using computer-assisted modeling techniques. Additionally, we limit our risk to such catastrophes through restraining the total policy limits written in each region and by purchasing reinsurance. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. In 2018, we had reinsurance protection of $300 million in excess of $25 million first-dollar retention for earthquakes in California and $325 million in excess of a $25 million first-dollar retention for earthquakes outside of California. These amounts are subject to certain co-participations by the Company on losses in excess of the $25 million retentions. Our second largest catastrophe exposure is to losses caused by wind storms to commercial properties throughout the Gulf and East Coasts, as well as to homes we insure in Hawaii. In 2018, these coverages were supported by $225 million in excess of a $25 million first-dollar retention in traditional catastrophe reinsurance protection, subject to certain co-participations by the Company in the excess layers. In addition, we have incidental exposure to international catastrophic events.
Our catastrophe reinsurance treaty renewed on January 1, 2019. We purchased reinsurance protection of $400 million in excess of $25 million first-dollar retention for earthquakes in California and $425 million in excess of a $25 million first-dollar retention for earthquakes outside of California. For other CAT events, such as hurricanes, we purchased reinsurance protection of $275 million in excess of a $25 million first dollar retention. These amounts are subject to certain co-participations by the Company on losses in excess of the $25 million retentions. 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 excess, general liability and discontinued assumed casualty reinsurance lines of business. Although exposure to environmental claims exists in these lines of business, we seek to mitigate or control the extent of this exposure on the vast majority of this business through the following methods: (1) our policies include pollution exclusions that have been continually updated to further strengthen them, (2) our policies primarily cover moderate hazard risks and (3) we began writing this business after the insurance industry became aware of the potential pollution liability exposure and implemented changes to limit exposure to this hazard.
Liquidity is essential to our business and a key component of our concept of asset-liability matching. Our liquidity may be impaired by an inability to collect premium receivable or reinsurance recoverable balances in a timely manner, an inability to sell assets or redeem our investments, an inability to access funds from our insurance subsidiaries, unforeseen outflows of cash or large claim payments or an inability to access debt or equity capital markets. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption, an operational problem that affects third parties or the Company, or even by the perception among market participants that we, or other market participants, are experiencing greater liquidity risk.
In addition, ratings are a critical factor in establishing the competitive position of insurance companies. Our insurance companies are rated by A.M. Best, S&P and Moody’s. Their ratings reflect their opinions of an insurance company’s and an insurance holding company’s financial strength, operating performance, strategic position and ability to meet its obligations to policyholders.
Gross unrealized losses in the corporate bond portfolio increased to $16.1 million in 2018 from $1.7 million at the end of 2017 as interest rates and credit spreads increased during the year. The corporate bond portfolio has an overall rating of A-.
As of December 31, 2018, municipal bonds totaled $320.1 million with gross unrealized losses of $1.3 million, the same as the previous year. As of December 31, 2018, approximately 42 percent of the municipal fixed income securities in the investment portfolio were general obligations of state and local governments and the remaining 58 percent were revenue based. Eighty-five percent of our municipal fixed income securities were rated AA or better while 99 percent were rated A or better.
Our equity portfolio consists of common stocks and exchange traded funds (ETF). Gross unrealized losses in the equity portfolio increased $9.2 million to $10.1 million in 2018 as equity markets declined during the year.
As part of our evaluation of whether particular securities are other-than-temporarily impaired, we consider our intent to sell a security (which is determined on a security-by-security basis) and whether it is more likely than not we will be required to sell the security before the recovery of our amortized cost basis. Significant changes in these factors could result in a charge to net earnings for impairment losses. Impairment losses result in a reduction of the underlying investment’s cost basis.
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:
Unrealized gains (losses) recognized during 2018 on equity securities still held as of December 31, 2018 were $(28.7) million. Unrealized gains (losses) recognized during 2017 on equity securities still held as of December 31, 2017 were $47.2 million.
As of December 31, 2018, $16.1 million of investments were pledged as collateral with the FHLBC to ensure timely access to the secured lending facility that ownership of the FHLBC stock provides. As of and during year ended December 31, 2018, there were no outstanding borrowings with the FHLBC.
As of December 31, 2018, fixed income securities with a carrying value of $59.2 million were on deposit with regulatory authorities as required by law.
As of December 31, 2018, outstanding debt balances totaled $149.1 million, net of unamortized discount and debt issuance costs, all of which were our long-term senior notes.
Premiums written and earned along with losses and settlement expenses incurred for the years ended December 31 are summarized as follows:
The following table displays net reinsurance balances recoverable, after consideration of collateral, from our top reinsurers as of December 31, 2018. These reinsurers all have financial strength ratings of “A” or better by A.M. Best and Standard and Poor’s ratings services. Also shown are the amounts of written premium ceded to these reinsurers during the calendar year 2018.
claims duration as of December 31, 2018. The loss information has been disaggregated so that only losses that are expected to develop in a similar manner are grouped together. This has resulted in the presentation of loss information for our property and surety segments at the segment level, while information for our casualty segment has been separated in four groupings: primary occurrence, excess occurrence, claims made and transportation. Primary occurrence includes select lines within the professional services product along with general liability, small commercial and other casualty products. Excess occurrence encompasses commercial excess and personal umbrella, while claims made includes select lines within the professional services product and medical professional liability and executive products. Reported claim counts represent claim events on a specified policy rather than individual claimants and includes claims that did not or are not expected to result in an incurred loss. The information about incurred and paid claims development for the years ended December 31, 2009 to 2017 is presented as unaudited required supplementary information.
The surety segment experienced $5.9 million of favorable development, inclusive of ULAE. The majority of the favorable development came from the 2017 accident year, which served to offset the unfavorable development from accident years 2011 and 2016. Commercial and energy surety contributed favorable development of $4.6 million and $1.7 million, respectively. Miscellaneous surety experienced adverse development totaling $0.8 million.
The marine product was the primary driver of the favorable development in the property segment. Marine contributed $6.8 million of the $12.1 million total favorable property development, inclusive of ULAE. Accident years 2015 and 2016 contributed to the marine products’ favorable development. Commercial property was favorable $3.2 million.
The surety segment experienced favorable development of $4.8 million, inclusive of ULAE. The majority of the favorable development was from accident year 2015, which offset the unfavorable development from accident years 2008 through 2011 and 2014. Commercial and energy surety products were the main contributors with favorable development of $1.7 million and $1.9 million, respectively. Miscellaneous surety had favorable development of $1.1 million and contract surety had favorable development of $0.1 million.
The following table represents paid and unpaid environmental, asbestos and mass tort claims data (including incurred but not reported losses) as of December 31, 2018, 2017 and 2016:
Income tax expense (benefit) attributable to income from operations for the years ended December 31, 2018, 2017 and 2016, differed from the amounts computed by applying the U.S. federal tax rate of 21 percent, 35 percent and 35 percent, respectively, to pretax income from continuing operations as demonstrated in the following table:
Among other provisions, the TCJA lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. Our deferred tax items were revalued as of year-end 2017 to reflect the lower rate, which reduced our net deferred tax liability and income tax expense by $32.8 million and decreased the effective tax rate by 38.8 percent.
Except for two aspects, the accounting for the tax effects of the enactment of the TCJA were completed as of December 31, 2017. The first provisional item recorded in 2017 was related to an expected disallowance of deductions for certain performance based compensation, including bonuses and stock options. At the time of enactment, there was a lack of clarity on
Our net earnings include equity in earnings of unconsolidated investees, Maui Jim and Prime. The investees do not have a policy or pattern of paying dividends. As a result, we record a deferred tax liability on the earnings at the recently revised corporate capital gains rate of 21 percent in anticipation of recovering our investments through means other than through the receipt of dividends, such as a sale. In the fourth quarter of 2017, Maui Jim gave notification that a $9.9 million dividend would be paid in January 2018. Even though no dividend was received in 2017, we were aware that the lower tax rate applicable to affiliated dividends (7.4 percent in 2018) would be applied when the dividend was paid in 2018 and we therefore recorded a $1.4 million tax benefit in 2017. We received a $9.9 million dividend from Maui Jim in the fourth quarter of 2016 and recognized a $2.8 million tax benefit from applying the lower tax rate applicable to affiliated dividends (7.0 percent in 2016), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. Standing alone, the dividends resulted in a 1.6 percent and 1.8 percent reduction to the 2017 and 2016 effective tax rates, respectively. As no additional dividends were declared from unconsolidated investees in 2018, there was no impact to the 2018 effective tax rate.
Our ESOP and 401(k) cover all employees meeting eligibility requirements. ESOP and 401(k) profit-sharing contributions are approved annually by our board of directors and are expensed in the year earned. ESOP and 401(k)-related expenses (basic and profit-sharing) were $8.8 million, $12.5 million and $11.7 million, for 2018, 2017 and 2016, respectively.
Annual awards are provided to executives, managers and associates through our incentive plans, provided certain financial and operational goals are met. Annual expenses for these incentive plans totaled $11.9 million, $19.7 million and $19.2 million for 2018, 2017 and 2016, respectively.
In 2018, the trusts purchased 7,049 shares of our common stock on the open market at an average price of $68.36 ($0.5 million). In 2017, the trusts purchased 7,464 shares of our common stock on the open market at an average price of $58.66 ($0.4 million). In 2016, the trusts purchased 6,702 shares of our common stock on the open market at an average price of $61.61 ($0.4 million). At December 31, 2018, the trusts’ assets were valued at $36.2 million.
In 2015, our shareholders approved the 2015 RLI Corp. Long-Term Incentive Plan (2015 LTIP), which provides for equity-based compensation and replaced the 2010 LTIP. In conjunction with the adoption of the 2015 LTIP, effective May 7, 2015, options were no longer granted under the 2010 LTIP. Awards under the 2015 LTIP may be in the form of restricted stock, stock options (non-qualified only), stock appreciation rights, performance units as well as other stock-based awards. Eligibility under the 2015 LTIP is limited to employees and directors of the company or any affiliate. The granting of awards under the 2015 LTIP is solely at the discretion of the board of directors. The maximum number of shares of common stock available for distribution under the 2015 LTIP is 4,000,000 shares (subject to adjustment for changes in our capitalization and other events). Since the plan’s approval in 2015, we have granted 1,903,630 awards under the 2015 LTIP, including 455,055 in 2018.
taxes result in a decrease to shareholders’ equity and the degree of the impact is dependent on the level of intrinsic value (i.e. market value in excess of exercise price). During 2016, the number of option exercises facilitated via net settlement and the level of intrinsic value on those exercises resulted in a decrease to paid-in-capital, as the reduction from tax withholdings exceeded the impact of other share-based compensation activity. This was not the case in 2018 and 2017, and the impacts of share-based compensation increased paid-in-capital. Refer to our consolidated statements of shareholders’ equity to see the impact share-based compensation had on shareholders’ equity. Prior to the adoption of FASB ASU 2016-09 in 2017, shareholders’ equity was also impacted by corporate tax deductions allowed as a result of option exercises. This tax benefit offset our current tax liability and was recorded as an increase to paid-in-capital. Beginning in 2017, all tax effects related to share-based payments were required to be recorded in net earnings and directly impact our effective tax rate. See note 7 for the impact in 2018 and 2017. For 2016, refer to our consolidated statements of shareholders’ equity for the impact to paid-in capital from this tax benefit.
The following tables summarize option activity in 2018, 2017 and 2016:
In 2018, 432,000 options were granted with an average exercise price of $64.91 and an average fair value of $10.58. Of these grants, 330,750 were granted at the board meeting in May with a calculated fair value of $10.31. We recognized $4.5 million of expense during 2018 related to options vesting. Since options granted under our plan are non-qualified, we recorded a deferred tax
The risk-free rate was determined based on U.S. treasury yields that most closely approximated the option’s expected life. The dividend yield for 2018 and 2017 was determined based on the average annualized quarterly dividends paid during the most recent five-year period and incorporated a consideration for special dividends paid in recent history. The dividend yield in 2016 was calculated based on the average annualized dividends paid during the most recent five-year period, exclusive of consideration for special dividends. The expected volatility was calculated based on the median of the rolling volatilities for the expected life of the options. The expected option life was 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.
In 2018, each outside director received RSUs with a fair market value of $50,000 on the date of grant as part of annual director compensation. Director RSUs vest one year from the date of grant. As of December 31, 2018, 8,430 restricted stock units were granted to directors under the 2015 LTIP. Due to dividend participation on RSUs, which accrue as additional units, 8,629 director RSUs were outstanding as of December 31, 2018. We recognized $0.3 million of compensation expense on these units during 2018. Total unrecognized compensation expense relating to outstanding and unvested director RSUs was $0.2 million, which will be recognized over the remainder of the vesting period.
The statutory financial statements of our three insurance companies are presented on the basis of accounting practices prescribed or permitted by the Illinois Department of Insurance (IDOI), which has adopted the NAIC statutory accounting principles as the basis of its statutory accounting principles. We do not use any permitted statutory accounting principles that differ from NAIC prescribed statutory accounting principles. 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 income securities.
The NAIC has risk based capital (RBC) requirements for 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, 2018, 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 $170.9 million, $157.7 million and $127.0 million as of December 31, 2018, 2017 and 2016, respectively, compared to actual statutory capital and surplus of $829.8 million, $864.6 million and $860.0 million, respectively, for these same periods.
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 2018, 2017 and 2016, our principal insurance subsidiary paid ordinary dividends totaling $13.0 million, $107.0 million and $123.6 million, respectively, to RLI Corp. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the IDOI. In 2018, our principal insurance subsidiary sought and received regulatory approval prior to the payment of extraordinary dividends totaling $110.0 million. No extraordinary dividends were paid in 2017 or 2016. Given the amount of dividends paid during the prior rolling 12-month period, the net assets of our principal insurance subsidiary are restricted until the fourth quarter of 2019 and cannot be distributed to RLI Corp. without prior approval of the IDOI. In addition to restrictions from our principal subsidiary’s insurance regulator, we also consider internal models and how capital adequacy is defined by our rating agencies in determining amounts available for distribution. However, as discussed above, RLI Corp. had the necessary amount of
We are party to numerous claims, losses and litigation matters that arise in the normal course of our business. Many of such claims, losses or litigation matters involve claims under policies that we underwrite as an insurer. We believe that the resolution of these claims and losses will not have a material adverse effect on our financial condition, results of operations or cash flows. We are also involved in various other legal proceedings and litigation unrelated to our insurance business that arise in the ordinary course of business operations. Management believes that any liabilities that may arise as a result of these legal matters will not have a material adverse effect on our financial condition, results of operations or cash flows.
Mt. Hawley vigorously contested all the claims against it in this matter and filed certain post-trial motions seeking to, among other things, vacate and withdraw the Order. As the result of Court-recommended mediation between the parties, all of the claims in this matter among all parties were settled on a confidential basis for an amount that did not have a material impact on the Company’s financial statements. On November 15, 2018, the Court vacated and withdrew the Order and the entire matter was dismissed with prejudice on November 28, 2018.
We have operating lease obligations for regional office facilities. These leases expire in various years through 2035. Expenses associated with these leases totaled $6.9 million in 2018, $6.8 million in 2017 and $6.4 million in 2016. Minimum future rental payments under non-cancellable leases are as follows:
As of December 31, 2018, we also had $18.8 million of unfunded commitments related to our investments in private funds and $7.4 million of unfunded commitments related to our low income housing tax credit investments. See note 2 for more information on these investments.
The segments of our insurance operations include casualty, property and surety. The casualty portion of our business consists largely of commercial excess, personal umbrella, general liability, transportation and executive products coverages, as
Net investment income consists 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, other director and shareholder relations costs and other compensation-related expenses incurred for the benefit of the corporation, but not attributable to the operations of our insurance segments. Investee earnings represent our share in Maui Jim and Prime earnings. We own 40 percent of Maui Jim, a privately-held company which operates in the sunglass and optical goods industries, and 23 percent of Prime Holdings Insurance Services, Inc., a privately-held insurance company which specializes in hard-to-place risks in the excess and surplus market and has recently expanded into certain coverages in the admitted market. Our investment in Maui Jim, which is carried at the holding company, is unrelated to our core insurance operations.
The following table summarizes our segment data based on the internal structure and reporting of information as it is used by management. The net earnings of each segment are before taxes and include revenues (if applicable), direct product or segment costs (such as commissions and claims costs), as well as allocated support costs from various support departments. While depreciation and amortization charges have been included in these measures via our expense allocation system, the related assets are not allocated for management use and, therefore, are not included in this schedule.
Opinions on the Consolidated Financial Statements and Internal Control Over Financial Reporting
We have audited the accompanying consolidated balance sheets of RLI Corp. and subsidiaries (the Company) as of December 31, 2018 and 2017, the related consolidated statements of earnings and comprehensive earnings, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2018, and the related notes and financial statement schedules I to VI (collectively, the consolidated financial statements). We also have audited the Company’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018 based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
As discussed in Note 1 to the consolidated financial statements, the Company has changed its method of accounting for equity investments in 2018 due to the adoption of ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to