Most of our branch offices and other company operations lease office space throughout the country. Management considers our office facilities suitable and adequate for our current levels of operations.
The following is selected financial data of RLI Corp. and Subsidiaries for the 5 years ended December 31, 2015.
The foundation of our overall business strategy is to underwrite for profit in all market conditions and we achieved this for the 20th consecutive year in 2015, averaging an 87.3 combined ratio over that period of time. This foundation drives our ability to provide shareholder returns in three different ways: the underwriting income itself, net investment income from our investment portfolio and long-term appreciation in our equity portfolio. Our investment strategy is based on preservation of capital as the first priority, with a secondary focus on generating total return. The fixed income portfolio consists primarily of highly-rated, diversified, liquid, investment-grade securities. Consistent underwriting income allows a portion of our investment portfolio to be invested in equity securities and other risk asset classes. Our equity portfolio consists of a core stock portfolio weighted toward dividend-paying stocks, as well as exchange traded funds (ETFs). Our minority equity ownership interests in Maui Jim, Inc. (Maui Jim), a manufacturer of high-quality sunglasses, and Prime Holdings Insurance Services, Inc. (Prime), a specialty E&S insurance company, has also enhanced returns. We have a diversified investment portfolio and closely monitor our investment risks. Despite periodic fluctuations in market value, our equity portfolio is part of a long-term asset allocation strategy and has contributed significantly to our historic growth in book value.
While rates generally improved in more recent years, many of our coverages experienced flat or declining prices in 2014 and 2015. Excess capital in the market impacted the rate environment, and 2015 represented the third consecutive year without a natural catastrophe significant to the industry. As a result, the insurance marketplace remains very competitive. Despite these challenges, we believe that our business model is geared to create underwriting income by focusing on sound risk selection and discipline. Our primary focus will continue to be on underwriting profitability, with a secondary focus on premium growth where we believe underwriting profit exists, as opposed to general premium growth or market share measurements.
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. Each of these captions is presented in the statements of earnings but 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 on investments, general corporate expenses, debt costs and unconsolidated investee earnings.
The most critical accounting policies involve significant estimates and include those used in determining the liability for unpaid losses and settlement expenses, investment valuation and other-than-temporary impairment (OTTI), recoverability of reinsurance balances, deferred policy acquisition costs and deferred taxes.
reported and settled. We rigorously attempt to consider all significant facts and circumstances known at the time loss reserves are established.
We establish IBNR reserves to estimate the amount we will have to pay for claims that have occurred, but have not yet been reported to us, claims that have been reported to us that may ultimately be paid out differently than reflected in our case-specific reserves and claims that have been closed but may reopen and require future payment.
LAE represents the cost involved in adjusting and administering losses from policies we issued. The LAE reserves are frequently separated into two components: allocated and unallocated. Allocated loss adjustment expense (ALAE) reserves represent an estimate of claims settlement expenses that can be identified with a specific claim or case. Examples of ALAE would be the hiring of an outside adjuster to investigate a claim or an outside attorney to defend our insured. The claim professional typically estimates this cost separately from the loss component in the case reserve. Unallocated loss adjustment expense (ULAE) reserves represent an estimate of claims settlement expenses that cannot be identified with a specific claim. An example of ULAE would be the cost of an internal claim examiner to manage or investigate claims.
A full analysis of our loss reserves takes place three times a year. The purpose of this analysis is to provide validation of our carried loss reserves. Estimates of the expected value of the unpaid loss and LAE are derived using actuarial methodologies. These estimates are then compared to the carried loss reserves to determine the appropriateness of the current reserve balance.
We classify our investments in debt and equity securities into one of three categories. Available-for-sale securities are carried at fair value with unrealized gains/losses recorded as a component of comprehensive earnings and shareholders’ equity,
Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, rather than being netted with the related liabilities, since reinsurance does not relieve us of our liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and settlement expenses impact the estimates for the ceded portion of such liabilities. We continually monitor the financial condition of our reinsurers. As part of our monitoring efforts, we review their annual financial statements, Securities and Exchange Commission filings for those reinsurers that are publicly traded, A.M. Best and S&P rating developments and insurance industry developments that may impact the financial condition of our reinsurers. In addition, we subject our reinsurance recoverables to detailed recoverability 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.
Consolidated revenue, as displayed in the table that follows, totaled $794.6 million for 2015, compared to $775.2 million for 2014 and $705.6 million in 2013.
Net earnings increased for the third consecutive year in 2015. Results for 2015 reflected both positive underwriting results for the current accident year and favorable loss reserve development on prior accident years. Catastrophe losses were relatively light in 2015, with the absence of significant earthquake or hurricane activity benefiting earnings, much like in 2014
and 2013. Catastrophe losses over the past three years related primarily to spring and winter storms totaling $12.1 million, $7.2 million and $10.0 million, respectively. In total, underwriting income was $108.6 million in 2015, compared to $107.0 million in 2014 and $106.8 million in 2013. Results for each of these years reflect combined ratios below 85. Our ability to continue to produce underwriting income, at margins which have consistently outperformed the broader industry, is a testament to our underwriters’ discipline throughout the insurance cycle and our continued commitment to underwriting for a profit. We believe our underwriting discipline can differentiate us from the broader insurance market by ensuring appropriate risk selection and pricing of both new and renewal business and can serve to slow the pace of deterioration in underwriting results. Since our products must be priced before the ultimate loss costs are known, it may take several years to know if pricing was adequate. Inadequate pricing may lead to adverse loss development in future periods. In 2015, we experienced $65.4 million in favorable development in prior accident years’ reserves, compared to favorable development of $64.8 million in 2014 and $72.5 million in 2013. Further discussion of reserve development can be found in note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Equity in earnings of unconsolidated investees totaled $10.9 million in 2015, $9.9 million of which was from Maui Jim. The combined effect of a loss on the sale of an asset and unfavorable foreign exchange results led to Maui Jim’s 16 percent decrease in earnings for 2015 compared to 2014. The remaining $1.0 million of equity in earnings of unconsolidated investees relates to our equity investment in Prime which increased from 2014 as a result of their growth and our additional investment in the company during the first quarter of 2015. Further discussion of the investment in Prime can be found in note 13 to the consolidated financial statements within Item 8, Financial Statement and Supplementary Data.
Our underwriting income and combined ratios are displayed in the following tables. Solid underwriting results were bolstered by relatively low levels of catastrophe losses and favorable development in prior accident years’ loss reserves in each of the last three years. The following tables and narrative provide a more detailed look at individual segment performance over the last three years.
Umbrella gross premiums written increased 5 percent in 2015, with most of this being exposure driven growth from commercial accounts, which are predominantly excess coverage. Growth of 8 percent on a net written basis outpaced gross premium growth due largely to increased retentions in 2015. Pricing trends for commercial umbrella have been less favorable compared to recent years, as rates for these coverages leveled off after experiencing double digit increases in 2013. For general liability, gross premiums written increased 1 percent to $83.8 million. The slightly improved top line follows a period of flat premiums in 2014 and an 11 percent decline in 2013, which related to re-underwriting efforts on habitational business. Re-underwriting efforts in 2013 led to non-renewal of certain policies and rate increases on others which had a negative net effect on the top line. Prior to re-underwriting, the habitational component represented nearly 50 percent of general liability revenue. By the end of 2013, this percentage had declined to nearly 25 percent. The increased rates and improved mix of business has resulted in improved current accident year underwriting results in each of the past three years.
Net premium growth outpaced the growth achieved in gross premiums written in each of the last three years. The higher rate of growth in net premium during 2015 and 2014 was largely due to cost savings realized during our annual reinsurance renewals. In 2015, net premiums written advanced $39.6 million (10 percent) while gross premiums increased $36.8 million (8 percent). In 2014, net premiums written growth of $33.4 million (9 percent) outpaced growth in gross premiums written of $25.9 million (6 percent). For 2013, however, the bulk of the higher growth rate in net premium related to increased retentions during our 2013 reinsurance renewal. Given improved pricing on business we underwrite and overall volume growth, particularly in umbrella, we increased retentions on certain casualty products in 2013. Net premiums written advanced 28 percent in 2013, compared to 17 percent on a gross written basis.
The segment’s loss ratio was 53.0 in 2015, compared to 52.1 in 2014 and 45.9 in 2013. Each year reflected varying degrees of favorable reserve development on prior accident years which benefited results. In 2013, modest rate increases, relatively benign loss cost inflation and an improved mix of business resulted in a reduction to the current accident year loss ratio of over 3 points. We maintained this level of current accident year loss ratio performance in 2015 and 2014. The expense ratio for the casualty segment was 35.8 in 2015, compared to 35.9 in 2014 and 36.9 in 2013. During each of these periods, we continued to invest in expansion and new product initiatives. Increased premium has resulted from these investments and provided for improved expense leverage and a lower trending expense ratio.
in 2015, 2014 and 2013, underperforming or underpriced accounts are non-renewed. These results include premiums from our facultative reinsurance unit, which we discontinued during the third quarter of 2015 as a result of challenging market conditions. The overall impact of our exit from this book is minimal, as our facultative reinsurance operations generated gross premiums written of $3.5 million, $5.9 million and $9.1 million for 2015, 2014 and 2013, respectively.
Gross premiums written for surety increased 6 percent in 2015, after increasing 4 percent in 2014 and being flat in 2013. While new entrants continue to impact this market, our underwriters have been able to find opportunities for growth, including through organic growth from our existing client base. The majority of products within the segment achieved premium growth, led by miscellaneous surety, our largest product line within the book. Miscellaneous surety increased 9 percent to $44.3 million in 2015, following a 6 percent increase in 2014 and a slight decline in 2013. Energy and commercial surety also contributed solid top line performance, up 8 percent and 7 percent, respectively. For energy surety, the improved result for 2015 followed declines posted in both 2014 and 2013. Falling energy prices over the last three years and M&A activity in the industry have continued to impact this business and pressure premium production. In 2015, however, we were able to take advantage of opportunities provided by industry consolidation and increase our top line. The increase for commercial surety represents continued growth, after increasing 15 percent in 2014 and 4 percent in 2013. Slightly offsetting this growth, our contract surety book declined 2 percent in 2015. Contract surety achieved modest top line growth in 2014 and 2013.
years’ reserve development. In addition to the reserve development, results for 2014 were also impacted by $1.3 million of reinsurance reinstatement premium related to unfavorable development on prior years’ surety reserves. The expense ratio for the segment was 62.3 in 2015, compared to 66.5 in 2014 and 64.1 in 2013. The decrease in 2015 was due to the combined effect of shifts in mix toward products with lower acquisition expense rates and improved leveraging of our expense base. In addition, the above-mentioned reinstatement premium contributed to a higher expense ratio in 2014.
During 2015, net investment income decreased by 2 percent. The decrease was primarily due to a smaller invested asset base for most of the year. Additionally, an increased allocation to municipal securities contributed to the decline. While yields are lower on a pretax basis, municipals often exhibit higher after-tax yields versus taxable alternatives. The average annual yields on our investments were as follows for 2015, 2014 and 2013:
We realized a total of $39.8 million in net investment gains in 2015. Included in this number is $22.1 million in net realized gains in the equity portfolio, $10.8 million in net realized gains in the fixed income portfolio and $6.9 million in other net realized losses related to the sale of RIC. In 2014, we realized $32.2 million in net investment gains. Included in this number is $29.5 million in net realized gains in the equity portfolio, $4.0 million in net realized gains in the fixed income portfolio and $1.3 million in other net realized losses. In 2013, we realized $22.0 million in net investment gains. We realized $21.5 million in net realized gains in the equity portfolio, $1.3 million in net realized gains in the fixed income portfolio and $0.8 million in other net realized losses.
The fixed income portfolio contained 472 positions at an unrealized loss as of December 31, 2015. Of these 472 securities, 44 have been in an unrealized loss position for 12 consecutive months or longer and represent $5.4 million in unrealized losses. All fixed income securities in the investment portfolio continue to pay the expected coupon payments under the contractual terms of the securities. Based on our analysis, our fixed income portfolio is of a high credit quality and we believe we will recover the amortized cost basis.
We maintain a diversified investment portfolio with an 80 percent fixed income and 20 percent equity target. We continually monitor economic conditions, our capital position and the insurance market to determine our tactical equity allocation. As of December 31, 2015, the portfolio had a fair value of $2.0 billion, a decrease of $12.7 million from the end of 2014.
In selecting the maturity of securities in which we invest, we consider the relationship between the duration of our fixed income investments and the duration of our liabilities, including the expected ultimate payout patterns of our reserves. We believe that both liquidity and interest rate risk can be minimized by such asset/liability management. As of December 31, 2015, our fixed income portfolio’s duration was 5.1 years.
Our equity portfolio had a fair value of $375.4 million at December 31, 2015, entirely classified as available-for-sale. Equities comprised 19 percent of our total 2015 portfolio, down from 21 percent in 2014. Securities within the equity portfolio are well diversified and are primarily invested in large-cap issues with a focus on dividend income. Our strategy is value oriented and security selection takes precedence over market timing. Likewise, low turnover throughout our long investment horizon minimizes transaction costs and taxes.
As of December 31, 2015, our fixed income portfolio had the following rating distributions:
Our allocation to agency mortgage-backed securities totaled $254.9 million as of December 31, 2015. MBS represented 17 percent of the fixed income portfolio compared to $264.5 million or 18 percent of that portfolio as of December 31, 2014.
We believe MBS investments add diversification, liquidity, credit quality and additional yield to our portfolio. Our objective for the MBS portfolio is to provide reasonable cash flow stability where we are compensated for the call risk associated with residential refinancing. The MBS portfolio includes mortgage-backed pass-through securities and collateralized
mortgage obligations (CMO). A mortgage pass-through is a security consisting of a pool of residential mortgage loans which returns principal and interest cash flows to investors each month. A CMO has a more finite payment structure and can reduce the risks associated with prepayment. CMO securities are divided into maturity classes that are paid off under certain expected interest rate conditions. Our MBS portfolio does not include interest-only securities or principal-only securities. As of December 31, 2015, all of the securities in our MBS portfolio were rated AAA and issued by Government Sponsored Enterprises (GSEs) such as the Governmental National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC).
Variability in the average life of principal repayment is an inherent risk of owning mortgage-related securities. However, we reduce our portfolio’s exposure to prepayment risk by seeking characteristics that tighten the probable scenarios for expected cash flows. As of December 31, 2015, the MBS portfolio contained 69 percent of pure pass-throughs compared to 76 percent as of December 31, 2014. An additional 17 percent of the MBS portfolio was invested in planned amortization class CMOs (PACs), up from 16 percent in 2014. CMO PACs are securities whose cash flows are designed to remain constant in a variety of mortgage prepayment environments.
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.
1000 Index, the S&P 500 Index, and the S&P 500 Utilities Index. No one fund makes up more than 50 percent of the ETF allocation, and the philosophy mirrors that of the actively managed equity portfolio, with a preference for dividend income and lower anticipated volatility than the market (as measured by the S&P 500). Additionally, we own two diversified energy ETF securities. We did not recognize any impairment losses in the equity portfolio during 2015 or 2014.
The following table illustrates the distribution by sector of our equity portfolio as of December 31, 2015, including fair value, cost basis and unrealized gains and losses:
On February 5, 2014, we invested $5.3 million for a 20 percent equity ownership interest in Prime Holdings Insurance Services, Inc. (Prime). On March 4, 2015, we invested an additional $1.7 million, increasing our total equity ownership to 27 percent. Prime writes business through two Illinois domiciled insurance carriers, Prime Insurance Company, and excess and surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company. In 2015, we recorded $1.0 million in investee earnings from this investment compared to $0.3 million in 2014. Additionally, we entered into a 25 percent quota share reinsurance treaty with Prime, effective January 1, 2014, which contributed $11.3 million of gross premiums written and $10.9 million of net premiums earned during 2015, compared to $10.2 million of gross premiums written and $5.3 million of net premiums earned during 2014.
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 corporate capital gains rate of 35 percent. In the fourth quarters of 2014 and 2013, we received a $6.6 million and $13.2 million dividend from Maui Jim, respectively. No dividend was received from any unconsolidated investee in 2015. In accordance with GAAP guidelines on income taxes, we recognized a $1.8 million and $3.7 million tax benefit for 2014 and 2013. The tax benefit is generated from applying the lower tax rate applicable to affiliated dividends (7 percent), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. Standing alone, the dividend resulted in a 1.0 percent and 2.1 percent reduction to the 2014 and 2013 effective tax rates, respectively. In determining the appropriate tax rate to apply, we anticipate recovering our investments through means other than the receipt of dividends, such as a sale.
In addition, our pretax earnings in 2015 included $25.1 million of investment income that is partially exempt from federal income tax, compared to $25.3 million and $24.5 million in 2014 and 2013, respectively.
Gross reserves (liability) and the reinsurance balances recoverable (asset) were both subject to the same influences that affected net reserves and behaved similarly. Total gross and ceded loss and LAE reserves decreased to $1.10 billion and $297.8 million, respectively, at December 31, 2015, from $1.12 billion and $335.1 million, respectively, at December 31, 2014.
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, 2015, our portfolio had a carrying value of $2.0 billion. Portfolio assets at December 31, 2015, decreased by $12.7 million, or 1 percent, from December 31, 2014.
In December 2012, we filed a universal shelf registration statement with the SEC for the potential offering and sale of securities, including debt and equity securities. The shelf registration facilitated our $150.0 million public debt offering completed in October 2013 and expired in December 2015.
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, 2015, our holding company had $823.5 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 $45.2 million in liquid assets, which approximates annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and 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 issuances of common stock and debt.
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 2015, 2014 and 2013, our principal insurance subsidiary paid ordinary dividends totaling $125.0 million, $185.0 million and $40.0 million, respectively, to RLI Corp. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the Illinois Department of Insurance. No extraordinary dividends were paid in 2015, 2014 or 2013. As of December 31, 2015, $58.2 million of the net assets of our principal insurance subsidiary are not restricted and could be distributed to RLI Corp. as ordinary dividends. Because the limitations are based upon a rolling 12-month period, the presence, amount and impact of these restrictions vary over time.
Our 159th consecutive dividend payment was declared in February 2016 and will be paid on March 18, 2016, in the amount of $0.19 per share. Since the inception of cash dividends in 1976, we have increased our annual dividend every year.
As the overall underwriting environment continues to perform well by historical standards, there are pockets of stress in particular lines of business that we anticipate will continue in 2016. For example, in the personal and commercial auto markets, increased loss activity and inadequate reserving have impacted a number of market participants. This market is also adjusting to new competitive dynamics and trends that may put long-term pressure on the insurance industry, such as the growth of ride-sharing services and technological advancements. Similarly, the property catastrophe market has been challenged by pricing declines over the last several years. The influx of alternative capital and lack of material catastrophe events have led to lower prices over the last three years, and we expect that soft pricing trend to continue in 2016.
Our business model is well suited to deal with difficult or uncertain market conditions. In particular, we remain well-diversified across products, industries and geographies. Our underwriters are empowered to navigate changing market conditions in a decentralized manner and incentivized to maximize profits, particularly by eschewing growth when market conditions warrant restraint. We expect to continue making investments in hiring underwriters and entering new product markets. Specific details regarding our insurance segments follows.
We underwrite selected property and casualty insurance coverages. We conduct operations principally through three insurance companies. These companies are organized in a vertical structure beneath RLI Corp. with RLI Insurance Company (RLI Ins.) as the first-level, or principal, insurance subsidiary. RLI Ins. 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, a subsidiary of RLI Ins., writes surplus lines insurance 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. In 2015, we sold RLI Indemnity Company (RIC), a former subsidiary of Mt. Hawley, as a “shell.” This transaction was essentially the sale of insurance licenses. All business and cash flows from the former subsidiary remain within the RLI Insurance Group. See note 13 for more information on the sale of RIC.
This ASU was issued to simplify the presentation of debt issuance costs by requiring them to be presented on the balance sheet as a direct deduction from the carrying amount of the related recognized debt liability, consistent with debt discounts. This ASU is effective for annual and interim reporting periods beginning after December 15, 2015. Early adoption is permitted. We have not early-adopted this ASU and do not believe adoption will have a material effect on our financial statements.
For all claims, the average annual percentage payout of incurred claims by age.
This ASU is effective for annual reporting periods beginning after December 15, 2015 and for interim periods beginning after December 15, 2016. Early adoption is permitted. We have not early adopted this ASU and while disclosures will be increased, we do not believe adoption will have a material effect on our financial statements.
This ASU is effective for interim and annual reporting periods beginning after December 15, 2017. Early adoption is only permitted for provision (e) above. Upon adoption, a cumulative-effect adjustment to the balance sheet will be made as of the beginning of the fiscal year of adoption. We have not yet completed the analysis of how adopting this ASU will affect our financial statements.
Debt and equity securities purchased for short-term resale are classified as trading securities. These securities are reported at fair value with unrealized gains and losses included in earnings. During 2013, we sold our remaining debt securities classified as trading.
For the years ended December 31, 2015, 2014 and 2013, no securities were transferred from held-to-maturity to available-for-sale or trading.
surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company. Our investment in Prime was $8.1 million at December 31, 2015 and $5.7 million at December 31, 2014. In 2015, we recorded $1.0 million in investee earnings for Prime, compared to $0.3 million in 2014. Additionally, we entered into a 25 percent quota share reinsurance treaty with Prime, effective January 1, 2014, which contributed $11.3 million of gross premiums written and $10.9 million of net premiums earned during 2015, compared to $10.2 million of gross premiums written and $5.3 million of net premiums earned during 2014.
Annual impairment testing was performed on each of these goodwill and indefinite-lived intangible assets during 2015. Based upon these reviews, none of the assets were impaired. In addition, as of December 31, 2015, there were no triggering events that occurred that would suggest an updated review was necessary. However, as a result of premium declines, the margin of fair value over carrying value on our medical professional liability goodwill is smaller than in previous years. We continue to monitor the performance of the medical professional liability reporting unit and will reexamine our valuation should results change from expectations or other triggering events occur.
As an insurance company, we are subject to minimal state income tax liabilities. On a state basis, since the majority of our income is from insurance operations, we pay premium taxes in lieu of state income taxes. Premium taxes are a component of policy acquisition costs and calculated as a percentage of gross premiums written.
Our comprehensive earnings include net earnings plus unrealized gains/losses on our available-for-sale investment securities, net of tax. In reporting the components of comprehensive earnings on a net basis in the statement of earnings, we used a 35 percent tax rate. Other comprehensive income (loss), as shown in the consolidated statements of earnings and comprehensive earnings, is net of tax expense (benefit) of $(25.3) million, $19.0 million and $(3.8) million for 2015, 2014 and 2013, respectively.
We calculate the tax effects of share-based compensation under the alternative transition method as permitted by GAAP guidance. The alternative transition method includes simplified methods to determine the impact on the additional paid-in capital pool and consolidated statements of cash flows of the tax effects of employee share-based compensation awards.
Our catastrophe reinsurance treaty renewed on January 1, 2016. We purchased the same limits over the same first-dollar retention amounts outlined above, subject to certain retentions by us in the excess layers. We actively manage our catastrophe program to keep our net retention in line with risk tolerances and to optimize the risk/return trade off.
Although historical experience on environmental claims may not accurately reflect future environmental exposures, we used this experience to record loss and settlement expense reserves in the exposed lines of business. See further discussion of environmental exposures in note 6.
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 us, or even by the perception among market participants that we, or other market participants, are experiencing greater liquidity risk.
Our credit ratings are important to our liquidity. A reduction in our credit ratings could adversely affect our liquidity and competitive position, by increasing our borrowing costs or limiting our access to the capital markets.
During 2015, we recorded $39.8 million in net realized gains, along with a change in net unrealized losses of $72.9 million. The majority of our net realized gains were due to sales of equity securities while the change in unrealized gains was due to increased credit spreads in the corporate fixed income sector as well as price declines in the equity portfolio. For 2015, the net realized gains (losses) and changes in unrealized gains (losses) on investments totaled $(33.1) million.
Assets measured at fair value on a recurring basis as of December 31, 2015, are summarized below:
As noted in the previous tables, we did not have any assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of December 31, 2015 and 2014. Additionally, there were no securities transferred in or out of levels 1 or 2 during 2015 or 2014.
The amortized cost and estimated fair value of fixed income securities at December 31, 2015, by contractual maturity, are shown as follows:
Expected maturities may differ from contractual maturities due to call provisions on some existing securities. At December 31, 2015, the net unrealized appreciation of available-for-sale fixed income and equity securities totaled $192.9 million pretax. At December 31, 2014, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $264.0 million pretax.
amortized cost basis of the security. If an entity intends to sell a security or if it is more likely than not the entity will be required to sell the security before recovery, an OTTI write-down is recognized in earnings equal to the difference between the security’s amortized cost and its fair value. If an entity does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income.
The following table is also used as part of our impairment analysis and displays the total value of securities that were in an unrealized loss position as of December 31, 2015, and December 31, 2014. The table segregates the securities based on type, noting the fair value, cost (or amortized cost) and unrealized loss on each category of investment as well as in total. The table further classifies the securities based on the length of time they have been in an unrealized loss position.
Based on our analysis, we concluded that the securities in an unrealized loss position were not other-than-temporarily impaired at December 31, 2015 and 2014. We did not recognize any impairment losses during 2015, 2014 or 2013.
Other invested assets shown on the balance sheet as of December 31, 2015 include investments in low income housing tax credit (LIHTC) partnerships, membership stock in the Federal Home Loan Bank of Chicago (FHLBC) and an investment in a real estate fund. During 2015, we recorded an additional $5.0 million interest in a low income housing tax credit partnership. Our LIHTC interests had a balance of $14.0 million at December 31, 2015 compared to $9.8 million at December 31, 2014 and recognized a total tax benefit of $1.1 million during 2015 compared to $0.2 million during 2014. During the fourth quarter of 2015 we invested $5.0 million in a real estate fund. Our investment in FHLBC stock totaled $1.6 million at the end of 2015 compared to $1.8 million at the end of the prior year.
As of December 31, 2015, outstanding debt balances totaled $149.7 million, net of unamortized discount, all of which were our long-term senior notes.
The assumed business is made up of short-tail property, casualty, catastrophe and multi-peril crop and hail reinsurance. The majority of this assumed reinsurance is proportional and a large portion of the assumed incurred losses can be attributed to crop-related reinsurance and specialty property treaties. As noted in previous filings, our portion of assumed crop reinsurance was reduced for 2015 and will end with the 2015 crop year due to the acquisition of the cedant. Losses for each crop season are ultimately determined and paid subsequent to December 31 of the crop year reinsured.
At December 31, 2015, we had prepaid reinsurance premiums and recoverables on paid and unpaid losses and settlement expenses totaling $332.9 million. More than 96 percent of our reinsurance recoverables are due from companies with financial strength ratings of “A” or better by A.M. Best and S&P rating services.
The following table displays net reinsurance balances recoverable, after consideration of collateral, from our top 10 reinsurers as of December 31, 2015. 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 2015.
systematic changes in the loss environment, we also must consider the volume of experience directly available to us and interpret any particular period’s indications with a realistic technical understanding of the reliability of those observations.
The following table summarizes our prior accident years’ loss reserve development by segment for 2015, 2014 and 2013:
The marine product was the primary driver of the favorable development in the property segment. Marine contributed $5.8 million of the $1.1 million total favorable property development. Accident years 2012 and 2013 contributed to the marine products’ favorable development. Assumed property and crop were unfavorable by $4.0 million and $1.2 million, respectively.
The surety segment experienced favorable development of $10.9 million. The majority of the favorable development was from accident year 2013. Contract and commercial surety products were the main contributors with favorable development of $4.6 million and $4.3 million, respectively. Energy surety had favorable development of $1.2 million and miscellaneous surety had favorable development of $0.9 million.
2013. We experienced favorable emergence relative to prior years’ reserve estimate in all our segments during 2013. The casualty segment contributed $61.8 million in favorable development. Accident year 2012 contributed significantly to the favorable development, with accident years 2008 to 2011 also continuing to develop favorably. The favorable development in 2013 was larger than 2012 and reflects the continuing favorable frequency and severity trends. In addition, the risk selection by our underwriters continued to provide results better than estimated in our reserving process. The general liability product contributed $28.5 million to our favorable development with all coverages, including habitational contributing to the favorable development in 2013. Executive products were the second largest contributor with $8.9 million in favorable development mostly from accident year 2011. Personal and commercial umbrella were favorable by $7.5 million and $6.5 million respectively. P&C package products were favorable by $8.1 million. Our run-off program business was favorable by $2.0 million mostly from the discontinued restaurant-bar-tavern business. Transportation and miscellaneous professional liability were the only products unfavorable at $3.5 million and $0.5 million, respectively.
Income tax expense attributable to income from operations for the years ended December 31, 2015, 2014 and 2013, differed from the amounts computed by applying the U.S. federal tax rate of 35 percent to pretax income from continuing operations as demonstrated in the following table:
Dividends paid to our ESOP result in a tax deduction. Dividends paid to the ESOP in 2015, 2014 and 2013 resulted in tax benefits of $3.4 million, $4.5 million and $2.5 million, respectively. These tax benefits reduced the effective tax rate for 2015, 2014 and 2013 by 1.7 percent, 2.4 percent and 1.4 percent, respectively.
Federal and state income taxes paid in 2015, 2014 and 2013, amounted to $44.2 million, $48.5 million and $36.8 million, respectively.
We maintain “rabbi trusts” for deferred compensation plans for directors, key employees and executive officers through which our shares are purchased. GAAP guidelines prescribe an accounting treatment whereby the employer stock in the plan is classified and accounted for as equity, in a manner consistent with the accounting for treasury stock.
During the second quarter of 2010, our shareholders approved the RLI Corp. Long-Term Incentive Plan (2010 LTIP), which provides for equity-based compensation and replaced the omnibus plan. In conjunction with the adoption of the 2010 LTIP, effective May 6, 2010, options were no longer granted under the omnibus plan. The 2010 LTIP provided for equity-based compensation, including stock options, up to a maximum of 4,000,000 shares of common stock (subject to adjustment for changes in our capitalization and other events). Between 2010 and 2015, we have granted 2,878,000 stock options under the 2010 LTIP, including 53,500 in 2015. The 2010 LTIP was replaced in the second quarter of 2015.
During the second quarter of 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). In 2015, we granted 510,000 stock options under the 2015 LTIP.
exercises during the period. This tax benefit offsets our current tax liability and is recorded as an increase to paid-in-capital. As shown in the consolidated statements of shareholders’ equity, the increase to paid-in-capital from this tax benefit is larger in periods when options are exercised with significant intrinsic value, as happened in 2015 and 2013.
On November 12, 2015, the board of directors declared a $2.00 per share special cash dividend to be paid on December 22, 2015, to shareholders of record at the close of business on November 30, 2015. To preserve the intrinsic value of the options, the board also approved, pursuant to the terms of our various stock option plans, a proportional adjustment to the exercise price (equivalent to the special dividend) for all outstanding non-qualified options. This adjustment did not result in any incremental compensation expense as the aggregate fair value, aggregate intrinsic value and the ratio of the exercise price to the market price were approximately equal immediately before and after the adjustment. Similarly, on November 13, 2014, the board of directors declared a $3.00 per share special cash dividend to be paid on December 22, 2014, to shareholders of record at the close of business on November 28, 2014. On November 14, 2013, the board of directors declared a $1.50 per share special cash dividend to be paid on December 20, 2013, to shareholders of record at the close of business on November 29, 2013. The exercise price adjustment made for the 2015 special dividend was also made for the 2014 and 2013 special dividends and did not result in any incremental compensation expense. Additionally, the board approved a proportional adjustment to the exercise price and the number of shares covered by each award for all outstanding ISOs in 2014 and 2013. Most (99 percent) of the outstanding options at the time of the adjustments were non-qualified and no incremental compensation expense was recognized as a result of the adjustments. No adjustments were made to ISOs in 2015 as all ISOs had been exercised before the special dividend occurred.
*An adjustment was made to the exercise price and number of ISOs outstanding for the special cash dividends paid during December 2014 and 2013. “Special dividend” represents the incremental ISOs issued as a result of these adjustments. No adjustments were made to ISOs in 2015 as all ISOs had been exercised before the special dividend occurred.
In 2014, 512,000 options were granted with an average exercise price of $40.46 and an average fair value of $7.89. Of these grants, 369,500 were granted at the board meeting in May with a calculated fair value of $7.71. We recognized $3.9 million of expense during 2014 related to options vesting. Since options granted under our plan are non-qualified, we recorded a deferred tax benefit of $1.4 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $4.8 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, 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 maturities.
Year-end statutory surplus for 2015 presented in the table below includes $117.5 million of RLI stock (cost basis of $64.6 million) held by Mt. Hawley Insurance Company, compared to $86.1 million and $64.0 million in 2014 and 2013, respectively. The Securities Valuation Office provides specific guidance for valuing this investment, which is eliminated in our GAAP consolidated financial statements.
As discussed in note 1.A., our insurance subsidiaries are organized in a vertical structure with RLI Ins. as the first-level, or principal, insurance subsidiary of RLI Corp. 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, 2015, our holding company had $823.5 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 $45.2 million in liquid assets, which approximates annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and 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 issuances of common stock and debt.
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 2015, 2014 and 2013, our principal insurance subsidiary paid ordinary dividends totaling $125.0 million, $185.0 million and $40.0 million, respectively, to RLI Corp. Any dividend distribution in excess of the
We have operating lease obligations for regional office facilities. These leases expire in various years through 2034. Expenses associated with these leases totaled $6.1 million in 2015, $5.8 million in 2014 and $5.7 million in 2013. Minimum future rental payments under non-cancellable leases are as follows:
Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions, marine, facultative and treaty reinsurance, including crop, and select personal lines policies, including recreational vehicle insurance and Hawaii homeowners coverages. Property insurance and reinsurance results are subject to the variability introduced by perils such as earthquakes, fires and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. Our second largest catastrophe exposure is to losses caused by 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 through extensive use of computer-assisted modeling techniques. These techniques provide estimates that help us carefully manage the concentration of risks exposed to catastrophic events. Our assumed multi-peril crop and hail treaty reinsurance business covers revenue shortfalls or production losses due to natural causes such as drought, excessive moisture, hail, wind, frost, insects and disease. Significant aggregation of these losses is mitigated by the Federal Government reinsurance program that provides stop loss protection inuring to our benefit. As noted in previous filings, our portion of assumed crop reinsurance was reduced for 2015 and will expire at the end of the 2015 crop year due to the acquisition of the cedant. Additionally, we discontinued offering facultative reinsurance at the end of the third quarter of 2015 as a result of challenging market conditions. Our facultative reinsurance operations generated $3.5 million, $5.9 million and $9.1 million of gross written premium in 2015, 2014 and 2013, respectively.
Net investment income is the by-product of the interest and dividend income streams from our investments in fixed income and equity securities. Interest and general corporate expenses include the cost of debt and other director and shareholder relations costs incurred for the benefit of the corporation, but not attributable to the operations of our insurance segments. Investee earnings represent our share in Maui Jim and Prime earnings. We own 40 percent of Maui Jim, a privately held company which operates in the sunglass and optical goods industries, and 27 percent of Prime, 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.