RLI Corp. is a U.S. based, specialty insurance company that underwrites select property and casualty insurance through major subsidiaries collectively known as RLI Insurance Group (Group). Our focus is on niche markets and developing unique products that are tailored to customers’ needs. We hire underwriters and claim examiners with deep expertise and provide exceptional customer service and support. We maintain a highly diverse product portfolio and underwrite for profit in all market conditions. In 2020, we achieved our 25th consecutive year of underwriting profitability. Over the 25-year period, we averaged an 88.4 combined ratio. This 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.
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 12 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, general corporate expenses, debt costs and our portion of earnings from unconsolidated investees. A reconciliation of net earnings to underwriting income follows:
The most critical accounting policies involve significant estimates and include those used in determining the liability for unpaid losses and settlement expenses, investment valuation, recoverability of reinsurance balances, deferred policy acquisition costs and deferred taxes.
The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables. These variables can be affected by both internal and external events, such as changes in claim handling procedures, claim personnel, economic inflation, legal trends and legislative changes, among others. The impact of many of these items on ultimate costs for loss and LAE is difficult to estimate. Loss reserve estimations also differ significantly by coverage due to differences in claim complexity, the volume of claims, the policy limits written, the terms and conditions of the underlying policies, the potential severity of individual claims, the determination of occurrence date for a claim and reporting lags (the time between the occurrence of the policyholder event and when it is actually reported to the insurer). Informed judgment is applied throughout the process. We continually refine our loss reserve estimates as historical loss experience develops and additional claims are reported and settled. We rigorously attempt to consider all significant facts and circumstances known at the time loss reserves are established.
The amount by which current estimated losses differ from those estimated for a period at a prior valuation date is known as development. Development is unfavorable when the losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable development of loss reserves in the results of operations in the period the estimates are changed.
High sensitivity to significant swings in loss trends, economic change or judicial change.
As a predominantly excess and surplus lines and specialty admitted insurer serving niche markets, we believe we are subject to above-average variation in estimates and that this variation is not symmetrical around the actuarial central estimate.
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 offer broad coverages (with named exclusion) and are issued on an occurrence basis. Claimants have at times sought coverage beyond the insurer’s original intent, including seeking to void or limit 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, 2020.
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 the Company of its liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. We continually monitor the financial condition of our reinsurers and actively follow up on any past due or disputed amounts. As part of our monitoring efforts, we review their annual financial statements 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 AM Best and Standard & Poor’s (S&P) ratings of our reinsurers. Additionally, we perform an in-depth reinsurer financial condition analysis prior to the renewal of our reinsurance placements.
It is difficult to predict how and to what extent the economic slowdown will impact our revenues in the coming quarters. To date, the product line that has experienced the greatest impact has been public transportation. Many of our passenger transportation customers have been unable to effectively operate under social-distancing protocols and stay-at-home orders. For the year ended December 31, 2020, transportation gross written premium was down $42.2 million when compared to 2019. We expect transportation premium to continue to be down from prior periods until the use of public transportation increases, which may not be until after a vaccine or effective treatment is readily available or there is a significant reduction in cases. Additionally, slowdowns in the construction industry contributed to premium declines for our general liability and surety products. A number of our products support the construction industry, and revenues may continue to be impacted as long as this sector experiences disruption. However, our personal lines products, management liability products and property businesses have seen little to no impact on premium from the pandemic.
We have been fair and flexible with our customers in modifying exposures and payment terms, and are in compliance with any applicable state regulatory directives on such changes. Insureds continue to make payments in accordance with the agreed upon schedules, and we have not experienced a material increase in the amount of expense associated with uncollectible receivables.
We continue to evaluate opportunities for expense savings and efficiencies and took targeted actions to reduce or defer expenses in 2020, including certain hiring freezes, position consolidations, travel limitations and executive merit increase suspensions. Bonus and profit-sharing expense, which is correlated with company performance, also declined.
The equity portfolio has more than recovered from the sharp market sell off in the first quarter, with $37.8 million of net after-tax realized and unrealized gains on equity securities in 2020. Additionally, lower interest rates increased the fair value of the fixed income portfolio, which resulted in $53.5 million of after-tax other comprehensive earnings. However, with the decline in yields, reinvestment rates are now lower than in previous years, which will limit the portfolio’s ability to generate higher levels of investment income, absent a larger invested asset base.
Maui Jim, Inc. (Maui Jim) and Prime Holdings Insurance Services, Inc. (Prime) contributed towards positive net earnings in 2020. While earnings for Prime were higher than in 2019, Maui Jim’s sales were negatively impacted by the shutdown much of the traditional retail sector experienced during the year. The economic downturn may continue to impact the results of these investees, particularly if there is any lasting impact on the retail sector as it relates to Maui Jim.
This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019, incorporated herein by reference.
Consolidated revenue for 2020 decreased $20.0 million from 2019. Net premiums earned for the Group increased 3 percent, driven by growth from our property and casualty segments, but performance in the equity portfolio was not able to match the return generated in 2019. Net investment income decreased by 1 percent in 2020, primarily due to lower reinvestment rates relative to the prior year. Additionally, we recorded net realized gains on our investment portfolio in 2020 and 2019, due to portfolio rebalancing.
Underwriting results for 2020 were impacted by significant catastrophe activity, including $51.5 million of pretax losses and $1.5 million of reinstatement premium from hurricanes, as well as $6.5 million of other storm and civil unrest losses. Additionally, $18.3 million of COVID-19 related loss and defense reserves were established in 2020. Comparatively, pretax storm losses were $9.5 million in 2019. Results for each period benefited, however, from favorable development on prior years’ loss reserves, which provided additional pretax earnings of $101.1 million in 2020, compared to $75.3 million in 2019. Further discussion of reserve development can be found in note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
In total, underwriting income was $69.6 million on a 92.0 combined ratio in 2020, compared to $67.6 million on a 91.9 combined ratio in 2019. The loss ratio was 51.2 in 2020, compared to 49.3 in 2019. The expense ratio decreased to 40.8 in 2020, from 42.6 in 2019. Travel and entertainment expenses, along with other discretionary costs, decreased in 2020 as we made adjustments to reduce the impact of COVID-19 on our results. Additionally, stronger growth in book value was experienced in 2019, which led to larger levels of bonus and profit-sharing expenses.
Commercial transportation has been significantly affected by the stay-at-home orders associated with COVID-19, particularly public auto, which focuses on charter, school and transit buses. The reduced utilization led to a $42.2 million decline in gross premiums written in 2020. General liability premiums also declined as a result of increased competition, as well as decreases in construction related activity and use-based exposures.
Favorable development on prior accident years’ loss reserves contributed to underwriting earnings in each of the past two years. The total benefit from favorable development on prior years’ reserves was $75.1 million for 2020, with the largest amounts of the development coming from accident years 2016 through 2019. Products which generated the majority of the favorable development include transportation, general liability, commercial excess and professional services. No active products experienced significant adverse development. Comparatively, overall results for the casualty segment in 2019 included favorable development of $62.5 million, with the bulk of the development attributable to transportation, general liability, professional services, commercial excess, personal umbrella and small commercial across accident years 2016 through 2018. Executive products and medical professional liability developed adversely in 2019. Favorable development on executive products and medical professional liability in 2020 was responsible for a significant amount of the increase between the releases in 2020 and 2019. Hurricane losses on casualty-oriented package policies that include property coverage resulted in $4.4 million of losses in 2020 and $12.9 million of current year reserves were established for COVID-19 loss and defense costs on financial-related product lines.
Underwriting income for the surety segment totaled $28.4 million on a 74.8 combined ratio in 2020, compared to $28.8 million on a 75.3 combined ratio in 2019. Underwriting performance for each year reflects a combination of positive current accident year results and favorable development in prior accident years’ loss reserves. The current accident year combined ratio for each period has been in the low 80s, with each product line contributing to underwriting profit. Results for 2020 included favorable development on prior accident years’ reserves, which decreased loss and settlement expenses for the segment by $13.0 million, and offset $3.4 million in current year reserves established for COVID-19 related losses. Comparatively, 2019 results included favorable development on prior accident years’ loss reserves, which decreased the segment’s loss and settlement expenses by $8.3 million.
During 2020, net investment income decreased by 1 percent. The decrease was primarily due to lower reinvestment rates relative to the prior year. The average annual yields on our investments were as follows for 2020 and 2019:
The after-tax yield reflects the different tax rates applicable to each category of investment. Our taxable fixed income securities were subject to a corporate tax rate of 21.0 percent, our tax-exempt municipal securities were subject to a tax rate of 5.3 percent and our dividend income was generally subject to a tax rate of 13.1 percent. During 2020, the average after-tax yield on the taxable fixed income portfolio was 2.5 percent, a decrease from 2.7 percent in the prior year. The average after-tax yield on the tax-exempt portfolio remained at 2.6 percent.
We regularly evaluate the quality of our investment portfolio. With the adoption of ASU 2016-13 on January 1, 2020, we started recognizing a reversible allowance for credit losses on available-for-sale fixed income securities. Prior to 2020, when we determined
We maintain a diversified investment portfolio with a prudent mix of fixed income and risk assets. We continually monitor economic conditions, our capital position and the insurance market to determine our tactical allocation. As of December 31, 2020, the portfolio had a fair value of $2.8 billion, an increase of $276.7 million from the end of 2019.
We determined the fair value of certain financial instruments based on their underlying characteristics and relevant transactions in the marketplace. We maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. For additional information, see notes 1 and 2 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
As of December 31, 2020, our investment portfolio had the following asset allocation breakdown:
Fixed income represented 77 percent of our total 2020 portfolio, the same as 2019. As of December 31, 2020, the fair value of our fixed income portfolio consisted of 44 percent AAA-rated securities, 19 percent AA-rated securities, 21 percent A-rated securities, 10 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities. This compares to 49 percent AAA-rated securities, 17 percent AA-rated securities, 19 percent A-rated securities, 9 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities in 2019.
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, 2020, our fixed income portfolio’s duration was 4.7 years.
Consistent underwriting income allows a portion of our investment portfolio to be invested in equity securities and other risk asset classes. Equities comprised 19 percent of our total 2020 portfolio, a slight increase from 18 percent in 2019. Securities within the equity portfolio are well diversified and are primarily invested in large-cap issues with a preference for dividend income. Our strategy has a value tilt and security selection takes precedence over market timing. Likewise, low turnover throughout our long investment horizon minimizes transaction costs and taxes.
The following table summarizes the distribution of our mortgage-backed securities (MBS) portfolio by investment type, as of December 31:
Agency MBS represented 18 percent of the fixed income portfolio, compared to 21 percent as of December 31, 2019. We believe agency MBS investments add diversification, liquidity, credit quality and additional yield to our portfolio. Our objective for the agency MBS portfolio is to provide reasonable cash flow stability where we are compensated for the call risk associated with residential refinancing. The agency MBS portfolio includes mortgage-backed pass-through securities and collateralized mortgage obligations (CMO), which include planned amortization classes (PACs) and sequential pay structures. As of December 31, 2020, all of the securities in our agency 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, 2020, the agency MBS portfolio contained 57 percent of pure pass-throughs, compared to 67 percent as of December 31, 2019. An additional 26 percent of the MBS portfolio was invested in sequential payer, the same as 2019.
The following table summarizes the distribution of our asset-backed and commercial mortgage-backed securities portfolio as of December 31:
As of December 31, 2020, municipal bonds composed 24 percent of our fixed income portfolio, compared to 21 percent as of December 31, 2019. We 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.
Our municipal fixed income portfolio is comprised of general obligation (GO) and revenue securities. The revenue sources include sectors such as sewer and water, public improvement, school, transportation and colleges and universities. As of December 31, 2020, approximately 43 percent of the municipal fixed income securities in the investment portfolio were GO and the remaining 57 percent were revenue based. The municipal portfolio is diversified amongst 280 issues with the largest single issuer representing less than 1 percent of invested assets.
Eighty-six percent of our municipal fixed income securities were rated AA or better, while 99 percent were rated A or better. The municipal portfolio includes 62 percent tax-exempt and 38 percent taxable securities.
The table below illustrates our corporate debt exposure as of December 31, 2020. Private placements include bank loan and Regulation D securities.
As of December 31, 2020, our equity portfolio comprised 19 percent of the investment portfolio, an increase of 1 percent from December 31, 2019. The securities within the equity portfolio remain primarily invested in large-cap issues with a focus on dividend income. In addition, we have investments in three broadly diversified, exchange traded funds (ETFs) that represent market indexes similar to the Russell 1000 Index, S&P 500 Index and S&P 600 Index. The ETF portfolio is congruent with the actively managed equity portfolios and solves for exposures that line up with our overall benchmark index, the Russell 3000. In total, the equity portfolio is comprised of 221 securities with the largest single company exposure representing less than 1 percent of invested assets.
We incurred $7.6 million of interest expense on outstanding debt during 2020 and 2019. At December 31, 2020 and 2019, our long-term debt consisted of $150.0 million in senior notes maturing September 15, 2023, and paying interest semi-annually at the rate of 4.875 percent.
As of December 31, 2020, we had a 23 percent interest in the equity and earnings of 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 private company, the market for Prime’s stock is limited. While we have certain rights under our shareholder agreement, we are subject to the decisions of the controlling shareholder, which may impact the value of our investment. In 2020, we recorded $10.8 million in investee earnings for Prime, compared to $7.4 million in 2019,
reflective of their growth in revenue. Additionally, we maintain a quota share reinsurance treaty with Prime, which contributed $15.7 million of gross premiums written and $14.3 million of net premiums earned during 2020, compared to $13.1 million of gross premiums written and $28.7 million of net premiums earned during 2019. The decrease in net premiums earned is reflective of our decreased quota share participation with Prime.
Our effective tax rates were 17.3 percent and 17.7 percent for 2020 and 2019, respectively. Effective rates are dependent upon components of pretax earnings, which is impacted by the volatility of unrealized gains and losses, and the related tax effects. The effective rate was lower in 2020 due to investment tax credits and lower levels of pretax earnings, which caused tax-favored adjustments to be larger on a percentage basis.
Dividends paid to our Employee Stock Ownership Plan (ESOP) also result in a tax deduction. Dividends paid to the ESOP in 2020 and 2019 resulted in tax benefits of $1.1 million in each year. These tax benefits reduced the effective tax rate for 2020 and 2019 by 0.6 percent and 0.5 percent, respectively.
The primary liability on our balance sheet relates to unpaid losses and settlement expenses, which represents our estimated liability for losses and related settlement expenses before considering offsetting reinsurance balances recoverable. The largest asset on our balance sheet, outside of investments, is the reinsurance balances recoverable on unpaid losses and settlement expenses, which serves to offset this liability. 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 $1.3 billion at December 31, 2020, from $1.2 billion as of December 31, 2019. This reflects incurred losses of $442.9 million in 2020 offset by paid losses of $325.1 million, compared to incurred losses of $413.4 million offset by $319.9 million paid in 2019. 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.
At December 31, 2020, we had cash, short-term investments and other investments maturing within one year of approximately $155.9 million and an additional $519.9 million of investments maturing between 1 to 5 years. We maintain a revolving line of credit with Bank of Montreal, Chicago Branch, which permits us to borrow up to an aggregate principal amount of $60.0 million. Under certain conditions, the line may be increased up to an aggregate principal amount of $120.0 million. The facility has a three-year term that expires on March 27, 2023. This facility replaced the previous $50.0 million facility with JP Morgan Chase Bank N.A., which was set to expire on May 24, 2020. As of and during the year ended December 31, 2020, no amounts were outstanding on these facilities.
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 with access to an additional source of liquidity via a secured lending facility. Based on qualifying assets at year-end, aggregate borrowing capacity is approximately $30.0 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, 2020, there were no outstanding borrowings with the FHLBC.
The following list highlights some of the major sources and uses of cash flow from investing activities:
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, 2020, our portfolio had a carrying value of $2.8 billion. Portfolio assets at December 31, 2020, increased by $276.7 million, or 11 percent, from December 31, 2019.
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, 2020, 46 percent of our shareholders’ equity was invested in equities, unchanged from December 31, 2019.
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 2020 and 2019, our principal insurance subsidiary paid ordinary dividends totaling $110.0 million and $59.0 million, respectively, to RLI Corp. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the IDOI. No extraordinary dividends were paid in 2020 or 2019. As of December 31, 2020, $25.3 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 amount and impact of these restrictions vary over time. 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.
We achieved our 25th consecutive year of underwriting profit in 2020, a notable milestone in the midst of challenging conditions. Despite the economic slowdown, we were able to grow premium 7 percent for the year and believe there is momentum for growth to continue in 2021. The support for broad-based rate increases in the industry go well beyond the influences of the pandemic and continue to be driven by loss cost inflation, elevated catastrophe activity, reinsurance pricing and prolonged low interest rates. We will benefit when rates exceed the trajectory of projected loss costs and should continue to see business opportunities that meet our risk appetite.
Terms and conditions are an important part of tailoring coverage for the specific needs of an insured. The evolution of policy language offers the potential for more business to align with our criteria, and we are better equipped to provide bespoke solutions to our distribution partners.
Government policy was swift and far reaching in response to the COVID-induced recession of mid-2020. Consumers, employers, the mortgage market and credit availability were all supported by large amounts of federal stimulus. Measures of employment have rebounded faster than expected, but the path toward full employment will take time, with affected industries (e.g. entertainment, travel, hospitality) requiring a prolonged recovery, well into 2022.
The Federal Reserve’s support of the capital markets last year seems to have forestalled a second financial crisis. However, this accommodation will extend the low interest rate environment for the foreseeable future. While this liquidity will support asset prices in much of our investment portfolio, longer term performance will require increasing earnings and sound fundamentals. Investment income will face some headwinds over the next several quarters, but a growing invested asset base may provide an important offset. Equity prices and credit markets have rebounded significantly from the lows in March 2020, and while there may be some volatility in 2021, we believe markets will continue to respond positively to the ongoing recovery.
The economy was on better footing in the last six months of 2020. However, there are segments of our business that remain highly sensitive to slowdowns in gross domestic product. A number of products in our casualty and surety segments touch the construction industry and any slide back into recession may shelve projects more permanently. Our expectation is that most planned commercial construction activity will continue as intended, although post pandemic preferences for real estate may change the landscape over time.
The casualty segment has experienced a number of cross currents on loss trends over the last several years, with volatile damage awards and changes to frequency adding to uncertainty of outcomes, especially for lines with longer duration. Pricing has responded with consecutive years of improvement in many lines, especially for products where the most challenging loss outcomes have impacted participants, and capacity is being removed from the market.
Surety premiums have been capped the last few years as we maintained disciplined underwriting, surrounded by higher levels of competition. Our actions are reflected in the stable underwriting profit the segment has produced. Looking ahead, we are ready to take advantage of improving market conditions and are cautiously optimistic that measured growth is possible for 2021. We will continue to take underwriting action where required and are monitoring how our accounts are faring in light of the current economy.
We adopted ASU 2016-13 on January 1, 2020 using the modified-retrospective approach. The standard applied to three of the Company’s balance sheet accounts: available-for-sale fixed income securities, premiums receivable and reinsurance balances recoverable. The impact of this standard was and is expected to continue to be immaterial, as our fixed income portfolio is weighted towards higher rated bonds (83 percent rated A or better at December 31, 2020 and 85 percent at December 31, 2019), we purchase reinsurance from financially strong reinsurers, we have a long history of collecting premium receivables through various economic cycles and we had previously maintained an allowance for uncollectible premium and reinsurance balances. In total, the cumulative-effect adjustment made to the balance sheet as of the beginning of the year resulted in a $1.1 million increase to retained earnings and an increase to accumulated other comprehensive earnings of less than $0.1 million
securities 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.
Cash consists of uninvested balances in bank accounts. Other invested assets include investments in low income housing tax credit partnerships (LIHTC), membership in the Federal Home Loan Bank of Chicago (FHLBC), investments in private funds and investments in restricted stock. Our LIHTC investments are carried at amortized cost, and our investment in FHLBC stock is carried at cost. Due to the nature of cash, the LIHTCs and our membership in the FHLBC, their carrying amounts approximate fair value. The private funds are carried at fair value, using each investment’s net asset value. Restricted stock is carried at quoted market prices, as the restrictions expire within one year.
Ceded unearned premiums and reinsurance balances recoverable on unpaid losses and settlement expenses are reported separately as an asset, rather than being netted with the related liability, since reinsurance does not relieve the Company of our liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. We continually monitor the financial condition of our reinsurers and actively follow up on any past due or disputed amounts. As part of our monitoring efforts, we review their annual financial statements and SEC filings for those 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 AM Best and S&P ratings of our reinsurers. In addition, we subject our reinsurance recoverables to detailed recoverability tests, including a segment-based analysis using the average default rating percentage by S&P rating, which assists the Company in assessing the sufficiency of the existing allowance. Additionally, we perform an in-depth reinsurer financial condition analysis prior to the renewal of our reinsurance placements.
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 process contemplates the premiums to be earned, anticipated losses and settlement expenses and certain other costs expected to be incurred, but does not consider investment income. 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.
quality sunglasses, and a minority representation on their board of directors. Maui Jim’s chief executive officer owns a controlling majority of the outstanding shares of Maui Jim. We carry this investment at the holding company level as it is not core to our insurance operations. Our investment in Maui Jim was $90.9 million at December 31, 2020 and $79.6 million at December 31, 2019. In 2020, we recorded $10.4 million in investee earnings for Maui Jim, compared to $13.6 million in 2019 and $12.5 million in 2018.
As of December 31, 2020, we had a 23 percent interest in the equity and earnings of 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. Our investment in Prime was $32.7 million at December 31, 2020 and $24.2 million at December 31, 2019. In 2020, we recorded $10.8 million in investee earnings for Prime, compared to $7.4 million in 2019 and $3.6 million in 2018. Additionally, we maintain a quota share reinsurance treaty with Prime, which contributed $15.7 million of gross premiums written and $14.3 million of net premiums earned during 2020, compared to $13.1 million of gross premiums written and $28.7 million of net premiums earned during 2019 and $41.1 million of gross premiums written and $34.2 million of net premiums earned during 2018. The decrease in premium is reflective of our decreased quota share participation with Prime.
Our equity method investments recorded net income of $70.4 million in 2020, $77.3 million in 2019 and $50.2 million in 2018. Additional summarized financial information for our equity method investments as of 2020 and 2019 is outlined in the following table:
The definite-lived intangible assets are amortized against future operating results based on their estimated useful lives. Amortization of intangible assets was $0.4 million for 2020, 2019 and 2018. We anticipate we will recognize amortization expense of $0.1 million in 2021 and less than $0.1 million in 2022.
diluted net earnings or net loss per share is computed excluding these items. The following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the consolidated financial statements:
Our comprehensive earnings include net earnings plus after-tax unrealized gains and losses on our available-for-sale fixed income portfolio. In reporting the components of comprehensive earnings, we used the federal statutory tax rate of 21 percent. Other comprehensive income (loss), as shown in the consolidated statements of earnings and comprehensive earnings, is net of tax expense (benefit) of $14.9 million, $17.8 million and $(9.0) million for 2020, 2019 and 2018, respectively.
ASU 2018-02 addressed issues arising from the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA). Deferred tax items are required to be revalued based on new tax laws with changes included in earnings. Since other comprehensive earnings was not affected by the revaluation of deferred tax items, the accumulated other comprehensive earnings balance was reflective of the historic tax rate instead of the newly enacted rate, which created a stranded tax effect. ASU 2018-02 allowed for the reclassification of our $3.7 million stranded tax effect out of accumulated other comprehensive earnings into retained earnings.
In 2020, credit losses or the sale of an available-for-sale security resulted in amounts being reclassified from accumulated other comprehensive earnings to current period net earnings. In 2019 and 2018, the sale or other-than-temporary impairment of an available-for-sale security resulted in amounts being reclassified from accumulated other comprehensive earnings to 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 a part of management’s process to determine fair value, we utilize widely recognized, third-party pricing sources to determine our fair values. We have obtained an understanding of the third-party pricing sources’ valuation methodologies and inputs.
Mortgage-backed Securities (MBS)/Collateralized Mortgage Obligations (CMO) and Asset-backed Securities (ABS): The pricing vendor evaluation methodology includes principally interest rate movements and new issue data. Evaluation of the tranches (nonvolatile, volatile or credit sensitivity) is based on the pricing vendors’ interpretation of accepted modeling and pricing conventions. This information is then used to determine the cash flows for each tranche, benchmark yields, pre-payment assumptions and to incorporate collateral performance. To evaluate CMO volatility, an option adjusted spread model is used in combination with models that simulate interest rate paths to determine market price information. This process allows the pricing vendor to obtain evaluations of a broad universe of securities in a way that reflects changes in yield curve, index rates, implied volatility, mortgage rates and recent trade activity. MBS/CMO and ABS with corroborated, observable inputs are classified as Level 2. All of our MBS/CMO and ABS are deemed Level 2.
Common Stock: As of December 31, 2020, all but one of our common stock holdings were 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.
Certain risks and uncertainties are inherent in our day-to-day operations and in the process of preparing our consolidated financial statements. The more significant risks and uncertainties, as well as our attempt to mitigate, quantify and minimize such risks, are presented below and throughout the notes to the consolidated financial statements.
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 loss reserves are based on estimates and may be inadequate to cover our actual insured losses, which would negatively impact our profitability. As of December 31, 2020, we had $1.8 billion of gross loss and LAE reserves. Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to the Company and our payment of that loss. As part of the reserving process, we review historical data and consider the impact of various factors such as trends in claim frequency and severity, emerging economic and social trends, inflation and changes in the regulatory and litigation environments. If the actual amount of insured losses is greater than the amount we have reserved for these losses, our profitability would suffer.
Our catastrophe reinsurance treaty renewed on January 1, 2021. 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.
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.
The National Association of Insurance Commissioners (NAIC) has developed Property/Casualty Risk-Based Capital (RBC) standards that relate an insurer’s reported statutory surplus to the risks inherent in its overall operations. The RBC formula uses the statutory annual statement to calculate the minimum indicated capital level to support investment and underwriting risk. The NAIC model law calls for various levels of regulatory action based on the magnitude of an indicated RBC capital deficiency, if any. We regularly monitor our subsidiaries’ internal capital requirements and the NAIC’s RBC developments. As of December 31, 2020, we determined that our capital levels are well in excess of the minimum capital requirements for all RBC action levels and that our capital levels are sufficient to support the level of risk inherent in our operations. See note 9 for further discussion of statutory information and related insurance regulatory restrictions.
Our investments are primarily composed of fixed income debt securities and common stock equity securities. All of our debt securities are classified as available-for-sale, which are carried at fair value. Our equity portfolio consists of common stocks and exchange traded funds (ETF), which are carried at fair value.
The change in unrealized gain (loss) position was due to declining interest rates, increasing the fair value of fixed income securities, as well as strong equity market returns.
The following is a summary of the disposition of fixed income securities and equities for the years ended December 31, with separate presentations for sales and calls/maturities:
Assets measured at fair value on a recurring basis as of December 31, 2020 and 2019, are summarized below:
The following table summarizes changes in the balance of Regulation D private placement fixed income securities whose fair value was measured using significant unobservable inputs (Level 3).
The amortized cost and estimated fair value of fixed income securities at December 31, 2020, by contractual maturity, are shown as follows:
The amortized cost and fair value of available-for-sale securities at December 31, 2020 and 2019 are presented in the tables below. Amortized cost does not include the $14.9 million and $13.5 million of accrued interest receivable as of December 31, 2020 and 2019, respectively.
Ninety-four percent of our collateralized securities carry the highest credit rating by one or more major rating agencies and continue to pay according to contractual terms.
We adopted ASU 2016-13, Financial Instruments - Credit Losses, on January 1, 2020, which required the recognition of a reversible allowance for credit losses on available-for-sale fixed income securities. See note 1. C. for more information on the adoption of the ASU. Available-for-sale securities in the fixed income portfolio are subjected to several criteria to determine if those securities should be included in the allowance for expected credit loss evaluation, including:
The discontinuance of a segment of business that may affect future earnings potential,
If changes in interest rates and credit spreads do not reasonably explain the unrealized loss for an available-for-sale security, or if any of the criteria above indicate a potential credit loss, the security is subjected to a discounted cash flow analysis. Inputs into the discounted cash flow analysis include prepayment assumptions for structured securities, default rates and recoverability rates based on credit rating. The allowance for any security is limited to the amount that the fair value is below amortized cost. As of December 31, 2020, the discounted cash flow analysis resulted in an allowance for credit losses on 21 securities. The following table presents changes in the allowance for expected credit losses on available-for-sale securities:
Prior to the adoption of ASU 2016-13, we conducted reviews of fixed income securities with unrealized losses to evaluate whether an impairment was other-than-temporary. Any credit-related impairment on fixed income securities we did not plan to sell and we were not more likely than not to be required to sell were recognized in net earnings, with the non-credit related impairment recognized in comprehensive earnings. We did not recognize any other-than-temporary impairment losses in earnings on the fixed income portfolio in 2019.
As of December 31, 2020, in addition to the securities included in the allowance for credit losses, the fixed income portfolio contained 142 securities with an unrealized loss position for which an allowance for credit losses had not been recorded. The $2.6 million in associated unrealized losses represents 0.1 percent of the fixed income portfolio’s cost basis and 0.1 percent of total invested assets. Isolated to these securities, unrealized losses at the end of 2020 were flat compared to the previous year. Of the total 142 securities, 31 have been in an unrealized loss position for 12 consecutive months or longer. The following table illustrates the total value of fixed income securities that were in an unrealized loss position as of December 31, 2020, after factoring in the allowance for credit losses, and December 31, 2019.
We had $54.2 million of other invested assets at December 31, 2020, compared to $70.4 million at the end of 2019. Other invested assets include investments in low income housing tax credit (LIHTC) partnerships, membership stock in the Federal Home Loan Bank of Chicago (FHLBC), investments in private funds and investments in restricted stock. Our LIHTC investments are carried at amortized cost and our investment in FHLBC stock is carried at cost. Due to the nature of the LIHTC and our membership in the FHLBC, their carrying amounts approximate fair value. The private funds are carried at fair value, using each investments’ net asset value. Restricted stock is carried at quoted market prices, as the restrictions expire within one year.
prior approval, were established and remain in place until the first quarter of 2021. Our remaining investment in restricted stock was $6.1 million as of December 31, 2020. For our remaining investments in private funds, the timed dissolution of the partnerships would trigger redemption.
As of December 31, 2020, fixed income securities with a carrying value of $77.7 million were on deposit with regulatory authorities as required by law.
As of December 31, 2020, outstanding debt balances totaled $149.5 million, net of unamortized discount and debt issuance costs, all of which were our long-term senior notes.
In the ordinary course of business, our insurance subsidiaries assume and cede premiums and selected insured risks with other insurance companies, known as reinsurance. A large portion of the reinsurance is put into effect under contracts known as treaties and, in some instances, by negotiation on each individual risk (known as facultative reinsurance). In addition, there are several types of
treaties including quota share, excess of loss and catastrophe reinsurance contracts that protect against losses over stipulated amounts arising from any one occurrence or event. The arrangements allow the Company to pursue greater diversification of business and serve to limit the maximum net loss to a single event, such as a catastrophe. Through the quantification of exposed policy limits in each region and the extensive use of computer-assisted modeling techniques, we monitor the concentration of risks exposed to catastrophic events.
More than 88 percent of our reinsurance recoverables are due from companies with financial strength ratings of A or better by AM Best and S&P rating services. The following table displays net reinsurance balances recoverable, after consideration of collateral, from our top reinsurers as of December 31, 2020. These reinsurers all have financial strength ratings of A or better by AM Best and S&P’s ratings services. Also shown are the amounts of written premium ceded to these reinsurers during the calendar year 2020.
All other reinsurance balances recoverable, when considered by individual reinsurer, are less than 2 percent of shareholders’ equity.
The following is information about incurred and paid loss development as of December 31, 2020, net of reinsurance, as well as cumulative claim frequency, the total of IBNR liabilities included within the net incurred loss amounts and average historical claims duration as of December 31, 2020. 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, executive products and other casualty. 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, 2011 to 2019 is presented as unaudited required supplementary information.
Actuarial models base future emergence on historic experience, with adjustments for current trends, and the appropriateness of these assumptions involved more uncertainty as of December 31, 2020. We expect there will be impacts to the timing of loss emergence and ultimate loss ratios for certain coverages we underwrite as a result of the spread of COVID-19 and the related
The following table summarizes our prior accident years’ loss reserve development by segment for 2020, 2019 and 2018:
The following table represents paid and unpaid environmental, asbestos and mass tort claims data (including incurred but not reported losses) as of December 31, 2020, 2019 and 2018:
During 2020, RLI experienced modest emergence of asbestos, environmental and mass tort losses and we increased our IBNR reserves for these exposures.
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are summarized below.
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 21 percent in anticipation of recovering our investments through means other than through the receipt of dividends, such as a sale. We received a $4.7 million dividend from Prime in 2020 and recognized a $0.5 million tax benefit from applying the lower tax rate applicable to affiliated dividends paid to insurance companies (10.8 percent in 2020), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. In 2019, we received a $13.2 million dividend from Maui Jim and recognized a $1.8 million tax benefit from applying the lower tax rate applicable to affiliated dividends paid to non-insurance companies (7.4 percent in 2019), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. Standing alone, the dividends resulted in a 0.2 percent and 0.8 percent reduction to the 2020 and 2019 effective tax rates, respectively. As no dividends were declared from unconsolidated investees in 2018, there was no impact to the 2018 effective tax rate.
Dividends paid to our Employee Stock Ownership Plan (ESOP) also result in a tax deduction. Dividends paid to the ESOP in 2020, 2019 and 2018 resulted in tax benefits of $1.1 million, $1.1 million and $1.2 million, respectively. These tax benefits reduced the effective tax rate for 2020, 2019 and 2018 by 0.6 percent, 0.5 percent and 1.8 percent and, respectively.
Federal and state income taxes paid in 2020, 2019 and 2018 amounted to $23.7 million, $25.6 million and $16.4 million, respectively.
Although we are not currently under audit by the IRS, tax years 2016 through 2020 remain open and are subject to examination.
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 $14.4 million, $15.7 million and $8.8 million for 2020, 2019 and 2018, respectively.
Annual awards are provided to executives, managers and associates through our incentive plans, provided certain strategic and financial goals are met. Annual expenses for these incentive plans totaled $26.6 million, $30.1 million and $11.9 million for 2020, 2019 and 2018, respectively.
For most participants, the requisite service period and vesting period will be the same. For participants who are retirement eligible, defined by the plan as those individuals whose age and years of service equals 75, the requisite service period is deemed to be met and options are immediately expensed on the date of grant. For participants who will become retirement eligible during the vesting period, the requisite service period over which expense is recognized is the period between the grant date and the attainment of retirement eligibility. Shares issued upon option exercise are newly issued shares.
The intrinsic value, which is the difference between the fair value and the exercise price, of options exercised was $15.5 million, $20.0 million and $24.3 million during 2020, 2019 and 2018, respectively.
The fair value of options were estimated using a Black-Scholes based option pricing model with the following weighted-average grant-date assumptions and weighted-average fair values as of December 31:
The risk-free rate was determined based on U.S. treasury yields that most closely approximated the option’s expected life. The dividend yield 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 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.
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’s statutory accounting principles (SAP). We do not use any permitted SAP that differ from NAIC prescribed SAP. In converting from SAP 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.
Year-end statutory surplus for 2020 presented in the table below includes $238.0 million of RLI Corp. stock (cost basis of $64.6 million) held by Mt. Hawley Insurance Company, compared to $190.9 million and $132.8 million in 2019 and 2018, 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 three insurance companies are subsidiaries of RLI Corp., with RLI Ins. as the first-level, or principal, insurance subsidiary. 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, 2020, our holding company had $1.1 billion 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 $64.6 million in liquid assets, which exceeds our normal 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 capital markets.
is expensed in the period in which the obligation is incurred. Sublease income is recognized on a straight-line basis over the sublease term.
The following table further summarizes revenues by major product type within each segment:
To the shareholders and the Board of Directors of RLI Corp
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020, and the results of its operations and its cash flow for the year ended December 31, 2020, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by COSO.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
The liability for unpaid losses and settlement expenses represents estimates of amounts needed to pay reported and unreported claims and related expenses. The estimates are based on certain actuarial and other assumptions related to the ultimate cost to settle such claims.
Our audit procedures related to unpaid losses and settlement expenses included the following, among others:
We tested the effectiveness of controls related to unpaid losses and settlement expenses, including those controls over the inputs, methods, and assumptions used in the Company’s estimation processes.
Comparing the Company’s prior year estimates of expected incurred losses to actual experience during the current year to identify potential management bias in the determination of the unpaid losses and settlement expenses.
We have audited the accompanying consolidated balance sheet of RLI Corp. and subsidiaries (the Company) as of December 31, 2019, the related consolidated statements of earnings and comprehensive earnings, shareholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2019, and the related notes and financial statement schedules I to VI (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.