We own five commercial buildings totaling 174,000 square feet on our 23-acre campus that serves as our corporate headquarters in Peoria, Illinois. All 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 five years ended December 31, 2017:
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. As a specialty insurance company with a niche focus, we offer insurance coverages in both the specialty admitted and excess and surplus markets. Coverages in the specialty admitted market, such as our energy surety bonds, are for risks that are unique or hard-to-place in the standard market, but must remain with an admitted insurance company for regulatory or marketing reasons. In addition, our coverages in the specialty admitted market may be designed to meet specific insurance needs of targeted insured groups, such as our professional liability and package coverages for design professionals and our stand-alone personal umbrella policy. The specialty admitted market is subject to more state regulation than the excess and surplus market, particularly with regard to rate and form filing requirements, restrictions on the ability to exit lines of business, premium tax payments and membership in various state associations, such as state guaranty funds and assigned risk plans. We also underwrite coverages in the excess and surplus market. The excess and surplus market, unlike the admitted market, is less regulated and more flexible in terms of policy forms and premium rates. This market provides an alternative for customers with risks or loss exposures that generally cannot be written in the standard market. This typically results in coverages that are more restrictive and more expensive than coverages in the admitted market. When we underwrite within the excess and surplus market, we are selective in the lines of business and type of risks we choose to write. Using our non-admitted status in this market allows us to tailor terms and conditions to manage these exposures effectively. Often, the development of these coverages is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients or loss exposures. Once a proposal is submitted, our underwriters determine whether it would be a viable product based on our business objectives.
We focus on niche markets and developing unique products that are tailored to customers’ needs. We hire underwriters 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 2017, we achieved our 22nd consecutive year of profitability, averaging an 87.8 combined ratio over that period. 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. 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 financial results. We have a diversified investment portfolio and closely monitor our investment risks. Despite periodic fluctuations in market value, our equity portfolio is part of a long-term asset allocation strategy and has contributed significantly to our historic growth in book value.
The casualty portion of our business consists largely of commercial umbrella, personal umbrella, general liability, transportation and executive products coverages, as well as package business and other specialty coverages, such as professional liability and workers’ compensation for office-based professionals. We also offer fidelity and crime coverage for commercial insureds and select financial institutions and medical and healthcare professional liability coverage. The casualty business is subject to the risk of estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty segment is also subject to inflation risk and may be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses.
aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and maintaining policy terms and conditions throughout market cycles. We also use computer-assisted modeling techniques to provide estimates that help us carefully manage the concentration of risks exposed to catastrophic events.
Underwriting income or profit represents one measure of the pretax profitability of our insurance operations and is derived by subtracting losses and settlement expenses, policy acquisition costs and insurance operating expenses from net premiums earned, which are all GAAP financial measures. Each of these captions is presented in the statements of earnings but is not subtotaled. However, this information is available in total and by segment in note 11 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data. The nearest comparable GAAP measure is earnings before income taxes which, in addition to underwriting income, includes net investment income, net realized gains or losses, general corporate expenses, debt costs and our portion of earnings from unconsolidated investees.
consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.
Loss and loss adjustment expense (LAE) reserves represent our best estimate of ultimate payments for losses and related settlement expenses from claims that have been reported but not paid and those losses that have occurred but have not yet been reported to us. Loss reserves do not represent an exact calculation of liability, but instead represent our estimates, generally utilizing individual claim estimates, actuarial expertise and estimation techniques at a given accounting date. The loss reserve estimates are expectations of what ultimate settlement and administration of claims will cost upon final resolution. These estimates are based on facts and circumstances then known to us, review of historical settlement patterns, estimates of trends in claims frequency and severity, projections of loss costs, expected interpretations of legal theories of liability and many other factors. In establishing reserves, we also take into account estimated recoveries from reinsurance, salvage and subrogation. The reserves are reviewed regularly by a team of actuaries we employ.
There is uncertainty in the estimates of ultimate losses. Significant risk factors to the reserve estimate include, but are not limited to, unforeseen or unquantifiable changes in:
Upon completion of our loss and LAE estimation analysis, the results are discussed with the LRC. As part of this discussion, the analysis supporting the actuarial central estimate of the IBNR reserve by product is reviewed. The actuaries also present explanations supporting any changes to the underlying assumptions used to calculate the indicated central estimate. A review of the resulting variance between the indicated reserves and the carried reserves takes place. Our actuaries make a recommendation to management in regards to booked reserves that reflect their analytical assessment and view of estimation risk. After discussion of these analyses and all relevant risk factors, the LRC determines whether the reserve balances require adjustment. Resulting reserve balances have always fallen within our actuaries’ reasonable range of estimates.
As a predominantly excess and surplus lines and specialty admitted insurer serving niche markets, we believe there are several reasons to carry, on an overall basis, reserves above the actuarial central estimate. We believe we are subject to above-average variation in estimates and that this variation is not symmetrical around the actuarial central estimate.
Consolidated revenue declined slightly in 2017, due to lower amounts of realized gains recognized during the year. However, both net premiums earned from insurance operations and net investment income increased in 2017. Net premiums earned were up 1 percent, driven by results from our casualty segment. The growth from casualty offset a decline from our property segment, while the surety segment was flat for the year. Net premiums earned also increased on an overall basis in 2016 and 2015, with growth of 4 percent and 2 percent, respectively. Premium results for each of these periods were impacted by recent exits from certain product lines, including our recreational vehicles (RV) and treaty reinsurance lines in 2016 and our crop and facultative reinsurance lines in 2015. Investment income increased by 3 percent in 2017, compared to a 3 percent decline during the prior year. The increase was primarily due to a larger asset base in 2017 as well as an increase in other invested assets. We recorded net realized gains on our investment portfolio in each of the past three years. The majority of gains realized over this period related to sales activities versus calls or maturities. Sales activity was largely due to normal portfolio rebalancing, as well as raising cash to support special dividends paid in each of the last three years. Net realized gains
Net earnings for 2017 totaled $105.0 million, down from $114.9 in the prior year. The components of net earnings differed significantly from prior years, due to record levels of hurricane losses during 2017 and the passage of The Tax Cuts and Jobs Act of 2017 (TCJA). Catastrophe losses totaled $39.8 million in 2017, with Hurricanes Harvey, Irma and Maria responsible for $36.0 million of the total, which added 4 points to the combined ratio. These hurricanes collectively represented the largest wind-related catastrophe loss in company history, and contributed heavily to the lower underwriting income result in 2017. Catastrophe losses in 2016 were $16.3 million, split evenly between amounts related to spring storms and Hurricane Matthew, while 2015 results included $12.1 in spring and winter storm losses. Apart from the catastrophe impact, results for each of these years also reflected a combination of positive underwriting results for the current accident year and favorable loss reserve development on prior accident years. The ex-catastrophe loss ratio has trended higher for the current accident year in 2017. The increase was largely driven by an overall shift in mix of business towards our casualty segment, as well as higher loss trends on certain lines within casualty. Favorable development in prior accident years’ reserves was similar in each of the past two years, as results for 2017 included $38.9 million in favorable development, compared to $42.0 million in 2016. The impact was greater in 2015, as favorable development in prior accident years’ reserves totaled $65.4 million, primarily due to larger amounts from our casualty segment. 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 $26.8 million in 2017, compared to $76.1 million in 2016 and $108.6 million in 2015. These results translate to combined ratios of 96.4 for 2017, 89.5 for 2016 and 84.5 for 2015. Our ability to continue to produce underwriting income, and to do so 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 sound risk selection and appropriate pricing which helps slow the pace of deterioration in our underwriting results.
We recorded an overall tax benefit in 2017 due to the impact of tax reform legislation enacted in late 2017. Among other provisions, the new law lowered the federal corporate tax rate from 35 percent to 21 percent effective January 1, 2018. As a result, we revalued deferred tax items as of year-end 2017 to reflect the lower rate. The revaluation reduced our net deferred tax liability and income tax expense by $32.8 million and decreased the effective tax rate by 38.8 percent. Additional information on the impact of tax reform and the revaluing of our deferred tax inventory can be found in note 7 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
The 2017 fiscal year was marked by a significant increase in U.S. catastrophe losses, as Hurricanes Harvey, Irma and Maria all made landfall during the third quarter. For the industry, this marked the most active year of U.S. catastrophes in over 20 years, and represented one of the costliest hurricane seasons in U.S. history. These losses served to erode some of the excess capital that has entered the marketplace in recent years, and modest increases to property primary and reinsurance rates started to emerge by the end of the year. Despite the large magnitude of these losses, the industry remains well capitalized, and the expectation is that the 2017 catastrophes do not represent a capital event for most insurers. Rather, the losses have been characterized as earnings events that do not call into question the adequacy of the insurance industry’s capital position. This is the case for RLI, as we remain adequately capitalized subsequent to these events, despite the fact that lower underwriting earnings were recorded during the year. The 2017 fiscal year marked our 22nd consecutive year of achieving an underwriting profit, as income from our casualty and surety segments outweighed the catastrophe-driven loss from our property segment.
Prior to the record hurricane activity, the trends and market conditions seen for much of 2017 were unchanged from the prior year in many respects. Competition in the industry remained intense across all of our segments, excess capital remains in the industry and elevated commercial auto loss trends were a focus for the industry and for RLI. Our efforts to address the problem areas within our transportation business made significant progress, as the combination of seeking adequate rate, non-renewing underperforming accounts and enhancing our processes led to steady improvements in results as the year progressed. While we continue to monitor this business closely, the transportation re-underwriting initiated in the fourth quarter of 2016 was completed in the second half of 2017. Our willingness to address underperforming businesses quickly is indicative of our disciplined underwriting approach, which we believe differentiates us from others in the industry. Despite the challenges in commercial auto, the industry benefited from favorable loss development in 2017 as a whole.
While not specific to the insurance industry and not a direct influence on our pretax underwriting performance, the passing of tax reform was also noteworthy in 2017. The enactment led to a one-time adjustment to our net deferred tax liability, which resulted in a $32.8 million reduction to our 2017 tax expense. Because our incentive and profit-sharing plans are influenced by corporate performance, including impacts such as this, we recorded an additional one-time $7.7 million in expenses related to this tax benefit. Of this total, $7.0 million is recorded in 2017 underwriting expenses. The segment level impact is discussed in the Underwriting Income sections that follow.
The following tables and narrative provide a more detailed look at individual segment performance over the last three years.
Gross premiums written in the property segment decreased 6 percent in 2017 after decreasing 11 percent in 2016 and 21 percent in 2015. These results reflect exits from RV and treaty reinsurance in 2016, and facultative reinsurance and crop reinsurance in 2015. For each of the exited lines, factors such as poor underwriting performance, lack of scale or unfavorable market conditions were key considerations in the decisions to exit. The exception is our exit from crop reinsurance, which occurred due to the acquisition of the cedant company. For 2017, excluding the impact of the exits from RV and treaty reinsurance, gross premiums written from the property segment were up 6 percent.
The property segment produced an underwriting loss of $11.9 million for 2017, which translates into a 108.6 combined ratio. The underwriting loss was driven by $38.4 million in catastrophe losses during the year, the bulk of which related to hurricane activity occurring in the third quarter. Property segment losses attributable to Hurricanes Harvey, Irma and Maria totaled $34.9 million, and amounted to the largest wind loss in the company’s history. The majority of our losses related to Hurricanes Harvey and Irma, and were associated with our commercial property and marine lines. The catastrophe losses resulted in an underwriting loss on the 2017 accident year. Comparatively, catastrophe losses were relatively small in each of the two prior years. For 2016, losses related to Hurricane Matthew and seasonal wind storm losses combined to impact the segment by $15.8 million, while 2015 results included $11.8 million in losses from winter and spring storms. Accident year results for the previous two years reflected profitable underwriting performance, driven by commercial property lines in 2016, and improved loss ratios from marine in 2015.
During 2017, net investment income increased by 3 percent. The increase was primarily due to a larger asset base in 2017, as well as the increase in other invested assets. The average annual yields on our investments were as follows for 2017, 2016 and 2015:
We regularly evaluate the quality of our investment portfolio. When we determine that a specific security has suffered an other-than-temporary decline in value, the investment’s value is adjusted by reclassifying the decline from unrealized to realized losses. This has no impact on shareholders’ equity. We recognized $2.6 million and $0.1 million in impairment losses in 2017 and 2016, respectively. All losses were taken on fixed income securities we no longer had the intent to hold until recovery. We did not recognize any OTTI losses during 2015.
As of December 31, 2017, we held three securities in our equity portfolio that were in unrealized loss positions. The total unrealized loss on these securities was $0.9 million. With respect to both the significance and duration of the unrealized loss positions, we have no equity securities in an unrealized loss position of greater than 20 percent for more than six consecutive months.
The fixed income portfolio contained 346 positions at an unrealized loss as of December 31, 2017. Of these 346 securities, 133 have been in an unrealized loss position for 12 consecutive months or longer and represent $5.1 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.
Key components to our OTTI procedures are discussed in our critical accounting policy on investment valuation and OTTI and in note 2 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data. Based on our analysis, we have concluded that the securities in an unrealized loss position were not other-than-temporarily impaired at December 31, 2017.
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, 2017, the portfolio had a fair value of $2.1 billion, an increase of $119.0 million from the end of 2016.
The following table summarizes the distribution of our mortgage-backed securities (MBS) portfolio by investment type, as of the dates indicated:
Our allocation to agency mortgage-backed securities totaled $328.5 million as of December 31, 2017. MBS represented 20 percent of the fixed income portfolio compared to $284.1 million or 18 percent of that portfolio as of December 31, 2016.
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) which include planned amortization classes (PACs) and sequential pay structures. 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. PACs are securities whose cash flows are designed to remain constant in a variety of mortgage prepayment environments. Sequential pay structures are a type of CMO where each risk tranche is paid off in a particular order. Our MBS portfolio does not include interest-only securities or principal-only securities. As of December 31, 2017, 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).
An asset-backed security (ABS) or commercial mortgage-backed security (CMBS) is a securitization collateralized by the cash flows from a specific pool of underlying assets. These asset pools can include items such as credit card payments, auto loans and residential or commercial mortgages. As of December 31, 2017, ABS/CMBS investments were $70.5 million (4 percent) of the fixed income portfolio, compared to $93.9 million (6 percent) as of December 31, 2016. All of the securities in the ABS/CMBS portfolio were rated AAA as of December 31, 2017. We believe that ABS/CMBS investments add diversification and additional yield to the portfolio while often adding superior cash flow stability over mortgage pass-throughs or CMOs.
and bonds that are below investment grade in credit quality and offer incremental yield over our core fixed income portfolio. Non-investment grade bonds totaled $93.0 million at the end of 2017. The corporate debt portfolio has an overall quality rating of BBB+, diversified among 563 issues.
We incurred $7.4 million of interest expense on outstanding debt during 2017, 2016 and 2015. We completed a public debt offering in October 2013, issuing $150.0 million in senior notes, and used a portion of the proceeds to repay $100.0 million in senior notes that were originally set to mature in January 2014. At December 31, 2017, 2016 and 2015, 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 discussed previously, general corporate expenses tend to fluctuate relative to our incentive compensation plans. Our compensation model measures components of comprehensive earnings against a minimum required return on our capital. Bonuses are earned as we generate earnings in excess of this required return. In 2017, 2016 and 2015, we exceeded the
We maintain a 40 percent equity interest in Maui Jim, a manufacturer of high-quality sunglasses. Maui Jim’s chief executive officer owns a controlling majority of the outstanding shares of Maui Jim. Maui Jim is a private company, and as such, the market for its stock is limited. Our investment in Maui Jim is carried at the holding company, RLI Corp., level as it is not core to our insurance operations. As a minority shareholder, we are subject to the decisions of the controlling shareholder, which may impact the value of our investment. In 2017, we recorded $14.4 million in earnings from this investment compared to $9.7 million in 2016 and $9.9 million in 2015. Sunglass sales were up 9 percent in 2017, after increasing 2 percent in 2016 and decreasing 2 percent in 2015. In addition to the increased sales, foreign exchange gains in 2017, compared to foreign exchange losses in 2016 and benefits associated with tax reform, led to Maui Jim’s increase in earnings for 2017.
In 2016, we received a dividend from Maui Jim. Dividends from Maui Jim have been irregular in nature and while they provide added liquidity when received, we do not rely on those dividends to meet our liquidity needs. While these dividends do not flow through the investee earnings line, they do result in the recognition of a tax benefit, which is discussed in the income tax section that follows.
As of December 31, 2017, we had a 23 percent interest in the equity and earnings of Prime Holdings Insurance Services, Inc. (Prime). Prime writes business through two Illinois domiciled insurance carriers, Prime Insurance Company, an excess and surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company. As a minority shareholder, we are subject to the decisions of the controlling shareholder, which may impact the value of our investment. In 2017, we recorded $2.8 million in investee earnings for Prime, compared to $1.1 million in 2016 and $1.0 million in 2015. Additionally, we maintain a 25 percent quota share reinsurance treaty with Prime, which contributed $29.6 million of gross premiums written and $21.0 million of net premiums earned during 2017, compared to $13.4 million of gross premiums written and $11.4 million of net premiums earned during 2016 and $11.3 million of gross premiums written and $10.9 million of net premiums earned during 2015.
Dividends paid to our Employee Stock Ownership Plan (ESOP) also result in a tax deduction. Special dividends paid to the ESOP in 2017, 2016 and 2015 resulted in tax benefits of $1.9 million, $2.4 million and $2.5 million, respectively. These tax benefits reduced the effective tax rate for 2017, 2016 and 2015 by 2.3 percent, 1.5 percent and 1.2 percent, respectively.
The liability can be split into two parts: (1) case reserves representing estimates of losses and settlement expenses on known claims and (2) IBNR reserves representing estimates of losses and settlement expenses on claims that have occurred but have not yet been reported to us. 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 $969.5 million at December 31, 2017, from $851.1 million as of December 31, 2016. This reflects incurred losses of $401.6 million in 2017 offset by paid losses of $283.2 million compared to incurred losses of $349.8 million offset by $304.6 million paid in 2016. For more information on the changes in loss and LAE reserves by segment, see note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Gross reserves (liability) and the reinsurance balances recoverable (asset) are generally subject to the same influences that affect net reserves, though changes to our reinsurance agreements can cause reinsurance balances recoverable to behave differently. Total gross loss and LAE reserves increased to $1.3 billion at December 31, 2017 from $1.1 billion at December 31, 2016 while ceded loss and LAE reserves increased to $302.0 million from $288.2 million over the same period.
We have three primary types of cash flows: (1) operating cash flows, which consist mainly of cash generated by our underwriting operations and income earned on our investment portfolio, (2) investing cash flows related to the purchase, sale and maturity of investments and (3) financing cash flows that impact our capital structure, such as changes in debt and shares outstanding. The following table summarizes these three cash flows over the last three years:
We have posted positive operating cash flow in each of the last three years. Variations in operating cash flow between periods are largely driven by the volume and timing of premium receipt, claim payments, reinsurance and taxes. In addition, fluctuations in insurance operating expenses impact operating cash flow. During 2017, the majority of cash flow uses were
related to financing and investing activities, and associated with the payments of dividends and net purchases of investments, respectively.
We have entered into certain contractual obligations that require us to make recurring payments. The following table summarizes our contractual obligations as of December 31, 2017:
The next largest contractual obligation relates to long-term debt outstanding. On October 2, 2013, we completed a public debt offering of $150.0 million in senior notes maturing September 15, 2023, (a 10-year maturity) and paying interest semi-annually at the rate of 4.875 percent. The notes were issued at a discount resulting in proceeds, net of discount and commission, of $148.6 million. We are not party to any off-balance sheet arrangements. See note 4 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data for more information on our long term debt. Additionally, see note 2 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data for information on our obligations for other invested assets.
At December 31, 2017, we had cash, short-term investments and other investments maturing within one year of approximately $50.2 million and an additional $323.0 million of investments maturing between 1 to 5 years. We maintain a revolving line of credit with JP Morgan Chase Bank N.A., which permits us to borrow up to an aggregate principal amount of $40.0 million. This facility was entered into during the second quarter of 2014 and replaced the previous $25.0 million facility which expired on May 31, 2014. Under certain conditions, the line may be increased up to an aggregate principal amount of $65.0 million. The facility has a four-year term that expires on May 28, 2018. As of and during the year ended December 31, 2017, no amounts were outstanding on the revolving line of credit.
approximately $20 million. However, under certain circumstances, that capacity may be increased based on additional FHLBC stock purchased and available collateral. Our membership allows each insurance subsidiary to determine tenor and structure at the time of borrowing. During the fourth quarter of 2017, we borrowed and repaid $5.5 million from the FHLBC. The borrowing occurred due to a timing difference between dividends paid and received at one of our subsidiaries. As of the year ended December 31, 2017, there were no outstanding borrowings with the FHLBC.
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, 2017, our portfolio had a carrying value of $2.1 billion. Portfolio assets at December 31, 2017, increased by $119.0 million, or 6 percent, from December 31, 2016.
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, 2017, 47 percent of our
shareholders’ equity was invested in equities, compared to 45 percent at December 31, 2016 and 46 percent at December 31, 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, 2017, our holding company had $853.6 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 $23.5 million in liquid investment assets, which approximates half of our annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and ordinary dividend payments to our shareholders. If necessary, the holding company also has other potential sources of liquidity that could provide for additional funding to meet corporate obligations or pay shareholder dividends, which include a revolving line of credit, as well as access to the capital markets.
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 2017, 2016 and 2015, our principal insurance subsidiary paid ordinary dividends totaling $107.0 million, $123.6 million and $125.0 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 (IDOI). No extraordinary dividends were paid in 2017, 2016 or 2015. Given the amount of dividends paid during the prior rolling 12-month period, the net assets of our principal insurance subsidiary are restricted through the third quarter of 2018 and cannot be distributed to RLI Corp. without prior approval of the IDOI. However, in addition to the unrestricted liquid net assets that RLI Corp. had on hand as of December 31, 2017, RLI Corp. has other anticipated cash inflows and access to lines of credit that would cover normal annual holding company expenditures as they are incurred and become payable.
The insurance industry is expected to post a sizable underwriting loss in 2017, with an estimated combined ratio of 107 as a direct result of the elevated catastrophe losses experienced during the year. Insurance margins had already declined by year-over-year rate reductions, impacted in part by excess capital in the market. Prior to 2017, however, benefits on prior year reserves and benign loss cost inflation had continued to support industry results. In 2017, catastrophe activity was heavier,
The 2017 catastrophes have resulted in risk bearers taking a moment of temporary reflection. Most reinsurers have acted rationally by taking the opportunity to moderately raise rates on underperforming contracts. Primary carriers are evaluating underwriting authority, rate adequacy and market opportunities. We are regularly faced with new entrants into the specialty insurance market, which requires a deep understanding and discipline to be successful. We believe we are in a good position to capitalize on this uncertainty. Our focus on narrow and deep talent in selected niche markets, combined with a disciplined underwriting culture and a compensation plan that reinforces ownership and accountability, allows us to act quickly and with confidence when opportunities arise. Our underwriters will continue to select the risks that should allow some underwriting margin regardless of the market rate even if that results in a temporarily smaller top line. We look to remain good stewards of the capital we are entrusted with and are optimistic that we will find worthy opportunities to put it to use.
We enter 2018 with a strong foundation, underlying momentum and unrealized potential. We spent a good portion of 2017 repositioning our portfolio by exiting some businesses in our property segment and addressing underperforming auto-related exposures. We did not just prune business, we also invested heavily in new casualty businesses, technology and improving the customer experience. Although we are not on the cutting edge of insurtech, we will continue to find ways to partner and learn from this wave of new ideas to become more effective, efficient and even easier to do business with. We did this in 2017 by partnering with one company to assess our exposures and triage the most pressing claims from the hurricanes.
We believe the top line momentum is sustainable into 2018. We expect the market disruption in commercial and personal auto to continue and we will take advantage of opportunities that meet our risk appetite. Our consistent and disciplined underwriting will continue to differentiate us. Automobile rate increases will persist, but we do expect at a diminutive pace. With this momentum, we expect our transportation division to grow in 2018. In our personal umbrella business, we expect to start seeing payback for investments in technology to enhance the customer experience and in our efforts to build relationships and expand distribution. The build out of a countrywide, admitted package capability will be completed in 2018. The slow, careful rollout to producers has begun with niche classes and will accelerate during the year. At the same time, we expect continued expansion of our package for professionals, as well as growth from our small contractor’s package as we make the product available in more states. The newer products launched in the last couple of years, including general binding authority, energy casualty, healthcare liability, cyber liability and mortgage reinsurance, are all building scale, which should continue. We anticipate that our growth from our reinsurance partnership with Prime will begin to moderate. Our established casualty businesses will likely remain steady unless there is more disruption in the market. We will keep a watchful eye on casualty loss cost trends. We believe the plaintiff bar has become more active and juries have become more receptive to reach beyond liability and put as much or more weight on an injured party’s needs than ever before. If this trend continues, loss cost inflation will rise which will drive more demand but may also increase loss severity. Overall, we expect more top line growth and current accident year underwriting margins to remain close to break-even for the near term.
and new production sources will benefit our Hawaii homeowners and marine business units. Bottom-line profitability should return assuming a more normal catastrophe year. The expense ratio should decline modestly with expected growth across all property business units.
The surety division competes in the most difficult market conditions of all of our segments. There is pressure to loosen underwriting standards, credit terms, indemnification provisions and rates while increasing commissions. Poor decision-making could eventually result in an aggregation of severe losses to the undisciplined surety. We hold firm and steadfast in these conditions. We will remain consistent and disciplined in our underwriting approach, though our top line has declined some as a result. This segment is highly impacted by the regulatory environment and overall economic conditions, particularly to those existing in the public construction sector. We remain focused on what we can control - adding value by investing in people, service and technology that differentiates us for the future. Surety is coming off their best year of underwriting performance since the segment was launched in 1992. This level of profitability would be difficult to achieve in 2018. However, with our diligent underwriting, we expect to continue producing an underwriting profit and to outperform in this segment despite ongoing pressure on the top line.
We are cautiously optimistic that conditions will remain supportive of asset prices, however we will remain disciplined in our approach to risk management and continue to regularly rebalance our portfolio positions. In the near term, the TCJA will require a reevaluation of the relative value of tax preferenced investments, including municipal holdings.
The accompanying consolidated financial statements were prepared in conformity with generally accepted accounting principles in the United States of America (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities. The consolidated financial statements include the accounts of our holding company and our subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain reclassifications were made to 2016 and 2015 to conform to the classifications used in the current year. The Company has evaluated subsequent events through the date these consolidated financial statements were issued. There were no subsequent events requiring adjustment to the financial statements or disclosure.
We adopted ASU 2016-09 on January 1, 2017. The guidance’s primary impact on our financial statements relates to the provision concerning the recognition of tax effects through the income statement in 2017 and forward. Excess tax benefits of $5.8 million were recognized during 2017 as a reduction to income tax expense rather than as an increase to additional paid-in-capital. The future impact to our income statement will vary depending upon the level of intrinsic value associated with option exercises in a particular period, as well as distributions from our deferred compensation plans. Additionally, the changes in cash flow presentation resulted in $5.8 million more operating cash flows and $5.8 million less financing cash flows for 2017 than would have been recognized under the previous guidance. We have historically estimated the number of forfeitures as part of our option valuation process and will continue to do so under the new guidance. As no aspect of the guidance that requires retrospective adoption impacted the Company, no prior period adjustments were made.
ASU 2017-04 was issued to simplify the subsequent measurement of goodwill. This update changes the impairment test by requiring an entity to compare the fair value of a reporting unit with its carrying amount as opposed to comparing the carrying amount of goodwill with its implied fair value. We adopted ASU 2017-04 during the second quarter of 2017 to coincide with the annual testing of our energy surety, small commercial and miscellaneous and contract surety reporting units.
ASU 2014-09 was issued to clarify and remove inconsistencies within revenue recognition requirements. The core principle of the update is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, the transaction price for a contract is allocated among separately identifiable performance obligations and a portion of the transaction price is recognized as revenue when the associated performance obligation has been completed or transferred to the customer. All contracts and fulfillment activities within the scope of Topic 944, Financial Services - Insurance, investment income, investment related gains and losses and equity in earnings of unconsolidated investees are outside the scope of this ASU.
This ASU was originally effective for interim and annual reporting periods beginning after December 15, 2016. However, in August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date, which deferred the effective date to interim and annual periods beginning after December 15, 2017. Upon adoption on January 1, 2018, the guidance will be retrospectively applied to each prior reporting period. However, nearly all (over 99 percent) of our consolidated revenue is scoped out and therefore exempt from the guidance contained within this ASU. For the remaining portion, we believe our current revenue recognition policy aligns with the new guidance and that there will not be any changes to the way we recognize revenue once this ASU is adopted. Although the recognition of earnings from equity method investees is out of scope from the update, the recognition of revenue by our two equity method investees would be subject to the new guidance if the revenue streams are within this update’s scope. Any top line impact would affect the net income of each of the equity method investees, upon which we calculate our portion of earnings to recognize. We do not expect a material impact to our earnings, as the revenue generated by both of our equity method investees will either be outside the scope of this update or largely unaffected by the changes. Furthermore, this guidance becomes effective for private companies in periods beginning after December 15, 2018 and will therefore not impact our 2018 results.
ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities
This ASU is effective for interim and annual reporting periods beginning after December 15, 2017. The primary impact this guidance will have on our financial statements relates to the provision requiring the recognition of changes in the fair value of equity securities through the income statement rather than through other comprehensive income. Upon adoption in 2018, a $142.2 million cumulative-effect adjustment will be made to move net unrealized gains and losses from accumulated other comprehensive income to retained earnings. The impact to our income statement will vary depending upon the level of volatility in the performance of the securities held in our equity portfolio and the overall market.
This ASU is effective for annual and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. Upon adoption, leases will be recognized and measured at the beginning of the earliest period presented using a modified retrospective approach. We do not have any financing leases, but recognized $6.8 million of operating lease expenses in 2017 and had $32.6 million of undiscounted future operating lease liabilities that would have to be discounted to present value and added to the balance sheet with a corresponding right-of-use asset if the guidance were applicable at December 31, 2017. We do not expect that there will be a materially different annual rental expense upon adoption.
ASU 2016-13 was issued to provide more decision-useful information about the expected credit losses on financial instruments. Current GAAP delays the recognition of credit losses until it is probable a loss has been incurred. The update will require a financial asset measured at amortized cost, including reinsurance balances recoverable, to be presented at the net amount expected to be collected by means of an allowance for credit losses that runs through net income. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses. However, the amendments would limit the amount of the allowance to the amount by which fair value is below amortized cost. The measurement of credit losses on available-for-sale securities is similar under current GAAP, but the update requires the use of the allowance account through which amounts can be reversed, rather than through an irreversible write-down.
ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
ASU 2018-02 was issued as a result of the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA) on December 22, 2017. Accounting guidance required deferred tax items to be revalued based on the new tax laws (the most significant of which reduced the corporate tax rate to 21 percent from 35 percent) and to include the change in income from continuing operations. Since other comprehensive income was not affected by the revaluation of the deferred tax items, the net accumulated other comprehensive income (AOCI) balance was reflective of the historic 35 percent tax rate instead of the newly enacted rate, a difference that is referred to as a stranded tax effect. This ASU allows for the option to reclassify the stranded tax effects resulting from the implementation of the TCJA out of AOCI and into retained earnings. ASU 2018-02 does not replace the guidance requiring changes from the enactment of other tax laws or rates to be included within income from continuing operations and is applicable only to changes from the TCJA.
Debt and equity securities not included as held-to-maturity or trading are classified as available-for-sale and reported at fair value. Unrealized gains and losses on these securities are excluded from net earnings but are recorded as a separate component of comprehensive earnings and shareholders’ equity, net of deferred income taxes. All of our debt and equity securities are classified as available-for-sale.
The length of time and the extent to which the fair value has been less than cost,
The probability of significant adverse changes to the cash flows on a fixed income investment,
For our equity securities, our expectation of recovery to cost within a reasonable period of time.
Cash consists of uninvested balances in bank accounts. Short-term investments consist of investments with original maturities of 90 days or less, primarily AAA-rated prime and government money market funds. Short-term investments are carried at cost. We have not experienced losses on these instruments. Other invested assets includes an investment in three low income housing tax credit partnerships (LIHTC), carried at amortized cost, membership in the Federal Home Loan Bank of Chicago (FHLBC), carried at cost, an investment in a real estate fund, carried at cost, an investment in a business development company (BDC), carried at fair value, and an investment in a global credit fund, carried at fair value. Due to the nature of cash, short-term investments, the LIHTC and our membership in the FHLBC, their carrying amounts approximate fair value.
Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not relieve us of our legal liability to our policyholders.
We defer commissions, premium taxes and certain other costs that are incrementally or directly related to the successful acquisition of new or renewal insurance contracts. Acquisition-related costs may be deemed ineligible for deferral when they are based on contingent or performance criteria beyond the basic acquisition of the insurance contract or when efforts to obtain or renew the insurance contract are unsuccessful. All eligible costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premiums to be earned and anticipated losses and settlement expenses, as well as certain other costs expected to be incurred as the premiums are earned. Judgments as to the ultimate recoverability of such deferred costs are reviewed on a segment basis and are highly dependent upon estimated future loss costs associated with the premiums written. This deferral methodology applies to both gross and ceded premiums and acquisition costs.
We maintain a 40 percent interest in the equity and earnings of Maui Jim, Inc. (Maui Jim), a manufacturer of high-quality sunglasses, which is accounted for by the equity method. We also maintain a similar minority representation on their board of directors. Maui Jim’s chief executive officer owns a controlling majority of the outstanding shares of Maui Jim. We carry this investment at the holding company level as it is not core to our insurance operations. Our investment in Maui Jim was $77.7 million in 2017 and $62.6 million in 2016. In 2017, we recorded $14.4 million in investee earnings for Maui Jim, compared to $9.7 million in 2016 and $9.9 million in 2015. Maui Jim recorded net income of $34.4 million in 2017, $26.9 million in 2016 and $23.7 million in 2015. Additional summarized financial information for Maui Jim for 2017 and 2016 is outlined in the following table:
Goodwill and intangibles totaled $59.3 million and $64.4 million at December 31, 2017 and 2016, respectively, as detailed in the following table.
* The medical professional liability goodwill balance reflects a cumulative non-cash impairment charge of $8.8 million and $7.2 million as of December 31, 2017 and 2016, respectively.
As the amortization of goodwill and indefinite-lived intangible assets is not permitted, the assets are tested for impairment on an annual basis, or earlier if there is reason to suspect that their values may have been diminished or impaired. Annual impairment testing was performed on each of our goodwill and indefinite-lived intangible assets during 2017. Based upon these reviews, our energy surety goodwill, miscellaneous and contract surety goodwill, small commercial goodwill and state insurance license indefinite-lived intangible asset were not impaired. In addition, as of December 31, 2017, there were no triggering events on the above mentioned goodwill and intangible assets that would suggest an updated review was necessary.
The following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the consolidated financial statements:
The following are the levels of the fair value hierarchy and a brief description of the type of valuation inputs that are used to establish each level:
Pricing Level 2 is applied to valuations based upon quoted prices for similar assets in active markets, quoted prices for identical or similar assets in inactive markets; or valuations based on models where the significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities) or can be corroborated by observable market data.
The tax effects related to share-based payments were made through net earnings in 2017. In 2016 and 2015, the tax effects of share-based compensation were recognized in additional paid-in capital under the alternative transition method. The alternative transition method used simplified methods to determine the impact on the additional paid-in capital pool and consolidated statements of cash flows.
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, 2017 we had $1.3 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 us 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
We are subject to environmental claims and exposures primarily through our commercial umbrella, general liability and discontinued assumed casualty reinsurance lines of business. Although exposure to environmental claims exists in these lines of business, we seek to mitigate or control the extent of this exposure on the vast majority of this business through the following methods: (1) our policies include pollution exclusions that have been continually updated to further strengthen them, (2) our policies primarily cover moderate hazard risks and (3) we began writing this business after the insurance industry became aware of the potential pollution liability exposure and implemented changes to limit exposure to this hazard.
We offer coverage for low to moderate environmental liability exposures for small contractors and asbestos and mold remediation specialists. We also provide limited coverage for individually underwritten underground storage tanks. The overall exposure is mitigated by focusing on smaller risks with low to moderate exposures. Risks that have large-scale exposures are avoided including petrochemical, chemical, mining, manufacturers and other risks that might be exposed to superfund sites. This business is covered under our casualty ceded reinsurance treaties.
Our investment portfolio is subject to market, credit and interest rate risks. The equity portfolio will fluctuate with movements in the overall stock market. While the equity portfolio has been constructed to have lower downside risk than the market, the portfolio is positively correlated with movements in domestic stocks. The bond portfolio is affected by interest rate changes and movement in credit spreads. We attempt to mitigate our interest rate and credit risks by constructing a well-
diversified portfolio with high-quality securities with varied maturities. Downturns in the financial markets could have a negative effect on our portfolio. However, we attempt to manage this risk through asset allocation, duration and security selection.
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, 2017, 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.
During 2017, we recorded $4.4 million in net realized gains, which included $3.4 million of other non-cash realized losses from goodwill and definite-lived intangible impairments. In addition, we recorded a change in net unrealized gains of $54.3 million. The majority of our net realized gains were due to sales of equity securities. The change in unrealized gains was due to strong equity market returns as well as spread compression in fixed income credit sectors. For 2017, the net realized gains (losses) and changes in unrealized gains (losses) on investments totaled $58.7 million.
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, 2017, are summarized below:
Gross unrealized losses in the collateralized securities bond portfolio increased to $4.4 million in 2017 as interest rates increased during the last four months of the year. All of our collateralized securities carry the highest credit rating by one or more major rating agencies and continue to pay according to contractual terms.
For all fixed income securities at an unrealized loss at December 31, 2017, we believe it is probable that we will receive all contractual payments in the form of principal and interest. In addition, we are not required to, nor do we intend to sell these investments prior to recovering the entire amortized cost basis of each security, which may be at maturity. We do not consider these investments to be other-than-temporarily impaired at December 31, 2017.
Our equity portfolio consists of common stocks and exchange traded funds (ETF). Gross unrealized losses in the equity portfolio decreased $0.4 million to $0.9 million in 2017. Given our intent to hold and expectation of recovery to cost within a reasonable period of time, we do not consider any of our equities to be other-than-temporarily impaired.
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, 2017, and December 31, 2016. 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.
As of December 31, 2017, we held three equity securities that were in unrealized loss positions. The total unrealized loss on these securities was $0.9 million. In considering both the significance and duration of the unrealized loss position, we have no equity securities in an unrealized loss position of greater than 20 percent for more than six consecutive months.
The fixed income portfolio contained 346 securities in an unrealized loss position as of December 31, 2017. Of these 346 securities, 133 have been in an unrealized loss position for 12 consecutive months or longer and represent $5.1 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. Credit-related impairments on fixed income securities that we do not plan to sell, and for which we are not more likely than not to be required to sell, are recognized in net earnings. Any non-credit related impairment is recognized in comprehensive earnings. Based on our analysis, our fixed income portfolio is of a high credit quality and we believe we will recover the amortized cost basis of our fixed income securities. We continually monitor the credit quality of our fixed income investments to assess if it is probable that we will receive our contractual or estimated cash flows in the form of principal and interest. There were no OTTI losses recognized in other comprehensive earnings in the periods presented. Key factors that we consider in the evaluation of credit quality include:
Based on our analysis, we concluded that the securities in an unrealized loss position were not other-than-temporarily impaired at December 31, 2017 and 2016. There were $2.6 million and $0.1 million in losses associated with OTTI of securities in 2017 and 2016, respectively. We did not recognize any impairment losses during 2015.
As required by law, certain fixed maturity investments amounting to $42.2 million at December 31, 2017, were on deposit with either regulatory authorities or banks.
Other invested assets shown on the balance sheet as of December 31, 2017 include investments in three low income housing tax credit (LIHTC) partnerships, carried at cost, membership stock in the Federal Home Loan Bank of Chicago (FHLBC), carried at cost, an investment in a real estate fund, carried at cost, an investment in a business development company (BDC), carried at fair value, and an investment in a global credit fund, carried at fair value. Our LIHTC interests had a balance of $15.5 million at December 31, 2017 compared to $17.5 million at December 31, 2016 and recognized a total tax benefit of $2.4 million during 2017 compared to $1.9 million during 2016 and $1.1 million during 2015. Our unfunded commitment for our LIHTC investments totaled $3.1 million at December 31, 2017 and will be paid out in installments through 2025. Our investment in FHLBC stock totaled $1.0 million at the end of 2017, compared to $1.6 million at the end of 2016. As of December 31, 2017, $18.9 million of investments were pledged as collateral with the FHLBC to ensure timely access to the secured lending facility that ownership of the FHLBC stock provides. During the fourth quarter of 2017, we borrowed and repaid $5.5 million from the FHLBC. The borrowing occurred due to a timing difference between dividends paid and received at one of our subsidiaries. As of December 31, 2017, there were no outstanding borrowings with the FHLBC. Our investment in the real estate fund was carried at $2.5 million, which approximated fair value at December 31, 2017, compared to a carrying value of $5.0 million, which approximated fair value at December 31, 2016. During 2017, we made an investment in a BDC which had a fair value of $7.3 million at December 31, 2017. The investment in the BDC is restricted from being transferred until after a qualified IPO unless prior consent is provided by the BDC. Our unfunded commitments related to this investment totaled $17.7 million at December 31, 2017. Additionally in 2017, we made an investment in a global credit fund that specializes in consumer loans. This investment had a fair value of $7.5 million and unfunded commitments of $7.2 million as of December 31, 2017.
At December 31, 2017, we had prepaid reinsurance premiums and recoverables on paid and unpaid losses and settlement expenses totaling $349.7 million. More than 94 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, 2017. 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 2017.
Ceded unearned premiums and reinsurance balances recoverable on paid losses and settlement expenses are reported separately as an asset, rather than being netted with the related liability, since reinsurance does not relieve us 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 A.M. Best and S&P ratings of our reinsurers. In
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. Once regulatory action (such as receivership, finding of insolvency, order of conservation or order of liquidation) is taken against a reinsurer, the paid and unpaid recoverable for the reinsurer are specifically identified and written off through the use of our allowance for estimated unrecoverable amounts from reinsurers. When we write-off such a balance, it is done in full. We then re-evaluate the remaining allowance and determine whether the balance is sufficient as detailed above and if needed, an additional allowance is recognized and income charged. The amounts of allowances for uncollectible amounts on paid and unpaid recoverables were $15.9 million and $10.0 million, respectively, at December 31, 2017. At December 31, 2016, the amounts were $15.2 million and $10.7 million, respectively. We have no receivables with a due date that extends beyond one year that are not included in our allowance for uncollectible amounts.
services product along with general liability, small commercial and other casualty products. Excess occurrence encompasses commercial and personal umbrella, while claims made includes select lines within the professional services product and medical professional liability and executive products. Reported claim counts represent claim events on a specified policy rather than individual claimants and includes claims that did not or are not expected to result in an incurred loss. The information about incurred and paid claims development for the years ended December 31, 2008 to 2016 is presented as unaudited required supplementary information.
The following table summarizes our prior accident years’ loss reserve development by segment for 2017, 2016 and 2015:
2015. We experienced favorable emergence relative to prior years’ reserve estimates in all of our segments during 2015. Development from the casualty segment totaled $45.7 million, inclusive of ULAE. The largest amounts of favorable development came from accident years 2010 through 2014. We continued to experience emergence that was generally better than previously estimated, but to a lesser degree in 2015 than in the previous year. Frequency and severity trends have been favorable relative to initial estimates and we believe this is largely due to risk selection by our underwriters, which has been effective in offsetting loss cost trends and a competitive pricing environment. Within the primary occurrence grouping, our general liability and small commercial products experienced favorable development of $15.4 million and $6.6 million, respectively. Although the habitational classes within general liability produced adverse development, it was more than offset by favorable development from the construction classes. However, the professional services product, experienced adverse development totaling $3.2 million in 2015. Within the excess occurrence grouping, our commercial umbrella product experienced $10.7 million of favorable development while the casualty runoff business experienced $5.4 million of adverse development, primarily on the 1983 accident year. The claims made and transportation groupings had favorable contributions of $3.9 million and $5.4 million, respectively.
Our marine product was the predominant driver of the favorable development in the property segment, accounting for $9.2 million of the $11.8 million total favorable development for the segment, inclusive of ULAE. The accident years making the largest contributions were 2010 through 2014. The inland marine and cargo coverages were responsible for the majority of the favorable loss experience. Our assumed property products contributed $4.9 million of favorable development with the majority of that coming from loss reductions on previous hurricanes and storms. Development on direct property products business was also favorable overall. Our recreational vehicle product experienced $1.3 million of adverse development, mostly due to auto physical damage coverages.
The following table represents paid and unpaid environmental, asbestos and mass tort claims data (including incurred but not reported losses) as of December 31, 2017, 2016 and 2015:
Calendar year 2017 included an increase in inception-to-date paid losses, offsetting a decrease in unpaid losses. The activity was related to payments on previously reserved claims. In aggregate, inception-to-date incurred losses increased on a gross and net.
Income tax expense (benefit) attributable to income from operations for the years ended December 31, 2017, 2016 and 2015, 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 also result in a tax deduction. Dividends paid to the ESOP in 2017, 2016 and 2015 resulted in tax benefits of $2.9 million, $3.3 million and $3.4 million, respectively. These tax benefits reduced the effective tax rate for 2017, 2016 and 2015 by 3.4 percent, 2.1 percent and 1.7 percent, respectively.
Federal and state income taxes paid in 2017, 2016 and 2015, amounted to $10.4 million, $26.9 million and $44.2 million, respectively.
We maintain ESOP, 401(k) and incentive plans covering executives, managers and associates. Funding of these plans is primarily dependent upon reaching predetermined levels of operating return on equity, combined ratio and Market Value Potential (MVP). MVP is a compensation model that measures components of comprehensive earnings against a minimum required return on our capital. Bonuses are earned as we generate earnings in excess of this required return. While some management incentive plans may be affected somewhat by other performance factors, the larger influence of corporate performance ensures that the interests of our executives, managers and associates correspond with those of our shareholders.
During 2017, the ESOP purchased 124,186 shares of RLI stock on the open market at an average price of $58.02 ($7.2 million) relating to the contribution for plan year 2016. Shares held by the ESOP as of December 31, 2017, totaled 3,206,518 and are treated as outstanding in computing our earnings per share. During 2016, the ESOP purchased 112,608 shares of RLI stock on the open market at an average price of $64.20 ($7.2 million) relating to the contribution for plan year 2015. During 2015, the ESOP purchased 178,492 shares of RLI stock on the open market at an average price of $49.98 ($8.9 million) relating to the contribution for plan year 2014. The above mentioned ESOP purchases relate only to our annual contributions to the plan and do not include amounts or shares resulting from the reinvestment of dividends.
Our RLI Corp. Omnibus Stock Plan (omnibus plan) was in place from 2005 to 2010. The omnibus plan provided for equity-based compensation, including stock options, up to a maximum of 3,000,000 shares (subject to adjustment for changes in our capitalization and other events). Between 2005 and 2010, we granted 2,458,059 stock options under this plan, including incentive stock options (ISOs). The omnibus plan was replaced in 2010.
The following tables summarize option activity in 2017, 2016 and 2015:
As of December 31, 2017, 15,450 RSUs have been granted and 15,300 remain outstanding. The weighted average grant date fair value was $56.71. We recognized $0.4 million of expense on these units during 2017. Total unrecognized compensation expense relating to outstanding and unvested RSUs was $0.5 million, which will be recognized over the remainder of the three-year vesting period.
The statutory financial statements of our three insurance companies are presented on the basis of accounting practices prescribed or permitted by the Illinois Department of Insurance (IDOI), which has adopted the NAIC statutory accounting principles as the basis of its statutory accounting principles. We do not use any permitted statutory accounting principles that differ from NAIC prescribed statutory accounting principles. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of statutory non-admitted assets and the inclusion of net unrealized holding gains or losses in shareholders’ equity relating to fixed maturities.
The NAIC has risk based capital (RBC) requirements for insurance companies to calculate and report information under a risk-based formula, which measures statutory capital and surplus needs based upon a regulatory definition of risk relative to the company’s balance sheet and mix of products. As of December 31, 2017, each of our insurance subsidiaries had an RBC amount in excess of the authorized control level RBC, as defined by the NAIC. RLI Insurance Company (RLI Ins.), our principal insurance company subsidiary, had an authorized control level RBC of $157.7 million, $127.0 million and $123.6 million as of December 31, 2017, 2016 and 2015, respectively, compared to actual statutory capital and surplus of $864.6 million, $860.0 million and $865.3 million, respectively, for these same periods.
Year-end statutory surplus for 2017 presented in the table below includes $106.9 million of RLI stock (cost basis of $64.6 million) held by Mt. Hawley Insurance Company, compared to $104.4 million and $117.5 million in 2016 and 2015, respectively. The Securities Valuation Office provides specific guidance for valuing this investment, which is eliminated in our GAAP consolidated financial statements.
We are party to numerous claims, losses and litigation matters that arise in the normal course of our business. Many of such claims, losses or litigation matters involve claims under policies that we underwrite as an insurer. We believe that the resolution of these claims and losses will not have a material adverse effect on our financial condition, results of operations or cash flows. We are also involved in various other legal proceedings and litigation unrelated to our insurance business that arise in the ordinary course of business operations. Management believes that any liabilities that may arise as a result of these legal matters will not have a material adverse effect on our financial condition or results of operations.
We have operating lease obligations for regional office facilities. These leases expire in various years through 2034. Expenses associated with these leases totaled $6.8 million in 2017, $6.4 million in 2016 and $6.1 million in 2015. Minimum future rental payments under non-cancellable leases are as follows:
The segments of our insurance operations include casualty, property and surety. The casualty portion of our business consists largely of commercial umbrella, personal umbrella, general liability, transportation and executive products coverages, as well as package business and other specialty coverages, such as professional liability and workers’ compensation for office-based professionals. We offer fidelity and crime coverage for commercial insureds and select financial institutions and medical and healthcare professional liability coverage in the excess and surplus market. We also assume a limited amount of hard-to-place risks through a quota share reinsurance agreement. The casualty business is subject to the risk of estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty
Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions and marine coverages. We also offer select personal lines policies, including homeowners’ coverages. Our crop, property reinsurance and recreational vehicle products are in runoff after we discontinued our crop relationship at the end of 2015 and began curtailing reinsurance and recreational vehicle offerings at the end of 2015 and 2016, respectively. Property insurance results are subject to the variability introduced by perils such as earthquakes, fires and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. Our second largest catastrophe exposure is to losses caused by wind storms to commercial properties throughout the Gulf and East Coast, as well as to homes we insure in Hawaii. We limit our net aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and maintaining policy terms and conditions throughout market cycles. We also use computer-assisted modeling techniques to provide estimates that help us carefully manage the concentration of risks exposed to catastrophic events.
The surety segment specializes in writing small to large-sized commercial and contract surety coverages, as well as those for the energy, petrochemical and refining industries. We also offer miscellaneous bonds including license and permit, notary and court bonds. Often, our surety coverages involve a statutory requirement for bonds. While these bonds typically maintain a relatively low loss ratio, losses may fluctuate due to adverse economic conditions affecting the financial viability of our insureds. The contract surety product guarantees the construction work of a commercial contractor for a specific project. Generally, losses occur due to the deterioration of a contractor’s financial condition. This line has historically produced marginally higher loss ratios than other surety lines during economic downturns.