We own five commercial buildings on our 23 acre corporate campus in Peoria, Illinois. Our primary building is a two-story 77,000 square foot office building, which serves as our corporate headquarters. Located on the same campus is a 24,000 square foot building, which is used by two branch offices of RLI Ins., and a 15,000 square foot office building. In addition, we own a 26,000 square foot multi-story building used for record storage and a 12,000 square foot building used for furniture and equipment storage.
See note 1.P to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
In 2014, RLI Corp. declared and paid a special cash dividend of $3.00 per share, which totaled $129.3 million. Special dividends were also declared and paid in each of the previous four years, totaling $64.5 million, $106.3 million, $105.8
RLI Corp. underwrites selected 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 oil and gas 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.
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. Our assumed multi-peril crop and hail treaty reinsurance business covers revenue shortfalls or production losses due to natural causes such as drought, excessive moisture, hail, wind, frost, insects and disease. Significant aggregation of these losses is mitigated by the U.S. Federal Government reinsurance program that provides stop loss protection inuring to our benefit.
On November 2, 2012, we acquired Rockbridge, a Houston-based managing general agency, for $15.5 million in cash, coupled with a contingent earn-out based on future underwriting profitability. Rockbridge specializes in medical professional liability insurance in the excess and surplus market. Coverage is offered to individual physicians and physician groups in all 50 states through a network of retail and wholesale brokers.
Underwriting income or profit represents one measure of the pretax profitability of our insurance operations and is derived by subtracting losses and settlement expenses, policy acquisition costs and insurance operating expenses from net premiums earned. Each of these captions is presented in the statements of earnings but not subtotaled. However, this information is available in total and by segment in note 11 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data. The nearest comparable GAAP measure is earnings before income taxes which, in addition to underwriting income, includes net investment income, net realized gains/losses on investments, general corporate expenses, debt costs and unconsolidated investee earnings.
This ratio is a common industry measure of profitability for any underwriting operation and is calculated in two components. First, the loss ratio is losses and settlement expenses divided by net premiums earned. The second component, the expense ratio, reflects the sum of policy acquisition costs and insurance operating expenses divided by net premiums earned. All items included in these components of the combined ratio are presented in our GAAP consolidated financial statements. The sum of the loss and expense ratios is the combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of underwriting income or loss. For example, a combined ratio of 85 implies that for every $100 of premium we earn, we record $15 of underwriting income.
LAE represents the cost involved in adjusting and administering losses from policies we issued. The LAE reserves are frequently separated into two components: allocated and unallocated. Allocated loss adjustment expense (ALAE) reserves represent an estimate of claims settlement expenses that can be identified with a specific claim or case. Examples of ALAE would be the hiring of an outside adjuster to investigate a claim or an outside attorney to defend our insured. The claim professional typically estimates this cost separately from the loss component in the case reserve. Unallocated loss adjustment expense (ULAE) reserves represent an estimate of claims settlement expenses that cannot be identified with a specific claim. An example of ULAE would be the cost of an internal claim examiner to manage or investigate a reported claim.
determined by IBNR percentages applied to premium earned. The percentages are determined based on historical reporting patterns and are updated periodically. In addition, for assumed property reinsurance, consideration is given to data compiled for a sizable sample of reinsurers. No deductions for paid or case reserves are made. This alternative method of determining initial IBNR allows incurred losses and ALAE to react more rapidly to the actual emergence and is more appropriate for our property products where final claim resolution occurs over a shorter period of time.
The historical and prospective loss and ALAE estimates, along with the risks listed, are the basis for determining our initial and subsequent carried reserves. Adjustments in the initial loss ratio by product and segment are made where necessary and reflect updated assumptions regarding loss experience, loss trends, price changes and prevailing risk factors. The LRC makes all final decisions regarding changes in the initial loss and ALAE ratios.
The process of estimating ultimate payment for claims and claim expenses begins with the collection and analysis of current and historical claim data. Data on individual reported claims, including paid amounts and individual claim adjuster estimates, are grouped by common characteristics. There is judgment involved in this grouping. Considerations when grouping data include the volume of the data available, the credibility of the data available, the homogeneity of the risks in each cohort and both settlement and payment pattern consistency. We use this data to determine historical claim reporting and payment patterns, which are used in the analysis of ultimate claim liabilities. For portions of the business without sufficiently large numbers of policies or that have not accumulated sufficient historical statistics, our own data is supplemented with external or
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. Quarterly, we also consider the most recent actual loss emergence compared to the expected loss emergence derived using the last full loss and ALAE analyses. 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.
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, 2014.
Throughout each year, we and our investment managers buy and sell securities to achieve investment objectives in accordance with investment policies established and monitored by our board of directors and executive officers.
We classify our investments in debt and equity securities into one of three categories. Available-for-sale securities are carried at fair value with unrealized gains/losses recorded as a component of comprehensive earnings and shareholders’ equity, net of deferred income taxes. During 2014, we sold our remaining debt securities classified as held-to-maturity. During 2013, we sold our remaining debt securities classified as trading.
Specific concerns related to the issuer’s industry or geographic area of operation,
We consider uncertainties in income taxes and recognize those in our financial statements as required. As it relates to uncertainties in income taxes, our unrecognized tax benefits, including interest and penalty accruals, are not considered material to the consolidated financial statements. Also, no tax uncertainties are expected to result in significant increases or decreases to unrecognized tax benefits within the next 12-month period. Penalties and interest related to income tax uncertainties, should they occur, would be included in income tax expense in the period in which they are incurred.
Additional discussion of other significant accounting policies may be found in note 1 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Consolidated revenue, as displayed in the table that follows, totaled $775.2 million for 2014, compared to $705.6 million for 2013 and $660.8 million in 2012.
serve to slow the pace of deterioration in underwriting results. Since our products must be priced before the ultimate loss costs are known, it may take several years to know if pricing was adequate or inadequate. Inadequate pricing may lead to adverse loss development in future periods. In 2014, we experienced $64.8 million in favorable development in prior accident years’ reserves, compared to favorable development of $72.5 million in 2013 and $64.6 million in 2012. Further discussion of reserve development can be found in note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Bonus and profit-sharing amounts earned by executives, managers and associates are predominately influenced by corporate performance including operating earnings, combined ratio and return on capital. Operating earnings refers to net earnings excluding after-tax net realized investment gains. Return on capital measures components of comprehensive earnings against a minimum required return on capital. Return on capital is the primary measure of executive bonus achievement and a significant component of manager and associate bonus targets. Bonus and profit sharing-related expenses attributable to the favorable reserve developments totaled $10.6 million, $11.2 million and $8.9 million for 2014, 2013 and 2012, respectively. These performance-related expenses impact policy acquisition, insurance operating and general corporate expenses line items in the financial statements. Partially offsetting the 2014, 2013 and 2012 increases were $1.1 million, $1.2 million and $4.2 million, respectively, in reductions to bonus and profit-sharing earned due to losses associated with natural catastrophe activity.
Across our segments, casualty has been the biggest driver of our growth with gross premiums written advancing in each of the past three years. Premiums increased 6 percent in 2014, following significant growth in 2013 and 2012. Improved pricing for many casualty coverages and new product offerings resulted in premium growth of 17 percent and 20 percent, respectively, for 2013 and 2012. Within our property segment, premium decreased 4 percent in 2014, following a 3 percent decline in 2013 and a 4 percent increase in 2012. Increased competition, rate declines and re-underwriting efforts have served to limit premium production in this book. Gross premiums written from our surety segment increased 4 percent in 2014 after being flat in 2013 and up 7 percent in 2012. While the surety market continues to be highly competitive, our growth is reflective of the CBIC acquisition and other expansion initiatives.
Our underwriting income and combined ratios are displayed in the following tables. For each of our segments, solid underwriting results were bolstered by favorable development in prior accident years’ loss reserves in each of the last three years. The property segment experienced reduced levels of catastrophe losses in 2014 and 2013, following more significant activity in 2012. The following tables and narrative provide a more detailed look at individual segment performance over the last three years.
Casualty gross premiums written of $482.8 million were up 6 percent in 2014, following an increase of 17 percent in 2013 and 20 percent in 2012. While growth within the segment has slowed relative to recent years, newer product initiatives continue to broaden our product offerings and geographic footprint. Our professional services group posted $74.2 million in gross premiums written, up 24 percent from the prior year. Since its launch in 2009, this business has continued to achieve year over year growth, most recently due to expanding its product offerings and broadening its target market. In 2013 and 2012, premiums from this book also advanced, up 38 percent and 30 percent, respectively. P&C package premiums totaled $42.0 million, a 14 percent increase from the prior year, as we continued our efforts to expand geographically. This business was added with the acquisition of CBIC in 2011 and premiums have continued to grow post-acquisition. Premiums from this coverage totaled $37.0 million for 2013 and $33.7 million for 2012. Other newer products have also contributed to growth during the year, including security guards coverages, which grew 30 percent, and our new assumed casualty reinsurance business (Prime), which posted gross premiums written of $10.2 million. This business relates to the reinsurance agreement that accompanied our minority investment in Prime, which occurred in the first quarter of 2014.
On an overall basis, net premium growth outpaced the growth achieved in gross premiums written in each of the last two years. In 2014, net premiums written advanced $33.4 million (9 percent) while gross premiums advanced $25.9 million (6 percent). The increased retention is due to cost savings realized during our 2014 reinsurance renewal. In 2013, net premiums written advanced 28 percent while gross premiums advanced 17 percent due largely to increased retentions at our 2013 casualty reinsurance renewal. Given improved pricing on business we underwrite and overall volume growth, particularly in umbrella, we increased retentions on certain casualty products in 2013.
Underwriting income for the casualty segment was $45.9 million in 2014, compared to $55.6 million in 2013 and $25.4 million in 2012. These results translated into combined ratios of 88.0, 82.8 and 90.5 for 2014, 2013 and 2012, respectively. Favorable development on prior accident years’ loss reserves totaled $52.8 million, $61.8 million and $40.4 million, for 2014, 2013 and 2012, respectively. In each of these years, actuarial studies indicated that cumulative experience attributable to many casualty coverages for mature accident years was lower than carried reserves, due to favorable loss frequency and severity trends, resulting in the release of reserves. We believe these improved trends are due in part to the quality of our underwriters’ risk selection, which has served to offset prior year rate declines and an assumed increase in loss cost trends. In 2014, favorable development was experienced across multiple products. A majority of this favorable development was attributable to accident years 2007 through 2013, with more recent years representing a larger portion of the release. Similarly in 2013, favorable development was experienced across multiple products. Accident years 2005 through 2012 accounted for the majority of favorable experience in 2013. In 2012, favorable development was concentrated in accident years 2007 through 2010.
The segment’s loss ratio was 52.1 in 2014, compared to 45.9 in 2013 and 53.8 in 2012. While each year benefited from varying degrees of favorable reserve development on prior accident years, the results also reflect lower current accident year loss ratios relative to previous years. In 2013, modest rate increases, relatively benign loss cost inflation and an improved mix of business resulted in a reduction to the current accident year loss ratio of over 3 points. We have maintained this level of performance on the 2014 current accident year loss ratio. These results follow a 1 point improvement in 2012, which was also driven by an improved rate environment and a shift in mix of business toward lower loss producing products. The expense ratio for the casualty segment was 35.9 in 2014, compared to 36.9 in 2013 and 36.7 in 2012. During each of these periods, we continued to invest in expansion and new product initiatives. Increased revenue from these investments has resulted in improved expense leverage and a lower trending expense ratio.
previously noted, we expect reduced premiums from this business going forward. In late 2014, we received a notice of cancellation on the largest portion of our assumed crop business along with notice of a 50 percent reduction on our remaining coverage. Gross and net premiums of approximately $10 million are expected for 2015, which represents a sizable decrease from recent levels. The impact of this change on underwriting income, however, is expected to be minimal. For other property reinsurance, excluding crop, gross premiums declined to $13.1 million in 2014, down from $16.1 million in 2013 and $37.8 million in 2012. A majority of business assumed in our other property reinsurance program is catastrophe exposed and is viewed as complementary and diversifying for our catastrophe strategy employed within our commercial property product. Where experience is adverse or pricing is deemed inadequate, as occurred in 2014 and 2013, underperforming or underpriced accounts are non-renewed. In addition, our exit from pet insurance in late 2012 negatively impacted premium in 2014 and 2013. Pet insurance contributed $5.0 million in gross premiums written in 2012.
Gross premiums written for surety increased 4 percent in 2014, after being flat in 2013 and increasing 7 percent in 2012. The addition of CBIC amplified growth in 2012, its first full year of production, while all periods were influenced by underwriter additions and geographic expansion. Commercial surety was the primary driver of growth during 2014, increasing 15 percent to $30.4 million, due, in part, to writing additional bonds for our existing accounts. Contract surety also improved, up 3 percent. Commercial and contract surety have increased top line production in each of the past three years. Miscellaneous surety increased 3 percent in 2014, after falling 1 percent in the prior year and increasing 11 percent 2012. Partially offsetting this growth was oil and gas surety, which declined 9 percent in 2014 and 5 percent in 2013, after being flat in 2012. Falling energy prices in recent periods have impacted premium from this product. On an overall basis, premium within the segment continues to be challenged by increased competition from new entrants into this market.
The fixed income portfolio increased by $54.4 million during the year as unrealized gains increased due to declining interest rates and operating cash flows contributed to net purchases. During 2014, the portfolio experienced net realized gains of $4.0 million and ended 2014 with net unrealized gains of $46.9 million. The tax-adjusted total return on a mark-to-market basis was 6.5 percent. During 2014, our equity portfolio decreased by $8.0 million to $410.6 million.
We realized a total of $32.2 million in net investment gains in 2014. Included in this number is $29.5 million in net realized gains in the equity portfolio, $4.0 million in net realized gains in the fixed income portfolio and $1.3 million in other net realized losses. In 2013, we realized $22.0 million in net investment gains. Included in this number is $21.5 million in net realized gains in the equity portfolio, $1.3 million in net realized gains in the fixed income portfolio and $0.8 million in other net realized losses. In 2012, we realized $25.4 million in net investment gains. We realized $15.1 million in net realized gains in the equity portfolio, $13.2 million in net realized gains in the fixed income portfolio and $2.9 million in net realized losses inclusive of an impairment of a long-lived asset.
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, 2014.
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, 2014, the portfolio had a fair value of $2.0 billion, an increase of $42.2 million from the end of 2013.
As of December 31, 2014, our investment portfolio had the following asset allocation breakdown:
Fixed income represented 76 percent of our total 2014 portfolio compared to 75 percent in 2013. As of December 31, 2014, the fair value of our fixed income portfolio consisted of 17 percent AAA-rated securities, 45 percent AA-rated securities, 22 percent A-rated securities, 10 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities. This compares to 17 percent AAA-rated securities, 46 percent AA-rated securities, 25 percent A-rated securities and 11 percent BBB-rated securities in 2013.
As of December 31, 2014, our fixed income portfolio had the following rating distributions:
When making investments in MBS/ABS/CMBS, we evaluate the quality of the underlying collateral, the structure of the transaction (which dictates how any losses in the underlying collateral will be distributed) and prepayment risks. All of our collateralized securities carry the highest credit rating by one or more major rating agency and continue to pay according to contractual terms. We had $0.4 million in unrealized losses in this asset class as of December 31, 2014.
As of December 31, 2014, municipal bonds totaled $481.4 million (32 percent) of our fixed income portfolio, compared to $522.7 million (36 percent) as of December 31, 2013. We decreased our allocation to the sector as tax-exempt municipal spreads tightened throughout the year. 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.
We maintain a 40 percent equity interest in Maui Jim, a manufacturer of high-quality polarized 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 2014, we recorded $12.0 million in earnings from this
In 2014, 2013 and 2012, we received dividends 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.
In addition, our pretax earnings in 2014 included $25.3 million of investment income that is partially exempt from federal income tax, compared to $24.5 million and $22.7 million in 2013 and 2012, respectively.
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. Operating cash flows in 2012 are lower than 2013 and 2014 largely due to the return of a $50.0 million cash deposit that was being held for a commercial surety customer in lieu of a letter of credit. During 2014 and 2012, the majority of cash flows were used in financing activities, due largely to the payment of special dividends. Financing cash flows noted in the above table include special dividends totaling $129.3 million, $64.5 million and $106.3 million for 2014, 2013 and 2012, respectively. In 2013, cash flows also reflect a net financing cash inflow related to our public debt offering.
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, 2014, our portfolio had a carrying value of $2.0 billion. Portfolio assets at December 31, 2014, increased by $42.2 million, or 2 percent, from December 31, 2013.
The fixed income portfolio is structured to meet policyholder obligations and optimize the generation of after-tax investment income and total return objectives.
In December 2012, we filed a universal shelf registration statement with the SEC for the potential offering and sale of securities, including debt and equity securities. The shelf registration facilitated our $150.0 million public debt offering completed in October 2013. The shelf registration will expire in December 2015.
At the holding company (RLI Corp.) level, we rely largely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt, corporate expenses and dividends to RLI Corp. shareholders. As discussed further below, dividend payments to RLI Corp. from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the insurance regulatory authorities of Illinois. As a result, we may not be able to receive dividends from such subsidiary at times and in amounts necessary to pay desired dividends to RLI Corp. shareholders. On a GAAP basis, as of December 31, 2014, our holding company had $845.1 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 $46.7 million in liquid assets, which approximates annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and dividend payments to our shareholders. If necessary, the holding company also has other potential sources of liquidity that could provide for additional funding to meet corporate obligations or pay shareholder dividends, which include a revolving line of credit, as well as issuances of common stock and debt.
Ordinary dividends, which may be paid by our principal insurance subsidiary without prior regulatory approval, are subject to certain limitations based upon statutory income, surplus and earned surplus. The maximum ordinary dividend
distribution from our principal insurance subsidiary in a rolling 12-month period is limited by Illinois law to the greater of 10 percent of RLI Ins. policyholder surplus, as of December 31 of the preceding year, or the net income of RLI Ins. for the 12-month period ending December 31 of the preceding year. Ordinary dividends are further restricted by the requirement that they be paid from earned surplus. In 2014, 2013 and 2012, our principal insurance subsidiary paid ordinary dividends totaling $185.0 million, $40.0 million and $13.0 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. While no extraordinary dividends were paid in 2014 or 2013, our principal insurance subsidiary sought and received regulatory approval in 2012, prior to the payment of extraordinary dividends totaling $125.0 million. As of December 31, 2014, $53.4 million of the net assets of our principal insurance subsidiary are not restricted and could be distributed to RLI Corp. as ordinary dividends. Because the limitations are based upon a rolling 12-month period, the presence, amount and impact of these restrictions vary over time.
Our 155th consecutive dividend payment was declared in February 2015 and will be paid on March 20, 2015, in the amount of $0.18 per share. Since the inception of cash dividends in 1976, we have increased our annual dividend every year.
As we look ahead to 2015, our outlook has not changed significantly from 2014. The insurance market continues to be a very crowded space with increased pressure from new entrants and alternative capital. Top-line growth is difficult under these conditions, and we will continue to emphasize risk selection and underwriting profit over premium growth. The economic recovery has not been as robust as in previous cycles. While volatile commodity prices continue to impact our risk appetite in the energy segment, a moderate uptick in construction and increases in payroll and shipping has created new business opportunities and the potential for increased premium from our insureds. The lack of significant catastrophe activity continues to pressure rates on property business. We expect a stable to slightly softening rate environment on an overall portfolio basis.
While the market remains very competitive, we will continue to focus on risk selection. We expect pricing to remain flat across most of our casualty portfolio and loss trends to remain below long-term averages. Growth will be weighted toward specialty admitted lines, where expected underwriting margins are lower than in our E&S coverages. The change in mix will challenge our ability to maintain similar underwriting margins in 2015.
Capital markets and the U.S. macroeconomic environment were heavily influenced by external factors in 2014. The year began with a harsh winter landscape that put a significant strain on GDP potential and resulted in an outright contraction for the first quarter. Worldwide, a slower growth trajectory materialized for emerging markets and developed economies in Europe and Japan. By October, crude oil prices were in precipitous decline on incremental worldwide supply, which translated into lower gasoline costs by the fourth quarter. All of this accumulated in a low level of inflation and renewed monetary policy accommodation from global central banks. In the U.S., however, domestic growth was strong enough by the second half of the year that the Federal Reserve suspended the extraordinary measures associated with quantitative easing. The Federal Open Market Committee, which sets the federal funds target interest rate, is in the early stages of normalizing U.S. monetary policy, the timing of which will remain data dependent but is expected to begin in mid-2015.
The United States remains one of the strongest world economies as we look forward, and we believe that our portfolio should be well positioned if growth continues to accelerate. The employment picture continues to be positive, although wage growth has been limited. And while lower gas prices should support the consumer, the strength of the U.S. dollar will be a headwind for multinational companies. Although capital markets may remain more volatile than the year ago period, the portfolio will continue to support operations through current income and contribute to long-term growth in book value via our low beta equity strategy. The near term yield environment will be challenging, and we expect little investment income growth over the next twelve months.
Prospective accounting standards are those which we have not implemented either because the standard has not been finalized or the implementation date has not yet occurred. For a discussion of relevant prospective accounting standards, see note 1.D. to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
We underwrite selected property and casualty insurance coverages. We conduct operations principally through four insurance companies. These companies are organized in a vertical structure beneath RLI Corp. with RLI Insurance Company (RLI Ins.) as the first-level, or principal, insurance subsidiary. RLI Ins. writes multiple lines of insurance on an admitted basis in all 50 states, the District of Columbia and Puerto Rico. Mt. Hawley Insurance Company, a subsidiary of RLI Ins., writes surplus lines insurance in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. RLI Indemnity Company (RIC), a subsidiary of Mt. Hawley Insurance Company, has authority to write multiple lines of insurance on an admitted basis in 48 states and the District of Columbia. Contractors Bonding and Insurance Company (CBIC), a subsidiary of RLI Ins., has authority to write multiple lines of insurance on an admitted basis in all 50 states and the District of Columbia.
This ASU permits an entity to account for investments in qualified affordable housing projects using the proportional amortization method if certain conditions are met. The proportional amortization method requires an entity to amortize the initial cost of the investment in proportion to the amount of tax credits and other tax benefits received and recognizes the net investment performance as a component of income tax expense.
There are no prospective accounting standards which would have a material impact on our financial statements as of December 31, 2014.
Debt and equity securities not included as held-to-maturity 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.
Debt securities that we have the positive intent and ability to hold to maturity are classified as held-to-maturity and carried at amortized cost. Except for declines that are other-than-temporary, changes in the fair value of these securities are not
For the years ended December 31, 2014, 2013 and 2012, no securities were transferred from held-to-maturity to available-for-sale or trading.
The occurrence of a discrete credit event resulting in the issuer defaulting on a material obligation, the issuer seeking protection from creditors under the bankruptcy laws, the issuer proposing a voluntary reorganization under which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than par value,
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, which approximates fair value. We have not experienced losses on these instruments. Other invested assets includes an investment in a low income housing tax credit partnership, carried at amortized cost, and membership in the Federal Home Loan Bank Chicago, carried at cost.
We maintain a 40 percent interest in the earnings of Maui Jim, Inc. (Maui Jim), a manufacturer of high-quality polarized 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, RLI Corp., level as it is not core to our insurance operations. Our investment in Maui Jim was $54.3 million in 2014 and $49.8 million in 2013. In 2014, we recorded $12.0 million in investee earnings for Maui Jim, compared to $10.9 million in 2013 and $8.9 million in 2012. Maui Jim recorded net income of $30.7 million in 2014, $26.1 million in 2013 and $22.6 million in 2012. Additional summarized financial information for Maui Jim for 2014 and 2013 is outlined in the following table:
Approximately $42.1 million of undistributed earnings from Maui Jim are included in our retained earnings as of December 31, 2014. In 2014, 2013 and 2012, we received dividends of $6.6 million, $13.2 million and $6.6 million, respectively, from Maui Jim.
On February 5, 2014, we invested $5.3 million for a 20 percent equity ownership interest in Prime Holdings Insurance Services, Inc. (Prime), an Illinois domiciled insurance carrier based in Salt Lake City, Utah. Prime is a privately-held excess and surplus lines insurance company that distributes its products through a network of wholesale brokers and specializes in hard-to-place risks. Our investment in Prime was $5.7 million at December 31, 2014 and we recorded $0.3 million in investee earnings during the year. Additionally, we entered into a 25 percent quota share reinsurance treaty with Prime, effective January 1, 2014, which contributed $10.2 million of gross premiums written and $5.3 million of net premiums earned during the year.
We perform annual impairment reviews of our investments in our unconsolidated investees, which considers current valuation and operating results. Based upon the most recent reviews, the assets were not impaired.
In accordance with GAAP guidelines, the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and 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. Goodwill and intangibles totaled $72.7 million at December 31, 2014. These assets relate to acquisition activity including our recent acquisitions of CBIC and Rockbridge Underwriting Agency (Rockbridge).
Goodwill and intangibles resulting from acquisitions completed prior to 2011 totaled $26.2 million and is attributable to our surety segment. Of this $26.2 million, $25.6 million relates to goodwill and $0.6 million relates to an indefinite-lived intangible asset. Goodwill and intangible assets resulting from the CBIC acquisition in April 2011 totaled $30.6 million. The CBIC-related assets include goodwill attributable to our casualty and surety segments of $5.3 million and $15.1 million, respectively, and an indefinite-lived intangible asset in the amount of $7.5 million, which relates to state insurance licenses. Annual impairment testing was performed on each of these goodwill and indefinite-lived intangible assets in the second quarter of 2014. Based upon these reviews, none of the assets were impaired. However, a fair value amount for state insurance licenses was obtained during the fourth quarter from a merger and acquisition broker with expertise in providing valuations for fully-licensed P&C shell companies, triggering the need for an interim impairment analysis of CBIC’s licenses. The carrying cost of CBIC’s licenses exceeded the fair value and resulted in a $1.3 million impairment included as a net realized investment loss in the consolidated statement of earnings. There were no other triggering events that occurred as of December 31, 2014 that would suggest an updated review was necessary. Definite-lived intangible assets related to the CBIC acquisition totaled $2.7 million, net of amortization, as of December 31, 2014.
The remaining $15.9 million of goodwill and intangibles relates to our purchase of Rockbridge in November 2012. Of this amount, $12.4 million is recorded as goodwill attributable to our casualty segment. The remaining $3.5 million relates to definite-lived intangible assets, net of amortization, as of December 31, 2014. Annual impairment testing was performed on this goodwill in the fourth quarter of 2014. Based upon this review, the asset was not impaired. In addition, as of December 31, 2014, there were no triggering events that occurred that would suggest an updated review was necessary.
Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the dilution that could occur if securities or other contracts to issue common stock or common stock equivalents were exercised or converted into common stock. When inclusion of common stock equivalents increases the earnings per share or reduces the loss per share, the effect on earnings is anti-dilutive. Under these circumstances, the diluted net earnings or net loss per share is computed excluding the common stock equivalents.
Our comprehensive earnings include net earnings plus unrealized gains/losses on our available-for-sale investment securities, net of tax. In reporting the components of comprehensive earnings on a net basis in the statement of earnings, we used a 35 percent tax rate. Other comprehensive income (loss), as shown in the consolidated statements of earnings and comprehensive earnings, is net of tax expense (benefit) of $19.0 million, $(3.8) million and $13.9 million for 2014, 2013 and 2012, respectively.
The following table illustrates the changes in the balance of each component of accumulated other comprehensive earnings for each period presented in the consolidated financial statements.
Fair value is defined as the price in the principal market that would be received for an asset to facilitate an orderly transaction between market participants on the measurement date. We determined the fair value of certain financial instruments based on their underlying characteristics and relevant transactions in the marketplace. GAAP guidance requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The guidance also describes three levels of inputs that may be used to measure fair value.
Pricing Level 1 is applied to valuations based on readily available, unadjusted quoted prices in active markets for identical assets.
Pricing Level 3 is applied to valuations that are derived from techniques in which one or more of the significant inputs are unobservable. Financial assets are classified based upon the lowest level of significant input that is used to determine fair value.
For common stock, we receive prices from the same nationally recognized pricing service. Prices are based on observable inputs in an active market and are therefore disclosed as Level 1. Based on this assessment, we determined that the fair values of our Level 1 securities provided by our pricing service are reasonable.
Our insurance coverages include exposure to catastrophic events. We monitor all catastrophe exposures by quantifying our exposed policy limits in each region and by using computer-assisted modeling techniques. Additionally, we limit our risk to such catastrophes through restraining the total policy limits written in each region and by purchasing reinsurance. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. In 2014, for this coverage, we had protection of $300 million in excess of $25 million first-dollar retention for earthquakes in California and $325 million in excess of a $25 million first-dollar retention for earthquakes outside of California. These amounts are subject to certain co-participations by us on losses in excess of the $25 million retentions. Our second largest catastrophe exposure is to losses caused by wind storms to commercial properties throughout the Gulf and East Coasts, as well as to homes we insure in Hawaii. In 2014, these coverages were supported by $225 million in excess of a $25 million first-dollar retention in traditional catastrophe reinsurance protection, subject to certain retentions by us in the excess layers. In addition, we have incidental exposure to international catastrophic events.
Our catastrophe reinsurance treaty renewed on January 1, 2015. 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.
In 2009, as an extension of our excess and surplus lines general liability product, we expanded our offerings into low to moderate environmental liability exposures for small contractors and asbestos and mold remediation specialists. The business unit also provides limited coverage for individually underwritten underground storage tanks. We attempted to mitigate the overall exposure by focusing on smaller risks with low to moderate exposures. A large portion of this business is also offered on a claims-made basis with relatively low limits. We avoid risks that have large-scale exposures 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. Since 2009, we have written a total of $13.0 million of premium from this new product extension with $3.7 million written in 2014.
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 sensitive to movements in the market. 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.
As noted in the previous tables, we did not have any assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of December 31, 2014 and 2013. Additionally, there were no securities transferred in or out of levels 1 or 2 during 2014 or 2013.
The amortized cost and estimated fair value of fixed income securities at December 31, 2014, by contractual maturity, are shown as follows:
In addition, the following table is a schedule of amortized costs and estimated fair values of investments in fixed income and equity securities as of December 31, 2014 and 2013:
**Trading securities are carried at fair value with unrealized gains (losses) included in earnings
Unrealized losses in the collateralized securities bond portfolio decreased to $1.8 million in 2014 due to the decrease in interest rates during the year. All of our collateralized securities carry the highest credit rating by one or more major rating agency and continue to pay according to contractual terms.
As of December 31, 2014, municipal bonds totaled $481.4 million with gross unrealized losses of $0.1 million, down from $12.7 of unrealized losses at the end of 2013. The decline was due to lower interest rates in conjunction with narrower risk premiums or tighter spreads when compared to last year. As of December 31, 2014, approximately 49 percent of the municipal fixed income securities in the investment portfolio were general obligations of state and local governments and the remaining 51 percent were revenue based. Ninety percent of our municipal fixed income securities were rated AA or better while 99 percent were rated A or better.
Under current accounting standards, an OTTI write-down of debt securities, where fair value is below amortized cost, is triggered by circumstances where (1) an entity has the intent to sell a security, (2) it is more likely than not that the entity will
be required to sell the security before recovery of its amortized cost basis or (3) the entity does not expect to recover the entire amortized cost basis of the security. If an entity intends to sell a security or if it is more likely than not the entity will be required to sell the security before recovery, an OTTI write-down is recognized in earnings equal to the difference between the security’s amortized cost and its fair value. If an entity does not intend to sell the security or it is not more likely than not that it will be required to sell the security before recovery, the OTTI write-down is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to all other factors, which is recognized in other comprehensive income.
Other invested assets shown on the balance sheet as of December 31, 2014 include an investment in a low income housing tax credit partnership as well as membership stock in the Federal Home Loan Bank of Chicago (FHLBC). During 2014, we recorded an interest in a low income housing tax credit partnership totaling $10.0 million. The interest had a balance of $9.8 million at December 31, 2014 and recognized a total tax benefit of $0.2 million during the year. Our investment in FHLBC stock totaled $1.8 million at the end of the year.
As of December 31, 2014, outstanding debt balances totaled $149.6 million, net of unamortized discount, all of which were our long-term senior notes.
On October 2, 2013, we completed a public debt offering, issuing $150.0 million in senior notes maturing September 15, 2023, 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. The amount of the discount is being charged to income over the life of the debt on an effective-yield basis. On December 12, 2013, a portion of the proceeds were used to redeem the $100.0 million in senior notes that were to mature on January 15, 2014, and the remaining proceeds were made available for general corporate purposes. The estimated fair value for the senior note is $159.0 million. The fair value of our long-term debt is estimated based on the limited observable prices that reflect thinly traded securities.
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. This facility has a four-year term that expires on May 28, 2018. As of and during the years ended December 31, 2014, 2013 and 2012, no amounts were outstanding on these facilities.
Through the purchase of reinsurance, we also generally limit our net loss on any individual risk to a maximum of $3.0 million, although retentions can range from $1.0 million to $8.8 million.
At December 31, 2014, we had prepaid reinsurance premiums and recoverables on paid and unpaid losses and settlement expenses totaling $355.5 million. More than 96 percent of our reinsurance recoverables are due from companies with financial strength ratings of “A” or better by A.M. Best and S&P rating services.
The following table displays net reinsurance balances recoverable, after consideration of collateral, from our top 10 reinsurers as of December 31, 2014. 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 2014.
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 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 us 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.
The following table is a reconciliation of our unpaid losses and settlement expenses (LAE) for the years 2014, 2013 and 2012.
The following table summarizes our prior accident years’ loss reserve development by segment for 2014, 2013 and 2012:
The marine product was the primary driver of the favorable development in the property segment. Marine contributed $5.8 million of the $1.1 million total favorable property development. Accident years 2012 and 2013 contributed to the marine products’ favorable development. Assumed property and crop were unfavorable by $4.0 million and $1.2 million, respectively. The unfavorable assumed property development was primarily attributable to 2012 spring storms on a treaty, covering mostly Texas homeowners, which was cancelled in early 2013.
development. Other direct property products contributed $3.5 million favorable development offsetting the unfavorable development of $1.4 million in the assumed property.
The surety segment experienced favorable development of $3.4 million. The majority of the favorable development was from accident year 2012, which offset the unfavorable development from accident years 2009 to 2011. The adverse development coincided with the economic environment in those years. The majority of the adverse development was from the contract and miscellaneous surety products. Though accident year 2012 was favorable for all of surety combined, oil and gas surety was unfavorable in accident year 2012.
2012. We experienced favorable emergence relative to prior years’ reserve estimates in all of our segments during 2012. Development from the casualty segment totaled $40.4 million with the largest amounts coming from accident years 2007 through 2010. We continue to experience emergence that is generally better than previously estimated, but to a lesser degree in 2012 than in the previous two years. 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. Our general liability product was the largest single contributor to this favorable development at $14.2 million. Although the habitational classes within this product produced adverse development, it was more than offset by favorable development from the construction classes. The second largest contributor was our personal umbrella product at $11.5 million and we also had a favorable contribution of $4.9 million from our commercial umbrella products. In addition, our active program business combined for $9.2 million of favorable development, coming mostly from the P&C package products that were added in 2011. Our run-off program business contributed $4.6 million of favorable development coming mostly from the discontinued restaurant-bar-tavern class. Two business units experienced adverse development in 2012. Transportation and executive products were unfavorable by $3.2 million and $2.2 million, respectively.
For the second year in a row, our marine product was the predominant driver of the favorable development in the property segment, accounting for $12.1 million of the $16.8 million total favorable development for the segment. The accident years making the largest contributions were 2008 through 2010. The marine protection & indemnity and liability coverages were responsible for the majority of the favorable loss experience. Our other direct property products contributed $3.5 million of favorable development with the majority of that coming from loss reductions on previous hurricanes and storms. Development on assumed reinsurance business was also favorable overall.
The following table represents paid and unpaid environmental, asbestos and mass tort claims data (including incurred but not reported losses) as of December 31, 2014, 2013 and 2012:
Calendar year 2014 included a higher than normal increase in inception-to-date paid losses on a net and gross basis. The increase was largely due to a commutation completed during the year on assumed business from the early 1980’s. The payment of the commutation resulted in a corresponding reduction in case reserves.
Dividends paid to our Employee Stock Ownership Plan (ESOP) result in a tax deduction. Special dividends paid to the ESOP in 2014, 2013 and 2012 resulted in tax benefits of $3.6 million, $1.7 million and $2.9 million, respectively. These tax benefits reduced the effective tax rate for 2014, 2013 and 2012 by 1.9 percent, 1.0 percent and 2.0 percent, respectively.
Federal and state income taxes paid in 2014, 2013 and 2012, amounted to $48.5 million, $36.8 million and $25.9 million, respectively.
Our ESOP and 401(k) cover all employees meeting eligibility requirements. ESOP and 401(k) profit-sharing contributions are determined annually by our board of directors and are expensed in the year earned. ESOP and 401(k)-related expenses (basic and profit-sharing) were $14.1 million, $12.4 million and $7.8 million, for 2014, 2013 and 2012, respectively.
During 2014, the ESOP purchased 178,987 shares of RLI stock on the open market at an average price of $44.43 ($7.9 million) relating to the contribution for plan year 2013. Shares held by the ESOP as of December 31, 2014, totaled 3,482,617 and are treated as outstanding in computing our earnings per share. During 2013, the ESOP purchased 140,484 shares of RLI stock on the open market at an average price of $35.03 ($4.9 million) relating to the contribution for plan year 2012. During 2012, the ESOP purchased 189,282 shares of RLI stock on the open market at an average price of $35.01 ($6.6 million) relating to the contribution for plan year 2011. 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.
During the second quarter of 2010, our shareholders approved the RLI Corp. Long-Term Incentive Plan (LTIP), which provides for equity-based compensation and replaced the omnibus plan. In conjunction with the adoption of the LTIP, effective May 6, 2010, options were no longer granted under the omnibus plan. Awards under the LTIP may be in the form of restricted stock, stock options (nonqualified only), stock appreciation rights, performance units, as well as other stock-based awards. Eligibility under the LTIP is limited to employees or directors of the company or any affiliate. The granting of awards under the LTIP is solely at the discretion of the executive resources committee of the board of directors. The maximum number of shares of common stock available for distribution under the LTIP is 4,000,000 shares (subject to adjustment for changes in our capitalization and other events). Since 2010, we have granted 2,824,500 stock options under the LTIP, including 512,000 in 2014.
In most instances, 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.
On November 13, 2014, the board of directors declared a $3.00 per share special cash dividend to be paid on December 22, 2014, to shareholders of record at the close of business on November 28, 2014. To preserve the intrinsic value for option holders, the board also approved, pursuant to the terms of our various stock option plans, a proportional adjustment to both the exercise price and the number of shares covered by each award for all outstanding ISOs and an adjustment to the exercise price (equivalent to the special dividend) for all outstanding non-qualified options. Most (99 percent) of the outstanding options at the time of the adjustment were non-qualified. These adjustments did not result in any incremental compensation expense as the aggregate fair value, aggregate intrinsic value and the ratio of the exercise price to the market price are approximately equal immediately before and after the adjustment. Similarly, on November 14, 2013, the board of directors declared a $1.50 per share special cash dividend to be paid on December 20, 2013, to shareholders of record at the close of business on November 29, 2013. On November 14, 2012, the board of directors declared a $2.50 per share special cash dividend to be paid on December 20, 2012, to shareholders of record at the close of business on November 30, 2012. The share and exercise price adjustments made for the 2014 special dividend were also made for the 2013 and 2012 special dividends and did not result in any incremental compensation expense.
*An adjustment was made to the exercise price and number of ISO options outstanding for the special cash dividends paid during December 2014, 2013 and 2012. “Special dividend” represents the incremental options issued as a result of this adjustment.
In 2014, 512,000 options were granted with an average exercise price of $40.46 and an average fair value of $7.89. Of these grants, 369,500 were granted at the board meeting in May with a calculated fair value of $7.71. We recognized $3.9 million of expense during 2014 related to options vesting. Since options granted under our plan are non-qualified, we recorded a tax benefit of $1.4 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $4.8 million, which will be recognized over the remainder of the vesting period.
In 2013, 632,700 options were granted with an average exercise price of $35.67 and an average fair value of $6.88. Of these grants, 472,700 were granted at the board meeting in May with a calculated fair value of $6.47. We recognized $3.8 million of expense during 2013 related to options vesting. Since options granted under our plan are non-qualified, we recorded a tax benefit of $1.3 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $4.5 million, which will be recognized over the remainder of the vesting period.
In 2013 and 2014, each director received $10,000 worth of restricted common shares as part of annual director compensation. The shares were issued from the LTIP during the first quarter of each year. The shares were directly owned by each director on the date of issuance and included a one-year restriction on the sale or transfer of such shares. In the first quarter of 2014, we issued a total of 2,097 restricted shares and recognized $0.1 million of compensation expense. In the first quarter of 2013, we issued a total of 2,320 restricted shares and recognized $0.1 million of compensation expense. This restricted share program was terminated in 2014.
The statutory financial statements of our four insurance companies are presented on the basis of accounting practices prescribed or permitted by the Illinois Department of Insurance, which has adopted the NAIC statutory accounting practices as the basis of its statutory accounting practices. We do not use any permitted statutory accounting practices that differ from NAIC prescribed statutory accounting practices. In converting from statutory to GAAP, typical adjustments include deferral of policy acquisition costs, the inclusion of statutory non-admitted assets and the inclusion of net unrealized holding gains or losses in shareholders’ equity relating to fixed maturities.
Year-end statutory surplus for 2014 presented in the table below includes $86.1 million of RLI stock (cost basis of $64.6 million) held by Mt. Hawley Insurance Company, compared to $64.0 million and $9.1 million in 2013 and 2012, respectively. The Securities Valuation Office provides specific guidance for valuing this investment, which is eliminated in our GAAP consolidated financial statements.
Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions, marine, facultative and treaty reinsurance, including crop, and select personal lines policies, including recreational vehicle insurance and Hawaii homeowners coverages. Property insurance and reinsurance results are subject to the variability introduced by perils such as earthquakes, fires and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. Our second largest catastrophe exposure is to losses caused by wind storms to commercial properties throughout the Gulf and East Coast, as well as to homes we insure in Hawaii. We limit our net aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and through extensive use of computer-assisted modeling techniques. These techniques provide estimates that help us carefully manage the concentration of risks exposed to catastrophic events. Our assumed multi-peril crop and hail treaty reinsurance business covers revenue shortfalls or production losses due to natural causes such as drought, excessive moisture, hail, wind, frost, insects and disease. Significant aggregation of these losses is mitigated by the Federal Government reinsurance program that provides stop loss protection inuring to our benefit.
depreciation and amortization charges have been included in these measures via our expense allocation system, the related assets are not allocated for management use and, therefore, are not included in this schedule.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RLI Corp. and subsidiaries as of December 31, 2014 and 2013, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements, taken as a whole, present fairly, in all material respects, the information set forth therein. In our opinion, RLI Corp. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).