Our regional locations in Westminster, Colorado, and Galveston, Texas, and our claims office in Metairie, Louisiana, conduct operations in leased office space. Due to Hurricane Ike, our leased office space in Galveston, Texas was damaged and is currently undergoing renovation. We are temporarily leasing office space in a suburb of Houston, Texas for our Gulf Coast Regional Office to conduct business.
The selected financial data herein has been derived from the consolidated financial statements of United Fire and its subsidiaries and affiliate. The data should be read in conjunction with Part II,
The adequacy of our loss reserves established for Hurricane Katrina, which are based on management estimates.
Developments in domestic and global financial markets that could affect our investment portfolio and financing plans.
Additional government and NASDAQ policies relating to corporate governance, and the cost to comply.
The ability to maintain and safeguard the security of our data.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006
We conduct our operations through two distinct segments: property and casualty insurance and life insurance. We manage these segments separately because they generally do not share the same customer base, and they each have different pricing and expense structures. We evaluate each of our segment’s profits based upon operating and investment results. Segment profit or loss described in the following sections of Management’s Discussion and Analysis is reported on a pre-tax basis. Additional segment information is presented in Part II, Item 8, Note 11 “Segment Information” to the Consolidated Financial Statements.
Our revenue is primarily comprised of premiums and investment income. Major categories of expenses include losses and loss settlement expenses, changes in reserves for future policy benefits, operating expenses and interest on policyholders’ accounts. Through disciplined underwriting and strong agency relationships, we have traditionally emphasized writing good business at an adequate price, preferring quality to volume. Our goal of consistent profitability is supported by these business strategies.
Over the past three years, our commercial lines of business have accounted for over 90 percent of premium revenue. We anticipate that our current composition of commercial lines and personal lines business will not change materially during the coming year.
In 2008, we had a net loss of $13.1 million, compared to net income of $111.4 million in 2007 and $88.1 million in 2006. The substantial deterioration of our underwriting and overall financial results in 2008 can be attributed to a significant increase in catastrophe losses and the deterioration of the performance of our core book of business. In 2008, we experienced catastrophe losses from 34 events totaling $76.1 million, or $1.83 per share, compared to 18 catastrophic loss events in 2007 totaling $14.1 million, or $.33 per share and 16 catastrophic loss events in 2006 totaling $59.8 million or $1.49 per share. In our core book of business we experienced an increase in loss ratios due to both an increase in severity and continued premium pressure. The combination of these factors had a significant impact on our overall performance. In addition, net investment income declined by $14.9 million to $107.6 million in 2008. This is attributable to lower market interest rates, primarily in short-term investments. Also contributing to this decline was a loss in investment income of $4.5 million due to the performance of our investment in certain limited liability partnership holdings. Further impacting our net income was the other-than-temporary impairment of investment securities totaling $9.9 million in 2008, compared to $.1 in 2007 and $.4 million in 2006.
The performance of our underlying book of property and casualty business deteriorated some in 2008, driven by an escalation in loss severity and a continuation of flat or falling premium rates. Excluding catastrophes our average incurred claim size was $8,444 in 2008, $6,452 in 2007 and $5,503 in 2006. Although we feel well positioned to withstand the current market conditions, as we have always competed on our products and services rather than on price, we are making some modifications to our underwriting guidelines in 2009 and expanding the use of our loss control unit, eliminating certain unprofitable classes of business and enhancing our predictive analysis tools.
We were directly affected by Hurricanes Gustav and Ike. Due to Hurricane Gustav, our New Orleans claims office in Metairie, Louisiana was closed for three days. Due to Hurricane Ike, our Gulf Coast regional office in Galveston, Texas closed for three weeks before reopening in a temporary facility in a suburb of Houston, Texas. As with the flooding in Cedar Rapids, our disaster recovery plan for these offices performed as expected, allowing our employees to access our major automated processing systems quickly and efficiently. We recorded $.4 million of hurricane-related expenses in 2008, which primarily relates to costs incurred to remove damaged contents from the affected areas and establish a temporary facility for our Gulf Coast regional office. We anticipate incurring additional expenses for the clean-up and restoration of the affected areas and other related costs in 2009. A portion of these costs will be subject to recovery under our insurance. As of December 31, 2008, no such recovery has been recorded against the expenses incurred.
The stable results and steady income produced by our life insurance segment has historically helped offset the volatility of our property and casualty insurance earnings that occurs due to the cyclical nature and weather patterns of the property and casualty insurance business. In order to maintain profitability within our life insurance segment we continue to diversify our product offerings in response to industry needs. Our new universal life product, introduced in 2007, has been well received by those agents accustomed to marketing universal life policies. Small- to mid-size employer groups have been our target market to date. In 2009 we plan to expand our target market with the goal of enrolling 100 new small- to mid-size employer groups. During 2008 we continued to see annuity withdrawals exceed new annuity deposits - although at a slower pace than experienced during 2007 and 2006. We will continue to monitor annuity withdrawals closely to determine if future interest rate adjustments are necessary. The current interest rate environment presents a challenge to maintaining a profitable interest rate spread for our annuity business. Although our life insurance segment had a good year operationally, nearly all of its income was lost to realized investment losses of $12.3 million in 2008 (primarily due to write-downs of Kaupthing Bank and Lehman Brothers fixed maturity securities), compared to realized investment gains of $2.6 million in 2007 and $3.0 million in 2006.
In August 2007, our Board of Directors authorized a share repurchase program with an initial authorization of 600,000 shares. This was added to our existing blanket repurchase authorization of 87,167 shares that remained from a previous authorization to repurchase shares. Following the program’s adoption in 2007, the Board of Directors increased the repurchase authorization by 500,000 shares in both February 2008 and August 2008, respectively. Under this share repurchase program, management may purchase our common stock from time to time through open market or privately negotiated transactions. In determining the amount and timing of stock repurchases, management considers many factors including the price of our common stock, general market and economic conditions, other corporate uses for capital and regulatory requirements. The share repurchase program expires on August 17, 2009 unless further extended by the Board of Directors, but the Board of Directors may modify or discontinue the program at any time. Since inception, we have repurchased a total of 1,078,292 shares of our common stock at an average stock price of $28.65 per share. During 2008, we repurchased 580,792 shares of our common stock at an average stock price of $25.51 and returned them to the status of authorized but unissued shares. As of December 31, 2008, our remaining repurchase authorization is 608,875 shares. We are faced with the challenge of balancing the capital adequacy requirements established by A.M. Best with market expectations regarding returns on equity investment. For a more detailed accounting of the shares repurchased under this program in the fourth quarter of 2008, refer to Part II, Item 5 “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”
We employ a multi-disciplinary approach to risk identification and evaluation - from claims to underwriting to financial to investments. Members of our ERM committee include our Chief Executive Officer, Chief Financial Officer, Executive Vice President, Vice President of Claims, Vice President of Corporate Underwriting, Chief Investment Officer and Vice President/Chief Operating Officer of our life insurance subsidiary (United Life Insurance Company), as well as United Life Insurance Company’s independent actuary. This committee meets on a quarterly basis with two members of our Board of Directors to oversee our risk management process and to implement risk management strategies.
One of the most significant risks in our business is our exposure to catastrophic events. We use various analyses and methods, including computer modeling techniques, to analyze catastrophic events and the risks associated with them. We use these analyses and methods as tools to make underwriting and reinsurance decisions designed to manage our exposure to catastrophic events.
Our property and casualty insurance segment reported a pre-tax loss of $36.4 million in 2008, compared to pre-tax income of $139.0 million in 2007 and $103.6 million in 2006. The deterioration in our 2008 results, compared to 2007 and 2006, was primarily due to the significant number of catastrophe losses we experienced in 2008. The financial impact from these catastrophes was realized largely on our commercial property line of business. Also contributing to the decline was an increase in the severity of non-catastrophe losses and the impact of competitive market conditions on pricing.
The decline in our net premiums written between years is attributable to reduced premium rates from increased competition in the insurance marketplace as well as the nonrenewal of business that does not meet our underwriting standards. According to industry estimates provided by A.M. Best, the property and casualty industry as a whole is expecting to see net premiums written decline by 0.8 percent in 2008 as compared to 2007.
In 2008, we implemented a program of new underwriting tools that we anticipate will contribute to the profitability of the workers’ compensation line of business. Also in 2008, as part of a continued commitment to grow our book of business, we appointed 24 new independent agents to promote and sell our products, bringing our total number of property and casualty agents to 837. On December 1, 2008, we began marketing our commercial insurance in the state of Montana, and we will begin offering our personal insurance in that state in mid-2009. To date, we have appointed one new Montana agency with five locations in the state, with plans to appoint additional agents in the near future. Also in 2009, we are working to revamp our business owner’s coverage program and enhance our commercial property underwriting through enhanced geocoding, loss modeling and address-specific hazard data.
As of December 31, 2008 we have only five active contracts in our assumed reinsurance business and a number of assumed reinsurance contracts that are in run-off. Late in 2006, we made the decision to cancel one of our largest remaining assumed contracts. This decision was made in response to the loss of available reinsurance protection, leaving us with a larger percentage of the total exposure than we were comfortable with. As a result of this decision, through 2008 our assumed premium writings were down 33.4 percent as compared to 2006 levels.
Net premiums earned are decreased by ceded premiums that we pay to reinsurers. In 2006, premium rates for our catastrophe and excess of loss reinsurance increased substantially from premium rates previously charged because of the significant losses incurred by reinsurers as a result of Hurricane Katrina and other catastrophes. Pricing of ceded reinsurance did not increase materially in 2007 or 2008. The reduction in ceded premiums written in 2007 and 2008 was due to the lower level of direct premiums written in each of those years. We anticipate that if the higher than normal catastrophe activity experienced by many insurers in 2008 continues into 2009, reinsurance pricing will increase in 2010.
In the five years prior to 2006, our net catastrophe losses incurred each year (excluding losses from Hurricane Katrina) averaged approximately $20.1 million. In 2006, our catastrophe losses totaled $59.8 million, with $31.7 million related to Hurricane Katrina development. In 2007, we incurred $14.1 million in catastrophe losses, with $6.3 million from Hurricane Katrina. In 2008, we incurred $76.1 million in catastrophe losses, with $15.8 million from Hurricane Katrina (not including a $10.8 million judgment, currently under appeal, net of reinsurance, which was entered into and incurred in 2008). In 2008, we experienced our second highest year for catastrophe losses in the past decade, with losses from 34 catastrophe events. Our largest losses during 2008 were related to Hurricane Ike ($20.2 million) and Hurricane Gustav ($15.8 million). During the fourth quarter of 2008, our losses from Hurricane Ike surpassed our catastrophe reinsurance loss retention limits. As a result, we recorded a reinsurance recoverable of $2.4 million related to Hurricane Ike through December 31, 2008.
As discussed in more detail elsewhere in this Management’s Discussion and Analysis section, we continue to experience the effects of soft market conditions within the insurance industry. These conditions have led to downward pressure on premium rates, particularly for mid-size to large commercial accounts. At the same time, during 2008 we experienced an unexpected increase in loss severity compared to prior years, while frequency of reported losses remained relatively stable between years, particularly in accounts under $100,000.
Late in 2008, we began a corporate-wide audit of our reported large claim losses to analyze the increase in severity that we experienced in 2008. While we were satisfied with the results of the audit, our review did result in the modification of certain underwriting guidelines. Examples of such modifications include an increase in the number of commercial accounts serviced by our loss control unit, the development of a new safety class for insureds, a decline in certain classes of commercial business that are no longer profitable and the introduction of pricing increases.
Certain of our lines of business, particularly workers’ compensation and other liability, are considered by us to be long-tail lines of business due to the length of time that may elapse before claims are finally settled. Therefore, we may not know our final development on individual claims for many years. Our estimates for losses, particularly in these long-tail lines, are dependent upon many factors, such as the legal environment, inflation and medical costs. We consider all of these factors, as well as others, in estimating our loss reserves. As conditions or trends with respect to these factors change, we change our estimate for loss reserves accordingly.
In 2008, we increased our reserves for losses that occurred in prior years, which resulted in a net deficiency of $.5 million. The primary cause of the deficiency is related to Hurricane Katrina, which occurred in 2005. We recorded $26.6 million in Hurricane Katrina losses and loss settlement expenses in 2008, which included $10.8 million in net losses incurred on a claim that resulted from the adverse jury verdict in a lawsuit related to Hurricane Katrina. These Hurricane Katrina-related losses contributed to a deficiency in the fire and allied lines business of $12.2 million.
Also contributing to our overall deficiency was an increase in general liability losses, which includes both other and products liability lines. Claims for construction defect losses are included in the products liability line of business. Incurred losses from construction defect claims for prior years were $7.7 million in 2008. These losses contributed to a deficiency in the other liability and products liability lines of business totaling $5.8 million.
In 2006, loss and loss settlement expenses incurred were $278.5 million, with $303.5 million of loss and loss settlement expenses that occurred in 2006 and a redundancy of $25.0 million ($62.2 million without the adverse development on Hurricane Katrina claims) on losses that occurred prior to 2006, which resulted from settling or reestimating claims for less than reserved at December 31, 2005. Due to Hurricane Katrina, our homeowners, allied lines and commercial multiple peril lines of business experienced a reserve deficiency, while our remaining lines of business experienced reserve redundancies for the year.
The following table illustrates the primary components of the net loss redundancy (deficiency) we experienced in our reserves for 2008, 2007 and 2006.
Salvage is the sale of damaged goods, for which the insured has been indemnified for and for which the insured has transferred title to the insurance company. Salvage reduces the cost incurred for property losses. Subrogation also reduces the costs incurred for a loss by seeking payment from other parties involved in the loss and/or from the other parties’ insurance company. Alternative dispute resolution facilitates settlements and reduces defense and legal costs through processes such as mediation and arbitration. Workers’ compensation medical bill review is a system designed to detect duplicate billings, unrelated and unauthorized charges and coding discrepancies. It also ensures that we are billed for medical services according to the fee schedule designated by each state in which we have claims.
“Other liability” is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured’s premises and products manufactured or sold.
The net loss ratio in our commercial lines of business was 82.1 percent in 2008, 51.8 percent in 2007 and 57.8 percent in 2006. Several factors contributed to the deterioration in 2008. Our other liability losses and loss settlement expenses incurred grew to $93.0 million in 2008, compared to $55.4 million in 2007. A portion of the increase in other liability losses was due to an increase in construction defect claims. In 2008, we experienced an increase in construction defect claims, with incurred losses of $11.0 million in 2008, compared to $5.4 million in 2007. Further discussion of these factors follows in subsequent subsections of this report.
Commercial fire and allied lines insurance covers losses to an insured’s property, including its contents, from weather, fire, theft or other causes. We provide this coverage through a variety of business policies. The net loss ratio for our commercial fire and allied lines was 122.7 percent in 2008, 56.0 percent in 2007 and 85.6 percent in 2006. The deterioration in these lines was driven by catastrophe losses, which increased by nearly $50.6 million in 2008 over 2007. Losses from Hurricanes Gustav and Ike contributed $3.6 million and $19.0 million respectively, to the commercial lines property losses in 2008. We also had an increase in commercial fire losses, with incurred losses from these claims increasing from $20.3 million in 2007 to $27.3 million in 2008. The number of claims reported decreased slightly, but the severity of commercial fire losses increased. The improvement in our 2007 results, as compared to 2006, was due to a lower frequency of fires and few catastrophe losses.
Without considering catastrophe losses, frequency has not changed significantly over the past three years, but severity has grown, and we are taking measures to address our increase in incurred losses in the commercial fire and allied lines of business. We have implemented a number of underwriting initiatives that we anticipate will improve our loss experience. We have a loss control unit that we intend to utilize more frequently in 2009 and we may augment the number of employees who perform loss control services for our customers. In a comprehensive review of our larger 2008 calendar year losses, our senior underwriters identified a number of building characteristics that we will scrutinize more closely when underwriting new and renewal business. We continue to utilize technology to evaluate and improve our spread of risk in hurricane-prone areas along the Gulf Coast. In addition, we are analyzing our policy and loss experience data so that we can enhance our use of predictive modeling in each of our commercial lines of business.
Within our other liability lines of business (other than construction defect), frequency remained virtually unchanged, with losses incurred on 4,493 claims in 2008, and 4,426 in 2007. Severity, however, has increased in other liability losses. Due to the increase in severity, our average pure loss incurred per general liability claim more than doubled in 2008, increasing to $9,551 from $4,590. Because of the long-tail nature of liability claims, significant periods of time, ranging up to several years, may elapse between the occurrence of the loss, the reporting of the loss to us and the settlement of the claim. Over 30 percent of our other liability losses incurred in 2008 resulted from losses that occurred prior to 2008. The prior years that were most significantly impacted were 2001, 2003, 2004 and 2005. During 2009, we will be implementing revised underwriting guidelines and utilizing our loss control unit more frequently, working to bring this line of business back to a higher level of profitability.
The deterioration in the net loss ratio in 2007 compared with 2006 was primarily related to increased severity. We had several large liability losses in 2007, but had not detected trends as to cause of loss or geographic location.
Our commercial automobile insurance covers physical damage to an insured’s vehicle, as well as liabilities to third parties. Automobile physical damage insurance covers loss or damage to vehicles from collision, vandalism, fire, theft, flood or other causes. Automobile liability insurance covers bodily injury, damage to property resulting from automobile accidents caused by the insured, uninsured or underinsured motorists and the legal costs of defending the insured against lawsuits. Generally, our company policy is to write standard automobile insurance. Our net loss ratio in commercial automobile was 71.5 percent in 2008, 64.1 percent in 2007 and 58.1 percent in 2006. Our policy count increased by approximately 4.0 percent, which resulted in an increase in premiums earned of $2.2 million between 2007 and 2008. Losses and loss settlement expenses increased in each of the past three years, rising from $55.4 million in 2006 to $63.5 million in 2007 and $72.4 million in 2008. We attribute the increase to an increase in the growth of the number of policies that we have written.
Our net loss ratio in the workers’ compensation line of business was 78.5 percent in 2008, 67.0 percent in 2007 and 74.1 percent in 2006. We consider our workers’ compensation business to be a companion product; we rarely write stand-alone workers’ compensation policies. Our workers’ compensation insurance covers primarily small- to mid-size accounts. In 2007 and 2008, we have written more workers’ compensation business in an effort to retain business with current insureds that require workers’ compensation insurance coverage. We believe that our underwriting expertise, loss control service and medical review programs will enable us to be profitable in the workers’ compensation line of business. The challenges faced by workers’ compensation insurance providers to attain profitability include the state regulatory climates in some states that make it difficult to obtain appropriate premium rate increases and inflationary medical costs. Despite these pricing issues, we continue to believe that we can improve profitability in the workers’ compensation line of business. Consequently, we have introduced predictive modeling analytics into our workers’ compensation underwriting process. In addition, we are going to increase our utilization of our loss control unit in the analysis of current risks, with the intent of increasing the quality of our workers’ compensation book of business.
The increase in the loss ratio in 2008 was due to an increase in loss settlement expenses. In 2008, a downturn in general economic conditions decreased demand for our surety products, as construction activity declined. This contributed to flat growth in premiums earned between years.
In our personal lines business, the net loss ratio was 135.3 percent in 2008, 60.7 percent in 2007 and 81.2 percent in 2006. The deterioration occurred throughout all of our personal lines and was due primarily to losses from catastrophes. In 2008, personal lines catastrophe losses totaled $21.6 million, compared to $1.4 million in 2007. The improvement in the 2007 over 2006 results was due primarily to the effect that Hurricanes Katrina and Rita had on our 2006 results.
In 2005, Hurricane Katrina resulted in a level of damage that we did not foresee and did not consider when we evaluated our reinsurance coverage for 2005. This resulted in a level of reinsurance coverage that did not adequately protect us from the devastation of Hurricane Katrina. During 2007 and 2006, in addition to strengthening our underwriting guidelines in the Gulf Coast region and reducing our exposure in Louisiana, we also evaluated and modified our catastrophe reinsurance coverage to lessen the impact of future catastrophes in this region.
Our assumed reinsurance line of business has improved over the most recent three year period as evidenced by the loss ratio which started at 57.5 percent in 2006 and dropped to 36.0 percent in 2007 and to 14.8 percent in 2008.
We attribute the favorable loss experience in 2008 to a general reduction in assumed business. In 2007, the improvement in losses and loss settlement expenses incurred resulted from a number of older runoff businesses where we were able to reduce reserves to zero. We anticipate that we will incur assumed losses from Hurricanes Gustav and Ike, both of which occurred in September 2008. Due to the time-lag associated with the reporting of claims under assumed reinsurance policies, it is likely that we will be notified in the first and/or second quarter(s) of 2009 of our share of incurred losses related to these hurricanes, which will be recorded upon notification.
United Life Insurance Company underwrites all of our life insurance business. Our principal life insurance products are single premium annuities, universal life products and traditional life (primarily single premium whole life insurance) products. Single premium annuities (81.0 percent), traditional life products (11.2 percent), universal life products (6.7 percent), and other life products (1.1 percent) comprised our 2008 life insurance premium revenues, as determined on the basis of statutory accounting principles. We also underwrite and market other traditional products, including term life insurance and whole life insurance. We do not write variable annuities or variable insurance products.
Our annuity deposits decreased by 0.2 percent in 2008 compared to an increase of 11.1 percent in 2007. Annuity deposit levels increased from 2006 to 2008, primarily due to an increase in renewals of existing annuities. Despite a challenging investment environment, we were able to increase interest rates on our annuity products during 2008 and still maintain our investment spread that also helped sustain our annuity activity.
We reported a federal income tax benefit of $20.1 million in 2008 resulting from a taxable loss in our property and casualty insurance operations. Our effective federal income tax rate was 30.1 percent for 2007 and 29.8 percent for 2006. Our effective federal tax rate varied from the generally applicable federal income tax expense rate of 35.0 percent, due primarily to our portfolio of tax-exempt securities.
During 2008, we saw an extraordinary deterioration in the financial markets. This deterioration impacted our investment income results and our capital position for 2008.
Our investment results, which are presented in accordance with GAAP, are summarized in the following table.
In 2007 as compared to 2006, our net investment income increased by 0.4 percent as a result of a 2.8 percent increase in our average invested assets, which was somewhat offset by depressed market interest rates and the contraction of our annuity business during this period.
In 2008, more than 90.0 percent of our investment income originated from interest on fixed maturities, compared to more than 80.0 percent in 2007 and 2006, respectively. Our remaining investment income is generated from dividends on equity securities; income from other long-term investments; interest on mortgage loans; interest on policy loans; interest on short-term investments, cash and cash equivalents; and rent earned from tenants in our home office. The average investment yield, which is investment income divided by average invested assets, was as follows for 2008, 2007 and 2006, respectively.
In April 2008, we began participating in a securities lending program, which generates investment income and discounts other investments fees we are charged, by lending certain investments to other institutions for short periods of time. Borrowers of these securities must deposit collateral, in the form of cash or U.S. Treasury securities, with The Northern Trust Company (“Northern Trust”), the third-party custodian. Collateral deposited by borrowing institutions must be equal to at least 102 percent of the market value of the securities loaned plus accrued interest. Northern Trust monitors the market value of our loaned securities on a daily basis. As the market value of loaned securities fluctuates, in order to maintain collateral values of at least 102 percent, the borrower either deposits additional collateral or Northern Trust refunds collateral to the borrower. If a borrower defaults under the lending agreement, Northern Trust will use the deposited collateral to purchase the same or similar security as a replacement for the security that was not returned by the borrower. However, if Northern Trust is unable to purchase the same or similar security, we will receive the deposited collateral in place of the borrowed security.
Due to the continued turmoil and illiquidity in the financial markets, and in accordance with GAAP, additional non-cash impairment write-downs may be required during 2009, including for securities that we believe continue to have strong underlying fundamentals.
In 2007, our net realized investment gains were due primarily to cash received as a result of transactions that impacted companies whose securities we held. The increase in net realized gains in 2006 is attributable primarily to the sale of our property and casualty insurance subsidiary, American Indemnity Company, which resulted in a realized gain of $3.4 million.
Changes in unrealized gains do not affect net income (loss) and earnings per common share but do impact comprehensive income (loss), stockholders’ equity and book value per common share. We record unrealized losses identified as other-than-temporary impairments as a component of net realized investment gains (losses). The amounts reported as net realized investment gains (losses) in 2008, 2007 and 2006 included other-than-temporary impairments of $9.9 million, $.1 million and $.4 million, respectively. We believe that our investment in high quality assets will help protect us from future credit quality issues and corresponding impairment write-downs.
Our invested assets at December 31, 2008 totaled $2.095 billion, compared to $2.147 billion at December 31, 2007. At December 31, 2008, fixed maturity securities comprised 91.3 percent of our investment portfolio, while equity securities accounted for 5.8 percent of the value of our portfolio. Because the primary purpose of the investment portfolio is to fund future claims payments, we utilize a conservative investment philosophy, investing in a diversified portfolio of high quality, intermediate-term taxable corporate bonds, taxable U.S. government bonds and tax-exempt U.S. municipal bonds.
The concentration of our investment portfolio at December 31, 2008, is presented in the following table.
At December 31, 2008, $1,898.6 million, or 99.2 percent, of our fixed maturities were classified as available-for-sale, compared with $1,812.8 million, or 98.5 percent, at December 31, 2007. We classify our remaining fixed maturities as held-to-maturity or trading. We record held-to-maturity securities at amortized cost. We record trading securities, primarily convertible redeemable preferred debt securities, at fair value, with any changes in fair value recognized in earnings.
The following table is a breakdown of our fixed maturity securities for our available-for-sale, held-to-maturity and trading security portfolios, by credit rating, at December 31, 2008 and 2007, respectively. Information contained in the table is based upon issue credit ratings provided by Moody’s unless the rating is unavailable, and then it is obtained from Standard & Poor’s:
Our investment portfolio is comprised primarily of fixed maturity securities whose fair value is susceptible to market risk, specifically interest rate changes. Duration is a measurement used to quantify our inherent interest rate risk and analyze our ability to match our invested assets to our claims liabilities. If our invested assets and claims liabilities have similar durations, then any change in interest rates will have an equal and opposite effect on our investments and claims liabilities. Mismatches in the duration of assets and liabilities can cause significant fluctuations in our results of operations. The primary purpose for matching invested assets and claims liabilities is liquidity. With appropriate matching, our investments will mature when cash is needed, preventing the need to liquidate other assets prematurely.
Our uses of cash include payment of losses and loss settlement expenses, annuity withdrawals, commissions, premium taxes, income taxes, operating expenses, dividends, and investment purchases. Cash outflows may be variable because of uncertainty regarding the settlement dates for losses. In addition, the timing and amount of catastrophe losses are inherently unpredictable and could increase our liquidity requirements.
Our cash flows from operations were sufficient to meet our liquidity needs in 2008, 2007 and 2006.
If our operating and investing cash flows had not been sufficient to support our operations, we may also borrow up to $50.0 million on a bank line of credit. Under the terms of our credit agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate, minus 1.0 percent. We did not utilize our line of credit during 2008 or 2007, other than to secure letters of credit utilized in our reinsurance operations. As of December 31, 2008 and 2007, $.2 million of our line of credit was allocated for that purpose.
The insurance laws of the states and jurisdictions where we and our insurance subsidiaries and affiliate are domiciled restrict the timing and the amount of dividends we or our subsidiaries and affiliate may pay without prior regulatory approval. In 2008, 2007 and 2006, respectively, United Fire received $4.0 million in dividends from its subsidiary, United Life Insurance Company. Pursuant to the sale of American Indemnity Company in May 2006, we implemented a plan of corporate reorganization. Part of this plan entailed the distribution of the majority of American Indemnity Company’s net assets to United Fire & Casualty Company. This distribution was recognized by United Fire as a $34.7 million intercompany dividend in 2006. In 2007, United Fire also received an $8.0 million dividend from its subsidiary, American Indemnity Financial Corporation.
Net cash flows provided by operating activities totaled $43.9 million in 2008, compared to $105.8 million in 2007 and $104.4 million in 2006, respectively. Net cash provided by operations varies with our underwriting profitability. Cash flows in 2008 were reduced primarily due to the increase in claims incurred, (including the impact of higher catastrophe losses). In addition, we were required to make a cash deposit of $29.0 million in 2008 in connection with litigation related to Hurricane Katrina.
Net cash flows used in financing activities totaled $79.6 million in 2008, compared to $91.9 million and $17.9 million in 2007 and 2006, respectively.
Over the past year, our Board of Directors granted an additional authorization of up to 1,000,000 shares of common stock under our share repurchase program. As of December 31, 2008, we had authorization from our Board of Directors to repurchase an additional 608,875 shares of our common stock.
The following table shows our contractual obligations and commitments, including our estimated payments due, by period at December 31, 2008.
The following table presents the categorization for our financial instruments measured at fair value on a recurring basis in our Consolidated Balance Sheets at December 31, 2008:
The fair value of securities that are categorized as Level 2 is determined by management, relying in part on market values obtained from independent pricing services and brokers. Such estimated fair values do not necessarily represent the values for which these securities could have been sold at the reporting date. Our independent pricing services and brokers obtain prices from reputable pricing vendors in the marketplace. They continually monitor and review the external pricing sources, while actively participating to resolve any pricing issues that may arise.
The amounts reported in the table above as realized and unrealized losses and transfers in relate primarily to the life insurance segment’s holdings of certain fixed maturity securities in default, for which an other-than-temporary impairment charge of $8.5 million was recorded in 2008.
For further discussion on SFAS No. 157 refer to Note 3. “Fair Value of Financial Instruments” contained in Part II, Item 8, “Financial Statements and Supplementary Data.”
The following table illustrates the hypothetical impact on the premium deficiency charge recorded at December 31, 2008 of reasonably likely changes in the assumed loss and loss settlement expense ratio utilized for purposes of this calculation. The entire impact of these changes would be recognized through income as other underwriting expenses. The base amount indicated below is the actual premium deficiency charge recorded as of December 31, 2008.
We incur these costs in connection with acquiring life insurance and annuity business. Costs that vary with and relate to the production of business are deferred and recorded as a deferred policy acquisition asset. Such costs consist principally of commissions and policy issue expenses.
We periodically review estimates of expected profitability and evaluate the need to “unlock” or revise the amortization of the deferred policy acquisition cost asset. The primary assumptions utilized when estimating future profitability relate to interest rate spread, mortality experience and policy lapse experience. The table below illustrates the impact that a reasonably likely change in our assumptions used to estimate expected gross profits would have on the deferred policy acquisition cost asset for our non-traditional business recorded as of December 31, 2008. The entire impact of the changes illustrated would be recognized through operations as an increase or decrease to amortization expense.
Sensitivity Analysis - Impact on DAC asset of changes in assumptions
The deferred policy acquisition costs in connection with our non-traditional business are adjusted with respect to estimated expected gross profits as a result of changes in the net unrealized gains or losses on available-for-sale fixed maturity securities allocated to support the block of fixed annuities and universal life policies. That is, because we carry available-for-sale fixed maturity securities at aggregate fair value, we make an adjustment to deferred policy acquisition costs equal to the change in amortization that would have been recorded if we had sold such securities at their stated aggregate fair value and reinvested the proceeds at current yields. We include the change in this adjustment, net of tax, as a component of accumulated other comprehensive income. This adjustment increased deferred policy acquisition costs by $28.3 million at December 31, 2008, compared with an adjustment that offset deferred policy acquisition costs by $8.0 million at December 31, 2007.
Reserves for losses and loss settlement expenses are reported using our best estimate of ultimate liability for claims that occurred prior to the end of any given accounting period but have not yet been paid. Before credit for reinsurance recoverables, these reserves were $586.1 million in 2008 and $496.1 million in 2007. We purchase reinsurance to mitigate the impact of large losses and catastrophic events. Loss reserves ceded to reinsurers was $52.5 million in 2008 and $38.8 million in 2007. Our reserves by line of business as of December 31, 2008, were as follows.
“Fire and allied lines” includes fire, allied lines, commercial multiple peril and inland marine.
Estimating case reserves is subjective and complex and requires us to make estimates about the future payout of claims, which is inherently uncertain. When we establish and adjust reserves, we do so based on our knowledge of the circumstances and facts of the claim. Upon notice of a claim, we establish a reserve based on the claim information reported to us at that time. Subsequently, we conduct an investigation of each reported claim, which allows us to more fully understand the factors contributing to the loss and our potential exposure. This investigation may extend over a long period of time. As our investigation of a claim develops, and as our claims personnel identify trends in claims activity, we refine and adjust our estimates of case reserves. To evaluate and refine our overall reserving process, we track and monitor all claims until they are settled and paid in full, with all salvage and subrogation claims being resolved.
Most of our insurance policies are written on an occurrence basis which provides coverage if a loss occurs in the policy period, even if the insured reports the loss many years later. For example, some general liability claims are reported 10 years or more after the policy period, and the workers’ compensation coverage provided by our policies pays unlimited medical benefits for the duration of the claimant’s injury up to the lifetime of the claimant. In addition, final settlement of certain claims can be delayed for years or decades due to litigation or other reasons. Reserves for these claims require us to estimate future costs, including the effect of judicial actions, litigation trends and medical cost inflation, among others. Reserve development can occur over time as conditions and circumstances change in years after the policy was issued.
Our long-tail lines of business include workers’ compensation and other liability. In addition, certain product lines such as personal and commercial auto, commercial multi-peril and surety include some long-tail coverages and some short-tail coverages. For many liability claims, significant periods of time, ranging up to several years, may elapse between the occurrence of the loss, the reporting of the loss to us and the settlement of the claim. As a result, loss experience in the more recent accident years for the long-tail liability classes has limited statistical credibility in our reserving process because a relatively small proportion of losses in these accident years are reported claims and an even smaller proportion are paid losses. In addition, long-tail liability claims are more susceptible to litigation and can be significantly affected by changing contract interpretations and the legal environment. Consequently, the estimation of loss reserves for long-tail classes is more complex and subject to a higher degree of variability than for short-tail classes.
For both our short-tail and long-tail lines of business, we establish our reserves for IBNR claims by applying a factor to our current pool of in-force premium. This factor has been developed through a historical analysis of company experience as to what level of IBNR reserve should be established to achieve an adequate IBNR reserve relative to our existing loss exposure base. Unique circumstances or trends which are evident as of the end of a given period may require us to refine our IBNR reserve calculation. This methodology for establishing our IBNR reserve has consistently resulted in aggregate reserve levels that management believes are reasonable in comparison to the reserve estimates prepared by Regnier Consulting Group, an independent actuary which we utilize in our reserving process.
In establishing an estimate of loss and loss settlement reserves, management uses a number of key assumptions. They are as follows:
To our knowledge, there are no new latent trends that would impact our case-basis reserves;
Our case-basis reserves reflect the most up-to-date information available about the unique circumstances of each claim;
As an example, if our reserve for loss and loss settlement expenses of $586.1 million as of December 31, 2008, is 10 percent inadequate, we would experience a reduction in future earnings of up to $58.6 million, before federal income taxes. This reduction could be recorded in one year or multiple years, depending on when we identify the deficiency. The deficiency would also affect our financial position in that our equity would be reduced by an amount equivalent to the reduction in net income. Any deficiency is recognized in the reserve for loss and loss settlement expenses and, accordingly, it usually does not have a material effect on our liquidity because the claims have not been paid. Conversely, if our estimates of ultimate unpaid loss and loss settlement expense liabilities prove to be redundant, our future earnings and financial position would be improved.
In 2008, we did not change the key assumptions on which we based our reserving calculations. In estimating our 2008 loss and loss settlement expense reserves, we did not anticipate future events or conditions that were inconsistent with past development patterns.
Certain of our lines of business are subject to the potential for greater loss and loss settlement expense development than others. These lines with greater potential for development are discussed below.
Our reserve for other liability claims at December 31, 2008, is $214.7 million and consists of 4,878 claims, compared with $176.3 million, consisting of 3,000 claims at December 31, 2007. Defense costs are a part of the insured costs covered by other liability policies and can be significant; sometimes greater than the cost of the actual paid claims. Of the $214.7 million total reserve for other liability claims, $58.9 million is identified as defense costs and $17.4 million is identified as general overhead required in the settlement of claims. If our reserve for other liability loss and loss settlement expenses is overstated or understated by 10 percent, the potential impact to our Consolidated Financial Statements would be approximately $21.5 million, before federal income taxes.
Included in the other liability line of business are gross reserves for construction defect losses and settlement expenses. Construction defect is a liability allegation relating to defective work performed in the construction of structures such as commercial buildings, apartments, condominiums, single family dwellings or other housing, as well as the sale of defective building materials. These claims seek recovery due to damage caused by alleged deficient construction techniques or workmanship. At December 31, 2008, we established $16.0 million in construction defect loss and loss settlement expense reserves, consisting of 243 claims, compared with $10.5 million, consisting of 211 claims, at December 31, 2007. The reporting of such claims can be delayed, as the statute of limitations can be up to 10 years. Also, recent court decisions have expanded insurers’ exposure to construction defect claims. As a result, claims may be reported more than 10 years after a project has been completed, as litigation can proceed for several years before an insurance company is identified as a potential contributor. Claims have also emerged from parties claiming additional insured status on policies issued to other parties, such as contractors seeking coverage from a subcontractor’s policy.
Included in the other liability lines of business are gross reserves for asbestos and other environmental losses and loss settlement expenses. At December 31, 2008, we had $3.8 million in direct and assumed asbestos and environmental loss reserves, compared with $5.0 million at December 31, 2007. In addition, we had ceded asbestos and environmental loss reserves of $.6 million at December 31, 2008 compared to $1.9 million at December 31, 2007. The estimation of loss reserves for environmental claims and claims related to long-term exposure to asbestos and other substances is one of the most difficult aspects of establishing reserves, especially given the inherent uncertainties surrounding such claims. Although we record our best estimate of loss and loss settlement expense reserves, the ultimate amounts paid upon settlement of such claims may be more or less than the amount of the reserves, because of the significant uncertainties involved and the likelihood that these uncertainties will not be resolved for many years.
Like the other liability line of business, workers’ compensation losses and loss settlement expense reserves are based upon variables that create imprecision in estimating the ultimate reserve. Estimates for workers’ compensation are particularly sensitive to assumptions about medical cost inflation, which has been steadily increasing over the past few years. Other variables that we consider and that contribute to the uncertainty in establishing reserves for workers’ compensation claims include: the state legislative and regulatory environments; trends in jury awards; and mortality rates. Because of these variables, the process of reserving for the ultimate loss and loss settlement expense requires the use of informed judgment and is inherently uncertain. Consequently, actual loss and loss settlement expense reserves may deviate from our estimates. Such deviations may be significant. Our reserve for workers’ compensation claims at December 31, 2008, is $126.6 million and consists of 3,386 claims, compared with $111.5 million, consisting of 2,191 claims, at December 31, 2007. If our reserve for workers’ compensation loss and loss settlement expenses is overstated or understated by 10 percent, the potential impact to our Consolidated Financial Statements would be approximately $12.7 million, before federal income taxes.
Generally, our best estimate of reserves is slightly above the midpoint of a range of reasonable estimates. We believe that in determining reserves, it is appropriate and reasonable to establish a best estimate within a range of reasonable estimates, especially when we are reserving for claims for bodily injury, disabilities and similar claims, for which settlements and verdicts can vary widely. Our reserving philosophy may result in favorable development in future years that will decrease loss and loss settlement expenses for prior year claims in the year of adjustment. While we realize that this philosophy, coupled with what we believe to be aggressive and successful claims management and loss settlement practices, has resulted in year-to-year redundancies in reserves, we believe our approach is better than experiencing year-to-year uncertainty as to the adequacy of our reserves.
Assuming that we have liability for all claims, even though the issue of liability may in some cases be resolved in our favor.
Based upon our comparison of carried reserves to actual claims experience over the last several years, we believe that using company historical premium and claims data to establish reserves for losses and loss settlement expenses results in adequate and reasonable reserves. Based upon this comparison, we believe that our total recorded loss reserves at December 31, 2008, are unlikely to vary by more than 10 percent of the recorded amounts, either positively or negatively. Historically, our reserves have had an average variance of less than 10 percent of recorded amounts, with our reserves booked as of December 31, 2007, generating a deficiency of 0.1 percent in 2008. Our reserves booked as of December 31, 2006, generated a reserve redundancy of 9.4 percent in 2007. These redundancies and deficiency are discussed in detail in the under the heading “Reserve Development” in the “Property and Casualty Insurance Segment” of the “Results of Operations” section in this item.
The following table details the pre-tax impact on our property and casualty insurance segment’s financial results and financial condition of reasonably likely changes in our reserve development. Our lines of business that have historically been most susceptible to significant volatility in reserve development have been shown separately and utilize hypothetical levels of volatility of five percent and ten percent. Our other, less volatile, lines have been aggregated and utilize hypothetical levels of volatility of three percent and five percent.
Pending the results of an appeal, this number does not include a $10.8 million judgment, net of reinsurance that was entered and incurred in 2008 in a lawsuit related to Hurricane Katrina.
Premiums are reported in income on a daily pro rata basis over the terms of the respective policies. Unearned premium reserves are established for the portion of premiums written applicable to the unexpired term of policies in force.
Certain costs of underwriting new business, principally commissions, premium taxes and variable underwriting and policy issue expenses, have been deferred. Such costs are being amortized as premium revenue is being recognized. Policy acquisition costs deferred in 2008, 2007 and 2006 were $111,521,000, $123,362,000 and $124,307,000, respectively. Amortization of deferred policy acquisition costs in 2008, 2007 and 2006 totaled $117,590,000, $123,420,000 and $118,756,000, respectively. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, losses and expenses to be incurred and certain other costs expected to be incurred as the premium is earned.
Our whole life and term insurance (traditional business) premiums are reported as earned when due and benefits and expenses are associated with premium income in order to result in the recognition of profits over the lives of the related contracts. On universal life and annuity policies (non-traditional business), income and expenses are reported when charged and credited to policyholder account balances in order to result in the recognition of profits over the lives of the related contracts. We accomplish this by means of a provision for future policy benefits and the deferral and subsequent amortization of life policy acquisition costs.
The effect on deferred policy acquisition costs that results from the assumed realization of unrealized gains (losses) is recognized with an offset to unrealized investment appreciation (depreciation) as of the balance sheet dates. As of December 31, 2008, pre-tax adjustments increased deferred policy acquisition costs by $36,284,000. As of December 31, 2007, pre-tax adjustments decreased deferred policy acquisition costs by $3,831,000.
In September 2005, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts.” SOP 05-1 provides guidance on accounting by insurance companies for deferred policy acquisition costs on internal replacements made primarily to contracts defined by SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” as short-duration and long-duration life insurance contracts, and by SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gain and Losses from the Sale of Investments,” as investment contracts. The SOP defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. Our adoption of SOP 05-1 effective January 1, 2007, did not have a material impact on the amounts reported for deferred life policy acquisition costs in our Consolidated Financial Statements.
In 2008, 2007 and 2006, we wrote-down certain holdings in our investment portfolio as a result of other-than-temporary declines in fair value and recorded a pre-tax realized loss of $9,904,000, $105,000 and $406,000, respectively. We continue to review all of our investment holdings for appropriate valuation on an ongoing basis. Refer to Note 2 “Summary of Investments” for a discussion of our accounting policy for impairment recognition.
In light of an April 8, 2008 Louisiana Supreme Court decision finding that flood damage was clearly excluded from coverage, state and federal courts have been reviewing the pending lawsuits seeking class certification and other pending lawsuits in order to expedite pre-trial discovery and to move the cases towards trial.
In July 2008, Lafayette Insurance Company participated in a hearing in St Bernard Parish, Louisiana after which the court entered a judgment certifying a class defined as all Lafayette Insurance Company personal lines policyholders within an eight parish area in and around New Orleans who sustained wind damage as a result of Hurricane Katrina and whose claim was at least partially denied or misadjusted. We have appealed this judgment as we feel it is not supported by the evidence. We expect the appeal process to take many months.
We intend to continue to defend the cases related to losses incurred as a consequence of Hurricane Katrina. We have established our loss and loss settlement expense reserves on the assumption that the application of the Valued Policy Law will not result in our having to pay damages for perils not otherwise covered. We believe that, in the aggregate, these reserves should be adequate. However, our evaluation of these claims and the adequacy of recorded reserves may change if we encounter adverse developments in the further defense of these claims.
We consider all of our other litigation pending at December 31, 2008, to be ordinary, routine, and incidental to our business.
For 2008, 2007 and 2006, we recognized stock-based compensation expense of $1,780,000, $1,377,000 and $1,175,000, respectively. As of December 31, 2008, we have $4,942,000 in stock-based compensation expense that has yet to be recognized through our results of operations. This compensation will be recognized over a term of five years, except with respect to awards that are accelerated by the Board of Directors, in which case any remaining compensation expense would be recognized in the period in which the awards are accelerated.
All collateral is held by Northern Trust. We have the right to access the deposited collateral only if the institution borrowing our securities is in default under the lending agreement. Therefore, we do not recognize the receipt of the deposited collateral held by Northern Trust, or the obligation to return it at the conclusion of the lending agreement, in our Consolidated Financial Statements. We also maintain effective control of the loaned securities, and have the right and ability to redeem the securities loaned on short notice. Therefore, we continue to classify these securities as invested assets in our Consolidated Financial Statements. Our participation in the securities lending program generated investment income of $89,000 in 2008. At December 31, 2008, we had no securities on loan under the program. We resumed our participation in the securities lending program in January 2009.
A reconciliation of the amortized cost (cost for equity securities) to fair value of investments in held-to-maturity and available-for-sale fixed maturity and equity securities as of December 31, 2008 and 2007, is as follows:
Our investment portfolio includes trading securities with embedded derivatives. These securities, which are primarily convertible redeemable preferred debt securities, are recorded at fair value. Income or loss, including the change in the fair value of these trading securities, is recognized currently in earnings as a component of realized investment gains. Our portfolio of trading securities had a fair value of $8,055,000 at December 31, 2008 and $10,793,000 at December 31, 2007.
Net investment income for the years ended December 31, 2008, 2007 and 2006, is composed of the following:
Includes an adjustment for the changes in fair value of our holdings in limited liability partnership funds, which are accounted for under the equity method of accounting.
We believe the deterioration in value of our fixed maturity portfolio is primarily attributable to changes in market interest rates and not the credit quality of the issuer. We have the ability and positive intent to hold the securities until such time as the value recovers or the securities mature.
Other long-term investments consist primarily of holdings in limited partnership funds that are valued by the various fund managers and are recorded on the equity method of accounting. In management’s opinion, these values represent fair value at December 31, 2008 and 2007.
The fair value of the liabilities for all annuity products is calculated based upon the estimated value of the business, using current market rates and forecast assumptions and risk-adjusted discount rates, in accordance with the provisions of SFAS No. 157, “Fair Value Measurements,” when relevant observable market data does not exist.
A summary of the carrying value and estimated fair value of our financial instruments at December 31, 2008 and 2007 is as follows:
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” which was effective January 1, 2008. SFAS No. 159 permits entities to choose to measure and report many financial instruments and certain other assets and liabilities at fair value. The objective of SFAS No. 159 is to improve financial reporting by providing entities the opportunity to reduce the complexity in accounting for financial instruments and to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently. The adoption of SFAS No. 159 did not have any impact on our Consolidated Financial Statements as we did not elect the fair value option to measure and report any eligible financial assets or financial liabilities at fair value.
In September 2006, the FASB issued SFAS No. 157, which was effective January 1, 2008. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosure requirements regarding fair value measurement. Where applicable, SFAS No. 157 simplifies and codifies previously issued guidance on fair value.
In February 2008, the FASB issued FASB Staff Position (FSP) SFAS No. 157-2, “Effective Date of FASB Statement No. 157,” which delays the application of SFAS No. 157, “Fair Value Measurements,” for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). As a result of the issuance of FSP SFAS 157-2, we did not apply the provisions of SFAS No. 157 to the nonfinancial assets, nonfinancial liabilities and reporting units within the scope of FSP FAS 157-2.
SFAS No. 157, as amended, establishes a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Our financial instruments are categorized into a three level hierarchy, which is based upon the priority of the inputs to the valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the instrument.
If the security has been written down or is in bankruptcy, management relies in part on outside opinions from rating agencies, our lien position on the security, general economic conditions and management’s expertise to determine fair value. We have the ability and the positive intent to hold these securities until such time that we are able to recover all or a portion of our original investment. If the security does not have a market at the balance sheet date, management will estimate the security’s fair value based on other securities in the market. Management will continue to monitor the security after the balance sheet date to confirm that their estimated fair value is reasonable.
The amounts reported in the previous table as realized and unrealized losses and transfers in relate primarily to the life insurance segment’s holdings of certain fixed maturity securities in default, for which an other-than-temporary impairment charge of $8,473,000 was recorded in 2008.
We maintain a $50,000,000 bank line of credit. Under the terms of the agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate minus 1.0 percent. No outstanding loan balances existed at December 31, 2008 and 2007, nor did we borrow against this line of credit in 2008, 2007 or 2006. As of December 31, 2008, approximately $186,000 of the line of credit was allocated towards letters of credit we have issued as a result of our reinsurance operations.
Reinsurance is a contract by which one insurer, called the reinsurer, agrees to cover, under certain defined circumstances, a portion of the losses incurred by a primary insurer if a claim is made under a policy issued by the primary insurer. Our property and casualty insurance companies follow the industry practice of reinsuring a portion of their exposure by ceding to reinsurers a portion of the premium received and a portion of the risk under the policies written. We purchase reinsurance to reduce the net liability on individual risks to predetermined limits and to protect us against catastrophic losses from a single catastrophe, such as a hurricane or tornado. We do not engage in any reinsurance transactions classified as finite risk reinsurance.
We account for premiums, written and earned, and losses incurred net of reinsurance ceded. The ceding of insurance does not legally discharge us from primary liability under our policies, and we must pay the loss if the reinsurer fails to meet its obligation. We periodically monitor the financial condition of our reinsurers to confirm that they are financially stable. We believe that all of our reinsurers are in an acceptable financial condition. At December 31, 2008, there were no reinsurance balances for which collection is at risk that would result in a material impact on our Consolidated Financial Statements.
Premiums, and loss and loss settlement expenses related to our ceded and assumed business is as follows:
We have several programs that provide reinsurance coverage. This reinsurance coverage limits the risk of loss that we retain by reinsuring direct risks in excess of our retention limits. The following table provides a summary of our primary reinsurance treaties. Retention amounts reflect the accumulated retentions and co-participation of all layers within a treaty.
In the event that we incur catastrophe losses covered by our reinsurance program, our catastrophe reinsurance treaty provides one guaranteed reinstatement at 100 percent of the original premium.
Because property and casualty insurance reserves are estimates of the unpaid portions of losses that have occurred, including IBNR losses, the establishment of appropriate reserves, including reserves for catastrophes, is an inherently uncertain and complex process. The ultimate cost of losses and related loss settlement expenses may vary materially from recorded amounts, which are based on management’s best estimates. We regularly update our reserve estimates as new information becomes available and as events unfold that may affect the resolution of unsettled claims. Changes in prior year reserve estimates, which may be material, are reported in losses and loss settlement expenses in the accompanying Consolidated Statements of Income in the period such changes are determined.
We are not aware of any significant contingent liabilities related to environmental issues. Because of the type of property coverage we write, we have potential exposure to environmental pollution, mold and asbestos claims. Our underwriters are aware of these exposures and use riders or endorsements to limit exposure.
Because United Fire & Casualty Company owns United Life Insurance Company, the property and casualty statutory capital and surplus includes life, accident and health statutory capital and surplus and therefore represents our total consolidated statutory capital and surplus.
We are directed by the state insurance departments’ solvency regulations to calculate a required minimum level of statutory capital and surplus based on insurance risk factors. The risk-based capital results are used by the NAIC and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 2008, both United Life Insurance Company and United Fire and its property and casualty subsidiaries and affiliate had statutory capital and surplus in regards to policyholders well in excess of their required levels.
A reconciliation of income tax expense (benefit) (computed at the applicable federal tax rate of 35 percent) to the amount recorded in the accompanying Consolidated Financial Statements is as follows:
The significant components of the net deferred tax liability at December 31, 2008 and 2007 are as follows:
The investment in United Fire common stock is stated at fair value based upon the closing price reported on a recognized securities exchange on the last business day of the year or, when no trades are reported, the bid price on that date. Our common stock is actively traded.
We use a December 31 measurement date for our noncontributory defined benefit pension plan and other retiree benefit plan. The following table provides a reconciliation of benefit obligations, plan assets and funded status of these plans:
Our accumulated pension benefit obligation was $58,227,000 and $55,993,000 at December 31, 2008 and 2007, respectively.
The following table summarizes the expected benefits to be paid from our plans over the next 10 years.
We have an employee stock ownership plan for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the plan upon completion of one year of service, meeting the hourly requirements with United Fire and attaining 21 years of age. Contributions to this plan are made at our discretion. These contributions are based upon a percentage of the total payroll and are allocated to participants on the basis of compensation. We make contributions in stock or cash, which the trustee uses to acquire shares of United Fire stock to allocate to participants’ accounts. As of December 31, 2008, 2007 and 2006, the employee stock ownership plan owned 241,796, 244,386 and 248,764 shares of United Fire common stock, respectively. Shares owned by the employee stock ownership plan are included in shares issued and outstanding for purposes of calculating earnings per share and dividends paid on the shares are charged to retained earnings. We made contributions to the plan of $150,000, $275,000 and $650,000 in 2008, 2007 and 2006, respectively.
At our annual stockholders’ meeting on May 21, 2008, United Fire stockholders approved the United Fire 2008 Stock Plan, which was an amendment and restatement of the United Fire Nonqualified Employee Stock Option Plan. The key changes to the plan increased the number of shares of our common stock available for issuance from 1,000,000 to 1,900,000 and provided for the issuance of restricted stock awards, stock appreciation rights, and incentive stock options, as defined in Section 422 of the Internal Revenue Code.
Option awards granted pursuant to the 2008 Stock Plan are granted to buy shares of United Fire’s common stock at the market value of the stock on the date of grant. Option awards vest and are exercisable in installments of 20.0 percent of the number of shares covered by the option award each year from the grant date, unless accelerated upon the approval by the Board of Directors. To the extent not exercised, vested option awards accumulate and are exercisable by the awardee, in whole or in part, in any subsequent year included in the option period, but not later than 10 years from the grant date. Restricted stock awards granted pursuant to the 2008 Stock Plan vest in five full years from the date of issuance, unless accelerated upon the approval of the Board of Directors, at which time United Fire common stock will be issued to the awardee. Restricted stock awards are generally granted free of charge to the eligible employees of United Fire as designated by the Board of Directors.
The activity in our nonemployee director stock option and restricted stock plan is displayed in the following table.
At December 31, 2008 we had 19,464 restricted stock awards outstanding, all of which were granted in May 2008 at a fair value of $33.43 per share, which resulted in $634,000 of compensation expense to be recognized over the next five years during the vesting period. The intrinsic value of the restricted stock awards outstanding totaled $605,000 for 2008.
The following table summarizes information regarding the stock options outstanding and exercisable at December 31, 2008:
We write both commercial and personal lines of property and casualty insurance. We focus on our commercial lines, which represented 92.6 percent of our property and casualty insurance premiums earned for 2008. Our personal lines represented 7.4 percent of our property and casualty insurance premiums earned for 2008.
In September 2008, our New Orleans, Louisiana claims office in Metairie closed for three days due to Hurricane Gustav and our Gulf Coast regional office in Galveston, Texas was temporarily closed for three weeks due to Hurricane Ike. We recorded $399,000 of hurricane-related expenses in 2008, which primarily relates to costs incurred to remove damaged contents from the affected areas and establish a temporary facility for our Gulf Coast regional office. We anticipate incurring additional expenses for the clean-up and restoration of the affected areas and other related costs. A portion of these costs will be subject to recovery under our insurance. As of December 31, 2008, no such recovery has been recorded against the expenses incurred.
We believe that any additional charges incurred in 2009 would be minimal and immaterial and to our results of operations.
Fire and allied lines includes fire, allied lines, homeowners, commercial multiple peril and inland marine.
Other liability is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured’s premises and products manufactured or sold.
Outstanding options to purchase shares of common stock (in all years presented) were excluded from the diluted earnings per share calculation because the effect of including them would have been anti-dilutive.
Comprehensive income (loss) includes changes in stockholders’ equity during a period except those resulting from investments by and dividends to stockholders. The following table sets forth the components of comprehensive income (loss) and the related tax effects for 2008, 2007 and 2006.
At December 31, 2008, we were obligated under noncancelable operating lease agreements for office space, vehicles, computer equipment and office equipment. Most of our leases include renewal options, purchase options or both. These provisions may be exercised by us upon the expiration of the related lease agreements. Rental expense under our operating lease agreements was $4,085,000, $4,785,000 and $4,714,000 for 2008, 2007 and 2006, respectively.
Our most significant lease arrangement is for office space for our regional office in Galveston, Texas. This lease expires in December 2014. The annual lease payments for this office space total approximately $2,100,000. Due to damage from Hurricane Ike, this office is currently undergoing reconstruction and we have not been obligated to make a lease payment since October 2008. Rental payments for this space will resume, if and when we return to this location. We are temporarily leasing office space in a suburb of Houston, Texas for our Gulf Coast Regional Office operations.
At December 31, 2008, our future minimum rental payments are as follows:
We have audited the accompanying consolidated balance sheets of United Fire & Casualty Company (United Fire) as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedules of United Fire listed in Item 15(a)(2). These financial statements and schedules are the responsibility of United Fire’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of United Fire & Casualty Company at December 31, 2008 and 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, 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 financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of United Fire’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report, dated March 2, 2009, expressed an unqualified opinion thereon.
The management of United Fire & Casualty Company is responsible for establishing and maintaining adequate internal control over financial reporting. United Fire & Casualty Company’s internal control over financial reporting is a process designed under the supervision of its Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of its consolidated financial statements for external purposes in accordance with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balances sheets of United Fire & Casualty Company as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008, and our report dated March 2, 2009, expressed an unqualified opinion thereon.