Item 1A. Risk Factors
Insurance Industry
Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance industry, which may cause the price of our securities to be volatile.
The results of operations of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by:
21
• Changes in the level of reinsurance capacity,
In addition, the demand for property and casualty insurance, both admitted and excess and surplus lines, can vary significantly, rising as the overall level of economic activity increases and falling as that activity decreases, causing our revenues to fluctuate. These fluctuations in results of operations and revenues may not reflect long-term results and may cause the price of our securities to be volatile.
Our business is concentrated in several key states and a change in our business in one of those states could disproportionately affect our financial condition or results of operations.
Although we operate in all 50 states, 51 percent of our direct premiums earned were generated in four states in 2020: California – 17 percent; New York – 14 percent: Florida – 10 percent; and Texas – 10 percent. An interruption in our operations, or a negative change in the business environment, insurance market or regulatory environment in one or more of these states could have a disproportionate effect on our business and direct premiums earned.
We compete with a large number of companies in the insurance industry to underwrite premium and their actions could ultimately impact our overall results.
We compete with a large number of other companies in our selected lines of business. We are vulnerable to the actions of other companies who may seek to write business without the appropriate regard for risk and profitability, especially during periods of intense competition for premium. During these times, it is very difficult to grow or maintain premium volume without sacrificing underwriting discipline and income.
We face competition from specialty insurance companies, underwriting agencies and intermediaries, as well as diversified financial services companies that are significantly larger than we are, and that have significantly greater financial, marketing, management and other resources. We may also face competition from new sources of capital such as institutional investors seeking access to the insurance market, sometimes referred to as alternative capital, which may depress pricing or limit our opportunities to write business. Some of these competitors also have stronger brand awareness than we do. We may incur increased costs in competing for premium. If we are unable to compete effectively in the markets we operate in or are not successful expanding our operations into new markets, the amount of premium we write may decline, as well as overall business results.
A number of new, proposed or potential legislative or industry developments could further increase competition in our industry, including:
New competition from these developments could cause the supply and/or demand for insurance or reinsurance to change, which could affect our ability to price our coverages at attractive rates and thereby adversely affect our underwriting results.
22
A downgrade in our ratings from AM Best, Standard & Poor’s or Moody’s could negatively affect our business.
Financial strength ratings are an important factor in establishing the competitive position of insurance companies. Our insurance companies are rated for overall financial strength by AM Best, Standard & Poor’s and Moody’s. AM Best, Standard & Poor’s and Moody’s ratings are independent opinions of an insurer’s financial strength and ability to meet ongoing insurance policy and contract obligations, based on a comprehensive quantitative and qualitative analysis of balance sheet strength, operating performance, business profile and enterprise risk management. These financial strength ratings are based on factors relevant to policyholders, agents, insurance brokers and intermediaries and are not specifically related to securities issued by the company. The view of required capital may differ between rating agencies, as well as from RLI Corp.’s own view of desired capital. Our ratings are subject to periodic review by such firms, and the criteria used in the rating methodologies is subject to change. As such, we cannot assure the continued maintenance of our current ratings.
All of our ratings were reviewed during 2020. AM Best reaffirmed its A+, Superior rating for the combined entity of RLI Ins., Mt. Hawley and CBIC (group-rated). Standard & Poor’s reaffirmed our A+, Strong rating for the group of RLI Ins. and Mt. Hawley and kept the group on negative outlook, indicating they believe the group may be downgraded over the next six to 24 months. Moody’s reaffirmed our group rating of A2 for RLI Ins. and Mt. Hawley. If our ratings are significantly reduced from their current levels by AM Best, Standard & Poor’s or Moody’s, our competitive position in the industry, and therefore our business, could be adversely affected. A measurable downgrade could result in a substantial loss of business, as policyholders might move to other companies with greater financial strength ratings.
We are subject to extensive governmental regulation, which may adversely affect our ability to achieve our business objectives. Moreover, if we fail to comply with these regulations, we may be subject to penalties, including fines and suspensions, which may adversely affect our financial condition, results of operations and reputation.
Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other stakeholders. These regulations, generally administered by a department of insurance in each state and territory in which we do business, relate to, among other things:
• Approval of policy forms and premium rates,
• Standards of solvency, including risk-based capital measurements,
• Licensing of insurers and their producers,
• Restrictions on agreements with our large revenue-producing agents,
• Cancellation and non-renewal of policies,
• Restrictions on the nature, quality and concentration of investments,
• Restrictions on the size of risks insurable under a single policy,
• Requiring deposits for the benefit of policyholders,
• Requiring certain methods of accounting,
• Periodic examinations of our operations and finances,
• Requiring reserves for unearned premium, losses and other purposes.
These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives.
In addition, regulatory authorities have relatively broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. In some instances, we follow practices based on our interpretations of regulations or practices that we believe
23
may be generally followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could initiate investigations or other proceedings, fine the Company, preclude or temporarily suspend the Company from carrying on some or all of its activities or otherwise penalize the Company. This could adversely affect our ability to operate our business. Further, changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect our ability to operate our business as currently conducted.
In addition to regulations specific to the insurance industry, including the insurance laws of our principal state regulator (Illinois), as a public company we are also subject to the rules and regulations of the U.S. Securities and Exchange Commission and the New York Stock Exchange (NYSE), each of which regulate many areas such as financial and business disclosures, corporate governance and shareholder matters. We are also subject to the corporation laws of Delaware, where we are incorporated. At the federal level, among other laws, we are subject to the Sarbanes-Oxley Act and the Dodd-Frank Act, each of which regulate corporate governance, executive compensation and other areas, as well as laws relating to federal trade restrictions, privacy/data security and terrorism risk insurance laws. We monitor these laws, regulations and rules on an ongoing basis to ensure compliance and make appropriate changes as necessary. Implementing such changes may require adjustments to our business methods, increases to our costs and other changes that could cause the Company to be less competitive in the industry.
Our loss reserves are based on estimates and may be inadequate to cover our actual insured losses, which would negatively impact our profitability.
Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the payment of that loss. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and the related loss adjustment expenses. Loss reserves are estimates of the ultimate cost of claims and do not represent an exact calculation of liability. These estimates are based on historical information and on estimates of future trends that may affect the frequency and severity of claims that may be reported in the future.
Estimating loss reserves is a difficult, complex and inherently uncertain process involving many variables and subjective judgments. Changes in industry practices, and in legal, legislative, regulatory, judicial, social and other conditions under which we operate may require us to pay claims we did not intend to cover when we wrote the policies. These changes may serve to extend the time for making claims, extend coverage and increase damages. These changes may not become apparent until after we have issued policies or bonds that are affected by the changes and, consequently, we may not know the extent of our liability and the impact to our financial performance until many years after a policy or bond was issued. The effects of these and other coverage issues are difficult to predict and could have a materially adverse effect on our financial performance.
As part of the reserving process, we review historical data and consider the impact of various factors such as:
• Loss emergence and cedant reporting patterns,
• Underlying policy terms and conditions,
• Business and exposure mix,
• Emerging coverage issues,
• Trends in claim frequency and severity,
• Changes in operations,
• Emerging economic and social trends,
• Inflation in amounts awarded by courts and juries and
• Changes in the regulatory and litigation environments.
This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. It also assumes adequate historical or other data exists upon which to make these judgments. For more information on the estimates used in the establishment of loss reserves, see the Loss and Settlement Expenses section of our Critical Accounting Policies contained within Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations. However, there is no precise method for evaluating the impact of any specific factor on the adequacy of
24
reserves and actual results are likely to differ from original estimates. If the actual amount of insured losses is greater than the amount we have reserved for these losses, our profitability could suffer.
Catastrophic losses, including those caused by natural disasters, such as earthquakes and hurricanes, or man-made events such as terrorist attacks, are inherently unpredictable and could cause the Company to suffer material financial losses. Our approaches to catastrophic risk mitigation are largely based on estimates and modeling and, thus, may be inadequate to cover the losses from such events. Climate change could further increase the severity and volatility of weather-related losses.
We face the risk of property damage resulting from catastrophic events, particularly earthquakes on the West Coast and hurricanes and tropical storms affecting the continental U.S. or Hawaii. We also face risk from lava flows in Hawaii impacting our homeowners’ business and from wildfires, particularly on the West Coast. Since the Northridge, California earthquake in 1994, most of our catastrophe-related claims have resulted from hurricanes and other seasonal storms such as tornadoes and hail storms.
The incidence and severity of CATs are inherently unpredictable. The extent of losses from a CAT is a function of both the total amount of insured values in the area affected by the event and the severity of the event. Most CATs are restricted to fairly specific geographic areas. However, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. In addition to hurricanes and earthquakes, CAT losses can occur from windstorms, severe winter weather and fires and may include terrorist events. In addition, climate change could have an impact on longer-term natural CAT trends. Extreme weather events that are linked to rising temperatures, changing global weather patterns, sea, land and air temperatures, as well as sea levels, rain and snow could result in increased occurrence and severity of CATs. CATs can cause losses in a variety of our property and casualty products, and it is possible that a catastrophic event or multiple catastrophic events could cause the Company to suffer material financial losses. In addition, CAT claim costs may be higher than we originally estimate and could cause substantial volatility in our financial results for any fiscal quarter or year. Our ability to write new business could also be affected. We believe that increases in the value and geographic concentration of insured property, the effects of inflation and the growth of our workers’ compensation business could also increase the severity of claims from CAT events in the future.
We use models to help assess exposure to catastrophic events against established thresholds. CAT models cannot contemplate all possible CAT scenarios and include underlying assumptions based on a limited set of actual events. The losses we might incur from an actual catastrophe could be higher than our expectation of losses generated from modeled catastrophe scenarios, which could have a materially adverse effect on our results of operations and financial condition. To address uncertainty related to CAT models, we also monitor against thresholds using non-modeled metrics.
For information on our approaches to catastrophe risk mitigation, including reinsurance and catastrophe modeling, see the Property Reinsurance – Catastrophe Coverage section within Item 1. Business and note 1.S. to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Our reinsurers may not pay on losses in a timely fashion, or at all, which may increase our costs and have an adverse effect on our business.
We purchase reinsurance to transfer part of the risk we have assumed (known as ceding) to a reinsurance company in exchange for part of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to the Company to the extent the risk is transferred or ceded to the reinsurer, it does not relieve the Company (the reinsured) of its liability to its policyholders. Accordingly, we bear credit risk with respect to our reinsurers. That is, our reinsurers may not pay claims made by the Company on a timely basis, or they may not pay some or all of these claims for a variety of reasons. Either of these events would increase our costs and could have a materially adverse effect on our business.
If we cannot obtain adequate reinsurance protection for the risks we have underwritten or at prices we deem acceptable, we may be exposed to greater losses from these risks or we may reduce the amount of business we underwrite, which would reduce our revenues.
Market conditions beyond our control determine the availability and cost of the reinsurance protection that we purchase. In addition, the historical results of reinsurance programs and the availability of capital also affect the availability of reinsurance. Our reinsurance agreements are generally subject to annual renewal. We cannot be sure that we can maintain our current reinsurance protection, obtain other reinsurance facilities in adequate amounts and at favorable rates, or diversify our exposure among an adequate number of high-quality reinsurance partners. If we are unable to renew our expiring facilities or to obtain new reinsurance facilities on terms we deem acceptable, either our net exposures would increase—which could increase the volatility of our results—or, if we were unwilling to bear an increase in net exposures, we would have to reduce the level of our underwriting commitments, which would reduce our revenues.
25
Financial and Investment
Adverse changes in the economy could lower the demand for our insurance products and could have an adverse effect on the revenue and profitability of our operations.
Factors such as business revenue, construction spending, government spending, the volatility and strength of the capital markets and inflation can all affect the business and economic environment. These same factors affect our ability to generate revenue and profits. Insurance premiums in our markets are heavily dependent on our customer revenues, value of goods transported, miles traveled and number of new projects initiated. In an economic downturn characterized by higher unemployment, declines in construction spending and reduced corporate revenues, the demand for insurance products is adversely affected. Adverse changes in the economy may lead our customers to have less need or desire for insurance coverage, to cancel existing insurance policies, to modify coverage or to not renew with the Company, all of which affect our ability to generate revenue. In addition, as approximately a third of our business relates to the construction industry, our results of operations could be significantly impacted in an economic downturn if the construction industry is affected disproportionally.
Access to capital and market liquidity may adversely affect our ability to take advantage of business opportunities as they arise.
Our ability to grow our business depends, in part, on our ability to access capital when needed. We cannot predict capital market liquidity or the availability of capital. We also cannot predict the extent and duration of future economic and market disruptions, the impact of government interventions into the market to address these disruptions and their combined impact on our industry, business and investment portfolios. If our company needs capital but cannot raise it, our business and future growth could be adversely affected.
We are an insurance holding company and therefore may not be able to receive adequate or timely dividends from our insurance subsidiaries.
RLI Corp. is the holding company for our three insurance operating companies. At the holding company level, our principal assets are the shares of capital stock of our insurance company subsidiaries. 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. 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 IDOI. As a result, we may not be able to receive dividends from such subsidiary at times and in amounts necessary to pay RLI Corp. obligations and desired dividends to shareholders. Ordinary dividends, which may be paid by our principal insurance subsidiary without prior regulatory approval, are subject to certain limitations based upon 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. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval (or non-disapproval) from the IDOI. Because the limitations are based upon a rolling 12-month period, the presence, amount and impact of these restrictions vary over time.
We may not be able to, or might not choose to, continue paying dividends on our common stock.
We have a history of paying regular, quarterly dividends and in recent years have paid special dividends. Any determination to pay either type of dividend to our stockholders in the future will be at the discretion of our board of directors and will depend on our results of operations, financial condition and other factors deemed relevant by our board of directors. Our ability to pay dividends depends largely on our subsidiaries’ earnings and operating capital requirements, and is subject to the regulatory, contractual and other constraints of our subsidiaries, including the effect of any such dividends or distributions on the AM Best rating or other ratings of our insurance subsidiaries. In addition, we may choose to retain capital to support growth or further mitigate risk, instead of returning excess capital to our shareholders.
Our investment results and, therefore, our financial condition may be impacted by changes in the business, financial condition or operating results of the entities in which we invest, as well as changes in interest rates, government monetary policies, general economic conditions, liquidity and overall market conditions.
We invest the premiums we receive from customers until they are needed to pay expenses or policyholder claims. Funds remaining after paying expenses and claims remain invested and are included in retained earnings. The value of our investment portfolio can fluctuate as a result of changes in the business, financial condition or operating results of the entities in which we invest. In addition, fluctuations can result from changes in interest rates, credit risk, government monetary policies, liquidity of holdings and general economic conditions. The equity portfolio will fluctuate with movements in the overall stock market. While the equity portfolio has been constructed to have lower downside risk than the market, the portfolio is positively correlated with movements in domestic stocks. The bond portfolio is affected by interest rate changes and movement in credit spreads. We attempt to mitigate our
26
interest rate and credit risks by constructing a well-diversified portfolio of high-quality securities with varied maturities. These fluctuations may negatively impact our financial condition.
Operational
Our success will depend on our ability to maintain and enhance effective operating procedures and manage risks on an enterprise wide basis.
Operational risk and losses can result from, among other things, fraud, errors, failure to document transactions properly, failure to obtain proper internal authorization, failure to comply with regulatory requirements, information technology failures or external events. We continue to enhance our operating procedures and internal controls to effectively support our business and our regulatory and reporting requirements. The NAIC and state legislatures have increased their focus on risks within an insurer’s holding company system that may pose enterprise risk to insurers. The Illinois legislature has adopted the Risk Management and ORSA Law, which requires domestic insurers to maintain a risk management framework and establishes a legal requirement for domestic insurers to conduct an ORSA in accordance with the NAIC’s ORSA Guidance Manual. The ORSA Law also provides that, no less than annually, an insurer must submit an ORSA summary report. Under the Illinois insurance holding company laws, on an annual basis, we are also required to file an enterprise risk report with the IDOI, which is intended to identify the material risks within our insurance holding company system that could pose enterprise risk to our insurance company subsidiaries. We operate within an enterprise risk management (ERM) framework designed to assess and monitor our risks. However, assurance that we can effectively review and monitor all risks or that all of our employees will operate within the ERM framework cannot be guaranteed. Assurances that our ERM framework will result in the Company accurately identifying all risks and accurately limiting our exposures based on our assessments also cannot be guaranteed.
We may not be able to effectively start up or integrate new product opportunities.
Our ability to grow our business depends, in part, on our creation, implementation or acquisition of new insurance products that are profitable and fit within our business model. Our ability to grow profitably requires that we identify market opportunities, which may include acquisitions, and that we attract and retain underwriting and claims expertise to support that growth. New product launches, as well as resources to integrate business acquisitions are subject to many obstacles, including ensuring we have sufficient business and systems processes, determining appropriate pricing, obtaining reinsurance, assessing opportunity costs and regulatory burdens and planning for internal infrastructure needs. If we cannot effectively or accurately assess and overcome these obstacles, or we improperly implement new insurance products, our ability to grow profitably could be impaired.
We may be unable to attract and retain qualified key employees.
We depend on our ability to attract and retain experienced underwriting and claim talent, who have deep knowledge of the niche business we write, and other skilled employees. If we cannot attract or retain top-performing executive officers, underwriters and other employees, the quality of their performance decreases or we fail to implement succession plans for our key employees, we may be unable to maintain our current competitive position in the markets in which we operate or expand our operations into new markets.
We rely on third-party vendors for a number of key components of our business.
We contract with a number of third-party vendors to support our business. For example, we have license agreements for software that we use to model natural catastrophes, process claims, and manage policies, producers and financial processes. The vendors range from large national companies, who are dominant in their area of expertise and would be difficult to quickly replace, to smaller or start-up vendors with leading technology, but with shorter operating histories and fewer financial resources. Failures of certain vendors to provide services could adversely affect our ability to deliver products and services to our customers, disrupting our business and causing the Company to incur significant expense. If one or more of our vendors fail to protect personal information of our customers, claimants or employees, we may incur operational impairments, or could be exposed to litigation, compliance costs or reputation damage. We maintain a vendor management program to establish procurement policies and to monitor vendor risk, including the security and stability of our critical vendors.
Any significant interruption in the operation of our facilities, systems and business functions could adversely affect our financial condition and results of operations.
We rely on multiple computer systems to interact with producers and customers, issue policies, pay claims, run modeling functions, assess insurance risks and complete various important internal processes including accounting and bookkeeping. Our business is highly dependent on our ability to access these systems to perform necessary business functions. Additionally, some of these systems may include or rely upon third-party systems not located on our premises. Any of these systems may be exposed to unplanned interruption, unreliability or intrusion from a variety of causes, including among others, storms and other natural disasters, terrorist attacks, utility outages or complications encountered as existing systems are replaced or upgraded.
27
Any such issues could materially impact our company including the impairment of information availability, compromise of system integrity/accuracy, misappropriation of confidential information, reduction of our volume of transactions and interruption of our general business. Although we believe our computer systems are secure and continue to take steps to ensure they are protected against such risks, we cannot guarantee such problems will not occur. If they do, interruption to our business and damage to our reputation and related costs, could be significant, which could impair our profitability.
Epidemics, pandemics and public health outbreaks, including the ongoing coronavirus (COVID-19) pandemic, could adversely affect our business, including revenues, profitability, results of operations and/or cash flows, in a manner and to a degree that could be material.
Epidemics, pandemics and other public health outbreaks generally result in significant disruptions in economic activity and financial markets. The cumulative effects on the Company could include, without limitation:
• Reduced cash flows from our policyholders, delaying premium payments,
• Increased claims, losses, litigation and related expenses,
• The decline in interest rates which could reduce future investment results.
Although we have investigated and closed a substantial number of COVID-19-related claims without payment, state and federal courts could rule that such claims are covered under our policies. Court decisions upholding our position that these COVID-19 related claims are not covered under our policies could also be overturned on appeal. These actions could result in an increase in claims and paid losses, which could have a materially adverse effect on our financial performance. Such appellate court decisions may take several years to become final and their ultimate outcome is uncertain at this time.
We have experienced declines in premium in select product lines and established loss and defense reserves for others as a result of COVID-19. The extent and duration of the premium declines cannot be determined and could continue to negatively impact our operating results. While other impacts that could result from pandemics have not manifested to a significant degree for RLI through the end of 2020, circumstances continue to change and we could be affected in different ways in the future. To the extent the COVID-19 pandemic adversely affects our business and financial results, it may also heighten many of the other risks described herein.
If we are unable to keep pace with the technological advancements in the insurance industry, our ability to compete effectively could be impaired.
Our operations rely upon complex and expensive information technology systems for interacting with policyholders, brokers and other business partners. The pace at which information systems must be upgraded is continually increasing, requiring an ongoing commitment of significant resources to maintain or upgrade to current standards and serve our customers. If we are unable to keep pace with the advancements being made in technology, our ability to compete with other insurance companies who have advanced technological capabilities will be negatively affected. Further, if we are unable to effectively update or replace our key legacy technology systems as they become obsolete or as emerging technology renders them competitively inefficient, our competitive position, security and our cost structure could be adversely affected.
28
Technology breaches or failures, including but not limited to cyber security incidents, could disrupt our operations, result in the loss of critical and confidential information and expose us to additional liabilities, which could adversely impact our reputation and results of operations.
Global cyber security threats can range from uncoordinated individual attempts to gain unauthorized access to our information technology systems and those of our business partners or service providers to sophisticated and targeted measures known as advanced persistent threats. Like other companies, RLI Corp. is also subject to insider threats that may impact the confidentiality, integrity or availability of our data. We, our business partners and service providers employ measures to prevent, detect, address and mitigate these threats (including access controls, data encryption, vulnerability assessments, continuous monitoring of information technology networks and systems and maintenance of backup and protective systems). However, cyber security incidents, depending on their nature and scope, could potentially result in the misappropriation, destruction, corruption or unavailability of critical data and confidential or proprietary information (our own or that of third parties) and the disruption of business operations. Security breaches could expose the Company to a risk of loss or misuse of our or our customers’ information, litigation and potential liability. In addition, cyber incidents that impact the availability, reliability, speed, accuracy or other proper functioning of our technology systems could impact our operations. We may not have the resources or technical sophistication to anticipate or prevent every type of cyber attack. A significant cyber incident, including system failure, security breach, disruption by malware or other damage could interrupt or delay our operations, result in a violation of applicable privacy and other laws, damage our reputation, cause a loss of customers or give rise to remediation costs, monetary fines and other penalties, which could be significant. We have cyber insurance, but it is possible that the coverage we have in place would not entirely protect the Company in the event that we experienced a cyber security incident, interruption or widespread failure of our information technology systems.
We may suffer losses from litigation, which could materially and adversely affect our financial condition and business operations.
We continually face risks associated with litigation of various types, including general commercial and corporate litigation, and disputes relating to bad faith allegations that could result in the Company incurring losses in excess of policy limits. We are party to a variety of litigation matters throughout the year. Litigation is subject to inherent uncertainties, and if there were an unfavorable outcome, there exists the possibility of a material adverse impact on our results of operations and financial position in the period in which the outcome occurs. Even if an unfavorable outcome does not materialize, we still may face substantial expense and disruption associated with the litigation.
Anti-takeover provisions affecting the Company could prevent or delay a change of control that is beneficial to you.
Provisions of our certificate of incorporation and by-laws, as well as applicable Delaware law, federal and state regulations and insurance company regulations may discourage, delay or prevent a merger, tender offer or other change of control that holders of our securities may consider favorable. Some of these provisions impose various procedural and other requirements that could make it more difficult for shareholders to effect certain corporate actions. These provisions could:
• Discourage bids for our securities at a premium over the market price,
• Impede the ability of the holders of our securities to change our management.
In particular, we are subject to Section 203 of the Delaware General Corporation Law which, under certain circumstances, restricts our ability to engage in a business combination, such as a merger or sale of assets, with any stockholder that, together with affiliates, owns 15 percent or more of our common stock, which similarly could prohibit or delay the accomplishment of a change of control transaction.
Item 1B. Unresolved Staff Comments - None.
Item 2.Properties
We own five commercial buildings totaling 173,000 square feet on our 23-acre campus that serves as our corporate headquarters in Peoria, Illinois. All of our branch offices and other company operations lease office space throughout the country. Management considers our office facilities suitable and adequate for our current levels of operations.
29
Item 3. Legal Proceedings
Information on our legal proceedings is set forth in note 10 to the Consolidated Financial Statements included under Item 8, Financial Statements and Supplementary Data.
Item 4.Mine Safety Disclosures - Not applicable.
30
PART II
Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
RLI Corp. common stock trades on the New York Stock Exchange under the symbol RLI. RLI Corp. has paid dividends for 178 consecutive quarters and increased quarterly dividends in each of the last 45 years. In December 2020 and 2019, RLI Corp. paid special cash dividends of $1.00 per share to shareholders. As of February 8, 2021, there were 853 registered holders of the Company’s common stock.
Performance
The following graph provides a five-year comparison of RLI Corp.’s total return to shareholders compared to that of the S&P 500 and S&P 500 P&C Index:
Assumes $100 invested on December 31, 2015, in RLI, S&P 500 and S&P 500 P&C Index, with reinvestment of dividends. Comparison of five-year annualized total return — RLI: 14.5%, S&P 500: 15.2% and S&P 500 P&C Index: 12.5%.
Securities Authorized for Issuance under Equity Compensation Plans
Refer to Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” of this document for information on securities authorized for issuance under our equity compensation plan.
Recent Sales of Unregistered Securities; Uses of Proceeds from Registered Securities - Not applicable.
Equity Repurchases
In 2010, our board of directors implemented a $100 million share repurchase program. We last repurchased shares in 2011. We have $87.5 million of remaining capacity from the repurchase program. The repurchase program may be suspended or discontinued at any time without prior notice.
Item 6. Selected Financial Data – Not applicable.
31
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
RLI Corp. is a U.S. based, specialty insurance company that underwrites select property and casualty insurance through major subsidiaries collectively known as RLI Insurance Group (Group). Our focus is on niche markets and developing unique products that are tailored to customers’ needs. We hire underwriters and claim examiners with deep expertise and provide exceptional customer service and support. We maintain a highly diverse product portfolio and underwrite for profit in all market conditions. In 2020, we achieved our 25th consecutive year of underwriting profitability. Over the 25-year period, we averaged an 88.4 combined ratio. This drives our ability to provide shareholder returns in three different ways: the underwriting income itself, net investment income from our investment portfolio and long-term appreciation in our equity portfolio.
We measure the results of our insurance operations by monitoring growth and profitability across three distinct business segments: casualty, property and surety. Growth is measured in terms of gross premiums written, and profitability is analyzed through combined ratios, which are further subdivided into their respective loss and expense components.
GAAP, NON-GAAP AND PERFORMANCE MEASURES
Throughout this annual report, we include certain non-generally accepted accounting principles (non-GAAP) financial measures. Management believes that these non-GAAP measures further explain the Company’s results of operations and allow for a more complete understanding of the underlying trends in the Company’s business. These measures should not be viewed as a substitute for those determined in accordance with generally accepted accounting principles in the United States of America (GAAP). In addition, our definitions of these items may not be comparable to the definitions used by other companies.
Following is a list of non-GAAP measures found throughout this report with their definitions, relationships to GAAP measures and explanations of their importance to our operations.
Underwriting Income
Underwriting income or profit represents one measure of the pretax profitability of our insurance operations and is derived by subtracting losses and settlement expenses, policy acquisition costs and insurance operating expenses from net premiums earned, which are all GAAP financial measures. Each of these captions is presented in the statements of earnings but is not subtotaled. However, this information is available in total and by segment in note 12 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data. The nearest comparable GAAP measure is earnings before income taxes which, in addition to underwriting income, includes net investment income, net realized gains or losses, net unrealized gains or losses on equity securities, general corporate expenses, debt costs and our portion of earnings from unconsolidated investees. A reconciliation of net earnings to underwriting income follows:
Year ended December 31,
Equity in earnings of unconsolidated investees (20,233 ) (20,960 )
Net unrealized gains on equity securities (32,101 ) (78,090 )
Combined Ratio
The combined ratio, which is derived from components of underwriting income, is a common industry performance measure of profitability for underwriting operations 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.
32
CRITICAL ACCOUNTING POLICIES
In preparing the consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.
The most critical accounting policies involve significant estimates and include those used in determining the liability for unpaid losses and settlement expenses, investment valuation, recoverability of reinsurance balances, deferred policy acquisition costs and deferred taxes.
LOSSES AND SETTLEMENT EXPENSES
Overview
Loss and loss adjustment expense (LAE) reserves represent our best estimate of ultimate payments for losses and related settlement expenses from claims that have been reported but not paid, and those losses that have occurred but have not yet been reported to the Company. Loss reserves do not represent an exact calculation of liability, but instead represent our estimates, generally utilizing individual claim estimates, actuarial expertise and estimation techniques at a given accounting date. The loss reserve estimates are expectations of what ultimate settlement and administration of claims will cost upon final resolution. These estimates are based on facts and circumstances then known to the Company, review of historical settlement patterns, estimates of trends in claims frequency and severity, projections of loss costs, expected interpretations of legal theories of liability and many other factors. In establishing reserves, we also take into account estimated recoveries from reinsurance, salvage and subrogation. The reserves are reviewed regularly by a team of actuaries we employ.
The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables. These variables can be affected by both internal and external events, such as changes in claim handling procedures, claim personnel, economic inflation, legal trends and legislative changes, among others. The impact of many of these items on ultimate costs for loss and LAE is difficult to estimate. Loss reserve estimations also differ significantly by coverage due to differences in claim complexity, the volume of claims, the policy limits written, the terms and conditions of the underlying policies, the potential severity of individual claims, the determination of occurrence date for a claim and reporting lags (the time between the occurrence of the policyholder event and when it is actually reported to the insurer). Informed judgment is applied throughout the process. We continually refine our loss reserve estimates as historical loss experience develops and additional claims are reported and settled. We rigorously attempt to consider all significant facts and circumstances known at the time loss reserves are established.
Due to inherent uncertainty underlying loss reserve estimates, including, but not limited to, the future settlement environment, final resolution of the estimated liability may be different from that anticipated at the reporting date. Therefore, actual paid losses in the future may yield a significantly different amount than currently reserved — favorable or unfavorable.
The amount by which current estimated losses differ from those estimated for a period at a prior valuation date is known as development. Development is unfavorable when the losses ultimately settle for more than the levels at which they were reserved or subsequent estimates indicate a basis for reserve increases on unresolved claims. Development is favorable when losses ultimately settle for less than the amount reserved or subsequent estimates indicate a basis for reducing loss reserves on unresolved claims. We reflect favorable or unfavorable development of loss reserves in the results of operations in the period the estimates are changed.
We record two categories of loss and LAE reserves: case-specific reserves and IBNR reserves.
Within a reasonable period of time after a claim is reported, our claim department completes an initial investigation and establishes a case reserve. This case-specific reserve is an estimate of the ultimate amount we will have to pay for the claim, including related legal expenses and other costs associated with resolving and settling it. The estimate reflects all of the current information available regarding the claim, the informed judgment of our professional claim personnel regarding the nature and value of the specific type of claim and our reserving practices. During the life cycle of a particular claim, as more information becomes available, we may revise the estimate of the ultimate value of the claim either upward or downward. We may determine that it is appropriate to pay portions of the reserve to the claimant or related settlement expenses before final resolution of the claim. The amount of the individual case reserve will be adjusted accordingly and is based on the most recent information available.
We establish IBNR reserves to estimate the amount we will have to pay for claims that have occurred, but have not yet been reported to the Company, claims that have been reported to the Company that may ultimately be paid out differently than reflected in our case-specific reserves and claims that have been closed but may reopen and require future payment.
33
Our IBNR reserving process involves three steps: (1) an initial IBNR generation process that is prospective in nature, (2) a loss and LAE reserve estimation process that occurs retrospectively and (3) a subsequent discussion and reconciliation between our prospective and retrospective IBNR estimates, which includes changes in our provisions for IBNR where deemed appropriate. These three processes are discussed in more detail in the following sections.
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 adjuster typically estimates this cost separately from the loss component in the case reserve. Unallocated loss adjustment expense (ULAE) reserves represent an estimate of claims settlement expenses that cannot be identified with a specific claim. An example of ULAE would be the cost of an internal claim examiner to manage or investigate claims.
Our best estimate of ultimate loss and LAE reserves are proposed by our lead reserving actuary and approved by our Loss Reserve Committee (LRC). The LRC is made up of various members of the management team including the lead reserving actuary, chief executive officer, chief operating officer, chief financial officer, chief legal officer and other selected executives. We do not use discounting (recognition of the time value of money) in reporting our estimated reserves for losses and settlement expenses. Based on current assumptions used in calculating reserves, we believe that our reserve levels at December 31, 2020, make a reasonable provision to meet our future obligations.
Initial IBNR Generation Process
Initial carried IBNR reserves are determined through a reserve generation process. The intent of this process is to establish an initial total reserve that will provide a reasonable provision for the ultimate value of all unpaid loss and ALAE liabilities. For most casualty and surety products, this process involves the use of an initial loss and ALAE ratio that is applied to the earned premium for a given period. The result is our best initial estimate of the expected amount of ultimate loss and ALAE for the period by product. Payments and case reserves are subtracted from this initial estimate of ultimate loss and ALAE to determine a carried IBNR reserve.
For certain property products, we use an alternative method of determining an appropriate provision for initial IBNR. Since this segment is characterized by a shorter period of time between claim occurrence and claim settlement, the IBNR reserves are determined by IBNR percentages applied to premium earned. The percentages are determined based on expected loss ratios and loss development assumptions. The loss development assumptions are typically based on historical reporting patterns but could consider alternative sources of information. The IBNR percentages are reviewed and updated periodically. 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.
We do not reserve for natural or man-made catastrophes until an event has occurred. Shortly after such occurrence, we review insured locations exposed to the event and industry loss estimates of the event. We also consider our knowledge of frequency and severity from early claim reports to determine an appropriate reserve for the catastrophe. These reserves are reviewed frequently to consider actual losses reported and appropriate changes to our estimates are made to reflect the new information.
The initial loss and ALAE ratios that are applied to earned premium are reviewed at least semi-annually. Prospective estimates are made based on historical loss experience adjusted for exposure mix, price change and loss cost trends. The initial loss and ALAE ratios also reflect our judgment as to estimation risk. We consider estimation risk by product and coverage within product, if applicable. A product with greater volatility and uncertainty has greater estimation risk. Products or coverages with higher estimation risk include, but are not limited to, the following characteristics:
• Significant changes in underlying policy terms and conditions,
• A new business or one experiencing significant growth and/or high turnover,
• Longer emergence patterns with exposures to latent unforeseen mass tort,
34
• High severity and/or low frequency,
• Operational processes undergoing significant change and/or
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 approves changes in the initial loss and ALAE ratios.
Loss and LAE Reserve Estimation Process
Estimates of the expected value of the unpaid loss and LAE are derived using standard actuarial methodologies on a quarterly basis. In addition, an emergence analysis is completed quarterly to determine if further adjustments are necessary. These estimates are then compared to the carried loss reserves to determine the appropriateness of the current reserve balance.
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. In some analyses, including business without sufficiently large numbers of policies or that have not accumulated sufficient historical statistics, our own data is supplemented with external or industry average data as available and when appropriate. For liabilities arising out of directors and officers, management liability, workers’ compensation and medical errors and omissions exposures, we utilize external data extensively.
In addition to the review of historical claim reporting and payment patterns, we also incorporate estimated losses relative to premium (loss ratios) by year into the analysis. The expected loss ratios are based on a review of historical loss performance, trends in frequency and severity and price level changes. The estimates are subject to judgment including consideration given to available internal and industry data, growth and policy turnover, changes in policy limits, changes in underlying policy provisions, changes in legal and regulatory interpretations of policy provisions and changes in reinsurance structure. For the most current year, these are equivalent with the ratios used in the initial IBNR generation process. Increased recognition is given to actual emergence as the years age.
We use historical development patterns, expected loss ratios and standard actuarial methods to derive an estimate of the ultimate level of loss and LAE payments necessary to settle all the claims occurring as of the end of the evaluation period.
Our reserve processes include multiple standard actuarial methods for determining estimates of IBNR reserves. Other supplementary methodologies are incorporated as necessary. Mass tort and latent liabilities are examples of exposures for which supplementary methodologies are used. Each method produces an estimate of ultimate loss by accident year. We review all of these various estimates and assign weights to each based on the characteristics of the product being reviewed.
Our estimates of ultimate loss and LAE reserves are subject to change as additional data emerges. This could occur as a result of change in loss development patterns, a revision in expected loss ratios, the emergence of exceptional loss activity, a change in weightings between actuarial methods, the addition of new actuarial methodologies, new information that merits inclusion or the emergence of internal variables or external factors that would alter our view.
There is uncertainty in the estimates of ultimate losses. Significant risk factors to the reserve estimate include, but are not limited to, unforeseen or unquantifiable changes in:
• Loss payment patterns,
• Loss reporting patterns,
• Frequency and severity trends,
• Underlying policy terms and conditions,
• Business or exposure mix,
35
• Regulatory and legal environment and/or
• Economic environment.
Our actuaries engage in discussions with senior management, underwriters and the claim department on a regular basis to ascertain any substantial changes in operations or other assumptions that are necessary to consider in the reserving analysis.
A considerable degree of judgment in the evaluation of all these factors is involved in the analysis of reserves. The human element in the application of judgment is unavoidable when faced with uncertainty. Different experts will choose different assumptions based on their individual backgrounds, professional experiences and areas of focus. Hence, the estimates selected by various qualified experts may differ significantly from each other. We consider this uncertainty by examining our historic reserve accuracy and through an internal and external review process.
Given the substantial impact of the reserve estimates on our financial statements, we subject the reserving process to significant diagnostic testing and reasonability checks. In addition, there are data validity checks and balances in our front-end processes. Data anomalies are researched and explained to reach a comfort level with the data and results. Leading indicators such as actual versus expected emergence and other diagnostics are also incorporated into the reserving processes.
Determination of Our Best Estimate
Upon completion of our loss and LAE estimation analysis, the results are discussed with the LRC. As part of this discussion, the analysis supporting the actuarial central estimate of the IBNR reserve by product is reviewed. The actuaries also present explanations supporting any changes to the underlying assumptions used to calculate the indicated central estimate. A review of the resulting variance between the indicated reserves and the carried reserves takes place. Our actuaries make a recommendation to management in regards to booked reserves that reflect both their analytical assessment and relevant qualitative factors, such as their view of estimation risk. After discussion of these analyses, recommendations and all relevant risk factors, the LRC determines whether the reserve balances require adjustment. Resulting reserve balances have always fallen within our actuaries’ reasonable range of estimates.
As a predominantly excess and surplus lines and specialty admitted insurer serving niche markets, we believe we are subject to above-average variation in estimates and that this variation is not symmetrical around the actuarial central estimate.
One reason for the variation is the above-average policyholder turnover and changes in the underlying mix of exposures typical of an excess and surplus lines business. This constant change can cause estimates based on prior experience to be less reliable than estimates for more stable, admitted books of business. Also, as a niche market insurer, there is little industry-level information for direct comparisons of current and prior experience and other reserving parameters. These unknowns create greater-than-average variation in the actuarial central estimates.
Actuarial methods attempt to quantify future outcomes. However, insurance companies are subject to unique exposures that are difficult to foresee at the point coverage is initiated and, often, many years subsequent. Judicial and regulatory bodies involved in interpretation of insurance contracts have increasingly found opportunities to expand coverage beyond that which was intended or contemplated at the time the policy was issued. Many of these policies offer broad coverages (with named exclusion) and are issued on an occurrence basis. Claimants have at times sought coverage beyond the insurer’s original intent, including seeking to void or limit exclusionary language.
Because of the variation and the likelihood that there are unforeseen and under-quantified liabilities absent from the actuarial estimate, we believe there are circumstances where it is prudent to enhance our normal reserving process. Generally, these are circumstances where we have qualitative information and knowledge of increased risk, but those circumstances have not occurred within the history of our quantitative data. In these situations, we will rely on that qualitative information, usually from our claim team or underwriting staff, and make an enhancement to our normal process. In general, these enhancements will result in an increased overall reserve level compared to reserves based only on quantitative information. In the cases where these risks fail to materialize, favorable loss development will likely occur in subsequent periods. It is also possible that the risks materialize above the enhanced reserve level, in which case unfavorable loss development will likely occur in subsequent periods.
Our best estimate of loss and LAE reserves may change as a result of a revision in the actuarial central estimate, the actuary’s certainty in the estimates and processes and our overall view of the underlying risks. From time to time, we benchmark our reserving policies and procedures and refine them by adopting industry best practices where appropriate. A detailed, ground-up analysis of the reserve estimation risks associated with each of our products and segments, including an assessment of industry information, is performed annually. This information is used when determining management’s best estimate of booked reserves.
36
Loss reserve estimates are subject to a high degree of variability due to the inherent uncertainty of ultimate settlement values. Periodic adjustments to these estimates will likely occur as the actual loss emergence reveals itself over time. Our loss reserving processes reflect accepted actuarial practices and our methodologies result in a reasonable provision for reserves as of December 31, 2020.
INVESTMENT VALUATION
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.
Equity securities are carried at fair value with unrealized gains and losses recorded within net earnings. We classify our investments in fixed income securities into one of three categories: trading, held-to-maturity or available-for-sale. We do not hold any securities classified as trading or held-to-maturity. Available-for-sale securities are carried at fair value with unrealized gains and losses recorded as a component of comprehensive earnings and shareholders’ equity, net of deferred income taxes.
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. We maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.
RECOVERABILITY OF REINSURANCE BALANCES
Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, rather than being netted with the related liabilities, since reinsurance does not relieve the Company of its liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. We continually monitor the financial condition of our reinsurers and actively follow up on any past due or disputed amounts. As part of our monitoring efforts, we review their annual financial statements and Securities and Exchange Commission (SEC) filings for reinsurers that are publicly traded. We also review insurance industry developments that may impact the financial condition of our reinsurers. We analyze the credit risk associated with our reinsurance balances recoverable by monitoring the AM Best and Standard & Poor’s (S&P) ratings of our reinsurers. Additionally, we perform an in-depth reinsurer financial condition analysis prior to the renewal of our reinsurance placements.
Once regulatory action (such as receivership, finding of insolvency, order of conservation or order of liquidation) is taken against a reinsurer, the paid and unpaid balance recoverable from the reinsurer are specifically identified and charged to earnings in the form of an allowance for uncollectible amounts. We subject our remaining reinsurance balances receivable to detailed recoverability tests, including a segment-based analysis using the average default rating percentage by S&P rating, and record an additional allowance for unrecoverable amounts from reinsurers. This credit allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover.
DEFERRED POLICY ACQUISITION COSTS
We defer incremental direct costs that relate to the successful acquisition of new or renewal insurance contracts, including commissions and premium taxes. Acquisition-related costs may be deemed ineligible for deferral when they are based on contingent or performance criteria beyond the basic acquisition of the insurance contract, or when efforts to obtain or renew the insurance contract are unsuccessful. All eligible costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This process contemplates the premiums to be earned, anticipated losses and settlement expenses and certain other costs expected to be incurred, but does not consider investment income. Judgments as to the ultimate recoverability of such deferred costs are reviewed on a segment basis and are highly dependent upon estimated future loss costs associated with the premiums written. This deferral methodology applies to both gross and ceded premiums and acquisition costs.
DEFERRED TAXES
We record deferred tax assets and liabilities to the extent that temporary differences between the tax basis and GAAP basis of an asset or liability result in future taxable or deductible amounts. Our deferred tax assets relate to expected future tax deductions arising from claim reserves and future taxable income related to changes in our unearned premium. We also have a significant amount of deferred tax liabilities from unrealized gains on the investment portfolio and deferred acquisition costs.
Periodically, management reviews our deferred tax positions to determine if it is more likely than not that the assets will be realized. These reviews include, among other things, the nature and amount of the taxable income and expense items, the expected timing of when assets will be used or liabilities will be required to be reported, as well as the reliability of historical profitability of
37
businesses expected to provide future earnings. Furthermore, management considers taxplanning strategies it can use to increase the likelihood that the tax assets will be realized. After conducting the periodic review, if management determines that the realization of the tax asset does not meet the more likely than not criteria, an offsetting valuation allowance is recorded, thereby reducing net earnings and the deferred tax asset in that period. In addition, management must make estimates of the tax rates expected to apply in the periods in which future taxable items are realized. Such estimates include determinations and judgments as to the expected manner in which certain temporary differences, including deferred amounts related to our equity method investment, will be recovered. These estimates enter into the determination of the applicable tax rates and are subject to change based on the circumstances.
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.
IMPACT OF COVID-19
The coronavirus (COVID-19) pandemic has impacted individuals, businesses and the economy throughout 2020. As an employee-owned company, the health and well-being of our customers, partners and associates is our highest priority. While a large percentage of our associates are still working from home, our processes and controls continue to operate effectively and we have been able to maintain the highest service and support levels possible for our customers.
It is difficult to predict how and to what extent the economic slowdown will impact our revenues in the coming quarters. To date, the product line that has experienced the greatest impact has been public transportation. Many of our passenger transportation customers have been unable to effectively operate under social-distancing protocols and stay-at-home orders. For the year ended December 31, 2020, transportation gross written premium was down $42.2 million when compared to 2019. We expect transportation premium to continue to be down from prior periods until the use of public transportation increases, which may not be until after a vaccine or effective treatment is readily available or there is a significant reduction in cases. Additionally, slowdowns in the construction industry contributed to premium declines for our general liability and surety products. A number of our products support the construction industry, and revenues may continue to be impacted as long as this sector experiences disruption. However, our personal lines products, management liability products and property businesses have seen little to no impact on premium from the pandemic.
We have been fair and flexible with our customers in modifying exposures and payment terms, and are in compliance with any applicable state regulatory directives on such changes. Insureds continue to make payments in accordance with the agreed upon schedules, and we have not experienced a material increase in the amount of expense associated with uncollectible receivables.
The loss exposure arising out of the spread of COVID-19 and resulting shutdown will take time to resolve. We do not offer event cancellation, travel, trade credit or pandemic-related coverages, which would be more directly impacted by the COVID-19 pandemic. The Company has received a number of claims, the majority of which relate to business interruption. We are reviewing the individual circumstances of each claim submitted and will fulfill our obligation to pay if coverage applies. The derivative implications that COVID-19 has on the economy may have negative implications on products that are correlated with the credit cycle, including, but not limited to, some of our executive products and surety offerings. Additionally, the professional services and executive product groups may be affected by claims made against companies who are reopening or returning to work. In 2020, $18.3 million of net reserves were established to address the increased risk of loss and expense that emanated from the economic downturn brought on by the pandemic.
Actuarial models base future emergence on historic experience, with adjustments for current trends, and the appropriateness of these assumptions involved greater uncertainty as of December 31, 2020. We expect there will be impacts to the timing of loss emergence and ultimate loss ratios for certain coverages. The industry is experiencing new issues, including the postponement of civil court cases, the extension of various statutes of limitations, changes in settlement trends and a significant reduction in economic activity and insured exposure in some classes. Our booked reserves include consideration of these factors, but the duration and degree to which these issues persist, along with potential legislative, regulatory or judicial actions, could result in loss reserve deficiencies and reduce earnings in future periods.
We continue to evaluate opportunities for expense savings and efficiencies and took targeted actions to reduce or defer expenses in 2020, including certain hiring freezes, position consolidations, travel limitations and executive merit increase suspensions. Bonus and profit-sharing expense, which is correlated with company performance, also declined.
38
The equity portfolio has more than recovered from the sharp market sell off in the first quarter, with $37.8 million of net after-tax realized and unrealized gains on equity securities in 2020. Additionally, lower interest rates increased the fair value of the fixed income portfolio, which resulted in $53.5 million of after-tax other comprehensive earnings. However, with the decline in yields, reinvestment rates are now lower than in previous years, which will limit the portfolio’s ability to generate higher levels of investment income, absent a larger invested asset base.
Maui Jim, Inc. (Maui Jim) and Prime Holdings Insurance Services, Inc. (Prime) contributed towards positive net earnings in 2020. While earnings for Prime were higher than in 2019, Maui Jim’s sales were negatively impacted by the shutdown much of the traditional retail sector experienced during the year. The economic downturn may continue to impact the results of these investees, particularly if there is any lasting impact on the retail sector as it relates to Maui Jim.
We produced solid operating results in 2020 and our financial position remained strong despite the impact of the COVID-19 pandemic. We generated $263.3 million of net operating cash inflows and believe we have adequate liquidity. Our revolving credit facility provides for a borrowing capacity of $60.0 million, which can be increased to $120.0 million under certain circumstances. Additionally, our membership in the Federal Home Loan Bank system provides a secured lending facility with an aggregate borrowing capacity of approximately $30.0 million. There were no amounts outstanding under any of these facilities as of December 31, 2020. In addition to the $155.9 million of cash and other investments maturing within one year as of December 31, 2020, we believe that cash generated from operations, the liquidity of our fixed income portfolio and our unused lines of credit provide sufficient sources of cash to meet our anticipated needs over the next 12 to 24 months.
Ultimately, the extent to which COVID-19 will impact our business will be influenced by how long it takes for the economy to recover. We continue to evaluate all aspects of our operations and are making necessary adjustments to manage our business. Our diversified portfolio of products and financial strength have allowed us to remain on solid footing. We believe we have a strong and sustainable underwriting approach that will allow us to weather the economic downturn and uncertainty we are currently experiencing.
RESULTS OF OPERATIONS
This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019, incorporated herein by reference.
Consolidated revenue for 2020 decreased $20.0 million from 2019. Net premiums earned for the Group increased 3 percent, driven by growth from our property and casualty segments, but performance in the equity portfolio was not able to match the return generated in 2019. Net investment income decreased by 1 percent in 2020, primarily due to lower reinvestment rates relative to the prior year. Additionally, we recorded net realized gains on our investment portfolio in 2020 and 2019, due to portfolio rebalancing.
CONSOLIDATED REVENUE Year ended December 31,
Net unrealized gains on equity securities 32,101 78,090
Net earnings for 2020 totaled $157.1 million, down from $191.6 million in 2019. Improved underwriting income was offset by a decline in unrealized gains on equity securities.
39
NET EARNINGS Year ended December 31,
Net unrealized gains on equity securities 32,101 78,090
Interest expense on debt (7,603 ) (7,588 )
Equity in earnings of unconsolidated investees 20,233 20,960
UNDERWRITING RESULTS
Gross premiums written increased $71.4 million, or 7 percent, in 2020 when compared to 2019. Excluding the decline in commercial transportation, which was impacted by the COVID-19 pandemic, written premium increased by 12 percent. Positive rate movement across most of the casualty and property portfolio and an expansion of distribution channels provided for growth opportunities in established lines.
Underwriting results for 2020 were impacted by significant catastrophe activity, including $51.5 million of pretax losses and $1.5 million of reinstatement premium from hurricanes, as well as $6.5 million of other storm and civil unrest losses. Additionally, $18.3 million of COVID-19 related loss and defense reserves were established in 2020. Comparatively, pretax storm losses were $9.5 million in 2019. Results for each period benefited, however, from favorable development on prior years’ loss reserves, which provided additional pretax earnings of $101.1 million in 2020, compared to $75.3 million in 2019. Further discussion of reserve development can be found in note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Incentive and profit-sharing amounts earned by executives, managers and associates are predominately influenced by corporate performance including operating return on equity, combined ratio and Market Value Potential (MVP). MVP is a compensation model that measures components of comprehensive earnings against a minimum required return on capital. MVP is the primary measure of executive bonus achievement and a significant component of manager and associate incentive targets. Incentive and profit-sharing related expenses attributable to the favorable reserve developments totaled $14.2 million and $11.1 million for 2020 and 2019, respectively. These performance-related expenses impact policy acquisition, insurance operating and general corporate expenses line items in the financial statements. Partially offsetting the 2020 and 2019 increases were $11.2 million and $1.4 million, respectively, in reductions to incentive and profit-sharing amounts earned due to losses associated with catastrophe activity, as well as the reserves that were established for COVID-19 in 2020.
In total, underwriting income was $69.6 million on a 92.0 combined ratio in 2020, compared to $67.6 million on a 91.9 combined ratio in 2019. The loss ratio was 51.2 in 2020, compared to 49.3 in 2019. The expense ratio decreased to 40.8 in 2020, from 42.6 in 2019. Travel and entertainment expenses, along with other discretionary costs, decreased in 2020 as we made adjustments to reduce the impact of COVID-19 on our results. Additionally, stronger growth in book value was experienced in 2019, which led to larger levels of bonus and profit-sharing expenses.
We achieved our 25th consecutive year of underwriting profit in 2020. Our ability to continue to produce underwriting income, and to do so at margins which have consistently outperformed the broader industry, is a testament to our underwriters’ discipline throughout the insurance cycle and our continued commitment to underwriting for a profit. We believe our underwriting discipline can differentiate the Company from the broader insurance market by ensuring sound risk selection and appropriate pricing.
The following tables and narrative provide a more detailed look at individual segment performance over the last two years.
40
GROSS PREMIUMS WRITTEN AND NET PREMIUMS EARNED
Gross Premiums Written Net Premiums Earned
CASUALTY
PROPERTY
SURETY
Casualty
Gross premiums written for the casualty segment were up $45.2 million for 2020. Rate increases were achieved across the segment, particularly in our executive products group. Small commercial continued to benefit from new production sources and geographic expansion, while personal umbrella expanded its distribution base. Other casualty increased $9.7 million, as our general binding authority (GBA) business continued to grow.
Commercial transportation has been significantly affected by the stay-at-home orders associated with COVID-19, particularly public auto, which focuses on charter, school and transit buses. The reduced utilization led to a $42.2 million decline in gross premiums written in 2020. General liability premiums also declined as a result of increased competition, as well as decreases in construction related activity and use-based exposures.
Property
Gross premiums written from our property segment were up $27.3 million in 2020. Our commercial property business was up $19.0 million, as an improving market allowed our underwriters to find more opportunities with acceptable rate levels. Additionally, rates on wind-prone and earthquake exposures continued to increase. Rate increases and market disruption, which created new business opportunities, led to $6.7 million of growth for our marine product. Other property premium increased as a result of property-exposed GBA business that continued to gain scale.
Surety
Gross premiums written from our surety segment were down $1.1 million in 2020. The economic slowdown reduced demand for surety bonds. Additionally, we continually monitor our portfolio for higher risk accounts and have selectively eliminated exposures that no longer met our underwriting standards.
41
UNDERWRITING INCOME
Casualty
Underwriting income for the casualty segment was $44.4 million on a 92.2 combined ratio in 2020, compared to $20.6 million on a 96.3 combined ratio in 2019. The improvement is the result of increased favorable development on prior accident years’ reserves and improved current accident year performance resulting from a shift in mix of business and lower levels of bonus and profit-sharing expenses.
Favorable development on prior accident years’ loss reserves contributed to underwriting earnings in each of the past two years. The total benefit from favorable development on prior years’ reserves was $75.1 million for 2020, with the largest amounts of the development coming from accident years 2016 through 2019. Products which generated the majority of the favorable development include transportation, general liability, commercial excess and professional services. No active products experienced significant adverse development. Comparatively, overall results for the casualty segment in 2019 included favorable development of $62.5 million, with the bulk of the development attributable to transportation, general liability, professional services, commercial excess, personal umbrella and small commercial across accident years 2016 through 2018. Executive products and medical professional liability developed adversely in 2019. Favorable development on executive products and medical professional liability in 2020 was responsible for a significant amount of the increase between the releases in 2020 and 2019. Hurricane losses on casualty-oriented package policies that include property coverage resulted in $4.4 million of losses in 2020 and $12.9 million of current year reserves were established for COVID-19 loss and defense costs on financial-related product lines.
The segment’s loss ratio was 56.6 in 2020, compared to 59.1 in 2019. The lower loss ratio in 2020 was due to the higher amounts of favorable development on prior years’ reserves. The expense ratio for the casualty segment decreased to 35.6 from 37.2 in 2019.
Property
Underwriting loss from the property segment was $3.2 million on a 101.7 combined ratio in 2020, compared to underwriting income of $18.1 million on an 88.9 combined ratio in 2019. Underwriting results for 2020 included $13.0 million of favorable development on prior years’ loss and catastrophe reserves, primarily from the marine business, $5.0 million of storm and civil unrest losses and $2.0 million of reserves related to COVID-19 investigative and defense costs. Hurricane activity resulted in $47.2 million of losses and $1.5 million of ceded reinstatement premium. Comparatively, results for 2019 included $4.5 million of favorable development in prior years’ reserves, largely from marine, and $8.8 million of storm losses.
The segment’s loss ratio was 60.6 in 2020, compared to 44.9 in 2019. Catastrophe losses added 30 points to the loss ratio in 2020, compared to 5 points of impact from catastrophe losses in 2019. Partially offsetting this increase was a reduction in current accident year non-catastrophe losses and larger favorable development on prior years’ reserves. The expense ratio for the property segment declined to 41.1 in 2020, from 44.0 in 2019, due in part to the larger premium base in 2020.
Surety
Underwriting income for the surety segment totaled $28.4 million on a 74.8 combined ratio in 2020, compared to $28.8 million on a 75.3 combined ratio in 2019. Underwriting performance for each year reflects a combination of positive current accident year results and favorable development in prior accident years’ loss reserves. The current accident year combined ratio for each period has been in the low 80s, with each product line contributing to underwriting profit. Results for 2020 included favorable development on prior accident years’ reserves, which decreased loss and settlement expenses for the segment by $13.0 million, and offset $3.4 million in current year reserves established for COVID-19 related losses. Comparatively, 2019 results included favorable development on prior accident years’ loss reserves, which decreased the segment’s loss and settlement expenses by $8.3 million.
42
The segment’s loss ratio was 8.4 in 2020, compared to 8.3 in 2019. As stated above, a larger amount of favorable development on prior years’ reserves in 2020 was offset by higher current accident year losses, primarily from reserves established for COVID-19, all of which was incurred on a lower premium base. The expense ratio for the surety segment was 66.4 in 2020, compared to 67.0 in 2019.
NET INVESTMENT INCOME AND REALIZED INVESTMENT GAINS
During 2020, net investment income decreased by 1 percent. The decrease was primarily due to lower reinvestment rates relative to the prior year. The average annual yields on our investments were as follows for 2020 and 2019:
PRETAX YIELD
Taxable (on book value) 3.10 % 3.39 %
Tax-exempt (on book value) 2.69 % 2.77 %
Equities (on fair value) 2.33 % 2.41 %
AFTER-TAX YIELD
Taxable (on book value) 2.45 % 2.68 %
Tax-exempt (on book value) 2.55 % 2.62 %
Equities (on fair value) 2.02 % 2.09 %
The after-tax yield reflects the different tax rates applicable to each category of investment. Our taxable fixed income securities were subject to a corporate tax rate of 21.0 percent, our tax-exempt municipal securities were subject to a tax rate of 5.3 percent and our dividend income was generally subject to a tax rate of 13.1 percent. During 2020, the average after-tax yield on the taxable fixed income portfolio was 2.5 percent, a decrease from 2.7 percent in the prior year. The average after-tax yield on the tax-exempt portfolio remained at 2.6 percent.
The fixed income portfolio increased by $213.5 million during the year, as the majority of operating cash flows were allocated to the fixed income portfolio and a decline in interest rates was experienced during the year, increasing the fair value of fixed income securities. The tax-adjusted total return on a mark-to-market basis was 6.6 percent. Our equity portfolio increased by $63.4 million to $524.0 million in 2020 as a result of the strong equity market returns during the year. The total return for the year on the equity portfolio was 12.5 percent.
Our investment results for the last five years are shown in the following table:
Tax
Pre-tax Equivalent
Annualized Annualized
Change in Return on Return on
Average Net Unrealized Avg. Avg.
Invested Investment Net Realized Appreciation Invested Invested
(in thousands) Assets (1) Income (2)(3) Gains (3) (3)(4) Assets Assets
(2) Investment income, net of investment expenses.
(3) Before income taxes.
(4) Relates to available-for-sale fixed income and equity securities.
In 2020, we recognized $15.8 million in net realized gains in the equity portfolio, $3.9 million in net realized gains in the fixed income portfolio and $1.8 million in other net realized losses. In 2019, we recognized $14.4 million in net realized gains in the equity portfolio, $3.2 million in net realized gains in the fixed income portfolio and $0.1 million in other net realized losses.
We regularly evaluate the quality of our investment portfolio. With the adoption of ASU 2016-13 on January 1, 2020, we started recognizing a reversible allowance for credit losses on available-for-sale fixed income securities. Prior to 2020, when we determined
43
that a fixed income security had suffered an other-than-temporary decline in value, the investment’s value was adjusted by reclassifying the decline from unrealized to realized losses. In 2020, we realized $0.6 million in losses on fixed income securities for which we had the intent to sell. We did not recognize any impairment losses in 2019.
As of December 31, 2020, in addition to the securities included in the allowance for credit losses, the fixed income portfolio contained 142 positions with an unrealized loss position for which an allowance for credit losses had not been recorded. Of these 142 securities, 31have been in an unrealized loss position for 12 consecutive months or longer and represent $0.4 million in unrealized losses. All fixed income securities in the investment portfolio continue to pay the expected coupon payments under the contractual terms of the securities. Based on our analysis, our fixed income portfolio is of a high credit quality and we believe we will recover the amortized cost basis.
INVESTMENTS
We maintain a diversified investment portfolio with a prudent mix of fixed income and risk assets. We continually monitor economic conditions, our capital position and the insurance market to determine our tactical allocation. As of December 31, 2020, the portfolio had a fair value of $2.8 billion, an increase of $276.7 million from the end of 2019.
We determined the fair value of certain financial instruments based on their underlying characteristics and relevant transactions in the marketplace. We maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. For additional information, see notes 1 and 2 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
As of December 31, 2020, our investment portfolio had the following asset allocation breakdown:
Cost or Unrealized % of Total
(in thousands) Amortized Cost Fair Value Gain/(Loss) Fair Value Quality*
* Quality ratings provided by Moody’s, S&P and Fitch
Quality in the previous table and in all subsequent tables is an average of each bond’s credit rating, adjusted for its relative weighting in the portfolio.
Fixed income represented 77 percent of our total 2020 portfolio, the same as 2019. As of December 31, 2020, the fair value of our fixed income portfolio consisted of 44 percent AAA-rated securities, 19 percent AA-rated securities, 21 percent A-rated securities, 10 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities. This compares to 49 percent AAA-rated securities, 17 percent AA-rated securities, 19 percent A-rated securities, 9 percent BBB-rated securities and 6 percent non-investment grade or non-rated securities in 2019.
In selecting the maturity of securities in which we invest, we consider the relationship between the duration of our fixed income investments and the duration of our liabilities, including the expected ultimate payout patterns of our reserves. We believe that both liquidity and interest rate risk can be minimized by such asset/liability management. As of December 31, 2020, our fixed income portfolio’s duration was 4.7 years.
Consistent underwriting income allows a portion of our investment portfolio to be invested in equity securities and other risk asset classes. Equities comprised 19 percent of our total 2020 portfolio, a slight increase from 18 percent in 2019. Securities within the equity portfolio are well diversified and are primarily invested in large-cap issues with a preference for dividend income. Our strategy has a value tilt and security selection takes precedence over market timing. Likewise, low turnover throughout our long investment horizon minimizes transaction costs and taxes.
44
FIXED INCOME PORTFOLIO
As of December 31, 2020, our fixed income portfolio had the following rating distributions:
FAIR VALUE Below
Investment
(in thousands) AAA AA A BBB Grade No Rating Fair Value
Bonds:
Structured:
Mortgage-Backed, Commercial Mortgage-Backed and Asset-Backed Securities
The following table summarizes the distribution of our mortgage-backed securities (MBS) portfolio by investment type, as of December 31:
(in thousands) Amortized Cost Fair Value % of Total
Agency MBS represented 18 percent of the fixed income portfolio, compared to 21 percent as of December 31, 2019. We believe agency MBS investments add diversification, liquidity, credit quality and additional yield to our portfolio. Our objective for the agency MBS portfolio is to provide reasonable cash flow stability where we are compensated for the call risk associated with residential refinancing. The agency MBS portfolio includes mortgage-backed pass-through securities and collateralized mortgage obligations (CMO), which include planned amortization classes (PACs) and sequential pay structures. As of December 31, 2020, all of the securities in our agency MBS portfolio were rated AAA and issued by Government Sponsored Enterprises (GSEs) such as the Governmental National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC).
45
Variability in the average life of principal repayment is an inherent risk of owning mortgage-related securities. However, we reduce our portfolio’s exposure to prepayment risk by seeking characteristics that tighten the probable scenarios for expected cash flows. As of December 31, 2020, the agency MBS portfolio contained 57 percent of pure pass-throughs, compared to 67 percent as of December 31, 2019. An additional 26 percent of the MBS portfolio was invested in sequential payer, the same as 2019.
The following table summarizes the distribution of our asset-backed and commercial mortgage-backed securities portfolio as of December 31:
Amortized
(in thousands) Cost Fair Value % of Total
An asset-backed security (ABS), commercial mortgage-backed security (CMBS) or non-agency residential mortgage-backed security (RMBS) is a securitization collateralized by the cash flows from a specific pool of underlying assets. These asset pools can include items such as credit card payments, auto loans, structured bank loans in the form of collateralized loan obligations (CLOs) and residential or commercial mortgages. As of December 31, 2020, ABS/CMBS/RMBS investments were 10 percent of the fixed income portfolio, compared to 11 percent as of December 31, 2019. Eighty-four percent of the securities in the ABS/CMBS/RMBS portfolio were rated AAA as of December 31, 2020, while 99 percent were rated A or better. We believe that ABS/CMBS investments add diversification and additional yield to the portfolio while often adding superior cash flow stability over mortgage pass-throughs or CMOs.
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. We had $1.2 million in unrealized losses in these asset classes as of December 31, 2020.
Municipal Fixed Income Securities
As of December 31, 2020, municipal bonds composed 24 percent of our fixed income portfolio, compared to 21 percent as of December 31, 2019. We believe municipal fixed income securities can provide diversification and additional tax-advantaged yield to our portfolio. Our objective for the municipal fixed income portfolio is to provide reasonable cash flow stability and increased after-tax yield.
Our municipal fixed income portfolio is comprised of general obligation (GO) and revenue securities. The revenue sources include sectors such as sewer and water, public improvement, school, transportation and colleges and universities. As of December 31, 2020, approximately 43 percent of the municipal fixed income securities in the investment portfolio were GO and the remaining 57 percent were revenue based. The municipal portfolio is diversified amongst 280 issues with the largest single issuer representing less than 1 percent of invested assets.
Eighty-sixpercent of our municipal fixed income securities were rated AA or better, while 99 percent were rated A or better. The municipal portfolio includes 62 percent tax-exempt and 38 percent taxable securities.
46
Corporate Debt Securities
As of December 31, 2020, our corporate debt portfolio comprised 37 percent of the fixed income portfolio, compared to 35 percent as of December 31, 2019. The corporate allocation includes floating rate bank loans and bonds that are below investment grade in credit quality and offer incremental yield over our core fixed income portfolio. Non-investment grade bonds totaled $134.0 million at the end of 2020. The corporate debt portfolio has an overall quality rating of BBB+ diversified among 657 issues.
The table below illustrates our corporate debt exposure as of December 31, 2020. Private placements include bank loan and Regulation D securities.
Gross Gross
Amortized Unrealized Unrealized
(in thousands) Cost Fair Value Gains Losses
Bonds:
Corporate utilities - private placements 2,700 2,898 198 —
We believe corporate debt investments add diversification and additional yield to our portfolio. Because corporates make up a large portion of the fixed income opportunity set, the corporate debt investments will continue to be a significant part of our investment program.
EQUITY SECURITIES
As of December 31, 2020, our equity portfolio comprised 19 percent of the investment portfolio, an increase of 1 percent from December 31, 2019. The securities within the equity portfolio remain primarily invested in large-cap issues with a focus on dividend income. In addition, we have investments in three broadly diversified, exchange traded funds (ETFs) that represent market indexes similar to the Russell 1000 Index, S&P 500 Index and S&P 600 Index. The ETF portfolio is congruent with the actively managed equity portfolios and solves for exposures that line up with our overall benchmark index, the Russell 3000. In total, the equity portfolio is comprised of 221 securities with the largest single company exposure representing less than 1 percent of invested assets.
INTEREST AND GENERAL CORPORATE EXPENSE
We incurred $7.6 million of interest expense on outstanding debt during 2020 and 2019. At December 31, 2020 and 2019, our long-term debt consisted of $150.0 million in senior notes maturing September 15, 2023, and paying interest semi-annually at the rate of 4.875 percent.
As discussed previously, general corporate expenses tend to fluctuate relative to our incentive compensation plans. Our compensation model measures components of comprehensive earnings against a minimum required return on our capital. Bonuses are earned as we generate earnings in excess of this required return. In 2020 and 2019, we exceeded the required return, resulting in the accrual of executive bonuses. Decreased levels of comprehensive earnings in 2020 resulted in lower variable compensation earned than in 2019.
INVESTEE EARNINGS
We maintain a 40 percent equity interest in Maui Jim, a manufacturer of high-quality sunglasses. As a private company, the market for Maui Jim’s stock is limited. Our investment in Maui Jim is carried at the RLI Corp. holding company level, as it is not core to our insurance operations. While we have certain rights under our shareholder agreement with Maui Jim as a minority shareholder, we are subject to the decisions of the controlling shareholder, which may impact the value of our investment. In 2020, we recorded $10.4 million in earnings from this investment, compared to $13.6 million in 2019. Sales were negatively impacted by the shutdown the traditional retail sector experienced during 2020.
As of December 31, 2020, we had a 23 percent interest in the equity and earnings of Prime. Prime writes business through two Illinois domiciled insurance carriers, Prime Insurance Company, an excess and surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company. As a private company, the market for Prime’s stock is limited. While we have certain rights under our shareholder agreement, we are subject to the decisions of the controlling shareholder, which may impact the value of our investment. In 2020, we recorded $10.8 million in investee earnings for Prime, compared to $7.4 million in 2019,
47
reflective of their growth in revenue. Additionally, we maintain a quota share reinsurance treaty with Prime, which contributed $15.7 million of gross premiums written and $14.3 million of net premiums earned during 2020, compared to $13.1 million of gross premiums written and $28.7 million of net premiums earned during 2019. The decrease in net premiums earned is reflective of our decreased quota share participation with Prime.
We received a dividend from Prime in 2020 and Maui Jim in 2019. Dividends from Maui Jim and Prime 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.
INCOME TAXES
Our effective tax rates were 17.3 percent and 17.7 percent for 2020 and 2019, respectively. Effective rates are dependent upon components of pretax earnings, which is impacted by the volatility of unrealized gains and losses, and the related tax effects. The effective rate was lower in 2020 due to investment tax credits and lower levels of pretax earnings, which caused tax-favored adjustments to be larger on a percentage basis.
Our net earnings include equity in earnings of unconsolidated investees, Maui Jim and Prime. The investees do not have a policy or pattern of paying dividends. As a result, we record a deferred tax liability on the earnings at the corporate capital gains rate of 21 percent in anticipation of recovering our investments through means other than through the receipt of dividends, such as a sale. We received a $4.7 million dividend from Prime in 2020 and recognized a $0.5 million tax benefit from applying the lower tax rate applicable to affiliated dividends paid to an insurance company (10.8 percent in 2020), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. We received a $13.2 million dividend from Maui Jim in 2019 and recognized a $1.8 million tax benefit from applying the lower tax rate applicable to affiliated dividends paid to a non-insurance company (7.4 percent in 2019), as compared to the corporate capital gains rate on which the deferred tax liabilities were based. Standing alone, the dividends resulted in a 0.2 percent and 0.8 percent reduction to the 2020 and 2019 effective tax rates, respectively.
Dividends paid to our Employee Stock Ownership Plan (ESOP) also result in a tax deduction. Dividends paid to the ESOP in 2020 and 2019 resulted in tax benefits of $1.1 million in each year. These tax benefits reduced the effective tax rate for 2020 and 2019 by 0.6 percent and 0.5 percent, respectively.
NET UNPAID LOSSES AND SETTLEMENT EXPENSES
The primary liability on our balance sheet relates to unpaid losses and settlement expenses, which represents our estimated liability for losses and related settlement expenses before considering offsetting reinsurance balances recoverable. The largest asset on our balance sheet, outside of investments, is the reinsurance balances recoverable on unpaid losses and settlement expenses, which serves to offset this liability. The liability can be split into two parts: (1) case reserves representing estimates of losses and settlement expenses on known claims and (2) IBNR reserves representing estimates of losses and settlement expenses on claims that have occurred but have not yet been reported to the Company. Our gross liability for both case and IBNR reserves is reduced by reinsurance balances recoverable on unpaid losses and settlement expenses to calculate our net reserve balance. This net reserve balance increased to $1.3 billion at December 31, 2020, from $1.2 billion as of December 31, 2019. This reflects incurred losses of $442.9 million in 2020 offset by paid losses of $325.1 million, compared to incurred losses of $413.4 million offset by $319.9 million paid in 2019. For more information on the changes in loss and LAE reserves by segment, see note 6 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data.
Gross reserves (liability) and the reinsurance balances recoverable (asset) are generally subject to the same influences that affect net reserves, though changes to our reinsurance agreements can cause reinsurance balances recoverable to behave differently. Total gross loss and LAE reserves increased to $1.8 billion at December 31, 2020, from $1.6 billion at December 31, 2019, while ceded loss and LAE reserves increased to $443.7 million from $384.5 million over the same period.
LIQUIDITY AND CAPITAL RESOURCES
OVERVIEW
We have three primary types of cash flows: (1) operating cash flows, which consist mainly of cash generated by our underwriting operations and income earned on our investment portfolio, (2) investing cash flows related to the purchase, sale and
48
maturity of investments and (3) financing cash flows that impact our capital structure, such as changes in debt, issuance of common stock and dividend payments. The following table summarizes these three cash flows over the last two years:
We have posted positive operating cash flow in the last two years. Variations in operating cash flow between periods are largely driven by the volume and timing of premium receipt, claim payments, reinsurance and taxes. In addition, fluctuations in insurance operating expenses impact operating cash flow. During 2020, the majority of cash flow uses were related to financing and investing activities and associated with the payments of dividends and net purchases of investments, respectively.
We have entered into certain contractual obligations that require the Company to make recurring payments. The following table summarizes our contractual obligations as of December 31, 2020:
Payments due by period
(in thousands) Less than 1 year 1-3 years 3-5 years More than 5 years Total
Loss and settlement expense reserves represent our best estimate of the ultimate cost of settling reported and unreported claims and related expenses. As discussed previously, the estimation of loss and loss expense reserves is based on various complex and subjective judgments. Actual losses and settlement expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the payments due by periods are based on our historical claims payment experience. Due to the uncertainty inherent in the process of estimating the timing of such payments, there is a risk that the amounts paid in any period can be significantly different than the amounts disclosed above. Amounts disclosed above are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable on unpaid loss and settlement reserves are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not discharge the Company of our liability to policyholders. Reinsurance balances recoverable on unpaid loss and settlement reserves totaled $443.7 million at December 31, 2020, compared to $384.5 million in 2019.
The next largest contractual obligation relates to long-term debt outstanding. On October 2, 2013, we completed a public debt offering of $150.0 million in senior notes maturing September 15, 2023, (a 10-year maturity) and paying interest semi-annually at the rate of 4.875 percent. The notes were issued at a discount resulting in proceeds, net of discount and commission, of $148.6 million. We are not party to any off-balance sheet arrangements. See note 4 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data for more information on our long-term debt. Additionally, see note 2 to the consolidated financial statements within Item 8, Financial Statements and Supplementary Data for information on our obligations for other invested assets.
Our primary objective in managing our capital is to preserve and grow shareholders’ equity and statutory surplus to improve our competitive position and allow for expansion of our insurance operations. Our insurance subsidiaries must maintain certain minimum capital levels in order to meet the requirements of the states in which we are regulated. Our insurance companies are also evaluated by rating agencies that assign financial strength ratings that measure our ability to meet our obligations to policyholders over an extended period of time.
We have historically grown our total capital as a result of three sources of funds: (1) earnings on underwriting and investing activities, (2) appreciation in the value of our investments and (3) the issuance of common stock and debt.
At December 31, 2020, we had cash, short-term investments and other investments maturing within one year of approximately $155.9 million and an additional $519.9 million of investments maturing between 1 to 5 years. We maintain a revolving line of credit with Bank of Montreal, Chicago Branch, which permits us to borrow up to an aggregate principal amount of $60.0 million. Under certain conditions, the line may be increased up to an aggregate principal amount of $120.0 million. The facility has a three-year term that expires on March 27, 2023. This facility replaced the previous $50.0 million facility with JP Morgan Chase Bank N.A., which was set to expire on May 24, 2020. As of and during the year ended December 31, 2020, no amounts were outstanding on these facilities.
49
Additionally, two of our insurance companies, RLI Ins. and Mt. Hawley, are members of the Federal Home Loan Bank of Chicago (FHLBC). Membership in the Federal Home Loan Bank system provides both companies with access to an additional source of liquidity via a secured lending facility. Based on qualifying assets at year-end, aggregate borrowing capacity is approximately $30.0 million. However, under certain circumstances, that capacity may be increased based on additional FHLBC stock purchased and available collateral. Our membership allows each insurance subsidiary to determine tenor and structure at the time of borrowing. As of and during the year ended December 31, 2020, there were no outstanding borrowings with the FHLBC.
We believe that cash generated by operations, cash generated by investments and cash available from financing activities will provide sufficient sources of liquidity to meet our anticipated needs over the next 12 to 24 months. We have consistently generated positive operating cash flow. The primary factor in our ability to generate positive operating cash flow is underwriting profitability, which we have achieved for 25 consecutive years.
OPERATING ACTIVITIES
The following list highlights some of the major sources and uses of cash flow from operating activities:
Sources Uses
Premiums received Claims
Loss payments from reinsurers Ceded premium to reinsurers
Investment income (interest and dividends) Commissions paid
Unconsolidated investee dividends from affiliates Operating expenses
Funds held Interest expense
Income taxes
Funds held
Our largest source of cash is from premiums received from our customers, which we receive at the beginning of the coverage period for most policies. Our largest cash outflow is for claims that arise when a policyholder incurs an insured loss. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various investment securities that earn interest and dividends. We use cash to pay commissions to brokers and agents, as well as to pay for ongoing operating expenses such as salaries, rent, taxes and interest expense. We also utilize reinsurance to manage the risk that we take on our policies. We cede, or pay out, part of the premiums we receive to our reinsurers and collect cash back when losses subject to our reinsurance coverage are paid.
The timing of our cash flows from operating activities can vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant, so their timing can influence cash flows from operating activities in any given period. We are subject to the risk of incurring significant losses on catastrophes, both natural (such as earthquakes and hurricanes) and man-made (such as terrorism). If we were to incur such losses, we would have to make significant claims payments in a relatively concentrated period of time.
INVESTING ACTIVITIES
The following list highlights some of the major sources and uses of cash flow from investing activities:
Sources Uses
Proceeds from sale, call or maturity of bonds Purchase of bonds
Proceeds from sale of stocks Purchase of stocks
Proceeds from sale of other invested assets Purchase of other invested assets
Acquisitions
Purchase of property and equipment
We maintain a diversified investment portfolio representing policyholder funds that have not yet been paid out as claims, as well as the capital we hold for our shareholders. As of December 31, 2020, our portfolio had a carrying value of $2.8 billion. Portfolio assets at December 31, 2020, increased by $276.7 million, or 11 percent, from December 31, 2019.
Our overall investment philosophy is designed to first protect policyholders by maintaining sufficient funds to meet corporate and policyholder obligations and then generate long-term growth in shareholders’ equity. Because our existing and projected liabilities are sufficiently funded by the fixed income portfolio, we can improve returns by investing a portion of the surplus (within limits) in a risk assets portfolio largely made up of equities. As of December 31, 2020, 46 percent of our shareholders’ equity was invested in equities, unchanged from December 31, 2019.
50
The fixed income portfolio is structured to meet policyholder obligations and optimize the generation of after-tax investment income and total return.
FINANCING ACTIVITIES
In addition to the previously discussed operating and investing activities, we also engage in financing activities to manage our capital structure. The following list highlights some of the major sources and uses of cash flow from financing activities:
Sources Uses
Proceeds from stock offerings Shareholder dividends
Proceeds from debt offerings Debt repayment
Short-term borrowing Share buy-backs
Shares issued under stock option plans
Our capital structure is comprised of equity and debt obligations. As of December 31, 2020, our capital structure consisted of $149.5 million in 10-year maturity senior notes (long-term debt) and $1.1 billion of shareholders’ equity. Debt outstanding comprised 12 percent of total capital as of December 31, 2020.
At the holding company (RLI Corp.) level, we rely largely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt, corporate expenses and dividends to RLI Corp. shareholders. As discussed further below, dividend payments to RLI Corp. from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the insurance regulatory authorities of Illinois. As a result, we may not be able to receive dividends from such subsidiary at times and in amounts necessary to pay desired dividends to RLI Corp. shareholders. On a GAAP basis, as of December 31, 2020, our holding company had $1.1 billion in equity. This includes amounts related to the equity of our insurance subsidiaries, which is subject to regulatory restrictions under state insurance laws. The unrestricted portion of holding company net assets is comprised primarily of investments and cash, including $64.6 million in liquid investment assets, which exceeds our normal annual holding company expenditures. Unrestricted funds at the holding company level are available to fund debt interest, general corporate obligations and regular dividend payments to our shareholders. If necessary, the holding company also has other potential sources of liquidity that could provide for additional funding to meet corporate obligations or pay shareholder dividends, which include a revolving line of credit, as well as access to the capital markets.
Ordinary dividends, which may be paid by our principal insurance subsidiary without prior regulatory approval, are subject to certain limitations based upon statutory income, surplus and earned surplus. The maximum ordinary dividend distribution from our principal insurance subsidiary in a rolling 12-month period is limited by Illinois law to the greater of 10 percent of RLI Ins. policyholder surplus, as of December 31 of the preceding year, or the net income of RLI Ins. for the 12-month period ending December 31 of the preceding year. Ordinary dividends are further restricted by the requirement that they be paid from earned surplus. In 2020 and 2019, our principal insurance subsidiary paid ordinary dividends totaling $110.0 million and $59.0 million, respectively, to RLI Corp. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the IDOI. No extraordinary dividends were paid in 2020 or 2019. As of December 31, 2020, $25.3 million of the net assets of our principal insurance subsidiary are not restricted and could be distributed to RLI Corp. as ordinary dividends. Because the limitations are based upon a rolling 12-month period, the amount and impact of these restrictions vary over time. In addition to restrictions from our principal subsidiary’s insurance regulator, we also consider internal models and how capital adequacy is defined by our rating agencies in determining amounts available for distribution.
Our 179th consecutive dividend payment was declared in February 2021 and will be paid on March 19, 2021, in the amount of $0.24 per share. Since the inception of cash dividends in 1976, we have increased our annual dividend every year.
OUTLOOK FOR 2021
We achieved our 25th consecutive year of underwriting profit in 2020, a notable milestone in the midst of challenging conditions. Despite the economic slowdown, we were able to grow premium 7 percent for the year and believe there is momentum for growth to continue in 2021. The support for broad-based rate increases in the industry go well beyond the influences of the pandemic and continue to be driven by loss cost inflation, elevated catastrophe activity, reinsurance pricing and prolonged low interest rates. We will benefit when rates exceed the trajectory of projected loss costs and should continue to see business opportunities that meet our risk appetite.
Terms and conditions are an important part of tailoring coverage for the specific needs of an insured. The evolution of policy language offers the potential for more business to align with our criteria, and we are better equipped to provide bespoke solutions to our distribution partners.
51
Brokers and agents that drive new business to RLI are demanding ease of use. As consolidation of these producers is likely to persist, the ability to maintain relationships through transitions is critical. Continued investment in people and technology is designed to address these trends and sustain our business. Our diversified portfolio of products allows us to respond to market opportunity and shift away from commoditized business with heavy competition.
Government policy was swift and far reaching in response to the COVID-induced recession of mid-2020. Consumers, employers, the mortgage market and credit availability were all supported by large amounts of federal stimulus. Measures of employment have rebounded faster than expected, but the path toward full employment will take time, with affected industries (e.g. entertainment, travel, hospitality) requiring a prolonged recovery, well into 2022.
The Federal Reserve’s support of the capital markets last year seems to have forestalled a second financial crisis. However, this accommodation will extend the low interest rate environment for the foreseeable future. While this liquidity will support asset prices in much of our investment portfolio, longer term performance will require increasing earnings and sound fundamentals. Investment income will face some headwinds over the next several quarters, but a growing invested asset base may provide an important offset. Equity prices and credit markets have rebounded significantly from the lows in March 2020, and while there may be some volatility in 2021, we believe markets will continue to respond positively to the ongoing recovery.
The economy was on better footing in the last six months of 2020. However, there are segments of our business that remain highly sensitive to slowdowns in gross domestic product. A number of products in our casualty and surety segments touch the construction industry and any slide back into recession may shelve projects more permanently. Our expectation is that most planned commercial construction activity will continue as intended, although post pandemic preferences for real estate may change the landscape over time.
CASUALTY
The casualty segment has experienced a number of cross currents on loss trends over the last several years, with volatile damage awards and changes to frequency adding to uncertainty of outcomes, especially for lines with longer duration. Pricing has responded with consecutive years of improvement in many lines, especially for products where the most challenging loss outcomes have impacted participants, and capacity is being removed from the market.
We will remain disciplined and aim to grow premium and underwriting profit, primarily from rate and by providing outstanding service to our producer partners and insureds.
PROPERTY
Market disruption for property has been ongoing for several years, driven by increased frequency of storm activity. Last year set a number of records for weather events and business interruption (BI) was a constant headline for the segment. The industry will be working through BI coverage issues beyond 2021, as cases make their way through the court system.
Capital constraints for other carriers, a reactive reinsurance market and higher loss activity should support continued positive rate change. Reduced capacity has increased new business opportunities in our excess and surplus commercial coverages. Over time and through major catastrophe events, we have demonstrated our commitment to serving our insureds through responsive claim handling, which has strengthened our relationships with producers as well as insureds. We believe growth is achievable in all of our property businesses in 2021, and underwriting profit will be dependent on the level of catastrophe activity.
SURETY
The surety market appears to be changing as macroeconomic factors and years of competitiveness have increased losses relative to premium. Capacity is available and relatively stable, but losses are beginning to influence terms, conditions and rate. Bankruptcy activity may be elevated over the next year, along with general deterioration in financial security, particularly in the energy sector.
Surety premiums have been capped the last few years as we maintained disciplined underwriting, surrounded by higher levels of competition. Our actions are reflected in the stable underwriting profit the segment has produced. Looking ahead, we are ready to take advantage of improving market conditions and are cautiously optimistic that measured growth is possible for 2021. We will continue to take underwriting action where required and are monitoring how our accounts are faring in light of the current economy.
* * *
In all, we see some momentum continuing into the new year, with a cautious eye on trends affecting our industry. We will maintain our disciplined approach and the cultural hallmarks that have enabled RLI to achieve an enviable track record over the past 25 years.
52
PROSPECTIVE ACCOUNTING STANDARDS
Prospective accounting standards are those which we have not implemented because 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.
53
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
MARKET RISK DISCLOSURE
Market risk is a general term describing the potential economic loss associated with adverse changes in the fair value of financial instruments. Management of market risk is a critical component of our investment decisions and objectives. We manage our exposure to market risk by using the following tools:
• Monitoring the fair value of all financial assets on a constant basis,
• Changing the character of future investment purchases as needed and
• Maintaining a balance between existing asset and liability portfolios.
FIXED INCOME AND INTEREST RATE RISK
The most significant short-term influence on our fixed income portfolio is a change in interest rates. Because there is intrinsic difficulty predicting the direction and magnitude of interest rate moves, we attempt to minimize the impact of interest rate risk on the balance sheet by matching the duration of assets to that of our liabilities. Furthermore, the diversification of sectors and given issuers is core to our risk management process, increasing the granularity of individual credit risk. Liquidity and call risk are elements of fixed income that we regularly evaluate to ensure we are receiving adequate compensation. Our fixed income portfolio has a meaningful impact on financial results and is a key component in our enterprise risk simulations.
Interest rate risk can also affect our consolidated statement of earnings due to its impact on interest expense. As of December 31, 2020 and 2019, we had no short-term debt obligations. We maintain a debt obligation that is long-term in nature and carries a fixed interest rate. As such, our interest expense on this obligation is not subject to changes in interest rates. As this debt is not due until 2023, we will not assume additional interest rate risk in our ability to refinance this debt for more than two years.
EQUITY PRICE RISK
Equity price risk is the potential that we will incur economic loss due to the decline of common stock prices. Beta analysis is used to measure the sensitivity of our equity portfolio to changes in the value of the S&P 500 Index (an index representative of the broad equity market). Our current equity portfolio has a beta of 0.9in comparison to the S&P 500 with a beta of 1.0. This lower beta statistic reflects our long-term emphasis on maintaining a value-oriented, dividend-driven investment philosophy for our equity portfolio.
SENSITIVITY ANALYSIS
The tables that follow detail information on the market risk exposure for our financial investments as of December 31, 2020. Listed on each table is the December 31, 2020 fair value for our assets and the expected pretax reduction in fair value given the stated hypothetical events. This sensitivity analysis assumes the composition of our assets remains constant over the period being measured and also assumes interest rate changes are reflected uniformly across the yield curve. For example, our ability to hold non-trading securities to maturity mitigates price fluctuation risks. For purposes of this disclosure, market risk sensitive instruments are all classified as held for non-trading purposes, as we do not hold any trading securities. The examples given are not predictions of future market events, but rather illustrations of the effect such events may have on the fair value of our investment portfolio.
As of December 31, 2020, our fixed income portfolio had a fair value of $2.2 billion. The sensitivity analysis uses scenarios of interest rates increasing 100 and 200 basis points from their December 31, 2020, levels with all other variables held constant. Such scenarios would result in modeled decreases in the fair value of the fixed income portfolio of $113.6 million and $219.9 million, respectively.
As of December 31, 2020, our equity portfolio had a fair value of $524.0 million. The base sensitivity analysis uses market scenarios of the S&P 500 Index declining both 10 percent and 20 percent. These scenarios would result in approximate decreases in the equity fair value of $46.9 million and $93.8 million, respectively.
While the declines in market value outlined below are modeled as instantaneous changes, we would expect movements in capital markets to occur over time, with investment income offering an offset to any decrease in prices.
Under the assumptions of rising interest rates and a decreasing S&P 500 Index, the fair value of our assets will decrease from their present levels by the indicated amounts.
54
Effect of a 100basis-point increase in interest rates and a 10 percent decline in the S&P 500:
(in thousands) Value Rate Risk Risk
Held for non-trading purposes:
Effect of a 200 basis-point increase in interest rates and a 20 percent decline in the S&P 500:
(in thousands) Value Rate Risk Risk
Held for non-trading purposes:
Comparatively, under the assumptions of falling interest rates and an increasing S&P 500 Index, the fair value of our assets will increase from their present levels by the indicated amounts.
Effect of a 100 basis-point decrease in interest rates and a 10 percent increase in the S&P 500:
(in thousands) Value Rate Risk Risk
Held for non-trading purposes:
Effect of a 200 basis-point decrease in interest rates and 20 percent increase in the S&P 500:
(in thousands) Value Rate Risk Risk
Held for non-trading purposes:
55
Item 8. Financial Statements and Supplementary Data
Index to Financial Statements Page
Consolidated Balance Sheets 57
Consolidated Statements of Earnings and Comprehensive Earnings 58
Consolidated Statements of Shareholders’ Equity 59
Consolidated Statements of Cash Flows 60
Notes to Consolidated Financial Statements 61-92
Reports of Independent Registered Public Accounting Firms 93
56
RLI Corp.
Consolidated Balance Sheets
December 31,
(in thousands, except per share data) 2020 2019
ASSETS
Investments and cash:
Fixed income:
(amortized cost of $2,061,467 and allowance for credit losses of $397 in 2020)
(amortized cost of $1,915,278 and allowance for credit losses of $0 in 2019)
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
SHAREHOLDERS' EQUITY
Common stock ($0.01 par value)
See accompanying notes to consolidated financial statements.
57
RLI Corp.
Consolidated Statements of Earnings and Comprehensive Earnings
Years ended December 31,
Other-than-temporary-impairment losses on investments — — (217 )
Income tax expense (benefit):
Basic net earnings per share $ 3.49 $ 4.28 $ 1.45
Diluted net earnings per share $ 3.46 $ 4.23 $ 1.43
Weighted average number of common shares outstanding:
See accompanying notes to consolidated financial statements.
58
RLI Corp.
Consolidated Statements of Shareholders’ Equity
Total Accumulated Other
Other comprehensive earnings (loss), net of tax — (33,997 ) — — (33,997 ) — — —
Deferred compensation — — — — — — (286 ) 286
Other comprehensive earnings (loss), net of tax — 67,045 — — 67,045 — — —
Deferred compensation — — — — — — (374 ) 374
Other comprehensive earnings (loss), net of tax — 56,219 — — 56,219 — — —
Deferred compensation — — — — — — 312 (312 )
See accompanying notes to consolidated financial statements.
59
RLI Corp.
Consolidated Statements of Cash Flows
Years ended December 31,
Cash flows from operating activities:
Net unrealized (gains) losses on equity securities (32,101 ) (78,090 ) 98,735
Change in:
Deferred policy acquisition costs (3,381 ) (110 ) (7,218 )
Changes in investment in unconsolidated investees:
Cash flows from investing activities:
Purchase of:
Investment in equity method investee (4,533 ) — —
Proceeds from sale of:
Property and equipment — — 167
Proceeds from call or maturity of:
Net proceeds from sale (purchase) of short-term investments — 11,550 (1,570 )
Cash flows from financing activities:
See accompanying notes to consolidated financial statements.
60
Notes to Consolidated Financial Statements
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A. DESCRIPTION OF BUSINESS
RLI Corp. is an insurance holding company. References to “the Company,” “we,” “our,” “us” or like terms refer to the business of RLI Corp. and its subsidiaries. We underwrite select property and casualty insurance coverages through major subsidiaries collectively known as RLI Insurance Group. We conduct operations principally through three insurance companies. RLI Insurance Company (RLI Ins.), a subsidiary of RLI Corp. and our principal insurance subsidiary, writes multiple lines of insurance on an admitted basis in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. Mt. Hawley Insurance Company (Mt. Hawley), a subsidiary of RLI Ins., writes excess and surplus lines insurance on a non-admitted basis in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. Contractors Bonding and Insurance Company (CBIC), a subsidiary of RLI Ins., writes multiple lines of insurance on an admitted basis in all 50 states and the District of Columbia.
On May 4, 2018, RLI Corp. changed its state of incorporation from the State of Illinois to the State of Delaware (the Reincorporation). The Reincorporation was effected by merging RLI Corp., an Illinois corporation (RLI Illinois), into RLI Corp., a Delaware corporation (RLI Delaware). The separate corporate existence of RLI Illinois ceased and RLI Delaware continues in existence as the surviving corporation and possesses all rights, privileges, powers and franchises of RLI Illinois. The Reincorporation did not result in any change in the name, business, management, fiscal year, location of the principal executive offices, assets or liabilities of the Company. Each outstanding share of RLI Illinois common stock, which had a par value of $1.00 per share, was automatically converted into one outstanding share of RLI Delaware common stock, with a par value of $0.01 per share. In order to reflect the new par value of common stock on the balance sheet, a $66.4 million reclassification from common stock to paid-in-capital was made.
B. PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION
The accompanying consolidated financial statements were prepared in conformity with generally accepted accounting principles in the United States of America (GAAP), which differ in some respects from those followed in reports to insurance regulatory authorities. The consolidated financial statements include the accounts of our holding company and our subsidiaries. Intercompany balances and transactions have been eliminated. The Company has evaluated subsequent events through the date these consolidated financial statements were issued. There were no subsequent events requiring adjustment to the financial statements or disclosure.
C. ADOPTED ACCOUNTING STANDARDS
ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments
ASU 2016-13 was issued to provide more decision-useful information about the expected credit losses on financial instruments. Previous guidance delayed the recognition of credit losses until it was probable a loss had been incurred. This update requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected by means of an allowance for credit losses that is included in net earnings. Credit losses relating to available-for-sale debt securities are also required to be recorded through a reversible allowance for credit losses, but is limited to the amount by which fair value is less than amortized cost.
We adopted ASU 2016-13 on January 1, 2020 using the modified-retrospective approach. The standard applied to three of the Company’s balance sheet accounts: available-for-sale fixed income securities, premiums receivable and reinsurance balances recoverable. The impact of this standard was and is expected to continue to be immaterial, as our fixed income portfolio is weighted towards higher rated bonds (83 percent rated A or better at December 31, 2020 and 85 percent at December 31, 2019), we purchase reinsurance from financially strong reinsurers, we have a long history of collecting premium receivables through various economic cycles and we had previously maintained an allowance for uncollectible premium and reinsurance balances. In total, the cumulative-effect adjustment made to the balance sheet as of the beginning of the year resulted in a $1.1 million increase to retained earnings and an increase to accumulated other comprehensive earnings of less than $0.1 million
D. PROSPECTIVE ACCOUNTING STANDARDS
There are no prospective accounting standards which would have a material impact on our financial statements as of December 31, 2020.
E. INVESTMENTS
Equity securities are carried at fair value with unrealized gains and losses recorded within net earnings. Investments in fixed income securities are classified into one of three categories: trading, held-to-maturity or available-for-sale. All of our fixed income
61
securities are classified as available-for-sale and reported at fair value. Unrealized gains and losses on these securities are excluded from net earnings but are recorded as a separate component of comprehensive earnings and shareholders’ equity, net of deferred income taxes.
Interest on fixed maturities and short-term investments is credited to earnings on an accrual basis. Premiums and discounts are amortized or accreted over the lives of the related fixed maturities. Dividends on equity securities are credited to earnings on the ex-dividend date. Realized gains and losses on disposition of investments are based on specific identification of the investments sold on the settlement date.
F. CASH, SHORT-TERM INVESTMENTS AND OTHER INVESTED ASSETS
Cash consists of uninvested balances in bank accounts. Other invested assets include investments in low income housing tax credit partnerships (LIHTC), membership in the Federal Home Loan Bank of Chicago (FHLBC), investments in private funds and investments in restricted stock. Our LIHTC investments are carried at amortized cost, and our investment in FHLBC stock is carried at cost. Due to the nature of cash, the LIHTCs and our membership in the FHLBC, their carrying amounts approximate fair value. The private funds are carried at fair value, using each investment’s net asset value. Restricted stock is carried at quoted market prices, as the restrictions expire within one year.
G. REINSURANCE
Ceded unearned premiums and reinsurance balances recoverable on unpaid losses and settlement expenses are reported separately as an asset, rather than being netted with the related liability, since reinsurance does not relieve the Company of our liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. We continually monitor the financial condition of our reinsurers and actively follow up on any past due or disputed amounts. As part of our monitoring efforts, we review their annual financial statements and SEC filings for those reinsurers that are publicly traded. We also review insurance industry developments that may impact the financial condition of our reinsurers. We analyze the credit risk associated with our reinsurance balances recoverable by monitoring the AM Best and S&P ratings of our reinsurers. In addition, we subject our reinsurance recoverables to detailed recoverability tests, including a segment-based analysis using the average default rating percentage by S&P rating, which assists the Company in assessing the sufficiency of the existing allowance. Additionally, we perform an in-depth reinsurer financial condition analysis prior to the renewal of our reinsurance placements.
Our policy is to charge to earnings, in the form of an allowance, an estimate of unrecoverable amounts from reinsurers. This allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover. Once regulatory action (such as receivership, finding of insolvency, order of conservation or order of liquidation) is taken against a reinsurer, the paid and unpaid recoverable for the reinsurer are specifically identified and written off through the use of our allowance for estimated unrecoverable amounts from reinsurers. When we write-off such a balance, it is done in full. We then re-evaluate the remaining allowance and determine whether the balance is sufficient as detailed above and if needed, an additional allowance is recognized and income charged.
H. POLICY ACQUISITION COSTS
We defer incremental direct costs that relate to the successful acquisition of new or renewal insurance contracts, including commissions and premium taxes. Acquisition-related costs may be deemed ineligible for deferral when they are based on contingent or performance criteria beyond the basic acquisition of the insurance contract or when efforts to obtain or renew the insurance contract are unsuccessful. All eligible costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This process contemplates the premiums to be earned, anticipated losses and settlement expenses and certain other costs expected to be incurred, but does not consider investment income. Judgments as to the ultimate recoverability of such deferred costs are reviewed on a segment basis and are highly dependent upon estimated future loss costs associated with the premiums written. This deferral methodology applies to both gross and ceded premiums and acquisition costs.
I. PROPERTY AND EQUIPMENT
Property and equipment are presented at cost less accumulated depreciation and are depreciated on a straight-line basis for financial statement purposes over periods ranging from 3 to 10 years for equipment and up to 30 years for buildings and improvements.
J. INVESTMENTS IN UNCONSOLIDATED INVESTEES
Our investments accounted for under the equity method are primarily related to Maui Jim, Inc. (Maui Jim) and Prime Holdings Insurance Services, Inc. (Prime). We maintain a 40 percent interest in the equity and earnings of Maui Jim, a manufacturer of high-
62
quality sunglasses, and a minority representation on their board of directors. Maui Jim’s chief executive officer owns a controlling majority of the outstanding shares of Maui Jim. We carry this investment at the holding company level as it is not core to our insurance operations. Our investment in Maui Jim was $90.9 million at December 31, 2020 and $79.6 million at December 31, 2019. In 2020, we recorded $10.4 million in investee earnings for Maui Jim, compared to $13.6 million in 2019 and $12.5 million in 2018.
As of December 31, 2020, we had a 23 percent interest in the equity and earnings of Prime. Prime writes business through two Illinois domiciled insurance carriers, Prime Insurance Company, an excess and surplus lines company, and Prime Property and Casualty Insurance Inc., an admitted insurance company. Our investment in Prime was $32.7 million at December 31, 2020 and $24.2 million at December 31, 2019. In 2020, we recorded $10.8 million in investee earnings for Prime, compared to $7.4 million in 2019 and $3.6 million in 2018. Additionally, we maintain a quota share reinsurance treaty with Prime, which contributed $15.7 million of gross premiums written and $14.3 million of net premiums earned during 2020, compared to $13.1 million of gross premiums written and $28.7 million of net premiums earned during 2019 and $41.1 million of gross premiums written and $34.2 million of net premiums earned during 2018. The decrease in premium is reflective of our decreased quota share participation with Prime.
Our equity method investments recorded net income of $70.4 million in 2020, $77.3 million in 2019 and $50.2 million in 2018. Additional summarized financial information for our equity method investments as of 2020 and 2019 is outlined in the following table:
Approximately $106.0 million of undistributed earnings from our equity method investees are included in our retained earnings as of December 31, 2020. We received dividends of $4.7 million, $13.2 million and $9.9 million from our equity method investees in 2020, 2019 and 2018, respectively.
We perform annual impairment reviews of our investments in unconsolidated investees, which take into consideration current valuation and operating results. Based upon the most recent reviews, the assets were not impaired.
K. INTANGIBLE ASSETS
The composition of goodwill and intangibles at December 31, 2020 and 2019, is detailed in the following table:
Goodwill
Intangibles
As the amortization of goodwill and indefinite-lived intangible assets is not permitted, the assets are tested for impairment on an annual basis, or earlier if there is reason to suspect that their values may have been diminished or impaired. Annual impairment testing was performed on each of our goodwill and indefinite-lived intangible assets during 2020. Based upon these reviews, our goodwill and state insurance license indefinite-lived intangible asset were not impaired. In addition, as of December 31, 2020, there were no triggering events on goodwill and intangible assets that would suggest an updated review was necessary.