UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
or
RLI Corp.
(309) 692-1000(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of July 16, 2004 the number of shares outstanding of the registrant’s Common Stock was 25,216,154.
TABLE OF CONTENTS
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
RLI Corp. and SubsidiariesCondensed Consolidated Statement of Earnings and Comprehensive Earnings
The accompanying notes are an integral part of the financial statements.
2
3
RLI Corp. and Subsidiaries Condensed Consolidated Balance Sheet
4
RLI Corp. and SubsidiariesCondensed Consolidated Statements of Cash Flows(Unaudited)
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
6
7
Had compensation cost for the plan been determined consistent with SFAS 123, our net income and earnings per share would have been reduced to the following pro forma amounts:
8
These pro forma amounts may not be representative of the effects of SFAS 123 on pro forma net income for future periods because options vest over several years and additional awards may be granted in the future.
Pension Plan: On December 31, 2003, our pension plan was amended to freeze benefit accruals as of March 1, 2004. As a result, we expensed the entire unrecognized service cost as of December 31, 2003. The plan was also closed to new participants after December 31, 2003. Participants’ benefits may increase in the future based on changes in their final average earnings. Future pay increases are indexed to a maximum of 5% annually. Increases in excess of 5% will not be reflected in the determination of participants’ final average earnings. The table below represents the various components of pension expense for the six month periods ended June 30, 2004 and 2003.
The decline in pension expense is reflective of the amendment to freeze benefit accruals and the closing of the plan to new participants. The ERISA required minimum contribution during the fiscal year ending December 31, 2004, is $0. We have not decided whether to contribute any amount in excess of this.
Intangible assets: In accordance with SFAS 142, “Goodwill and Other Intangible Assets,” the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is reason to suspect that their values may have been diminished or impaired. Goodwill and indefinite-lived intangible assets, which relate to our surety segment, are listed separately on the balance sheet and totaled $26.2 million at June 30, 2004 and December 31, 2003. Impairment testing was performed during the second quarter of 2004, pursuant to the requirements of SFAS 142. Based upon this valuation analysis, these assets do not appear to be impaired.
9
Intangible assets with definite lives continue to be amortized over their estimated useful lives. Definite-lived intangible assets that continue to be amortized under SFAS 142 relate to our purchase of customer-related and marketing-related intangibles. These intangibles have useful lives ranging from five to 10 years. Amortization of intangible assets was $661,000 for the first half of 2004, compared to $335,000 for the same period last year. Amortization expense in 2004 includes $307,000 of additional expense recorded in June, pursuant to our review of the recoverability of the definite-lived intangible asset relating to contract surety. Definite-lived intangibles are subject to review for impairment pursuant to the requirements of SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS 144 requires, among other things, that we review our long-lived assets and certain related intangibles for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. While results for contract surety have improved, the improvement has not been as rapid as anticipated. In accordance with SFAS 144, we compared the asset’s projected undiscounted cash flows, over its remaining useful life, to its current carrying value. The result of this test indicated that $307,000 of the current carrying value was not recoverable. We recorded $307,000 of additional amortization expense to reflect this write down. Subsequent to this adjustment, the asset has a carrying value of $396,000. At June 30, 2004, net intangible assets totaled $1.6 million, net of $4.1 million of accumulated amortization, and are included in other assets.
2. INDUSTRY SEGMENT INFORMATION - Selected information by industry segment for the six months ended June 30, 2004 and 2003 is presented below.
10
The following table further summarizes revenues by major product type within each segment:
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
“SAFE HARBOR” STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: This discussion and analysis may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Various risk factors that could affect future results are listed in the Company’s filings with the Securities & Exchange Commission, including the Form 10-K for the year ended December 31, 2003.
OVERVIEW
We are a holding company that underwrites selected property and casualty insurance through major subsidiaries collectively known as RLI Insurance Group, or the Group. The Group provides property and casualty coverages primarily for commercial risks and has accounted for approximately 89% of our consolidated revenue for the first half of 2004 compared to 90% for the same period last year.
11
As a “niche” company, we offer specialty insurance products designed to meet specific insurance needs of targeted insured groups. A niche company underwrites a particular type of coverage for certain markets that are underserved by the insurance industry, such as our commercial earthquake coverage or oil and gas surety bonds. A niche company also provides a type of product not generally offered by other companies, such as our stand-alone personal umbrella policy, which we offer without the underlying auto or homeowners coverage. The excess and surplus lines market provides an alternative for customers with hard-to-place risks and risks that admitted insurers specifically refuse to write. When we underwrite within the excess and surplus lines market, we are selective in the lines of business and types of risks we choose to write. Often the development of these specialty insurance products is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients. Once a proposal is submitted, underwriters determine whether a proposal would be a viable product in keeping with our business objectives.
Management measures the results of our insurance operations by monitoring certain measures of 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 GAAP (accounting principles generally accepted in the United States of America) combined ratios, which are further subdivided into their respective loss and expense components. The GAAP combined ratios represent the profit generated from our insurance operations.
The foundation of our overall business strategy is to underwrite for profit. This drives our ability to provide shareholder returns in three different ways: the underwriting profit itself, investment income from fixed-income portfolios, and long-term growth in our equity portfolio. Our investment strategy is based on preservation of capital as the first priority, with a secondary focus on generating total return.
The property and casualty insurance business is cyclical and influenced by many factors, including price competition, economic conditions, natural or man-made disasters (for example, earthquakes and terrorism), interest rates, state regulations, court decisions and changes in the law. One of the unique and challenging features of the property and casualty insurance business is that products must be priced before costs have fully developed, because premiums are charged before claims are incurred. This requires that liabilities be estimated and recorded in recognition of future loss and settlement obligations. Due to the inherent uncertainty in estimating these liabilities, there can be no assurance that actual liabilities will not exceed recorded amounts; if actual liabilities do exceed recorded amounts, there will be an adverse effect on net earnings. In evaluating the objective performance measures previously mentioned, it is important to consider the following individual characteristics of each major insurance segment.
12
Our property segment primarily underwrites commercial fire, earthquake, builders’ risk, difference in conditions, other inland marine coverages and, in the state of Hawaii, select personal lines policies. Property insurance results are subject to the variability introduced by perils such as earthquakes, fires and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, as approximately 40% of first half 2004’s total property premiums were written in California. We limit our net aggregate exposure to a catastrophic event by purchasing reinsurance and through extensive use of computer-assisted modeling techniques. These techniques provide estimates of the concentration of risks exposed to catastrophic events.
The casualty portion of our business consists largely of general liability, transportation, multi-peril program business, commercial umbrella, personal umbrella, executive products and other specialty coverages. In addition, we provide employers indemnity and in-home business owners coverage. The casualty book of business is subject to the risk of accurately estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty line may also be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses.
The surety segment specializes in writing small to large commercial and small contract surety products, as well as those for the energy (plugging and abandonment), petrochemical and refining industries. The commercial surety products usually involve a statutory requirement for bonds. This industry has historically maintained a relatively low loss ratio. Losses may fluctuate, however, due to adverse economic conditions that may affect the financial viability of an insured. The contract surety market guarantees the construction work of a commercial contractor for a specific project. As such, this line has historically produced marginally higher loss ratios than other surety lines. Generally, losses occur due to adverse economic conditions, inclement weather conditions or the deterioration of a contractor’s financial condition.
13
Critical Accounting Policies
GAAP and non-GAAP Financial Performance Metrics
Throughout this quarterly report, we present our operations in the way we believe will be most meaningful, useful and transparent to anyone using this financial information to evaluate our performance. In addition to the GAAP presentation of net income and certain statutory reporting information, we show certain non-GAAP financial measures that are valuable in managing our business, including gross revenues, gross written premiums, net written premiums and combined ratios.
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.
Gross revenues
This is an RLI-defined metric equaling the sum of gross premiums written, net investment income and realized gains (losses). It is used by our management as an overall gauge of gross business volume across all operating segments.
Gross premiums written
While net premiums earned is the related GAAP measure used in the statement of earnings, gross premiums written is the component of net premiums earned that measures insurance business produced before the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an overall gauge of gross business volume in our insurance underwriting operations with some indication of profit potential subject to the levels of our retentions, expenses and loss costs.
Net premiums written
While net premiums earned is the related GAAP measure used in the statement of earnings, net premiums written is the component of net premiums earned that measures the difference between gross premiums written and the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an indication of retained or net business volume in our insurance underwriting operations. It is an indicator of future earnings potential subject to our expenses and loss costs.
Combined ratios
This ratio is a common industry measure of profitability for any underwriting operation, and is calculated in two segments. First, the expense ratio component reflects the sum of policy acquisition costs and insurance operating expenses, divided by net premiums earned. The second component, the loss ratio, is losses and settlement expenses divided by net premiums earned. 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 profit or loss.
14
In preparing the consolidated financial statements, our management is 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 and deferred policy acquisition costs.
Unpaid Losses and Settlement Expenses
The liability for unpaid losses and settlement expenses represents estimates of amounts needed to pay reported and unreported claims and related expenses. The estimates are based on certain actuarial and other assumptions related to the ultimate cost to settle such claims. Such assumptions are subject to occasional changes due to evolving economic, social and political conditions. All estimates are periodically reviewed and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments are reflected in the results of operations in the period in which they are determined.
Generally, we have not experienced significant development, favorable or unfavorable, either with the liability in total or within industry segments. Additional information with respect to reserve development patterns for individual calendar year-end liabilities can be found on pages 11-14 of our 2003 Annual Report on Form 10K. Adding to the complexities inherent in the reserving process are issues related to coverage, expansion of coverage, and reinsurance program applicability.
We have insignificant exposure to asbestos and environmental policy liabilities, as a result of entering liability lines after the industry had already recognized it as a problem. What exposure does exist is through our commercial umbrella, general liability, and discontinued assumed reinsurance lines of business. The majority of that exposure is in the excess layers of our commercial umbrella and assumed reinsurance books of business. Although our asbestos and environmental exposure is limited, management cannot determine our ultimate liability with any reasonable degree of certainty. This ultimate liability is difficult to assess due to evolving legislation on such issues as joint and several liability, retroactive liability, and standards of cleanup. Additionally, we participate primarily in the excess layers, making it even more difficult to assess the ultimate impact.
Investment Valuation
Throughout each year, our external investment managers buy and sell securities to maximize overall investment returns in accordance with investment policies established and monitored by our board of directors and officers. This includes selling individual securities that have unrealized losses when the investment manager believes future performance can be surpassed by buying other securities deemed to offer superior long-term return potential.
15
We classify our investments in debt and equity securities with readily determinable fair values into one of three categories: held-to-maturity securities are carried at amortized cost, while both available-for-sale securities and trading securities are carried at fair value.
Management regularly evaluates our fixed maturity and equity securities portfolio to determine impairment losses for other-than-temporary declines in the fair value of the investments. Criteria considered during this process include, but are not limited to: the current fair value as compared to the cost (amortized, in certain cases) of the security, degree and duration of the security’s fair value being below cost, credit ratings, current economic conditions, the anticipated speed of cost recovery, and our decisions to hold or divest a security. Impairment losses result in a reduction of the underlying investment’s cost basis. Significant changes in these factors could result in a considerable charge for impairment losses as reported in the consolidated financial statements.
Part of our evaluation of whether particular securities are other than temporarily impaired involves assessing whether we have both the intent and ability to continue to hold securities in an unrealized loss position. We have not sold any securities for the purpose of generating cash over the last several years to pay claims, dividends or any other expense or obligation. Accordingly, we believe that our sale activity supports our ability to continue to hold securities in an unrealized loss position until our cost may be recovered.
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 appropriate liabilities, since reinsurance does not relieve us of our legal liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and settlement expenses impact the estimates for the ceded portion of such liabilities. We continually monitor the financial condition of our reinsurers. Our policy is to periodically charge to earnings an estimate of unrecoverable amounts from troubled or insolvent reinsurers. Further discussion of the security of our recoverable reinsurance balances can be found in note 5 to the financial statements included in our 2003 Annual Report on Form 10-K.
Deferred Policy Acquisition Costs
We defer commissions, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premiums to be earned, related investment income, anticipated losses and settlement expenses as well as certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the premiums written.
16
SIX MONTHS ENDED JUNE 30, 2004, COMPARED TO SIX MONTHS ENDED JUNE 30, 2003
Consolidated gross revenues, as displayed in the table that follows, totaled $412.6 million for the first half of 2004 compared to $387.9 million for the same period in 2003.
Gross premium writings of the Group improved 5% over 2003 levels due to growth in the casualty segment, as market conditions remained firm in general liability and umbrella. Net investment income improved 19% to $25.7 million. This growth is attributable to increased cash flows from operations and the infusion of new capital from the December 2003 bond offering. Additionally, the sale of certain securities during the first half of 2004 resulted in the recognition of $4.3 million in realized gains.
Consolidated net revenue for the first half of 2004 increased $36.1 million, or 15%, from the same period in 2003. Net premiums earned, the main driver of this measurement, jumped 14%, benefiting from increased retentions in certain product lines and the momentum gained from last year’s written premium growth in the casualty segment.
Net after-tax earnings for the first half of 2004 totaled $35.3 million, $1.35 per diluted share, compared to $29.8 million, $1.16 per diluted share, for the same period in 2003. Improved underwriting income on the casualty and surety segments, coupled with growth in investment income and increased realized investment gains, favorably impacted 2004 earnings.
Results for the first half of 2004 include realized gains of $4.3 million, $0.10 per diluted share, compared to $2.4 million, $0.06 per diluted share for the same period last year. Increased gains in 2004 relate primarily to the sale of certain equity securities that had reached high valuation metrics.
Comprehensive earnings, which include net earnings plus unrealized gains/losses net of tax, totaled $20.9 million, $0.80 per diluted share, for the first half of 2004, compared to comprehensive earnings of $49.7 million, $1.93 per diluted share, for the same period in 2003. Unrealized losses, net of tax, for the first half of 2004 were $14.4 million, $0.55 per diluted share, compared to unrealized gains of $19.9 million, $0.77 per diluted share, for the same period in 2003. 2004 results were negatively impacted by the rising interest rate environment and volatility experienced in the bond market. Unrealized losses, net of tax, on the bond portfolio totaled $15.9 million for the first half of 2004.
17
RLI INSURANCE GROUP
As indicated earlier, gross premiums written for the Group increased to $382.6 million for the first half of 2004, compared to $364.0 million reported for the same period in 2003. Improved pricing and various growth initiatives in certain casualty products positively impacted gross premiums written. Gross writings for the property segment advanced 2%, as selected opportunities were available despite a continued trend of rate softening. The surety segment reversed a trend of declining premiums, posting a 6% increase in writings. Surety’s growth came from commercial and energy business, areas that have traditionally posted profits. Underwriting income improved to a pre-tax profit of $22.6 million for the first half of 2004 compared to $17.1 million for the same period in 2003. The GAAP combined ratio totaled 91.1 for the first half of 2004, compared to 92.3 for the same period in 2003. With continued favorable loss experience, the property segment led the way posting an impressive 67.4 combined ratio. On a 96.3 combined ratio, the casualty segment recorded improved earnings from last year, while the surety segment posted near breakeven results, well ahead of last year’s results.
Gross premiums written for the Group’s property segment increased $1.6 million, or 2% from the same period last year. For the first half of 2004, gross property premiums totaled $102.1 million. Rate softening, which began in 2003 continued during the first half of 2004 in our domestic fire and California earthquake business. Increased competition and market capacity continue to drive down pricing. While pricing in these lines declined, rates for construction business remained firm during the first half of 2004.
18
Increased pricing on renewal business and new growth opportunities resulted in a $6.2 million increase in construction writings, offsetting the declines experienced in commercial fire and California earthquake. Net premiums written and net premiums earned declined in 2004, primarily due to the continued decline in California earthquake writings, coupled with the purchase of additional catastrophe protection and other reinsurance cessions designed to reduce our overall earthquake exposure. Underwriting profit for the property segment was $16.1 million for the first half of 2004, compared to $18.9 million for the same period in 2003. The GAAP combined ratio increased slightly to 67.4, compared to 65.0 for the same period last year. Both periods represent exceptional results for the segment. The loss ratio, at 29.7, decreased 1.3 points from last year’s posting, while the expense ratio, at 37.7, advanced 3.7 points from last years posting. Loss experience continues to track favorably, while the expense ratio has advanced due to the decline in net premiums relative to the fixed nature of certain expenses.
The casualty segment posted gross premiums written of $252.5 million for the first half of 2004, up $15.5 million, or 7%, from 2003. Premium growth is coming from our general liability and umbrella products, where the rate environment remains favorable. General liability writings advanced $24.6 million, while umbrella was up $6.2 million. We remain focused on growing areas that provide the best return. Other casualty products are seeing rates flatten and, in some instances, begin to decline, as competition has increased. The result of increased competition and an adherence to tight underwriting standards has resulted in the loss of some accounts, particularly in executive products and programs. The casualty segment posted an underwriting profit of $6.6 million, compared to a profit of $1.4 million for the same period last year. These results translate into a combined ratio of 96.3 in the first half of 2004 versus 99.1 for the same period in 2003. A shift in mix of business toward products with lower loss ratios has resulted in a 3.1 point drop in the loss ratio and has accounted for the majority of this improvement. The expense ratio was 26.8 in 2004, compared to 26.5 in 2003.
The surety segment posted gross premiums written of $28.0 million for the first half of 2004, up 6% from 2003’s $26.5 million. Premium growth came from commercial and energy business, areas that have traditionally posted profits. Partially offsetting this growth, gross writings on contract surety were down 20% due to the continuation of tighter underwriting standards. We are encouraged by the improvement in underwriting results during the first half of 2004, as the segment posted near breakeven results. Underwriting loss for the first half of 2004 totaled $127,000, compared to a loss of $3.2 million during 2003. Results in 2003 were impacted by adverse loss experience on contract bonds written in 2002 and prior. The combined ratio for the surety segment totaled 100.5 in 2004, versus 113.3 for the same period in 2003. The segment’s loss ratio was 38.6 for 2004, compared to 49.1 for 2003, reflective of the decline in claim frequency, particularly on the contract book. In the second quarter of 2004, we performed a review of the intangible asset relating to contract surety. While contract surety experience has improved in 2004, the improvement has not been as rapid as anticipated. A review of the intangible asset, which compares future undiscounted cash flows to the current
19
asset value, indicated that the asset was not fully recoverable. As a result, we recorded $307,000 of additional amortization expense. Despite this expense addition, the overall surety expense ratio improved 2.3 points to 61.9, compared to 64.2 in 2003.
We are in litigation regarding certain commercial surety bond claims arising out of a specific bond program. We are currently investigating and evaluating our obligations due to a variety of complex coverage issues. A detailed discussion on this litigation can be found on page 23 of our 2003 Annual Report on Form 10K. There have not been any significant changes or new information as of the first half of 2004.
INVESTMENT INCOME AND REALIZED CAPITAL GAINS
During the first half of 2004, net investment income increased by 19.2% over that reported for the same period in 2003. The improvement in income is due to increased cash flow from operating and financing activities allocated to the investment portfolio. On an after-tax basis, investment income increased by 18.9%. Operating cash flows were $97.0 million in the first half of 2004, up from $47.7 million reported for the same period in 2003. Cash flows in excess of current needs were primarily used to purchase fixed-income securities, which continue to be comprised primarily of high-grade, tax-exempt, corporate and U.S. government/agency issues. The average annual yields on our investments were as follows for the first half of 2004 and 2003.
During the first half of 2004, the average after-tax yield of the fixed-income portfolio decreased slightly due to decreases in both taxable and tax-exempt yields on new purchases. The decline in yields is primarily due to fluctuations in interest rates and the subsequent reinvestment of called and matured bonds at lower yields. Despite the lower yields, the overall impact on investment income has been limited due to the continued growth in operational cash flow and the investment of the proceeds from our December 2003 debt offering. During the first half of 2004, we focused on purchasing high-quality investments, including corporate bonds, municipal bonds, mortgage-backed securities and asset-backed securities, primarily in the 0-10 year part of the yield curve.
The fixed-income portfolio increased by $32.6 million during the first half of 2004. This portfolio had a tax-adjusted total return on a mark-to-market basis of negative 0.1%. Our equity portfolio increased by $21.4 million during the first half of 2004, to $297.4 million. The equity portfolio had a total return of 3.6% during the first half of 2004. During the second quarter of 2004, we
20
invested in an index mutual fund that invests in publicly traded real estate investment trusts (REITs). The purpose of this investment was to further diversify our equity portfolio in an attempt to improve long-term risk adjusted returns. These investments were made at our holding company, RLI Corp., and were valued at $16.1 million at June 30, 2004.
We maintain an equity investment in a private mortgage banking company. As of June 30, 2004, our equity investment, which consisted of common shares and warrants to acquire common shares, had a carrying value and estimated market value of $7.1 million. We recorded a gain of $179,000 in net investment income during the first half of 2004 in accordance with Statement of Financial Accounting Standards (SFAS) 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133). SFAS 133 requires that we recognize the change in fair value of stock warrants received with the purchase of a note receivable. This compares to income of $1.1 million recognized in the first half of 2003. We employ a consistent valuation formula to recognize investment income or loss each quarter and to adjust the carrying value of our investment. This formula is based on the investee’s book value, the volume of mortgages originated and profitability. Income in 2004 was negatively impacted by reduced mortgage origination volume as a result of reduced demand for refinance loans.
We realized a total of $4.3 million in capital gains in the first half of 2004, compared to capital gains of $2.4 million for the same period in 2003. The increase in net realized gains is due in part to the timing of the sale of individual securities.
We regularly evaluate the quality of our investment portfolio. When we believe that a specific security has suffered an other-than-temporary decline in value, the investment’s value is adjusted by reclassifying the decline from unrealized to realized losses, which has no impact on shareholders’ equity. There were no losses associated with the other-than-temporary impairment of securities in 2003 or 2004.
The following table is used as part of our impairment analysis and illustrates certain industry-level measurements relative to our equity portfolio as of June 30, 2004, including market value, cost basis, and unrealized gains and losses.
21
The following table is also used as part of our impairment analysis and illustrates the total value of securities that were in an unrealized loss position as of June 30, 2004. It segregates the securities based on type, noting the fair value, cost (or amortized cost), and unrealized loss on each category of investment as well as in total. The table further classifies the securities based on the length of time they have been in an unrealized loss position.
Investment Positions with Unrealized LossesSegmented by Type and Period of ContinuousUnrealized Loss at June 30, 2004
The following table shows the composition of the fixed income securities in loss positions at June 30, 2004 by NAIC rating and the generally equivalent S&P and Moody’s ratings. Not all of the securities are rated by S&P and/or Moody’s.
22
As of June 30, 2004, we held no equity or fixed income securities that individually had an unrealized loss greater than 12%. As of June 30, 2004, we held one common stock position that was in an unrealized loss position. The total unrealized loss on this security was $21,000. This security has been in an unrealized loss position for less than six months.
The fixed income portfolio contained 254 positions at a loss as of June 30, 2004. Of these 254 securities, 13 have been in an unrealized loss position for more than 12 consecutive months. The fixed income unrealized losses can primarily be attributed to an increase in medium and long-term interest rates since the purchase of many of these fixed income securities. After a lengthy period of downward pressure on medium and long-term interest rates, this trend started to reverse in June 2003. This upward trend in interest rates created unrealized losses for many fixed income investors. As interest rates rise, the prices of many of the fixed income securities in our portfolio will decline, generating increasing levels of unrealized losses. We continually monitor the credit quality of our fixed income investments to gauge our ability to be repaid principal and interest. We consider price declines of securities in our other-than-temporary-impairment analysis where such price declines provide evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration, as opposed to rising interest rates.
INCOME TAXES
Our effective tax rate for the first half of 2004 and 2003 was 29%. Effective rates are dependent upon components of pretax earnings and the related tax effects. Income tax expense attributable to income from operations differed from the amounts computed by applying the U.S. federal tax rate of 35% to pretax income for the first half of 2004 and 2003 as a result of the following:
23
LIQUIDITY AND CAPITAL RESOURCES
We have three primary types of cash flows; (1) cash flows from operating activities, which consist mainly of cash generated by our underwriting operations and income earned on our investment portfolio, (2) cash flows from investing activities related to the purchase, sale and maturity of investments, and (3) cash flows from financing activities that impact our capital structure, such as changes in debt and shares outstanding.
Cash flows from operating activities increased during the first half of 2004 compared to last year, primarily due to timing of premium receipts, reinsurance deposits and certain reinsurance recoveries. On a full-year 2004 basis, we expect operating cash flow to track favorably with the prior two years. The following table summarizes these cash flows for the six month periods ended June 30, 2004 and 2003.
Our largest contractual obligation relates to long-term debt outstanding. On December 12, 2003, we completed a public debt offering, issuing $100 million in senior notes maturing January 15, 2014 (a 10-year maturity), and paying interest semi-annually at the rate of 5.95%. The notes were issued at a discount resulting in proceeds, net of discount and commission, of $98.9 million. As of June 30, 2004, we were party to seven reverse repurchase agreements (short-term debt) totaling $47.1 million. We are not party to any off-balance sheet arrangements.
24
At June 30, 2004, we had short-term investments, cash and other investments maturing within one year, of approximately $89.5 million and additional investments of $337.3 maturing within five years. We maintain a $40.0 million revolving line of credit with two financial institutions. The facility has a three-year term that expires on May 31, 2005. As of June 30, 2004, no amounts were outstanding on this facility.
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 maintain a well-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 June 30, 2004, our portfolio had a book value of $1.4 billion. Invested assets at June 30, 2004, increased by $83.0 million, or 6%, from December 31, 2003.
We regularly evaluate our asset allocation among stocks and bonds, and may choose to invest new cash into stocks in the future. As of June 30, 2004, our fixed-income portfolio had the following rating distribution:
As of June 30, 2004, the average duration of our fixed income portfolio was 5.0 years. Our fixed-income portfolio remained well diversified, with 630 individual issues as of June 30, 2004. During the first six months of 2004, the total return on our bond portfolio on a tax-equivalent, mark-to-market basis was negative 0.1%.
In addition, at June 30, 2004, our equity portfolio had a value of $297.4 million, all of which is classified as available-for-sale and is also a source of liquidity. The securities within the equity portfolio remain primarily invested in large-cap issues with strong dividend performance. We also maintain an investment in an index mutual fund that invests in publicly traded real estate investment trust (REITs). These investments are owned by our holding company, RLI Corp., and were valued at $16.1 million as of June 30, 2004. The strategy remains one of value investing, with security selection taking precedence over market timing. A buy-and-hold strategy is used, minimizing both transactional costs and taxes.
As of June 30, 2004, our portfolio had a dividend yield of 2.9% compared to 1.6% for the S&P 500 index. Because of the corporate-dividend-received deduction applicable to our dividend income, we pay an effective tax rate of only 14.2% on dividends, compared to 35.0% on taxable interest income and 5.0% on municipal bond interest income. As with our bond portfolio, we maintain a well-diversified group of 108 equity securities. During the first half of 2004, the total return on our equity portfolio on a mark-to-market basis was 3.6%.
25
Our capital structure is comprised of equity and debt outstanding. As of June 30, 2004, our capital structure consisted of $100.0 million in 10-year maturity senior notes maturing in 2014 (long-term debt), $47.1 million in reverse repurchase debt agreements with maturities from zero to nine months (short-term debt), and $569.7 million of shareholders’ equity. Debt outstanding comprised 20.5% of total capital as of June 30, 2004.
Our 112th consecutive dividend payment was declared in the second quarter of 2004 and paid on July 15, 2004, in the amount of $0.13 per share. Since the inception of cash dividends in 1976, we have increased our annual dividend every year. In its annual “Handbook of Dividend Achievers,” Mergent FIS (formerly a division of Moody’s) ranked us 191st of more than 11,000 U.S. public companies in dividend growth over the last decade.
Dividend payments to us from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the regulatory authority of Illinois. The maximum dividend distribution is limited by Illinois law to the greater of 10% of RLI Insurance Company’s policyholder surplus as of December 31 of the preceding year or its net income for the 12-month period ending December 31 of the preceding year. Therefore, the maximum dividend distribution that can be paid by RLI Insurance Company during 2004 without prior approval is $54.7 million. The actual amount paid in 2003 was $5.5 million.
Interest and fees on debt obligations increased to $3.4 million for the first half of 2004, an increase of $3.0 million from the same period in 2003. The increased expense is the result of the December 12, 2003 issuance of $100 million in senior notes at an effective rate of 6.02%. As of June 30, 2004, outstanding debt balances totaled $147.1 million, compared to $49.0 million at June 30, 2003. The June 30, 2004 debt balance is comprised of the $100 million in senior notes and $47.1 million in reverse repurchase agreements. The June 30, 2003 balance of $49.0 million consisted only of reverse repurchase agreements. The Company has incurred interest expense on debt at the following average interest rates for the three month periods ended June 30, 2004 and 2003:
26
THREE MONTHS ENDED JUNE 30, 2004, COMPARED TO THREE MONTHS ENDED JUNE 30, 2003
Consolidated gross revenues, as displayed in the table that follows, totaled $214.9 million for the second quarter of 2004 compared to $202.9 million for the same period in 2003.
Gross premium writings of the Group improved 5% over 2003 levels fueled by growth in the casualty segment, where market conditions remain firm. Net investment income improved 23% to $13.4 million, due to increased cash flows from operations and the infusion of new capital from the December 2003 bond offering.
Consolidated net revenue for the second quarter of 2004 increased $15.7 million or 12% from the same period in 2003. Net premiums earned, the main driver of this measurement, increased $13.3 million or 12%, benefiting from the significant momentum gained from last year’s premium volume growth and increased retentions.
Net after-tax earnings for the second quarter of 2004 totaled $18.4 million, $0.71 per diluted share, compared to $15.4 million, $0.60 per diluted share, for the same period in 2003. Improved underwriting income in all three segments, coupled with growth in investment income, favorably impacted 2004 earnings.
Results for the second quarter of 2004 include realized gains of $1.9 million, $0.05 per diluted share, equaling last year’s posting.
Comprehensive earnings, which include net earnings plus unrealized gains/losses net of tax, were negatively impacted by the rising interest rate environment and the volatility experienced in the bond market during the second quarter of 2004. Comprehensive loss for the second quarter of 2004 totaled $3.6 million, $0.14 per diluted share, compared to comprehensive earnings of $40.7 million, $1.58 per diluted share, for the same period in 2003. Unrealized losses, net of tax, for the second quarter of 2004 were $22.0 million, $0.85 per diluted share. Unrealized losses were driven by the bond portfolio, which experienced $22.9 million in unrealized losses, net of tax, for the second quarter of 2004. During the second quarter of 2003, we experienced unrealized gains, net of tax, of $25.3 million, $0.98 per diluted share, as the equity and bond markets rallied.
27
As indicated earlier, gross premiums written for the Group increased 5% to $199.6 million for the second quarter of 2004, as the casualty segment continued to experience a favorable rate environment and the surety segment posted improved writings. Underwriting income improved to a pre-tax profit of $11.8 million for the second quarter of 2004, compared to $7.4 million for the same period in 2003. The GAAP combined ratio declined to 90.7 for the second quarter of 2004, as all three segments posted improvements.
Gross premiums written for the Group’s property segment was flat for the quarter at $52.3 million. Premiums increased on our construction business, where the rate environment remained stable and new opportunities were available. Construction’s growth served to offset the declines experienced in commercial fire and California earthquake, where competitive pressures continued to impact premium volume. Net premiums earned declined in the quarter, primarily due to the continued decline of California earthquake writings, coupled with the purchase of additional catastrophe protection and other reinsurance cessions designed to reduce our overall earthquake exposure. Underwriting profit for the property segment was $8.2 million for the second quarter of 2004, compared to $7.7 million for the same period in 2003. The GAAP combined ratio decreased to 66.1 compared to 71.5 for the same period last year. Improved earnings on construction business during the quarter accounted for these changes.
28
The casualty segment posted gross premiums written of $132.3 million for the second quarter of 2004, up $7.5 million, or 6%, from 2003. Growth initiatives and a continued favorable rate environment contributed to growth in general liability and umbrella, where premiums advanced $10.9 million and $3.1 million, respectively. Partially offsetting these increases, premiums written on executive products are off nearly 50% as competition has increased and rates have declined significantly. We continue to adhere to tight underwriting standards on this business, which has resulted in the loss of several accounts. The casualty segment posted an underwriting profit of $3.7 million for the second quarter of 2004, compared to profits of $1.2 million last year. These results translate into a combined ratio of 95.9 for the second quarter of 2004 versus 98.5 for the same period in 2003. A shift in mix of business toward products with lower loss ratios has resulted in a drop of over 3 points in loss ratio and has accounted for the majority of this improvement.
Gross premiums written for the surety segment totaled $15.0 million for the second quarter of 2004, up $2.1 million, or 16%, from the same period in 2003. This increase reverses a trend of declining premiums. Premium growth occurred in commercial and energy business, areas that have traditionally posted profits. Partially offsetting this improvement, gross writings on contract surety were down 14% due to the continuation of tighter underwriting standards. The surety book reported an underwriting loss of $101,000 for the second quarter of 2004, compared to an underwriting loss of $1.4 million for the same period in 2003. 2003 results were impacted by adverse loss experience on contract bonds written in 2002 and prior. The combined ratio for the surety segment totaled 100.8 in 2004, versus 112.0 for the same period in 2003, as loss experience improved significantly.
Our investment portfolio generated net dividend and interest income of $13.4 million during the second quarter of 2004, an increase of 22.7% over that reported for the same period in 2003. The improvement in income is due to increased cash flow from operating and financing activities allocated to the investment portfolio. On an after-tax basis, investment income increased by 20.6%.
Yields on our fixed income investments for the second quarter of 2004 and 2003 are as follows:
29
In the second quarter of 2004, compared to the second quarter of 2003, the average after-tax yield of the fixed-income portfolio decreased slightly due to decreases in both taxable and tax-exempt yields on new purchases. The decline in yields is primarily due to fluctuations in interest rates and the subsequent reinvestment of called and matured bonds at lower yields. Despite the lower yields, the overall impact on investment income has been limited due to the continued growth in operational cash flow and the investment of the proceeds from our December 2003 debt offering.
We recorded a gain of $307,000 in net investment income during the second quarter of 2004 in accordance with Statement of Financial Accounting Standards (SFAS) 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133). SFAS 133 requires that we recognize the change in fair value of stock warrants received with the purchase of a note receivable. This compares to income of $513,000 recognized in the second quarter of 2003. We employ a consistent valuation formula to recognize investment income or loss each quarter and to adjust the carrying value of our investment. This formula is based on the investee’s book value, the volume of mortgages originated and profitability. Income in the second quarter of 2004 was lower than the second quarter of 2003 due to reduced mortgage origination volume as a result of reduced demand for refinance loans.
We realized a total of $1.9 million in capital gains in the second quarter of 2004, in line with gains experienced in the second quarter of 2003.
We regularly evaluate the quality of our investment portfolio. When we believe that a specific security has suffered an other-than-temporary decline in value, the investment’s value is adjusted by reclassifying the decline from unrealized to realized losses. This has no impact on shareholders’ equity. There were no losses associated with the other-than-temporary impairment of securities in the second quarters of 2004 or 2003.
The Company’s effective tax rate for the second quarter of 2004 was 29%, compared to 28% for the same period in 2003. Income tax expense attributable to income from operations differed from the amounts computed by applying the U.S. federal tax rate of 35% to pretax income for the second quarter of 2004 and 2003 as a result of the following:
30
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the risk of economic losses due to adverse changes in the estimated fair value of a financial instrument as the result of changes in equity prices, interest rates, foreign exchange rates and commodity prices. Our consolidated balance sheets include assets and liabilities whose estimated fair values are subject to market risk. The primary market risks are equity price risk associated with investments in equity securities and interest rate risk associated with investments in fixed maturities. From time to time, equity prices and interest rates fluctuate causing an effect on our investment portfolio. We have no exposure to foreign exchange risk and no direct commodity risk.
Our market risk exposures at June 30, 2004, have not materially changed from those identified in our 2003 Annual Report on Form 10-K.
ITEM 4. Controls and Procedures
We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. An evaluation of the effectiveness of the design and operation of our disclosure controls and procedures was performed, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective, as of the end of the period covered by this report.
In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurances of achieving the desired control objective, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. We believe that our disclosure controls and procedures provide such reasonable assurance.
No changes were made to our internal control over financial reporting during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
31
PART II — OTHER INFORMATION
Continuing directors of the Company were: John T. Baily, William R. Keane, Gerald I. Lenrow and Edwin S. Overman whose terms expire in 2005, and Charles Linke, Jonathan E. Michael, and Edward F. Sutkowski, whose terms expire in 2006.
Non-employee Directors’ Stock Plan
32
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
33