UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

 

ý		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		For the quarterly period ended September 30, 2004
		Or
o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		For the transition period from              to

 

Commission File Number:                0-6612

 

RLI Corp.

(Exact name of registrant as specified in its charter)

 

ILLINOIS		37-0889946
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)
9025 North Lindbergh Drive, Peoria, IL		61615
(Address of principal executive offices)		(Zip Code)
(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.

Yes  ý                   No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  ý                   No o

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

As of October 18, 2004 the number of shares outstanding of the registrant’s Common Stock was 25,262,293.

 

 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

RLI Corp. and Subsidiaries

Condensed Consolidated Statement of Earnings and Comprehensive Earnings

 

 

		For the Three-Month Period Ended September 30,
(Unaudited)		2004			2003
Net premiums earned		$	128,017,839		$	118,953,696
Net investment income		13,653,889			11,205,067
Net realized investment gains		4,902,803			8,970,646
		146,574,531			139,129,409
Losses and settlement expenses		95,578,156			73,271,740
Policy acquisition costs		32,770,650			30,314,044
Insurance operating expenses		6,797,003			6,754,906
Interest expense on debt		1,722,352			146,441
General corporate expenses		1,075,003			821,571
		137,943,164			111,308,702
Equity in earnings of uncons. investee		1,294,020			1,623,632
Earnings before income taxes		9,925,387			29,444,339
Income tax expense		1,670,003			4,075,019
Net earnings		$	8,255,384		$	25,369,320
Other comprehensive earnings (loss),net of tax		13,087,557			(7,583,532		)
Comprehensive earnings		$	21,342,941		$	17,785,788
Earnings per share:
Basic:
Basic net earnings per share		$	0.33		$	1.01
Basic comprehensive earnings per share		$	0.85		$	0.71
Diluted:
Diluted net earnings per share		$	0.32		$	0.98
Diluted comprehensive earnings per share		$	0.82		$	0.69
Weighted average number of common shares outstanding
Basic		25,227,770			25,126,924
Diluted		26,063,979			25,921,958
Cash dividends declared per common share		$	0.13		$	0.10

 

The accompanying notes are an integral part of the financial statements.

 

2

 

		For the Nine-Month Period Ended September 30,
(Unaudited)		2004			2003
Net premiums earned		$	380,792,244		$	341,725,342
Net investment income		39,330,580			32,755,092
Net realized investment gains		9,225,878			11,322,861
		429,348,702			385,803,295
Losses and settlement expenses		244,363,479			206,798,410
Policy acquisition costs		99,595,577			88,624,737
Insurance operating expenses		21,361,723			20,587,186
Interest expense on debt		5,128,325			593,169
General corporate expenses		3,524,159			2,870,921
		373,973,263			319,474,423
Equity in earnings of uncons. investee		4,366,496			5,166,277
Earnings before income taxes		59,741,935			71,495,149
Income tax expense		16,175,935			16,298,025
Net earnings		$	43,566,000		$	55,197,124
Other comprehensive earnings (loss),net of tax		(1,306,258		)	12,316,686
Comprehensive earnings		$	42,259,742		$	67,513,810
Earnings per share:
Basic:
Basic net earnings per share		$	1.73		$	2.20
Basic comprehensive earnings per share		$	1.68		$	2.69
Diluted:
Diluted net earnings per share		$	1.67		$	2.14
Diluted comprehensive earnings per share		$	1.62		$	2.62
Weighted average number of common shares outstanding
Basic		25,200,558			25,107,405
Diluted		26,072,391			25,793,093
Cash dividends declared per common share		$	0.37		$	0.29

 

The accompanying notes are an integral part of the financial statements.

 

3

 

RLI Corp. and Subsidiaries Condensed Consolidated Balance Sheet

 

		September 30 2004			December 31 2003
		(Unaudited)
ASSETS
Investments
Fixed maturities
Held-to-maturity, at amortized cost		$	162,469,149		$	180,700,429
Trading, at fair value		10,493,651			8,405,629
Available-for-sale, at fair value		974,452,162			835,229,109
Equity securities, at fair value		301,213,242			276,021,362
Short-term investments, at cost		105,654,099			33,003,709
Total investments		1,554,282,303			1,333,360,238
Accrued investment income		14,477,498			12,914,660
Premiums and reinsurance balances receivable		141,834,181			152,859,640
Ceded unearned premium		102,940,702			101,748,341
Reinsurance balances recoverable on unpaid losses		429,868,452			372,047,884
Deferred policy acquisition costs		68,979,827			63,737,449
Property and equipment		17,894,198			18,615,651
Investment in unconsolidated investee		35,271,237			30,683,166
Goodwill and indefinite-lived intangibles		26,214,491			26,214,491
Other assets		3,306,893			22,182,273
TOTAL ASSETS		$	2,395,069,782		$	2,134,363,793
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Unpaid losses and settlement expenses		$	1,086,493,119		$	903,440,601
Unearned premiums		378,348,427			367,642,210
Reinsurance balances payable		79,623,088			92,382,139
Notes payable, short-term debt		46,617,500			47,560,000
Income taxes-current		12,797,558			7,151,884
Income taxes-deferred		31,885,787			38,818,180
Bonds payable, long-term debt		100,000,000			100,000,000
Other liabilities		71,695,668			23,234,578
TOTAL LIABILITIES		1,807,461,147			1,580,229,592
Shareholders’ Equity
Common stock ($1 par value) (31,055,046 shares issued at 9/30/04) (30,957,837 shares issued at 12/31/03)		31,055,046			30,957,837
Paid-in Capital		180,143,946			179,683,913
Accumulated other comprehensive earnings		96,392,549			97,698,805
Retained Earnings		361,041,846			326,808,157
Deferred compensation		6,639,621			6,069,534
Less: Treasury shares at cost (5,792,753 shares at 9/30/04) (5,792,487 shares at 12/31/03)		(87,664,373		)	(87,084,045		)
TOTAL SHAREHOLDERS’ EQUITY		587,608,635			554,134,201
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY		$	2,395,069,782		$	2,134,363,793

 

The accompanying notes are an integral part of the financial statements.

 

4

 

RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

		For the Nine Month Period Ended September 30,
		2004			2003
Net cash provided by operating activities		$	175,317,435		$	149,828,290
Cash Flows from Investing Activities
Investments purchased		(339,646,570		)	(366,777,772		)
Investments sold		125,680,801			175,104,977
Investments called or matured		71,185,856			44,541,962
Net proceeds from sale of insurance shell		0			5,100,000
Net increase in short term investments		(23,271,026		)	(3,694,641		)
Changes in notes receivable		1,500,000			1,500,000
Net property and equipment purchased		(1,554,565		)	(3,199,574		)
Net cash used in investing activities		(166,105,504		)	(147,425,048		)
Cash Flows from Financing Activities
Cash dividends paid		(8,816,432		)	(6,994,044		)
Payments on debt		(1,057,500		)	(6,500,000		)
Proceeds from issuance of debt		115,000			426,500
Proceeds from issuance of common stock		0			10,047,504
Stock option plan share issuance		557,242			638,839
Treasury shares purchased		(10,241		)	(22,041		)
Net cash used in financing activities		(9,211,931		)	(2,403,242		)
Net increase in cash		0			0
Cash at the beginning of the year		0			0
Cash at September 30		$	0		$	0

 

The accompanying notes are an integral part of the financial statements.

 

5

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.             SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - The financial information is prepared in conformity with accounting principles generally accepted in the United States of America (GAAP), and such principles are applied on a basis consistent with those reflected in the 2003 annual report filed with the Securities and Exchange Commission. Management has prepared the financial information included herein without audit by independent certified public accountants.  The condensed consolidated balance sheet as of December 31, 2003 has been derived from, and does not include all the disclosures contained in, the audited consolidated financial statements for the year ended December 31, 2003.

 

The information furnished includes all adjustments and normal recurring accrual adjustments that are, in the opinion of management, necessary for a fair statement of results for the interim periods. Results of operations for the three and nine-month periods ended September 30, 2004 and 2003 are not necessarily indicative of the results of a full year.

 

The accompanying financial data should be read in conjunction with the notes to the financial statements contained in the 2003 Annual Report on Form 10-K.

 

Earnings Per Share: Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the dilution that could occur if securities or other contracts to issue common stock (common stock equivalents) were exercised or converted into common stock. When inclusion of common stock equivalents increases the earnings per share or reduces the loss per share, the effect on earnings is antidilutive. Under these circumstances, the diluted net earnings or net loss per share is computed excluding the common stock equivalents.

 

Pursuant to disclosure requirements contained in Statement 128,”Earnings Per Share,” the following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the financial statements.

 

		For the Nine-Month Period Ended September 30, 2004
		Income (Numerator)			Shares (Denominator)		Per Share Amount
Basic EPS
Income available to common stockholders		$	43,566,000		25,200,558		$	1.73
Effect of Dilutive Securities
Incentive Stock Options		—			871,833
Diluted EPS
Income available to common stockholders		$	43,566,000		26,072,391		$	1.67

 

6

 

		For the Nine-Month Period Ended September 30, 2003
		Income (Numerator)			Shares (Denominator)		Per Share Amount
Basic EPS
Income available to common stockholders		$	55,197,124		25,107,405		$	2.20
Effect of Dilutive Securities
Incentive Stock Options		—			685,688
Diluted EPS
Income available to common stockholders		$	55,197,124		25,793,093		$	2.14

 

Other Accounting Standards: In December 2002, the Financial Accounting Standards Board (FASB) published Statement of Financial Accounting Standards (SFAS) 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS 148 amended SFAS 123, “Accounting for Stock-Based Compensation” and provided alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation.  In addition, SFAS 148 amended the disclosure requirements of SFAS 123, requiring more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation, including disclosures in interim financial statements. The provisions for interim-period disclosures are summarized in the following stock based compensation section.

 

Stock based compensation:  We grant to officers and directors stock options for shares with an exercise price equal to the fair market value of the shares at the date of grant. We account for stock option grants in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and accordingly recognize no compensation expense for the stock option grants.

 

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:

 

		For the Nine-Month Period Ended September 30,
		2004			2003
Net income, as reported		$	43,566,000		$	55,197,124
Add: Stock-based employee compensation expense included in reported income, net of related tax effects		—			—
Deduct: Total stock-based employee compensation expense determined under fair-value-based methods for all awards, net of related tax methods		(1,465,663		)	(1,256,847		)
Pro forma net income		$	42,100,337		$	53,940,277
Earnings per share:
Basic – as reported		$	1.73		$	2.20
Basic – pro forma		$	1.67		$	2.15
Diluted – as reported		$	1.67		$	2.14
Diluted – pro forma		$	1.61		$	2.09

 

		For the Three-Month Period Ended September 30,
		2004					2003
Net income, as reported		$	8,255,384				$		25,369,320
Add: Stock-based employee compensation expense included in reported income, net of related tax effects		—					—
Deduct: Total stock-based employee compensation expense determined under fair-value-based methods for all awards, net of related tax methods		(491,814				)	(424,468			)
Pro forma net income		$		7,763,570			$	24,944,852
Earnings per share:
Basic – as reported		$			0.33		$	1.01
Basic – pro forma		$			0.31		$	0.99
Diluted – as reported		$			0.32		$	0.98
Diluted – pro forma		$			0.30		$	0.96

 

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 nine month periods ended September 30, 2004 and 2003.

 

Pension Expense (in thousands)		2004			2003
Service Cost		$	—		$	1,035
Interest Cost		537			537
Expected Return on Assets		(588		)	(522		)
Prior Service Cost		—			27
Recognition of Transition Asset		(3		)	(26		)
Recognition of (Gains)/Losses		354			444
Net Periodic Cost		$	300		$	1,495
Estimated Settlement Losses		375			—
Total Pension Cost		$	675		$	1,495

 

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 September 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 $1.2 million for the first nine months of 2004, compared to $502,000 for the same period last year. Amortization expense in 2004 includes $674,000 of additional expense recorded, 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. We performed this evaluation in June, which 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 in June.  In September, we performed a similar review of this asset and determined that the remaining asset was impaired.  As a result, we recorded  $367,000 of additional amortization expense to reflect this write down.  Subsequent to this adjustment, this asset has a carrying value of $0. At September 30, 2004, net intangible assets totaled $1.1 million, net of $4.6 million of accumulated amortization, and are included in other assets.

 

2. INDUSTRY SEGMENT INFORMATION - Selected information by industry segment for the nine-month and three-month periods ended September 30, 2004 and 2003 is presented below.

 

		For the Nine-Month Periods Ended September 30,
SEGMENT DATA (in thousands)		EARNINGS								REVENUES
		2004				2003				2004				2003
Property		$		9,926		$		26,866		$	73,458			$	82,088
Casualty		5,633				3,410				271,731				224,271
Surety		(88			)	(4,561			)	35,603				35,366
Net investment income		39,331				32,755				39,331				32,755
Realized gains		9,226				11,323				9,226				11,323
General corporate expense and interest on debt		(8,652			)	(3,464			)
Equity in earnings of unconsolidated investee		4,366				5,166
Total segment earnings before income taxes		$		59,742		$		71,495
Income taxes		16,176				16,298
Total		$	43,566			$	55,197			$		429,349		$		385,803

 

10

 

		For the Three-Month Periods Ended September 30,
SEGMENT DATA (in thousands)		EARNINGS						REVENUES
		2004			2003			2004				2003
Property		$	(6,203	)	$	7,923		$		23,951		$	27,959
Casualty		(964		)	2,047			91,879				79,766
Surety		39			(1,357		)	12,188				11,228
Net investment income		13,654			11,205			13,654				11,205
Realized gains		4,903			8,971			4,903				8,971
General corporate expense and interest on debt		(2,798		)	(968		)
Equity in earnings of unconsolidated investee		1,294			1,623
Total segment earnings before income taxes		$	9,925		$	29,444
Income taxes		1,670			4,075
Total		$	8,255		$	25,369		$	146,575			$		139,129

 

Segment results for 2004 were adversely impacted by the combined effects of four hurricanes making landfall in the Southeastern U.S. during the third quarter.  We recorded $19.0 million in pre-tax underwriting losses from Hurricanes Charley, Frances, Ivan and Jeanne.  These losses impacted both the property and casualty segments.  Property results include $13.0 million in pre-tax hurricane losses, while casualty results include $6.0 million in pre-tax losses.  Hurricane losses recorded include actual reported claims as well as some reserve estimates.  The process of adjusting these claims started with our proactive efforts to contact all policyholders that may have been in the path of any of these storms.  Losses recorded to date include all known claims, as well as reserves for unreported losses and potential development on existing losses.  These estimates are subject to the risks inherent in the reserving process.  A further discussion of the risks surrounding the reserving process can be found in the critical accounting policy discussion on page 16 of this document.

 

11

 

The following table further summarizes revenues by major product type within each segment:

 

		For the Nine-Month Period Ended September 30,
(in thousands)		2004			2003
Property
Commercial property		$	68,146		$	76,724
Homeowners/residential property		5,312			5,364
Total		$	73,458		$	82,088
Casualty
General liability		$	129,287		$	92,800
Specialty program business		35,488			38,846
Commercial transportation		41,512			37,277
Commercial and personal umbrella		39,361			30,748
Executive products		10,373			9,810
Other		15,710			14,790
Total		$	271,731		$	224,271
Surety		$	35,603		$	35,366
Grand Total		$	380,792		$	341,725

 

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 nine months of 2004 and 2003.

 

12

 

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, hurricanes, 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.

 

13

 

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 29% of 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.

 

14

 

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.

 

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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.

 

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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.

 

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NINE MONTHS ENDED SEPTEMBER 30, 2004, COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2003

 

Consolidated gross revenues, as displayed in the table that follows, totaled $622.7 million for the first nine months of 2004 compared to $602.1 million for the same period in 2003.

 

		For the Nine-Month Period Ended September 30,
Gross revenues (in thousands)		2004				2003
Gross premiums written		$		574,093		$	558,037
Net investment income		39,331				32,755
Net realized investment gains		9,226				11,323
Total gross revenues		$	622,650			$		602,115

 

Gross premium writings of the Group improved 3% over 2003 levels due to growth in certain casualty products.  Net investment income improved 20% to $39.3 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 nine months of 2004 resulted in the recognition of $9.2 million in realized gains.

 

Consolidated net revenue for the first nine months of 2004 increased $43.5 million, or 11%, from the same period in 2003. Net premiums earned, the main driver of this measurement, jumped 11%, 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 nine months of 2004 totaled $43.6 million, $1.67 per diluted share, compared to $55.2 million, $2.14 per diluted share, for the same period in 2003.  2004’s results were adversely impacted by the combined effects of four hurricanes making landfall in the Southeastern U.S. during the third quarter.  Cumulative after-tax losses recorded from Hurricanes Charley, Frances, Ivan and Jeanne totaled $12.4 million, $0.47 per diluted share.

 

Results for the first nine months of 2004 include realized gains of $9.2 million, $0.23 per diluted share, compared to $11.3 million, $0.47 per diluted share for the same period last year.  Results for the first nine months of 2003 include a realized gain of $3.4 million, $0.13 per diluted share, related to the sale of an insurance company shell, which was completed on July 1, 2003.  Additionally, we recognized a $3.5 million, $0.14 per diluted share, tax benefit from the sale of the insurance company shell.  Excluding the sale of the shell, all other realized investment gains totaled $7.9 million, $0.20 per diluted share, for the first nine months of 2003.

 

Comprehensive earnings, which include net earnings plus unrealized gains/losses net of tax, totaled $42.3 million, $1.62 per diluted share, for the first nine months of 2004, compared to comprehensive earnings of $67.5 million, $2.62 per diluted share, for the same period in 2003. Unrealized losses, net of tax, for the first nine months of 2004 were $1.3 million, $0.05 per diluted share, compared to unrealized gains of $12.3 million, $0.48 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 and equity markets.

 

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RLI INSURANCE GROUP

 

As indicated earlier, gross premiums written for the Group increased to $574.1 million for the first nine months of 2004, compared to $558.0 million reported for the same period in 2003.  Improved pricing and various growth initiatives in certain casualty and surety products positively impacted gross premiums written.  Gross writings for the property segment declined 5%, due to a continued trend of rate softening and increased competition.  Underwriting income declined to a pre-tax profit of $15.5 million for the first nine months of 2004, compared to $25.7 million for the same period in 2003.  Results for 2004 were adversely impacted by $19.0 million in pre-tax losses from Hurricanes Charley, Frances, Ivan and Jeanne.  The GAAP combined ratio totaled 96.0 for the first nine months of 2004, compared to 92.5 for the same period in 2003.  The Group’s loss ratio increased to 64.2 for 2004, compared to 60.5 for 2003, reflective of the losses incurred for the four hurricanes.

 

 

		For the Nine-Month Period Ended September 30,
		2004				2003
Gross premiums written (in thousands)
Property		$	141,997			$		148,938
Casualty		389,220				368,787
Surety		42,876				40,312
Total		$	574,093			$	558,037
Underwriting profits (losses) (in thousands)
Property		$		9,926		$	26,866
Casualty		5,633				3,410
Surety		(88			)	(4,561			)
Total		$		15,471		$	25,715
Combined ratio
Property		86.4				67.3
Casualty		97.9				98.4
Surety		100.2				112.8
Total		96.0				92.5

 

Gross premiums written for the Group’s property segment decreased $6.9 million, or 5% from the same period last year.  For the first nine months of 2004, gross property premiums totaled $142.0 million.  Rate softening, which began in 2003 continued during 2004 in our domestic fire and California earthquake business.  Increased competition and market capacity continue to drive down pricing. Net premiums written and net premiums earned declined 9% and 11%, respectively, in 2004, driven primarily by 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 $9.9 million for the first nine months of 2004, compared to $26.9 million for the same period in 2003.  Underwriting income for the segment was adversely impacted by $13.0 million in pre-tax losses from the four hurricanes.  These results translate into a GAAP combined ratio of 86.4 in 2004, compared to 67.3 for the same period last year.  The loss ratio, at 49.8, increased from last year’s posting, as hurricane losses added 17.7 points to 2004’s result.  The expense ratio, at 36.6, advanced 2.9 points from last year’s posting, reflective of the decline in net premiums relative to the fixed nature of certain expenses and reinsurance costs.

 

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The casualty segment posted gross premiums written of $389.2 million for the first nine months of 2004, up $20.4 million, or 6%, from 2003.  Premium growth is coming from our general liability, umbrella, and transportation products.  General liability writings advanced $26.0 million, while umbrella was up $9.3 million and transportation advanced $5.6 million.  While we are seeing signs of rates beginning to flatten on these products, particularly in general liability, the rate environment has been favorable for most of 2004.  We continue to remain focused on growing areas that provide the best return, while maintaining strict adherence to underwriting discipline.  The result of increased competition and an adherence to tight underwriting standards has resulted in the loss of some accounts, particularly in executive products, where rates have declined 25-50%, and in specialty program business.  The casualty segment posted an underwriting profit of $5.6 million, compared to a profit of $3.4 million for the same period last year. While improved from 2003’s posting, casualty results were adversely impacted by $6.0 million hurricane losses experienced on our specialty program business.  Specialty program business includes package policies underwritten on service station businesses, which incurred losses as a result of the four hurricanes.  These results translate into a combined ratio of 97.9 for the first nine months of 2004 versus 98.4 for the same period in 2003.  Despite $6.0 million in hurricane losses, the loss ratio improved 0.8 points to 71.3, due to a shift in mix of business toward products with lower loss ratios.  The expense ratio, at 26.6, remained flat.

 

The surety segment posted gross premiums written of $42.9 million for the first nine months of 2004, up 6% from 2003’s $40.3 million.  Premium growth came from commercial, miscellaneous 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 nine months of 2004, as the segment posted near breakeven results.  Underwriting loss for the first nine months of 2004 totaled $88,000, compared to a loss of $4.6 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 100.2 in 2004, versus 112.8 for the same period in 2003. The segment’s loss ratio was 39.1 for 2004, compared to 49.2 for 2003, reflective of the decline in claim frequency, particularly on the contract book. During 2004, reviews of the intangible asset relating to contract surety indicated the asset was not recoverable.  As a result, we recorded $674,000 of additional amortization expense(impairment).  Despite this expense addition, the overall surety expense ratio improved 2.5 points to 61.1, compared to 63.6 in 2003, as reinsurance costs have declined and premium volume has advanced.

 

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 nine months of 2004.

 

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INVESTMENT INCOME AND REALIZED CAPITAL GAINS

 

During the first nine months of 2004, net investment income increased by 20.1% 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 20.2%. Operating cash flows were $175.3 million in the first nine months of 2004, up from $149.8 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 nine months of 2004 and 2003.

 

Pretax Yield		2004		2003
Taxable		4.89	%	5.16	%
Tax-Exempt		4.08	%	4.34	%
After-tax yield
Taxable		3.18	%	3.35	%
Tax-Exempt		3.87	%	4.11	%

 

During the first nine months 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.

 

The fixed-income portfolio increased by $123.1 million during the first nine months of 2004. This portfolio had a tax-adjusted total return on a mark-to-market basis of 3.58%. Our equity portfolio increased by $25.2 million during the nine months of 2004, to $301.2 million. The equity portfolio had a total return of 4.5% during the first nine months of 2004.  During the second quarter of 2004, we 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 $20.7 million at September 30, 2004.

 

We maintain an equity investment in a private mortgage banking company. As of September 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 $6.9 million. We recorded a gain of $90,000 in net investment income during the first nine months 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 $2.0 million recognized in the first nine months of 2003. We employ a consistent valuation formula to recognize investment income or loss each quarter and to adjust the

 

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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 $9.2 million in capital gains in the first nine months of 2004, compared to capital gains of $11.3 million in the first nine months of 2003. The decrease in net realized gains is due in part to the timing of the sale of individual securities.  Additionally, 2003 results included $3.4 million in realized gains from the sale of an insurance company shell.

 

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 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 September 30, 2004, including market value, cost basis, and unrealized gains and losses.

 

(dollars in thousands)		Cost Basis			9/30/04 Mkt Value			Gross Unrealized						Net			Unrealized Gain/Loss% (1)
								Gains			Losses
Consumer Discretionary		$	14,437		$	17,893		$	3,639		$	(183	)	$	3,456		23.9	%
Consumer Staples		16,668			36,069			19,401			—			19,401			116.4	%
Energy		7,434			19,390			11,956			—			11,956			160.8	%
Financials		31,514			61,068			29,667			(113		)	29,554			93.8	%
Healthcare		8,925			23,854			14,929			—			14,929			167.3	%
Industrials		15,707			33,230			17,523			—			17,523			111.6	%
Materials		11,711			16,782			5,071			—			5,071			43.3	%
Information Technology		9,851			12,482			2,964			(333		)	2,631			26.7	%
Telecommunications		8,878			14,667			5,789			—			5,789			65.2	%
Utilities		39,837			58,756			18,919			—			18,919			47.5	%
Private Investments		7,022			7,022			—			—			—			0.0	%
		$	171,984		$	301,213		$	129,858		$	(629	)	$	129,229		75.1	%

 

(1) Calculated as the percentage of net unrealized gain (loss) to cost basis.

 

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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 September 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 Losses

Segmented by Type and Period of Continuous

Unrealized Loss at September 30, 2004

 

(dollars in thousands)		0-12 Mos.				> 12 Mos.				Total
U.S Government
Fair value		$	2,525			$	244			$		2,769
Cost or Amortized Cost		2,570				250				2,820
Unrealized Loss		(45			)	(6			)	(51			)
Corporate
Fair value		$	166,816			$	46,921			$	213,737
Cost or Amortized Cost		169,398				48,891				218,289
Unrealized Loss		(2,582			)	(1,970			)	(4,552			)
States, political subdivisions & revenues
Fair value		$		63,572		$		3,793		$	67,365
Cost or Amortized Cost		63,860				3,843				67,703
Unrealized Loss		(288			)	(50			)	(338			)
Subtotal, debt securities
Fair value		$		232,913		$		50,958		$	283,871
Cost or Amortized Cost		235,828				52,984				288,812
Unrealized Loss		(2,915			)	(2,026			)	(4,941			)
Common Stock
Fair value		$		4,360		$		0		$	4,360
Cost or Amortized Cost		4,989				0				4,989
Unrealized Loss		(629			)	(0			)	(629			)
Total
Fair value		$		237,273		$		50,958		$	288,231
Cost or Amortized Cost		240,817				52,984				293,801
Unrealized Loss		(3,544			)	(2,026			)	(5,570			)

 

The following table shows the composition of the fixed income securities in loss positions at September 30, 2004 by the National Association of Insurance Commissioners (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.

 

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