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RLI RLI

Filed: 24 Jul 20, 12:47pm

13

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2020

or

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: 001-09463

RLI Corp.

(Exact name of registrant as specified in its charter)

Delaware

37-0889946

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification Number)

9025 North Lindbergh Drive, PeoriaIL

61615

(Address of principal executive offices)

(Zip Code)

(309) 692-1000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Trading Symbol

Name of each exchange on which registered

Common Stock $0.01 par value

RLI

New York Stock Exchange

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     No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).   Yes     No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer 

Accelerated filer 

Non-accelerated filer 

Smaller reporting company 

Emerging growth company 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes    No

APPLICABLE ONLY TO CORPORATE ISSUERS:

As of July 16, 2020, the number of shares outstanding of the registrant’s Common Stock was 44,952,602.

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Earnings and Comprehensive Earnings

(Unaudited)

For the Three-Month Periods

For the Six-Month Periods

Ended June 30,

Ended June 30,

(in thousands, except per share data)

2020

2019

2020

2019

Net premiums earned

   

$

208,734

    

$

207,541

$

424,316

$

412,230

Net investment income

 

16,917

 

16,998

 

34,695

 

33,563

Net realized gains (losses)

 

(2,109)

 

4,764

 

13,043

 

13,832

Net unrealized gains (losses) on equity securities

74,705

8,810

(55,690)

42,308

Consolidated revenue

$

298,247

$

238,113

$

416,364

$

501,933

Losses and settlement expenses

 

101,202

 

103,919

 

212,223

 

198,216

Policy acquisition costs

 

69,463

 

71,742

 

142,404

 

143,034

Insurance operating expenses

 

13,906

 

16,948

 

28,287

 

33,615

Interest expense on debt

 

1,903

 

1,861

 

3,800

 

3,722

General corporate expenses

 

1,994

 

3,283

 

3,749

 

6,559

Total expenses

$

188,468

$

197,753

$

390,463

$

385,146

Equity in earnings of unconsolidated investees

 

5,100

 

8,468

 

9,614

 

13,782

Earnings before income taxes

$

114,879

$

48,828

$

35,515

$

130,569

Income tax expense

 

22,713

 

8,361

 

4,616

 

24,629

Net earnings

 

$

92,166

 

$

40,467

$

30,899

$

105,940

Other comprehensive earnings, net of tax

 

53,571

 

27,864

 

40,540

 

57,165

Comprehensive earnings

 

$

145,737

 

$

68,331

$

71,439

$

163,105

Earnings per share:

Basic:

Basic net earnings per share

 

$

2.05

 

$

0.91

$

0.69

$

2.37

Basic comprehensive earnings per share

 

$

3.24

 

$

1.53

$

1.59

$

3.66

Diluted:

Diluted net earnings per share

 

$

2.04

 

$

0.89

$

0.68

$

2.35

Diluted comprehensive earnings per share

 

$

3.22

 

$

1.51

$

1.58

$

3.62

Weighted average number of common shares outstanding:

Basic

 

44,951

 

44,704

 

44,936

 

44,620

Diluted

 

45,274

 

45,219

 

45,311

 

45,056

See accompanying notes to the unaudited condensed consolidated interim financial statements.

3

RLI Corp. and Subsidiaries

Condensed Consolidated Balance Sheets

(Unaudited)

June 30,

December 31,

(in thousands, except share and per share data)

 

2020

 

2019

ASSETS

  

  

Investments and cash:

Fixed income:

Available-for-sale, at fair value

 

$

2,075,093

 

$

1,983,086

(amortized cost of $1,956,137 and allowance for credit losses of $985 at 6/30/20)

(amortized cost of $1,915,278 and allowance for credit losses of $0 at 12/31/19)

 

 

Equity securities, at fair value (cost - $270,987 at 6/30/20 and $262,131 at 12/31/19)

 

422,198

 

460,630

Other invested assets

63,440

70,441

Cash

 

84,797

 

46,203

Total investments and cash

$

2,645,528

$

2,560,360

Accrued investment income

 

15,142

 

14,587

Premiums and reinsurance balances receivable, net of allowances for uncollectible amounts of $17,139 at 6/30/20 and $16,682 at 12/31/19

 

154,941

 

160,369

Ceded unearned premium

 

93,679

 

93,656

Reinsurance balances recoverable on unpaid losses and settlement expenses, net of allowances for uncollectible amounts of $8,035 at 6/30/20 and $9,402 at 12/31/19

 

364,756

 

384,517

Deferred policy acquisition costs

 

87,560

 

85,044

Property and equipment, at cost, net of accumulated depreciation of $65,762 at 6/30/20 and $62,703 at 12/31/19

 

52,350

 

53,121

Investment in unconsolidated investees

 

112,662

 

103,836

Goodwill and intangibles

 

53,923

 

54,127

Other assets

 

38,738

 

36,104

TOTAL ASSETS

 

$

3,619,279

 

$

3,545,721

LIABILITIES AND SHAREHOLDERS’ EQUITY

Liabilities

Unpaid losses and settlement expenses

 

$

1,590,996

 

$

1,574,352

Unearned premiums

 

543,113

 

540,213

Reinsurance balances payable

 

24,777

 

25,691

Funds held

 

84,430

 

83,358

Income taxes-deferred

 

57,421

 

56,727

Bonds payable, long-term debt

 

149,395

 

149,302

Accrued expenses

 

35,998

 

66,626

Other liabilities

 

81,691

 

54,064

TOTAL LIABILITIES

 

$

2,567,821

 

$

2,550,333

Shareholders’ Equity

Common stock ($0.01 par value)

(Shares authorized - 200,000,000 at 6/30/20 and 100,000,000 at 12/31/19)

(67,882,816 shares issued, 44,952,602 shares outstanding at 6/30/20)

(67,799,229 shares issued, 44,869,015 shares outstanding at 12/31/19)

$

679

$

678

Paid-in capital

 

325,862

 

321,190

Accumulated other comprehensive earnings

 

93,035

 

52,473

Retained earnings

 

1,024,881

 

1,014,046

Deferred compensation

 

7,600

 

7,980

Less: Treasury shares at cost

(22,930,214 shares at 6/30/20 and 12/31/19)

 

(400,599)

 

(400,979)

TOTAL SHAREHOLDERS’ EQUITY

$

1,051,458

$

995,388

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

 

$

3,619,279

 

$

3,545,721

See accompanying notes to the unaudited condensed consolidated interim financial statements.

4

RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Shareholders’ Equity

(Unaudited)

   

   

   

   

   

Accumulated

   

   

   

 

Total

Other

Common

Shareholders’

Common

Paid-in

Comprehensive

Retained

Deferred

Treasury

(in thousands, except share and per share data)

Shares

Equity

Stock

Capital

Earnings (Loss)

Earnings

Compensation

Shares at Cost

Balance, January 1, 2019

 

44,504,043

$

806,842

$

674

$

305,660

$

(14,572)

$

908,079

$

8,354

$

(401,353)

Net earnings (loss)

 

65,473

65,473

Other comprehensive earnings (loss), net of tax

 

 

29,301

 

 

 

29,301

 

 

 

Deferred compensation

 

 

 

 

 

 

 

(1,039)

 

1,039

Share-based compensation

 

50,213

 

2,892

 

1

 

2,891

 

 

 

 

Dividends and dividend equivalents ($0.22 per share)

 

 

(9,803)

 

 

 

 

(9,803)

 

 

Balance, March 31, 2019

 

44,554,256

$

894,705

$

675

$

308,551

$

14,729

$

963,749

$

7,315

$

(400,314)

Net earnings (loss)

 

40,467

40,467

Other comprehensive earnings (loss), net of tax

 

 

27,864

 

 

 

27,864

 

 

 

Deferred compensation

 

 

 

 

 

 

 

215

 

(215)

Share-based compensation

 

232,941

 

7,217

 

2

 

7,215

 

 

 

 

Dividends and dividend equivalents ($0.23 per share)

 

 

(10,305)

 

 

 

 

(10,305)

 

 

Balance, June 30, 2019

 

44,787,197

$

959,948

$

677

$

315,766

$

42,593

$

993,911

$

7,530

$

(400,529)

   

   

   

   

   

Accumulated

   

   

   

Total

Other

 

Common

Shareholders’

Common

Paid-in

Comprehensive

Retained

Deferred

Treasury

 

(in thousands, except share and per share data)

Shares

Equity

Stock

Capital

Earnings (Loss)

Earnings

Compensation

Shares at Cost

 

Balance, January 1, 2020

 

44,869,015

$

995,388

$

678

$

321,190

$

52,473

$

1,014,046

$

7,980

$

(400,979)

Cumulative-effect adjustment from ASU 2016-13

1,095

22

1,073

Net earnings (loss)

 

(61,267)

(61,267)

Other comprehensive earnings (loss), net of tax

 

 

(13,031)

 

 

 

(13,031)

 

 

 

Deferred compensation

 

 

 

 

 

 

 

(1,010)

 

1,010

Share-based compensation

 

53,641

 

3,863

 

1

 

3,862

 

 

 

 

Dividends and dividend equivalents ($0.23 per share)

 

 

(10,343)

 

 

 

 

(10,343)

 

 

Balance, March 31, 2020

 

44,922,656

$

915,705

$

679

$

325,052

$

39,464

$

943,509

$

6,970

$

(399,969)

Net earnings (loss)

 

92,166

92,166

Other comprehensive earnings (loss), net of tax

 

 

53,571

 

 

 

53,571

 

 

 

Deferred compensation

 

 

 

 

 

 

 

630

 

(630)

Share-based compensation

 

29,946

 

810

 

 

810

 

 

 

 

Dividends and dividend equivalents ($0.24 per share)

 

 

(10,794)

 

 

 

 

(10,794)

 

 

Balance, June 30, 2020

 

44,952,602

$

1,051,458

$

679

$

325,862

$

93,035

$

1,024,881

$

7,600

$

(400,599)

See accompanying notes to the unaudited condensed consolidated interim financial statements.

5

RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

For the Six-Month Periods

Ended June 30,

(in thousands)

2020

2019

Net cash provided by operating activities

    

$

83,773

    

$

105,347

Cash Flows from Investing Activities

Purchase of:

Fixed income securities, available-for-sale

$

(185,502)

$

(214,332)

Equity securities

(48,473)

(59,861)

Property and equipment

(3,413)

(3,004)

Other

(6,651)

(7,122)

Proceeds from sale of:

Fixed income securities, available-for-sale

40,333

132,153

Equity securities

52,533

33,360

Other

2,596

1,842

Proceeds from call or maturity of:

Fixed income securities, available-for-sale

121,911

52,113

Net proceeds from sale (purchase) of short-term investments

 

-

 

(35,803)

Net cash used in investing activities

 

$

(26,666)

 

$

(100,654)

Cash Flows from Financing Activities

Cash dividends paid

 

$

(21,119)

 

$

(20,092)

Proceeds from stock option exercises

 

2,606

 

10,093

Net cash used in financing activities

 

$

(18,513)

 

$

(9,999)

Net increase (decrease) in cash

$

38,594

$

(5,306)

Cash at the beginning of the period

46,203

30,140

Cash at June 30

 

$

84,797

 

$

24,834

See accompanying notes to the unaudited condensed consolidated interim financial statements.

6

NOTES TO UNAUDITED CONDENSED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

A. BASIS OF PRESENTATION

The unaudited condensed consolidated interim financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (GAAP) for interim financial reporting and with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the disclosures required by GAAP for complete financial statements. As such, these unaudited condensed consolidated interim financial statements should be read in conjunction with our 2019 Annual Report on Form 10-K. Management believes that the disclosures are adequate to make the information presented not misleading, and all normal and recurring adjustments necessary to present fairly the financial position at June 30, 2020 and the results of operations of RLI Corp. and subsidiaries for all periods presented have been made. The results of operations for any interim period are not necessarily indicative of the operating results for a full year. Certain reclassifications were made to 2019 to conform to the classifications used in the current year.

The preparation of the unaudited condensed consolidated interim financial statements requires management to make estimates and assumptions relating to the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the unaudited condensed consolidated interim financial statements and the reported amounts of revenue and expenses during the period. These estimates are inherently subject to change and actual results could differ significantly from these estimates.

B. ADOPTED ACCOUNTING STANDARDS

ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments

ASU 2016-13 was issued to provide more decision-useful information about the expected credit losses on financial instruments. Previous guidance delayed the recognition of credit losses until it was probable a loss had been incurred. This update requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected by means of an allowance for credit losses that is included in net earnings. Credit losses relating to available-for-sale debt securities are also required to be recorded through a reversible allowance for credit losses, but is limited to the amount by which fair value is less than amortized cost.

We adopted ASU 2016-13 on January 1, 2020 using the modified-retrospective approach. The standard applied to three of the Company’s balance sheet accounts: available-for-sale fixed income securities, premiums receivable and reinsurance balances recoverable. The impact of this standard was and is expected to continue to be immaterial, as our fixed income portfolio is weighted towards higher rated bonds (84 percent rated A or better at June 30, 2020 and 85 percent at December 31, 2019), we purchase reinsurance from financially strong reinsurers, we have a long history of collecting premium receivables through various economic cycles and we had previously maintained an allowance for uncollectible premium and reinsurance balances. In total, the cumulative-effect adjustment made to the balance sheet as of the beginning of the year resulted in a $1.1 million increase to retained earnings and an increase to accumulated other comprehensive earnings of less than $0.1 million.

C. REINSURANCE

Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not relieve the Company of our legal liability to our policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. We continuously monitor the financial condition of our reinsurers and actively follow up on any past due or disputed amounts. As part of our monitoring efforts, we review their annual financial statements, quarterly disclosures and Securities and Exchange Commission (SEC) filings for those reinsurers that are publicly traded. We also review insurance industry developments that may impact the financial condition of our reinsurers. We analyze the credit risk associated with our reinsurance balances recoverable by monitoring the AM Best and Standard & Poor’s (S&P) ratings of our reinsurers. Additionally, we perform an in depth reinsurer financial condition analysis prior to the renewal of our reinsurance placements.

Once regulatory action (such as receivership, finding of insolvency, order of conservation or order of liquidation) is taken against a reinsurer, the paid and unpaid balances recoverable from the reinsurer are specifically identified and charged to earnings in the form of an allowance for uncollectible amounts. We subject our remaining reinsurance balances receivable to detailed recoverability tests, including a segment-based analysis using the average default rating percentage by S&P rating, and

7

record an additional allowance for unrecoverable amounts from reinsurers. This credit allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover.

The allowances for uncollectible amounts on paid and unpaid reinsurance recoverables were $15.9 million and $8.0 million, respectively, at June 30, 2020. At December 31, 2019, the amounts were $15.7 million and $9.4 million, respectively. Adoption of ASU 2016-03 resulted in a $1.3 million decrease to the allowance for uncollectible amounts on reinsurance recoverables in 2020, while other changes in the allowances were due to changes in the amount of reinsurance balances outstanding, the composition of reinsurers from whom the balances were recoverable and their associated S&P default ratings. NaN write-offs or recoveries were applied to the allowances in the first six months of 2020.

D. INTANGIBLE ASSETS

Goodwill and intangible assets totaled $53.9 million and $54.1 million at June 30, 2020 and December 31, 2019, respectively, as detailed in the following table:

Goodwill and Intangible Assets

June 30,

December 31,

(in thousands)

2020

2019

Goodwill

Energy surety

$

25,706

$

25,706

Miscellaneous and contract surety

15,110

15,110

Small commercial

5,246

5,246

Total goodwill

$

46,062

$

46,062

Intangibles

Indefinite-lived intangibles - state insurance licenses

7,500

7,500

Definite-lived intangibles, net of accumulated amortization of $3,674 at 6/30/20 and $3,470 at 12/31/19

361

565

Total intangibles

$

7,861

$

8,065

Total goodwill and intangibles

$

53,923

$

54,127

All definite-lived intangible assets are amortized based on their estimated useful lives. Amortization of intangible assets was $0.1 million for the second quarter of 2020 and $0.2 million for the six-month period ended June 30, 2020, the same as for the comparable periods in 2019.

Annual impairment assessments were performed on our energy surety goodwill, miscellaneous and contract surety goodwill, small commercial goodwill and state insurance license indefinite-lived intangible asset during the second quarter of 2020. Based upon these reviews, NaN of the assets were impaired. In addition, there were no triggering events as of June 30, 2020 that would suggest an updated impairment test would be needed for our goodwill and intangible assets.

E. EARNINGS PER SHARE

Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the dilution that could occur if securities or other contracts to issue common stock or common stock equivalents were exercised or converted into common stock. When inclusion of common stock equivalents increases the earnings per share or reduces the loss per share, the effect on earnings is anti-dilutive. Under these circumstances, the diluted net earnings or net loss per share is computed excluding the common stock equivalents. The following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the unaudited condensed consolidated interim financial statements:

8

For the Three-Month Period

For the Three-Month Period

Ended June 30, 2020

Ended June 30, 2019

Income

Shares

Per Share

Income

Shares

Per Share

(in thousands, except per share data)

    

(Numerator)

    

(Denominator)

    

Amount

    

(Numerator)

    

(Denominator)

    

Amount

Basic EPS

Earnings available to common shareholders

 

$

92,166

 

44,951

 

$

2.05

    

$

40,467

 

44,704

 

$

0.91

Effect of Dilutive Securities

Stock options and restricted stock units

 

-

 

323

 

-

 

515

Diluted EPS

Earnings available to common shareholders

 

$

92,166

 

45,274

 

$

2.04

 

$

40,467

 

45,219

 

$

0.89

Anti-dilutive options excluded from diluted EPS

94

-

For the Six-Month Period

For the Six-Month Period

Ended June 30, 2020

Ended June 30, 2019

Income

Shares

Per Share

Income

Shares

Per Share

(in thousands, except per share data)

    

(Numerator)

    

(Denominator)

    

Amount

    

(Numerator)

    

(Denominator)

    

Amount

Basic EPS

Earnings available to common shareholders

 

$

30,899

 

44,936

 

$

0.69

 

$

105,940

 

44,620

 

$

2.37

Effect of Dilutive Securities

Stock options and restricted stock units

 

-

 

375

 

-

 

436

Diluted EPS

Earnings available to common shareholders

 

$

30,899

 

45,311

 

$

0.68

 

$

105,940

 

45,056

 

$

2.35

Anti-dilutive options excluded from diluted EPS

335

254

F. COMPREHENSIVE EARNINGS

Our comprehensive earnings include net earnings plus after-tax unrealized gains and losses on our fixed income portfolio. In reporting other comprehensive earnings on a net basis in the statement of earnings, we used the federal statutory tax rate of 21 percent. Other comprehensive earnings, as shown in the consolidated statements of earnings and comprehensive earnings, is net of tax expense of $14.2 million and $7.4 million for the second quarter of 2020 and 2019, respectively. For the six-month period ended June 30, 2020 and 2019, other comprehensive earnings is net of tax expense of $10.8 million and $15.2 million, respectively.

Unrealized gains, net of tax, on the fixed income portfolio were $40.5 million for the first six months of 2020, compared to $57.2 million during the same period last year. The unrealized gains were attributable to declining interest rates in both periods, which increased the fair value of securities held in the fixed income portfolio. For the first half of 2020, widening credit spreads partially offset the impact of the declining interest rates.

The following table illustrates the changes in the balance of each component of accumulated other comprehensive earnings for each period presented in the unaudited condensed consolidated interim financial statements:

(in thousands)

For the Three-Month Periods

For the Six-Month Periods

Ended June 30,

Ended June 30,

Unrealized Gains/Losses on Available-for-Sale Securities

    

2020

    

2019

    

2020

    

2019

Beginning balance

 

$

39,464

 

$

14,729

 

$

52,473

 

$

(14,572)

Cumulative-effect adjustment of ASU 2016-13 (see note 1.B.)

-

-

22

-

Adjusted beginning balance

$

39,464

$

14,729

$

52,495

$

(14,572)

Other comprehensive earnings before reclassifications

 

53,733

 

 

28,388

 

41,853

 

58,183

Amounts reclassified from accumulated other comprehensive earnings

 

(162)

 

 

(524)

 

(1,313)

 

(1,018)

Net current-period other comprehensive earnings (loss)

 

$

53,571

 

$

27,864

 

$

40,540

 

$

57,165

Ending balance

 

$

93,035

 

$

42,593

 

$

93,035

 

$

42,593

Balance of securities for which an allowance for credit losses has been recognized in net earnings

$

1,752

 

$

-

9

Credit losses on or the sale of an available-for-sale security results in amounts being reclassified from accumulated other comprehensive earnings to current period net earnings. We recognized $0.1 million of credit loss expense on available-for-sale securities in the second quarter of 2020 and $1.0 million in the first six months of 2020, increasing the allowance for credit losses on fixed income securities to $1.0 million. NaN write-offs or recoveries were applied to the allowances in the first half of 2020. The effects of reclassifications out of accumulated other comprehensive earnings by the respective line items of net earnings are presented in the following table:

Amount Reclassified from Accumulated Other

(in thousands)

Comprehensive Earnings

For the Three-Month

For the Six-Month

Component of Accumulated 

Periods Ended June 30, 

Periods Ended June 30, 

Affected line item in the

Other Comprehensive Earnings

    

2020

    

2019

    

2020

    

2019

    

Statement of Earnings

Unrealized gains and losses on available-for-sale securities

$

312

$

664

$

2,618

$

1,289

Net realized gains (losses)

(107)

-

(956)

-

Credit losses presented within net realized gains

$

205

$

664

$

1,662

$

1,289

Earnings before income taxes

(43)

(140)

(349)

(271)

Income tax expense

$

162

$

524

$

1,313

$

1,018

Net earnings

G. FAIR VALUE MEASUREMENTS

Fair value is defined as the price in the principal market that would be received for an asset to facilitate an orderly transaction between market participants on the measurement date. We determined the fair value of certain financial instruments based on their underlying characteristics and relevant transactions in the marketplace. We maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The following are the levels of the fair value hierarchy and a brief description of the type of valuation inputs that are used to establish each level. Financial assets are classified based upon the lowest level of significant input that is used to determine fair value.

Pricing Level 1 is applied to valuations based on readily available, unadjusted quoted prices in active markets for identical assets.

Pricing Level 2 is applied to valuations based upon quoted prices for similar assets in active markets, quoted prices for identical or similar assets in inactive markets; or valuations based on models where the significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities) or can be corroborated by observable market data.

Pricing Level 3 is applied to valuations that are derived from techniques in which one or more of the significant inputs are unobservable.

As a part of management’s process to determine fair value, we utilize widely recognized, third-party pricing sources to determine our fair values. We have obtained an understanding of the third-party pricing sources’ valuation methodologies and inputs. The following is a description of the valuation techniques used for financial assets that are measured at fair value, including the general classification of such assets pursuant to the fair value hierarchy.

Corporate, Agencies, Government and Municipal Bonds: The pricing vendor employs a multi-dimensional model which uses standard inputs including (listed in approximate order of priority for use) benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, market bids/offers and other reference data. The pricing vendor also monitors market indicators, as well as industry and economic events. All bonds valued using these techniques are classified as Level 2. All corporate, agency, government and municipal securities were deemed Level 2.

Mortgage-backed Securities (MBS)/Commercial Mortgage-backed Securities (CMBS) and Asset-backed Securities (ABS): The pricing vendor evaluation methodology includes principally interest rate movements and new issue data. Evaluations of the tranches (non-volatile, volatile or credit sensitivity) are based on the pricing vendors’ interpretation of accepted modeling and pricing conventions. This information is used to determine the cash flows for each tranche, benchmark yields, prepayment assumptions and to incorporate collateral performance. To evaluate MBS and CMBS volatility, an option

10

adjusted spread model is used in combination with models that simulate interest rate paths to determine market price information. This process allows the pricing vendor to obtain evaluations of a broad universe of securities in a way that reflects changes in yield curve, index rates, implied volatility, mortgage rates and recent trade activity. MBS/CMBS and ABS with corroborated, observable inputs are classified as Level 2. All of our MBS/CMBS and ABS are deemed Level 2.

Regulation D Private Placement Securities: All Regulation D privately placed bonds are classified as corporate securities and deemed Level 3. The pricing vendor evaluation methodology for these securities includes a combination of observable and unobservable inputs. Observable inputs include public corporate spread matrices classified by sector, rating and average life, as well as investment and non-investment grade matrices created from fixed income indices. Unobservable inputs include a liquidity spread premium calculated based on public corporate spread and private corporate spread matrices. The quantitative detail of the liquidity spread premium is neither provided nor reasonably available to the Company. An increase to the credit spread assumptions would result in a lower fair value measurement.

For all of our fixed income securities classified as Level 2, as described above, we periodically conduct a review to assess the reasonableness of the fair values provided by our pricing services. Our review consists of a two-pronged approach. First, we compare prices provided by our pricing services to those provided by an additional source. In some cases, we obtain prices from securities brokers and compare them to the prices provided by our pricing services. In both comparisons, if discrepancies are found, we compare our prices to actual reported trade data for like securities. No changes to the fair values supplied by our pricing services have occurred as a result of our reviews. Based on these assessments, we have determined that the fair values of our Level 2 securities provided by our pricing services are reasonable.

Common Stock: As of June 30, 2020, all of our common stock holdings are traded on an exchange. Exchange traded equities have readily observable price levels and are classified as Level 1 (fair value based on quoted market prices).

Due to the relatively short-term nature of cash, short-term investments, accounts receivable and accounts payable, their carrying amounts are reasonable estimates of fair value. Our investments in private funds, classified as other invested assets, are measured using the investments’ net asset value per share and are not categorized within the fair value hierarchy.

H. RISKS AND UNCERTAINTIES

Certain risks and uncertainties are inherent to our day-to-day operations. Adverse changes in the economy could lower demand for our insurance products or negatively impact our investment results, both of which could have an adverse effect on the revenue and profitability of our operations. The COVID-19 pandemic has resulted in and is expected to continue to result in significant disruptions in economic activity and financial markets. The cumulative effects of COVID-19 on the Company, and the effect of any other public health outbreak, cannot be predicted at this time, but could reduce demand for our insurance policies, result in increased level of losses, settlement expenses or other operating costs, reduce the market value of invested assets held by the Company or negatively impact the fair value of our goodwill.

Catastrophe Exposures

Our catastrophe reinsurance treaty renewed on January 1, 2020. We purchased limits of $400 million in excess of $25 million first-dollar retention for earthquakes in California, $425 million in excess of $25 million first-dollar retention for earthquakes outside of California and $275 million in excess of $25 million first-dollar retention for all other perils. These amounts are subject to certain co-participations by the Company on losses in excess of the $25 million retentions. On March 1, 2020, we purchased $100 million of additional catastrophe reinsurance protection on top of the previously described coverage. This increases the limits to $500 million for earthquakes in California, $525 million for earthquakes outside of California and $375 for all other perils, all of which are still subject to $25 million first-dollar retentions and certain co-participations in excess of the retentions.

2. INVESTMENTS

Our investments are primarily composed of fixed income debt securities and common stock equity securities. We carry our equity securities at fair value and categorize all of our debt securities as available-for-sale, which are carried at fair value.

Realized gains and losses on disposition of investments are based on specific identification of the investments sold on the settlement date. The following is a summary of the disposition of fixed income and equity securities for the six-month periods ended June 30, 2020 and 2019:

11

SALES

Proceeds

Gross Realized

Net Realized

(in thousands)

 

From Sales

 

Gains

 

Losses

 

Gain (Loss)

2020

Available-for-sale

$

42,874

$

3,495

$

(1,162)

$

2,333

Equities

 

52,533

 

19,569

 

(6,732)

 

12,837

2019

Available-for-sale

$

133,473

$

2,346

$

(1,106)

$

1,240

Equities

 

33,360

 

13,016

 

(711)

 

12,305

CALLS/MATURITIES

Gross Realized

Net Realized

(in thousands)

    

Proceeds

    

Gains

    

Losses

    

Gain (Loss)

2020

Available-for-sale

$

121,911

$

294

$

(9)

$

285

2019

Available-for-sale

$

53,113

$

58

$

(9)

$

49

FAIR VALUE MEASUREMENTS

Assets measured at fair value on a recurring basis as of June 30, 2020 and December 31, 2019 are summarized below:

As of June 30, 2020

Fair Value Measurements Using

    

Quoted Prices in

    

Significant Other

    

Significant

    

    

Active Markets for

Observable

Unobservable

Identical Assets

Inputs

Inputs

(in thousands)

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

Total

Fixed income securities - available-for-sale

U.S. government

$

$

186,838

$

$

186,838

U.S. agency

32,091

32,091

Non-U.S. govt. & agency

7,692

7,692

Agency MBS

409,167

409,167

ABS/CMBS*

218,507

218,507

Corporate

758,066

7,059

765,125

Municipal

455,673

455,673

Total fixed income securities - available-for-sale

$

$

2,068,034

$

7,059

$

2,075,093

Equity securities

422,198

422,198

Other invested assets

15,792

15,792

Total

$

437,990

$

2,068,034

$

7,059

$

2,513,083

As of December 31, 2019

Fair Value Measurements Using

Quoted Prices in

    

Significant Other

    

Significant

    

    

Active Markets for

Observable

Unobservable

Identical Assets

Inputs

Inputs

(in thousands)

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

Total

Fixed income securities - available-for-sale

U.S. government

$

$

193,661

$

$

193,661

U.S. agency

38,855

38,855

Non-U.S. govt. & agency

7,628

7,628

Agency MBS

420,165

420,165

ABS/CMBS*

224,870

224,870

Corporate

690,297

1,770

692,067

Municipal

405,840

405,840

Total fixed income securities - available-for-sale

$

$

1,981,316

$

1,770

$

1,983,086

Equity securities

460,630

460,630

Total

$

460,630

$

1,981,316

$

1,770

$

2,443,716

* Non-agency asset-backed and commercial mortgage-backed

12

As of June 30, 2020, we had $7.1 million of Regulation D private placement fixed income securities whose fair value was measured using significant unobservable inputs (Level 3). The following table summarizes changes in the balance of these Level 3 securities.

Level 3

(in thousands)

Securities

Balance as of January 1, 2020

$

1,770

Net realized and unrealized gains (losses)

 

Included in net earnings as a part of:

Net investment income

(10)

Net realized gains (losses)

(96)

Included in other comprehensive earnings

 

(282)

Total net realized and unrealized gains (losses)

$

(388)

Purchases

5,677

Balance as of June 30, 2020

$

7,059

Change in unrealized gains (losses) during the period for Level 3 assets held at period-end -
included in net realized gains

$

(96)

Change in unrealized gains (losses) during the period for Level 3 assets held at period-end -
included in other comprehensive earnings (loss)

$

(282)

The amortized cost and fair value of available-for-sale fixed income securities by contractual maturity as of June 30, 2020 were as follows:

June 30, 2020

Available-for-sale

Amortized

Fair

(in thousands)

    

Cost

    

Value

Due in one year or less

$

75,077

$

75,888

Due after one year through five years

472,458

495,968

Due after five years through 10 years

526,480

571,103

Due after 10 years

279,538

304,460

Mtge/ABS/CMBS*

602,584

627,674

Total available-for-sale

$

1,956,137

$

2,075,093

*Mortgage-backed, asset-backed and commercial mortgage-backed

The amortized cost and fair value of available-for-sale securities at June 30, 2020 and December 31, 2019 are presented in the tables below. Amortized cost does not include the $14.1 million and $13.5 million of accrued interest receivable as of June 30, 2020 and December 31, 2019, respectively.

Available-for-sale

June 30, 2020

(in thousands)

    

Cost or

Allowance

    

Gross

    

Gross

    

    

Amortized

for Credit

Unrealized

Unrealized

Fair

Asset Class

    

Cost

Losses

Gains

    

Losses

    

Value

U.S. government

$

171,174

$

-

$

15,664

$

-

$

186,838

U.S. agency

27,913

-

4,178

-

32,091

Non-U.S. govt. & agency

7,316

-

401

(25)

7,692

Agency MBS

388,036

-

21,208

(77)

409,167

ABS/CMBS*

214,548

(54)

5,218

(1,205)

218,507

Corporate

717,748

(931)

54,610

(6,302)

765,125

Municipal

429,402

-

26,341

(70)

455,673

Total Fixed Income

$

1,956,137

$

(985)

$

127,620

$

(7,679)

$

2,075,093

*Non-agency asset-backed and commercial mortgage-backed

13

Available-for-sale

December 31, 2019

(in thousands)

    

Cost or

Allowance

    

Gross

    

Gross

    

    

Amortized

for Credit

Unrealized

Unrealized

Fair

Asset Class

    

Cost

Losses

    

Gains

    

Losses

    

Value

U.S. government

$

186,699

$

-

$

6,994

$

(32)

$

193,661

U.S. agency

36,535

-

2,362

(42)

38,855

Non-U.S. govt. & agency

7,333

-

295

-

7,628

Agency MBS

411,808

-

8,920

(563)

420,165

ABS/CMBS*

222,832

-

2,514

(476)

224,870

Corporate

659,640

-

33,245

(818)

692,067

Municipal

390,431

-

16,131

(722)

405,840

Total Fixed Income

$

1,915,278

$

-

$

70,461

$

(2,653)

$

1,983,086

*Non-agency asset-backed and commercial mortgage-backed

Allowance for Credit Losses and Unrealized Losses on Fixed Income Securities

We adopted ASU 2016-13, Financial Instruments – Credit Losses, on January 1, 2020, which required the recognition of a reversible allowance for credit losses on available-for-sale fixed income securities. See note 1. B. for more information on the adoption of the ASU. Available-for-sale securities in the fixed income portfolio are subjected to several criteria to determine if those securities should be included in the allowance for expected credit loss evaluation, including:

Changes in technology that may impair the earnings potential of the investment,

The discontinuance of a segment of business that may affect future earnings potential,

Reduction of or non-payment of interest and/or principal,

Specific concerns related to the issuer’s industry or geographic area of operation,

Significant or recurring operating losses, poor cash flows and/or deteriorating liquidity ratios and

Downgrades in credit quality by a major rating agency.

If changes in interest rates and credit spreads do not reasonably explain the unrealized loss for an available-for-sale security or if any of the criteria above indicate a potential credit loss, the security is subjected to a discounted cash flow analysis. Inputs into the discounted cash flow analysis include prepayment assumptions for structured securities, default rates and recoverability rates based on credit rating. The allowance for any security is limited to the amount that the securities fair value is below amortized cost.

As of June 30, 2020, the discounted cash flow analysis resulted in an allowance for credit losses on 36 securities totaling $1.0 million. All fixed income securities in the investment portfolio continue to pay the expected coupon payments under the contractual terms of the securities. Based on our analysis, we believe we will recover the amortized cost basis on the available-for-sale securities not included in the allowance for credit losses. We do not intend to sell the available-for-sale securities in an unrealized loss position and it is not more likely than not that we will be required to sell the investments before recovery of the amortized cost basis. We continually monitor the credit quality of our fixed income investments to assess if it is probable that we will receive our contractual or estimated cash flows in the form of principal and interest.

Prior to the adoption of ASU 2016-13, we conducted reviews of fixed income securities with unrealized losses to evaluate whether an impairment was other-than-temporary. Any credit-related impairment on fixed income securities we did not plan to sell and for which we were not more likely than not to be required to sell were recognized in net earnings, with the non-credit related impairment recognized in comprehensive earnings. We did not recognize any other-than-temporary impairment losses in earnings on the fixed income portfolio in the first six months of 2019.

As of June 30, 2020, in addition to the securities included in the allowance for credit losses, the fixed income portfolio contained 249 securities with an unrealized loss position for which an allowance for credit losses had not been recorded. The $7.7 million in associated unrealized losses represents 0.4 percent of the fixed income portfolio’s cost basis and 0.3 percent of total invested assets. Isolated to these securities, unrealized losses increased through the first six months of 2020, as increased credit

14

spreads more than offset declines in interest rates during the period, primarily in the corporate portfolio. Of the total 285 securities, 32 have been in an unrealized loss position for 12 consecutive months or longer. The following table illustrates the total value of fixed income securities that were in an unrealized loss position as of June 30, 2020, after factoring in the allowance for credit losses, and December 31, 2019.

June 30, 2020

December 31, 2019

(in thousands)

    

< 12 Mos.

    

12 Mos. & 
Greater

    

Total

    

< 12 Mos.

    

12 Mos. & 
Greater

    

Total

U.S. government

Fair value

$

$

$

$

2,505

$

8,463

$

10,968

Amortized cost

2,506

8,494

11,000

Unrealized Loss

$

$

$

$

(1)

$

(31)

$

(32)

U.S. agency

Fair value

$

$

$

$

6,794

$

$

6,794

Amortized cost

6,836

6,836

Unrealized Loss

$

$

$

$

(42)

$

$

(42)

Non-U.S. government

Fair value

$

1,995

$

$

1,995

$

$

$

Amortized cost

2,020

2,020

Unrealized Loss

$

(25)

$

$

(25)

$

$

$

Agency MBS

Fair value

$

22,294

$

468

$

22,762

$

21,548

$

41,718

$

63,266

Amortized cost

22,368

471

22,839

21,664

42,165

63,829

Unrealized Loss

$

(74)

$

(3)

$

(77)

$

(116)

$

(447)

$

(563)

ABS/CMBS*

Fair value

$

34,445

$

15,578

$

50,023

$

74,968

$

18,036

$

93,004

Amortized cost

35,297

15,931

51,228

75,332

18,148

93,480

Unrealized Loss

$

(852)

$

(353)

$

(1,205)

$

(364)

$

(112)

$

(476)

Corporate

Fair value

$

110,503

$

5,185

$

115,688

$

16,478

$

9,348

$

25,826

Amortized cost

116,140

5,850

121,990

16,950

9,694

26,644

Unrealized Loss

$

(5,637)

$

(665)

$

(6,302)

$

(472)

$

(346)

$

(818)

Municipal

Fair value

$

12,038

$

$

12,038

$

47,018

$

$

47,018

Amortized cost

12,108

12,108

47,740

47,740

Unrealized Loss

$

(70)

$

$

(70)

$

(722)

$

$

(722)

Total fixed income

Fair value

$

181,275

$

21,231

$

202,506

$

169,311

$

77,565

$

246,876

Amortized cost

187,933

22,252

210,185

171,028

78,501

249,529

Unrealized Loss

$

(6,658)

$

(1,021)

$

(7,679)

$

(1,717)

$

(936)

$

(2,653)

* Non-agency asset-backed and commercial mortgage-backed

The following table shows the composition of the fixed income securities in unrealized loss positions, after factoring in the allowance for credit losses, at June 30, 2020 by the National Association of Insurance Commissioners (NAIC) rating and the generally equivalent Standard & Poor’s (S&P) and Moody’s ratings. The vast majority of the securities are rated by S&P and/or Moody’s.

15

Equivalent

Equivalent

(dollars in thousands)

NAIC

    

S&P

    

Moody’s

Amortized

    

    

    

Unrealized

Percent

Rating

    

Rating

    

Rating

    

Cost

    

Fair Value

    

Loss

    

to Total

1

AAA/AA/A

Aaa/Aa/A

$

100,257

$

98,089

$

(2,168)

28.2

%

2

BBB

Baa

10,076

9,860

(216)

2.8

%

3

BB

Ba

51,161

49,264

(1,897)

24.7

%

4

B

B

42,541

40,086

(2,455)

32.0

%

5

CCC

Caa

5,822

5,019

(803)

10.5

%

6

CC or lower

Ca or lower

328

188

(140)

1.8

%

Total

$

210,185

$

202,506

$

(7,679)

100.0

%

Unrealized Gains and Losses on Equity Securities

Unrealized gains recognized on equity securities still held as of June 30, 2020 were $72.4 million during the second quarter, while unrealized losses were $42.9 million during the first half of 2020. Comparatively, unrealized gains recognized on equity securities still held as of June 30, 2019 were $12.9 million during the second quarter and $54.8 million during the first half of 2019.

Other Invested Assets

We had $63.4 million of other invested assets at June 30, 2020, compared to $70.4 million at the end of 2019. Other invested assets include investments in low income housing tax credit partnerships (LIHTC), membership in the Federal Home Loan Bank of Chicago (FHLBC), investments in private funds and investments in restricted stock. Our LIHTC investments are carried at amortized cost and our investment in FHLBC stock is carried at cost. Due to the nature of the LIHTC and our membership in the FHLBC, their carrying amounts approximate fair value. The private funds are carried at fair value, using each investment’s net asset value. Restricted stock is carried at quoted market prices, as the restrictions expire within one year.

Our LIHTC interests had a balance of $21.6 million at June 30, 2020, compared to $23.3 million at December 31, 2019 and recognized a total tax benefit of $0.9 million during the second quarter of 2020, compared to $0.6 million the prior year. For the six-month periods ended June 30, 2020 and 2019, our LIHTC interest recognized a total benefit of $1.8 million and $1.2 million, respectively. Our unfunded commitment for our LIHTC investments totaled $7.4 million at June 30, 2020 and will be paid out in installments through 2035.

As of June 30, 2020, $14.6 million of investments were pledged as collateral with the FHLBC to ensure timely access to the secured lending facility that ownership of FHLBC stock provides. As of and during the six-month period ended June 30, 2020, there were 0 outstanding borrowings with the FHLBC.

Our investments in private funds totaled $24.4 million at June 30, 2020, compared to $46.0 million at December 31, 2019, and we had $10.4 million of associated unfunded commitments at June 30, 2020. Our interest in private funds is generally restricted from being transferred or otherwise redeemed without prior consent by the respective entities. During the first quarter of 2020, one of the private funds transitioned into a publicly traded common stock. Short term restrictions, limiting our ability to sell without prior approval, were established and remain in place. Our investment in restricted stock was $15.8 million as of June 30, 2020. For our remaining investments in private funds, the timed dissolution of the partnerships would trigger redemption.

Cash

Cash consists of uninvested balances in bank accounts. We had a cash balance of $84.8 million at June 30, 2020, compared to $46.2 million at the end of 2019.

16

3. HISTORICAL LOSS AND LAE DEVELOPMENT

The following table is a reconciliation of our unpaid losses and settlement expenses (LAE) for the first six months of 2020 and 2019:

For the Six-Month Periods

Ended June 30,

(in thousands)

    

2020

    

2019

Unpaid losses and LAE at beginning of year

Gross

$

1,574,352

$

1,461,348

Ceded

 

(384,517)

 

(364,999)

Net

$

1,189,835

$

1,096,349

Adoption impact of ASU 2016-13 on reinsurance balances recoverable

$

(1,345)

$

Increase (decrease) in incurred losses and LAE

Current accident year

$

253,031

$

239,053

Prior accident years

 

(40,808)

 

(40,837)

Total incurred

$

212,223

$

198,216

Loss and LAE payments for claims incurred

Current accident year

$

(25,588)

$

(23,624)

Prior accident years

 

(148,885)

 

(126,972)

Total paid

$

(174,473)

$

(150,596)

Net unpaid losses and LAE at June 30

$

1,226,240

$

1,143,969

Unpaid losses and LAE at June 30

Gross

$

1,590,996

$

1,506,279

Ceded

 

(364,756)

 

(362,310)

Net

$

1,226,240

$

1,143,969

We adopted ASU 2016-13, Financial Instruments – Credit Losses, on January 1, 2020, which required financial assets, including reinsurance balances recoverable, to be presented at the net amount expected to be collected. We previously maintained an allowance for uncollectible reinsurance balances prior to the adoption of this update. However, in order to comply with the updated requirements, we released $1.3 million of the allowance on uncollectible reinsurance balances upon adoption. The implementation guidance required the cumulative-effect adjustment be made to the beginning balance of retained earnings, rather than through net earnings like historical changes have and ongoing modifications will continue to be recorded. See note 1. B. for more information on the adoption of the ASU.

For the first six months of 2020, incurred losses and LAE included $40.8 million of favorable development on prior years’ loss reserves. The majority of products experienced modest amounts of favorable development on prior accident years, with notable contributions from transportation, executive products, general liability, marine, small commercial and surety. No products experienced significant adverse development.

For the first six months of 2019, incurred losses and LAE included $40.8 million of favorable development on prior years’ loss reserves. Transportation, general liability, commercial excess and personal umbrella, professional services and surety were drivers of the favorable development. Executive products experienced adverse development.

Actuarial models base future emergence on historic experience, with adjustments for current trends, and the appropriateness of these assumptions involved more uncertainty as of June 30, 2020. We expect there will be impacts to the timing of loss emergence and ultimate loss ratios for certain coverages we underwrite as a result of the spread of COVID-19 and the related economic shutdown. The industry is experiencing new issues, including the postponement of civil court cases, the extension of various statutes of limitations, changes in settlement trends and a significant reduction in economic activity and insured exposure in some classes. Our booked reserves include consideration of these factors, but the duration and degree to which these issues persist, along with potential legislative, regulatory or judicial actions, could result in loss reserve deficiencies and reduce earnings in future periods.

17

4. INCOME TAXES

Our effective tax rate for the three and six-month periods ended June 30, 2020 was 19.8 percent and 13.0 percent, respectively, compared to 17.1 percent and 18.9 percent, respectively, for the same periods in 2019. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate was higher for the three-month period in 2020 due to higher levels of pre-tax earnings and lower levels of tax-favored adjustments compared to 2019. For the six-month period, lower levels of pre-tax earnings caused tax-favored adjustments to be larger on a percentage basis in 2020 compared to the prior year.

Income tax expense (benefit) attributable to income from operations for the three and six-month periods ended June 30, 2020 and 2019 differed from the amounts computed by applying the U.S. federal tax rate of 21 percent to pretax income by the items detailed in the below table. In interim periods, income taxes are adjusted to reflect the effective tax rate we anticipate for the year, with adjustments flowing through the other items, net line.

For the Three-Month Periods Ended June 30,

 

For the Six-Month Periods Ended June 30,

2020

2019

2020

2019

(in thousands)

 

Amount

 

%

    

 

Amount

 

%

 

Amount

 

%

    

Amount

 

%

Provision for income taxes at the statutory rate of 21%

$

24,124

21.0

%

$

10,254

21.0

%

$

7,458

21.0

%

$

27,419

21.0

%

Increase (reduction) in taxes resulting from:

Excess tax benefit on share-based compensation

(265)

(0.2)

%

(2,191)

(4.5)

%

(1,293)

(3.6)

%

(2,932)

(2.3)

%

Tax exempt interest income

(323)

(0.3)

%

(309)

(0.6)

%

(636)

(1.8)

%

(654)

(0.5)

%

Dividends received deduction

(212)

(0.2)

%

(214)

(0.4)

%

(484)

(1.4)

%

(417)

(0.3)

%

ESOP dividends paid deduction

(137)

(0.1)

%

(140)

(0.3)

%

(269)

(0.8)

%

(277)

(0.2)

%

Nondeductible expenses

161

0.1

%

414

0.8

%

364

1.0

%

922

0.7

%

Other items, net

(635)

(0.5)

%

547

1.1

%

(524)

(1.4)

%

568

0.5

%

Total tax expense (benefit)

$

22,713

19.8

%

$

8,361

17.1

%

$

4,616

13.0

%

$

24,629

18.9

%

5. STOCK BASED COMPENSATION

Our RLI Corp. Long-Term Incentive Plan (2010 LTIP) was in place from 2010 to 2015. The 2010 LTIP provided for equity-based compensation, including stock options, up to a maximum of 4,000,000 shares of common stock (subject to adjustment for changes in our capitalization and other events). Between 2010 and 2015, we granted 2,878,000 stock options under the 2010 LTIP. The 2010 LTIP was replaced in 2015.

In 2015, our shareholders approved the 2015 RLI Corp. Long-Term Incentive Plan (2015 LTIP), which provides for equity-based compensation and replaced the 2010 LTIP. In conjunction with the adoption of the 2015 LTIP, effective May 7, 2015, options were no longer granted under the 2010 LTIP. Awards under the 2015 LTIP may be in the form of restricted stock, restricted stock units, stock options (non-qualified only), stock appreciation rights, performance units as well as other stock-based awards. Eligibility under the 2015 LTIP is limited to employees and directors of the Company or any affiliate. The granting of awards under the 2015 LTIP is solely at the discretion of the board of directors. The maximum number of shares of common stock available for distribution under the 2015 LTIP is 4,000,000 shares (subject to adjustment for changes in our capitalization and other events). Since the plan’s approval in 2015, we have awarded 2,312,835 stock options and restricted stock units under the 2015 LTIP.

Stock Options

Under the 2015 LTIP, as under the 2010 LTIP, we grant stock options for shares with an exercise price equal to the fair market value of the shares at the date of grant (subject to adjustments for changes in our capitalization, special dividends and other events as set forth in such plans). Options generally vest and become exercisable ratably over a five-year period and expire eight years after grant.

For most participants, the requisite service period and vesting period will be the same. For participants who are retirement eligible, defined by the plan as those individuals whose age and years of service equals 75, the requisite service period is deemed to be met and options are immediately expensed on the date of grant. For participants who will become retirement eligible during the vesting period, the requisite service period over which expense is recognized is the period between the grant date and the attainment of retirement eligibility. Shares issued upon option exercise are newly issued shares.

18

The following tables summarize option activity for the six-month periods ended June 30, 2020 and 2019:

    

    

    

    

Weighted

    

    

Weighted

Average

Aggregate

Number of

Average

Remaining

Intrinsic

Options

Exercise

Contractual

Value

    

Outstanding

    

Price

    

Life

    

(in 000’s)

Outstanding options at January 1, 2020

1,667,290

$

62.52

Options granted

30,375

94.62

Options exercised

(72,180)

45.92

$

3,181

Options canceled/forfeited

(2,370)

66.57

Outstanding options at June 30, 2020

1,623,115

$

63.86

4.82

$

30,819

Exercisable options at June 30, 2020

878,335

$

57.70

3.89

$

21,544

    

    

    

    

Weighted

    

    

Weighted

Average

Aggregate

Number of

Average

Remaining

Intrinsic

Options

Exercise

Contractual

Value

    

Outstanding

    

Price

    

Life

    

(in 000’s)

Outstanding options at January 1, 2019

1,964,880

$

54.24

Options granted

292,150

80.36

Options exercised

(414,470)

44.70

$

14,941

Options canceled/forfeited

(33,600)

57.61

Outstanding options at June 30, 2019

1,808,960

$

60.59

5.57

$

45,448

Exercisable options at June 30, 2019

672,110

$

52.17

4.21

$

22,544

Through 2019, the majority of our annual stock option grants were authorized at our regular board meeting in May. In addition, quarterly grants to certain retirement eligible employees were historically authorized at the May meeting. Since stock option grants to retirement eligible employees are fully expensed when issued, the approach allowed for a more even expense distribution throughout the year. In 2020, the COVID-19 pandemic created economic uncertainty and the Company deemed it prudent to defer any decision on whether to grant stock options until a later date. The options granted in the six-month period ended June 30, 2020 related to the quarterly grants authorized at the May 2019 board meeting.

In the first six months of 2020, 30,375 stock options were granted with a weighted average exercise price of $94.62 and a weighted average fair value of $14.48. We recognized $0.6 million of expense in the second quarter of 2020 and $1.6 million in the first six months of 2020 related to options vesting. Since options granted under our 2015 LTIP are non-qualified, we recorded a tax benefit of $0.1 million in the second quarter of 2020 and $0.3 million in the first six months of 2020 related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $3.6 million, which will be recognized over the remainder of the vesting period. Comparatively, we recognized $1.4 million of compensation expense in the second quarter of 2019 and $2.4 million in the first six months of 2019. We recorded a tax benefit of $0.3 million in the second quarter of 2019 and $0.5 million in the first six months of 2019 related to this compensation expense.

The fair value of options was estimated using a Black-Scholes based option pricing model with the following weighted average grant-date assumptions and weighted average fair values as of June 30:

    

2020

    

2019

 

Weighted-average fair value of grants

$

14.48

$

13.33

Risk-free interest rates

1.54

%

2.42

%

Dividend yield

2.69

%

2.69

%

Expected volatility

22.68

%

22.71

%

Expected option life

4.99

years

4.96

years

The risk-free rate was determined based on U.S. treasury yields that most closely approximated the option’s expected life. The dividend yield was determined based on the average annualized quarterly dividends paid during the most recent five-year period and incorporated a consideration for special dividends paid in recent history. The expected volatility was calculated based

19

on the median of the rolling volatilities for the expected life of the options. The expected option life was determined based on historical exercise behavior and the assumption that all outstanding options will be exercised at the midpoint of the current date and remaining contractual term, adjusted for the demographics of the current year’s grant.

Restricted Stock Units

In addition to stock options, restricted stock units (RSUs) are granted with a value equal to the closing stock price of the Company’s stock on the dates the units are granted. These units generally have a three-year cliff vesting, but have an accelerated vesting feature for participants who are retirement eligible, defined by the plan as those individuals whose age and years of service equals 75. In addition, the RSUs have dividend participation, which accrue as additional units and are settled with granted stock units at the end of the vesting period. RSUs are generally granted at our regular board meeting in May. However, in 2020, the COVID-19 pandemic created economic uncertainty and the Company deferred the decision on whether to grant RSUs to employees and outside directors until a later date.

As of June 30, 2020, 45,350 RSUs have been granted to employees under the 2015 LTIP and 28,946 remain outstanding. We recognized $0.1 million of expense on these units in the second quarter of 2020 and $0.3 million in the first six months of 2020. Total unrecognized compensation expense relating to outstanding and unvested RSUs was $0.6 million, which will be recognized over the remainder of the vesting period. Comparatively, we recognized $0.2 million in the second quarter of 2019 and $0.3 million in the first six months of 2019.

In 2019, each outside director received RSUs with a fair market value that approximated $50 thousand on the date of grant as part of annual director compensation. Director RSUs vest one year from the date of grant. As of June 30, 2020, 15,085 restricted stock units have been granted to directors under the 2015 LTIP and NaN remain outstanding. We recognized less than $0.1 million of compensation expense on these units in the second quarter of 2020 and $0.2 million in the first six months of 2020. Comparatively, we recognized $0.2 million of compensation expense on these units in the second quarter of 2019 and $0.3 million in the first six months of 2019.

6. OPERATING SEGMENT INFORMATION

Selected information by operating segment is presented in the table below. Additionally, the table reconciles segment totals to total earnings and total revenues.

For the Three-Month Periods

For the Six-Month Periods

REVENUES

Ended June 30,

Ended June 30,

(in thousands)

    

2020

    

2019

    

2020

    

2019

Casualty

$

135,215

$

138,344

$

278,635

$

275,244

Property

45,387

39,972

89,735

78,718

Surety

28,132

29,225

55,946

58,268

Net premiums earned

$

208,734

$

207,541

$

424,316

$

412,230

Net investment income

16,917

16,998

34,695

33,563

Net realized gains (losses)

(2,109)

4,764

13,043

13,832

Net unrealized gains (losses) on equity securities

74,705

8,810

(55,690)

42,308

Total consolidated revenue

$

298,247

$

238,113

$

416,364

$

501,933

NET EARNINGS (LOSS)

(in thousands)

    

2020

    

2019

    

2020

    

2019

Casualty

$

9,733

$

6,939

$

8,410

$

12,282

Property

6,167

(436)

16,075

7,810

Surety

8,263

8,429

16,917

17,273

Net underwriting income

$

24,163

$

14,932

$

41,402

$

37,365

Net investment income

16,917

16,998

34,695

33,563

Net realized gains (losses)

(2,109)

4,764

13,043

13,832

Net unrealized gains (losses) on equity securities

74,705

8,810

(55,690)

42,308

General corporate expense and interest on debt

(3,897)

(5,144)

(7,549)

(10,281)

Equity in earnings of unconsolidated investees

5,100

8,468

9,614

13,782

Earnings before income taxes

$

114,879

$

48,828

$

35,515

$

130,569

Income tax expense

22,713

8,361

4,616

24,629

Net earnings

$

92,166

$

40,467

$

30,899

$

105,940

20

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

For the Three-Month Periods

For the Six-Month Periods

NET PREMIUMS EARNED

Ended June 30,

Ended June 30,

(in thousands)

    

2020

    

2019

    

2020

    

2019

Casualty

Commercial excess and personal umbrella

$

42,321

$

34,340

$

82,409

$

66,621

General liability

22,651

25,347

46,649

49,235

Professional services

21,384

19,275

42,079

39,574

Commercial transportation

11,139

20,508

32,324

40,912

Small commercial

15,791

13,315

31,424

26,503

Executive products

6,975

6,381

14,306

12,450

Other casualty

14,954

19,178

29,444

39,949

Total

$

135,215

$

138,344

$

278,635

$

275,244

Property

Marine

$

20,712

$

18,579

$

40,289

$

35,600

Commercial property

19,048

16,275

38,203

33,150

Specialty personal

4,936

4,792

9,936

9,376

Other property

691

326

1,307

592

Total

$

45,387

$

39,972

$

89,735

$

78,718

Surety

Commercial

$

10,806

$

10,975

$

21,744

$

21,787

Miscellaneous

10,499

11,280

21,015

22,882

Contract

6,827

6,970

13,187

13,599

Total

$

28,132

$

29,225

$

55,946

$

58,268

Grand Total

$

208,734

$

207,541

$

424,316

$

412,230

7. LEASES

Right-of-use (ROU) assets are included in the other assets line item and lease liabilities are included in the other liabilities line item of the consolidated balance sheet. We determine if a contract contains a lease at inception and recognize operating lease ROU assets and operating lease liabilities based on the present value of the future minimum lease payments at the commencement date. As our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at the commencement date in determining the present value of future payments. Lease agreements may include options to extend or terminate. The options are exercised at our discretion and are included in operating lease liabilities if it is reasonably certain the option will be exercised. Lease agreements have lease and non-lease components, which are accounted for as a single lease component. Operating lease cost for future minimum lease payments is recognized on a straight-line basis over the lease term. Variable lease cost is expensed in the period in which the obligation is incurred. Sublease income is recognized on a straight-line basis over the sublease term.

The Company’s operating lease obligations are for branch office facilities. Our leases have remaining lease terms of 1 to 15 years. The components of lease expense and other lease information as of and during the three and six-month periods ended June 30, 2020 and 2019 are as follows:

21

For the Three-Month Periods

For the Six-Month Periods

Ended June 30,

Ended June 30,

(in thousands)

2020

 

2019

 

2020

 

2019

Operating lease cost

$

1,370

$

1,445

$

2,776

$

2,927

Variable lease cost

320

892

675

1,210

Sublease income

(42)

-

(42)

-

Total lease cost

$

1,648

$

2,337

$

3,409

$

4,137

Cash paid for amounts included in measurement of lease liabilities

Operating cash outflows from operating leases

$

1,503

$

1,402

$

2,990

$

2,797

ROU assets obtained in exchange for new operating lease liabilities

$

-

$

231

$

15

$

951

Reduction to ROU assets resulting from reduction to lease liabilities

$

-

$

1,279

$

-

$

1,279

Other non-cash reductions to ROU assets

$

-

$

-

$

1,192

$

-

(in thousands)

June 30, 2020

    

December 31, 2019

Operating lease ROU assets

$

18,648

$

22,335

Operating lease liabilities

$

21,766

$

24,475

Weighted-average remaining lease term - operating leases

4.26

years

4.69

years

Weighted-average discount rate - operating leases

2.34

%

2.33

%

Future minimum lease payments under non-cancellable leases as of June 30, 2020 were as follows:

(in thousands)

June 30, 2020

2020

$

3,002

2021

5,976

2022

5,904

2023

4,386

2024

2,334

Thereafter

1,365

Total future minimum lease payments

$

22,967

Less imputed interest

(1,201)

Total operating lease liability

$

21,766

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

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 appear throughout this report. These statements relate to our current expectations, beliefs, intentions, goals or strategies regarding the future and are based on certain underlying assumptions by the Company. These forward looking statements generally include words such as “expect,” “predict,” “estimate,” “will,” “should,” “anticipate,” “believe” and similar expressions. Such assumptions are, in turn, based on information available and internal estimates and analyses of general economic conditions, competitive factors, conditions specific to the property and casualty insurance and reinsurance industries, claims development and the impact thereof on our loss reserves, the adequacy and financial security of our reinsurance programs, developments in the securities market and the impact on our investment portfolio, regulatory changes and conditions and other factors and are subject to various risks, uncertainties and other factors, including, without limitation those set forth in “Item 1A. Risk Factors” within the Annual Report on Form 10-K for the year ended December 31, 2019 and Part II within this report. Actual results could differ materially from those expressed in, or implied by, these forward looking statements. We assume no obligation to update any such statements. You should review the various risks, uncertainties and other factors listed from time to time in our Securities and Exchange Commission filings.

22

OVERVIEW

RLI Corp. is a U.S.-based, specialty insurance company that underwrites select property and casualty insurance through major subsidiaries collectively known as RLI Insurance Group (Group). Our focus is on niche markets and developing unique products that are tailored to customers’ needs. We hire underwriters and claim examiners with deep expertise and provide exceptional customer service and support. We maintain a highly diverse product portfolio and underwrite for profit in all market conditions. In 2019, we achieved our 24th consecutive year of underwriting profitability. Over the 24 year period, we averaged an 88.3 combined ratio. This drives our ability to provide shareholder returns in three different ways: the underwriting income itself, net investment income from our investment portfolio and long-term appreciation in our equity portfolio.

We measure the results of our insurance operations by monitoring growth and profitability across three distinct business segments: casualty, property and surety. Growth is measured in terms of gross premiums written, and profitability is analyzed through combined ratios, which are further subdivided into their respective loss and expense components.

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, pandemics 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 coverages 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 be more or less than recorded amounts; if actual liabilities differ from recorded amounts, there will be an adverse or favorable effect on net earnings.

The casualty portion of our business consists largely of commercial excess, personal umbrella, general liability, transportation and executive products coverages, as well as package business and other specialty coverages, such as professional liability and workers’ compensation for office-based professionals. We also assume a limited amount of hard-to-place risks through a quota share reinsurance agreement. The casualty business is subject to the risk of estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty segment is also subject to inflation risk and may be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses.

Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions and marine coverages. We also offer select personal lines policies, including homeowners’ coverages. Property insurance results are subject to the variability introduced by perils such as earthquakes, fires, hurricanes and other storms. Our major catastrophe exposure is to losses caused by earthquakes, primarily on the West Coast. Our second largest catastrophe exposure is to losses caused by wind storms to commercial properties throughout the Gulf and East Coast, as well as to homes we insure in Hawaii. We seek to limit our net aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and maintaining consistent policy terms and conditions throughout insurance cycles. We also use computer-assisted modeling techniques to provide estimates that help the Company carefully manage the concentration of risks exposed to catastrophic events.

The surety segment specializes in writing small to large-sized commercial and contract surety coverages, including payment and performance bonds. We also offer miscellaneous bonds including license and permit, notary and court bonds. Often, our surety coverages involve a statutory requirement for bonds. While these bonds typically maintain a relatively low loss ratio, losses may fluctuate due to adverse economic conditions affecting the financial viability of our principals. The contract surety product guarantees the construction work of a commercial contractor for a specific project. Generally, losses occur due to the deterioration of a contractor’s financial condition. This line has historically produced marginally higher loss ratios than other surety lines during economic downturns.

The insurance marketplace is intensely competitive across all of our segments. However, we believe that our business model is built to create underwriting income by focusing on sound risk selection and discipline. Our primary focus will continue to be on underwriting profitability, with a secondary focus on premium growth where we believe underwriting profit exists, as opposed to general premium growth or market share measurements.

23

GAAP, non-GAAP and Performance Measures

Throughout this quarterly report, we include certain non-generally accepted accounting principles (non-GAAP) financial measures. Management believes that these non-GAAP measures further explain the Company’s results of operations and allow for a more complete understanding of the underlying trends in the Company’s business. These measures should not be viewed as a substitute for those determined in accordance with generally accepted accounting principles in the United States of America (GAAP). In addition, our definitions of these items may not be comparable to the definitions used by other companies.

The following is a list of non-GAAP measures found throughout this report with their definitions, relationships to GAAP measures and explanations of their importance to our operations.

Underwriting Income

Underwriting income or profit represents one measure of the pretax profitability of our insurance operations and is derived by subtracting losses and settlement expenses, policy acquisition costs and insurance operating expenses from net premiums earned, which are all GAAP financial measures. Each of these captions is presented in the statements of earnings but is not subtotaled. However, this information is available in total and by segment in note 6 to the unaudited condensed consolidated interim financial statements in this quarterly report on Form 10-Q and in note 12 to the consolidated financial statements in our 2019 Annual Report on Form 10-K, regarding operating segment information. The nearest comparable GAAP measure is earnings before income taxes which, in addition to underwriting income, includes net investment income, net realized gains or losses, net unrealized gain or losses on equity securities, general corporate expenses, debt costs and our portion of earnings from unconsolidated investees. A reconciliation of net earnings to underwriting income follows:

For the Three-Month Periods

For the Six-Month Periods

Ended June 30,

Ended June 30,

(in thousands)

2020

 

2019

 

2020

 

2019

Net earnings

$

92,166

$

40,467

$

30,899

$

105,940

Income tax expense

22,713

8,361

4,616

24,629

Earnings before income taxes

$

114,879

$

48,828

$

35,515

$

130,569

Equity in earnings of unconsolidated investees

(5,100)

(8,468)

(9,614)

(13,782)

General corporate expenses

1,994

3,283

3,749

6,559

Interest expense on debt

1,903

1,861

3,800

3,722

Net unrealized (gains) losses on equity securities

(74,705)

(8,810)

55,690

(42,308)

Net realized (gains) losses

2,109

(4,764)

(13,043)

(13,832)

Net investment income

(16,917)

(16,998)

(34,695)

(33,563)

Net underwriting income

$

24,163

$

14,932

$

41,402

$

37,365

Combined Ratio

The combined ratio, which is derived from components of underwriting income, is a common industry performance measure of profitability for underwriting operations and is calculated in two components. First, the loss ratio is losses and settlement expenses divided by net premiums earned. The second component, the expense ratio, reflects the sum of policy acquisition costs and insurance operating expenses divided by net premiums earned. All items included in these components of the combined ratio are presented in our GAAP consolidated financial statements. The sum of the loss and expense ratios is the combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of underwriting income or loss.

Critical Accounting Policies

In preparing the unaudited condensed consolidated interim financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.

The most critical accounting policies involve significant estimates and include those used in determining the liability for unpaid losses and settlement expenses, investment valuation, recoverability of reinsurance balances, deferred policy acquisition costs and deferred taxes. For a detailed discussion of each of these policies, refer to our 2019 Annual Report on Form 10-K.

24

We adopted ASU 2016-13, Financial Instruments – Credit Losses, on January 1, 2020, which eliminated the concept of other-than-temporary impairment and required the recognition of a reversible allowance for credit losses on available-for-sale fixed income securities. See note 1. B. for more information on the adoption of the ASU. Available-for-sale securities in the fixed income portfolio are subjected to several criteria to determine if those securities should be included in the allowance for expected credit loss evaluation, including:

Changes in technology that may impair the earnings potential of the investment,

The discontinuance of a segment of business that may affect future earnings potential,

Reduction of or non-payment of interest and/or principal,

Specific concerns related to the issuer’s industry or geographic area of operation,

Significant or recurring operating losses, poor cash flows and/or deteriorating liquidity ratios and

Downgrades in credit quality by a major rating agency.

If changes in interest rates and credit spreads do not reasonably explain the unrealized loss for an available-for-sale security or if any of the criteria above indicate a potential credit loss, the security is subjected to a discounted cash flow analysis. Inputs into the discounted cash flow analysis include prepayment assumptions for structured securities, default rates and recoverability rates based on credit rating. The allowance for any security is limited to the amount that the securities fair value is below amortized cost. If we intend to sell a security or if we determine it is more likely than not that we will be required to sell a security before recovery of its amortized cost basis, any allowance for credit loss or unrealized loss would be written off and the amortized cost basis of the security would be written down to the security’s fair value.

There have been no other significant changes to critical accounting policies during the year.

IMPACT OF COVID-19

The coronavirus (COVID-19) pandemic continues to impact individuals, businesses and the economy. As an employee-owned company, the health and well-being of our customers, partners and associates is our highest priority. While a large percentage of our associates are still working from home, our processes and controls continue to operate effectively and we have been able to maintain the highest service and support levels possible for our customers.

It is difficult to predict how and to what extent the economic slowdown will have on our revenues in the coming months. To date, our most impacted product line has been public transportation. A large number of our passenger transportation customers have been unable to effectively operate under social-distancing protocols and stay-at-home orders. For the six-month period ended June 30, 2020, transportation gross written premium was down $33.3 million when compared to 2019. We would expect transportation premium to continue to be down from prior periods until the use of public transportation increases, which may not be until after there is a vaccine, effective treatment or significant reduction in cases. Additionally, slowdowns in the construction industry contributed to premium declines for our general liability and surety products in the second quarter. A number of our products support the construction industry and revenues may continue to be impacted to the extent this sector experiences disruption. However, we have many product lines that may see little to no impact on the amount of premium we write, including our personal lines products, management liability products and property businesses.

We have been fair and flexible with our customers in regards to modifying exposures and payment terms and we are in compliance with any applicable state regulatory directives on such changes. Insureds continue to make payments in accordance with the agreed upon schedules and we have not experienced a material increase in the amount of expense associated with uncollectible receivables.

The loss exposure arising out of the spread of COVID-19 and resulting shutdown will take time to resolve. We do not offer event cancellation, travel, trade credit or pandemic-related coverages which would be more directly impacted by the COVID-19 pandemic. The Company has received a number of claims, the majority of which relate to business interruption. We are reviewing the individual circumstances of each claim submitted and will fulfill our obligation to pay if coverage applies. The derivative implications that COVID-19 has on the economy may have negative implications on products that are correlated with the credit cycle, including, but not limited to, some of our executive products and surety offerings. In the second quarter of 2020, $5.8 million of net reserves were established to address the increased risk of loss and expense that emanated from the economic downturn brought on by the pandemic. Combined with the reserves established in the first quarter

25

that addressed the expected increase in costs to investigate and defend business interruption claims, $10.8 million of COVID-19 related net losses have been recognized in the first six months of 2020.

Actuarial models base future emergence on historic experience, with adjustments for current trends, and the appropriateness of these assumptions involved greater uncertainty as of June 30, 2020. We expect there will be impacts to the timing of loss emergence and ultimate loss ratios for certain coverages. The industry is experiencing new issues, including the postponement of civil court cases, the extension of various statutes of limitations, changes in settlement trends and a significant reduction in economic activity and insured exposure in some classes. Our booked reserves include consideration of these factors, but the duration and degree to which these issues persist, along with potential legislative, regulatory or judicial actions, could result in loss reserve deficiencies and reduce earnings in future periods.

We continue to evaluate opportunities for expense savings and efficiencies and have taken targeted actions to reduce or defer expenses, including certain hiring freezes, position consolidations and executive merit increase suspensions. Travel was limited and any decision on granting share-based compensation, which normally takes place at our May board meeting, was deferred until a later date, resulting in a reduced level of compensation expense in the second quarter. Bonus and profit sharing expense is correlated with company performance and is responsible for the largest portion of the total expense decline for the six-month period ended June 30, when compared to 2019. The performance-related expenses recognized for the 2020 fiscal year will be dependent on the full year’s results and may increase or decrease in the second half of the year.

Although we have recovered a large portion of the market value declines recorded in the first quarter, equity securities have not fully returned to levels recorded at year end. Net after-tax realized and unrealized losses on equity securities were $33.9 million in the first half of 2020. Conversely, lower interest rates increased the fair value of the fixed income portfolio, which resulted in $40.5 million of after-tax other comprehensive earnings for the six-month period ended June 30, 2020. With the decline in yields, reinvestment rates are now lower than in previous years, which will cap the portfolio’s ability to generate higher levels of investment income, absent a larger invested asset base.

Maui Jim, Inc. (Maui Jim) and Prime Holdings Insurance Services, Inc. (Prime) continued to contribute towards positive net earnings. While earnings for Prime were modestly higher, Maui Jim results were negatively impacted by the shutdown much of the traditional retail sector experienced during the second quarter. The economic downturn may continue to impact the results of these investees, particularly if there is any lasting impact on the retail sector as it relates to Maui Jim.

We produced solid operating results in the first half of the year and believe our financial position has remained strong despite the impact of the COVID-19 pandemic. We generated $83.8 million of net operating cash inflows and believe we have adequate liquidity. Our revolving credit facility provides for a borrowing capacity of $60.0 million, which can be increased to $120.0 million under certain circumstances. Additionally, our membership in the Federal Home Loan Bank system provides a secured lending facility with an aggregate borrowing capacity of approximately $30.0 million. There were no amounts outstanding under any of these facilities as of June 30, 2020. In addition to the $160.7 million of cash and other investments maturing within one year as of June 30, 2020, we believe that cash generated from operations, the liquidity of our fixed income portfolio and our unused lines of credit provide sufficient sources of cash to meet our anticipated needs over the next 12 to 24 months.

Ultimately, the extent to which COVID-19 will impact our business will be influenced by how long it takes for the economy to recover. We continue to evaluate all aspects of our operations and are making necessary adjustments to manage our business. Our diversified portfolio of products and financial strength have allowed us to remain on solid footing. We believe we have a strong and sustainable underwriting approach that will allow us to weather the economic downturn and uncertainty we are currently experiencing.

RESULTS OF OPERATIONS

Six Months Ended June 30, 2020 Compared to Six Months Ended June 30, 2019

Consolidated revenue for the first half of 2020 decreased $85.6 million from the first half of 2019 as performance in the equity portfolio varied significantly between the periods. Overall market declines resulted in $55.7 million of unrealized losses on equity securities in 2020, while positive returns generated $42.3 million of unrealized gains in our equity portfolio in the first half of 2019. Net premiums earned for the Group increased 3 percent, driven by growth from our casualty and property segments. Investment income increased 3 percent due to a larger asset base relative to the prior year. Realized gains during the first half were $13.0 million and were comprised of $12.8 million of realized gains on equity securities from rebalancing our portfolio, $2.6 million of realized gains on the fixed income portfolio and $2.4 million of other realized losses. This compares

26

to $12.3 million of realized gains on the equity portfolio, $1.3 million of realized gains on the fixed income portfolio and $0.2 million of other realized gains for the same period in 2019.

For the Six-Month Periods

Ended June 30,

    

2020

    

2019

Consolidated revenues (in thousands)

Net premiums earned

$

424,316

$

412,230

Net investment income

34,695

33,563

Net realized gains (losses)

13,043

13,832

Net unrealized gains (losses) on equity securities

(55,690)

42,308

Total consolidated revenue

$

416,364

$

501,933

Net earnings for the first six months of 2020 totaled $30.9 million, compared to $105.9 million for the same period last year. The decrease in earnings for 2020 was primarily attributed to $44.0 million of net after-tax unrealized losses on equity securities, compared to $33.4 million of after-tax unrealized gains in 2019. Underwriting results for both periods reflect profitable current accident year results and favorable development from prior years’ loss reserves. Favorable development on prior years’ loss reserves provided additional pretax earnings of $40.8 million in the first half of 2020 and 2019. Pretax losses from storms and civil unrest were $6.5 million, compared to $5.0 million of storm losses for the same period in 2019. Pretax bonus and profit sharing-related expenses associated with the net impact of prior years’ reserve development and catastrophe losses totaled $5.1 million in 2020, compared to $5.3 million in 2019. These performance-related expenses affected policy acquisition, insurance operating and general corporate expenses. Bonus and profit-sharing amounts earned by executives, managers and associates are predominately influenced by corporate performance including operating earnings, combined ratio and return on capital.

During the first half of 2020, equity in earnings of unconsolidated investees totaled $9.6 million. This amount includes $5.2 million from Maui Jim and $4.4 million from Prime. Comparatively, the first half of 2019 reflected $13.8 million of earnings, including $10.1 million from Maui Jim and $3.7 million from Prime. The decline in earnings from Maui Jim is reflective of the shutdown much of the traditional retail sector experienced as a result of the pandemic during the second quarter.

Comprehensive earnings totaled $71.4 million for the first six months of 2020, compared to $163.1 million for the first half of 2019. Other comprehensive earnings primarily included net after-tax unrealized gains from the fixed income portfolio and totaled $40.5 million in the first half of 2020, compared to $57.2 million in 2019. The unrealized gains were attributable to declining interest rates in both periods, which increased the fair value of securities held in the fixed income portfolio. However, wider credit spreads partially offset the impact of the lower treasury rates in 2020.

Premiums

Gross premiums written for the Group increased $18.8 million, or 4 percent, for the first half of 2020 when compared to the same period of 2019. Products in our property and casualty segments drove the growth. Net premiums earned increased $12.1 million, or 3 percent, also driven by products in our property and casualty segments.

27

Gross Premiums Written

Net Premiums Earned

For the Six-Month Periods Ended June 30,

For the Six-Month Periods Ended June 30,

(in thousands)

2020

    

2019

% Change

    

2020

    

2019

% Change

Casualty

Commercial excess and personal umbrella

$

115,533

$

90,422

28

%

$

82,409

$

66,621

24

%

General liability

51,357

54,773

(6)

%

46,649

49,235

(5)

%

Professional services

45,967

44,984

2

%

42,079

39,574

6

%

Commercial transportation

15,097

48,391

(69)

%

32,324

40,912

(21)

%

Small commercial

33,257

30,208

10

%

31,424

26,503

19

%

Executive products

47,959

37,649

27

%

14,306

12,450

15

%

Other casualty

40,113

34,803

15

%

29,444

39,949

(26)

%

Total

$

349,283

$

341,230

2

%

$

278,635

$

275,244

1

%

Property

Marine

$

46,925

$

44,150

6

%

$

40,289

$

35,600

13

%

Commercial property

67,090

57,450

17

%

38,203

33,150

15

%

Specialty personal

10,177

10,957

(7)

%

9,936

9,376

6

%

Other property

1,815

824

120

%

1,307

592

121

%

Total

$

126,007

$

113,381

11

%

$

89,735

$

78,718

14

%

Surety

Commercial

$

20,902

$

22,223

(6)

%

$

21,744

$

21,787

(0)

%

Miscellaneous

22,260

22,400

(1)

%

21,015

22,882

(8)

%

Contract

14,533

14,949

(3)

%

13,187

13,599

(3)

%

Total

$

57,695

$

59,572

(3)

%

$

55,946

$

58,268

(4)

%

Grand Total

$

532,985

$

514,183

4

%

$

424,316

$

412,230

3

%

Casualty

Gross premiums written for the casualty segment were up $8.1 million in the first six months of 2020. Premiums from commercial excess and personal umbrella increased $25.1 million, due to an expanded distribution base in personal umbrella and rate increases. Small commercial continued to benefit from new production sources and geographic expansion. Substantial rate increases led to a 27 percent increase for our executive products group. Other casualty increased $5.3 million, as our general binding authority (GBA) business continued to grow.

Commercial transportation has been significantly affected by the stay at home orders associated with COVID-19, particularly our public lines. Public transportation focuses on charter, school and transit busses, which stopped running to a large degree in March. The reduced utilization led to a $33.3 million decline in gross premiums written in the first six months of 2020.

Property

Gross premiums written for the property segment were up $12.6 million in the first half of 2020. Our commercial property business was up $9.6 million, as an improving market allowed our underwriters to find more opportunities with acceptable rate levels. Additionally, rates on wind-prone and earthquake exposures continued to increase over the first half of the year. Rate increases and market disruption, which created new business opportunities, led to $2.8 million of growth for our marine product. Other property premium increased as a result of property exposed GBA business that continues to gain scale.

Surety

The surety segment recorded gross premiums written of $57.7 million for the first six months of 2020, a decrease of $1.9 million from the same period last year. The economic slowdown and decreased commodity pricing has reduced demand for surety bonds. Additionally, we continually monitor our portfolio for higher risk accounts and have selectively eliminated exposures that no longer met our underwriting standards.

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Underwriting Income

Underwriting income for the Group totaled $41.4 million for the first six months of 2020, compared to $37.4 million in the same period of 2019. Both periods reflect positive underwriting results for the current accident year and similar amounts of favorable reserve development on prior accident years. The combined ratio for the Group totaled 90.2 in the first half of 2020, compared to 90.9 in the same period of 2019. The loss ratio increased to 50.0 from 48.1, primarily due to the addition of $10.8 million in current accident year reserves related to COVID-19 loss and claim defense costs. The Group’s expense ratio decreased to 40.2 from 42.8, as 2019 experienced stronger growth in book value, which led to larger levels of bonus and profit-sharing expenses.

For the Six-Month Periods

Ended June 30,

    

2020

    

2019

Underwriting income (in thousands)

Casualty

$

8,410

$

12,282

Property

16,075

7,810

Surety

16,917

17,273

Total

$

41,402

$

37,365

Combined ratio

Casualty

97.0

95.5

Property

82.1

90.1

Surety

69.8

70.4

Total

90.2

90.9

Casualty

The casualty segment recorded underwriting earnings of $8.4 million in the first half of 2020, compared to $12.3 million of underwriting income for the same period last year. Reserve releases reduced loss and settlement expenses for the casualty segment by $27.5 million, primarily on accident years 2016 through 2019. Transportation, general liability, executive products and small commercial were drivers of the favorable development. In comparison, $30.7 million of reserves were released in the first half of 2019. General liability, professional services, transportation, commercial excess, personal umbrella and small commercial developed favorably, while executive products developed adversely.

The combined ratio for the casualty segment was 97.0 in 2020, compared to 95.5 in 2019. The segment’s loss ratio was 61.7 in 2020, up from 58.3 in 2019. The loss ratio increased in 2020 as a result of less favorable development on prior years’ reserves and the addition of $7.7 million in current year reserves related to COVID-19 loss and defense costs. The expense ratio for the casualty segment was 35.3, down from 37.2 for the same period last year, as reduced levels of bonus and profit-sharing expenses were incurred.

Property

The property segment recorded underwriting income of $16.1 million for the first six months of 2020, compared to $7.8 million for the same period last year. Underwriting results for 2020 included $5.5 million of favorable development on prior years’ loss and catastrophe reserves, primarily from the marine business, $5.3 million of storm and civil unrest losses and $2.0 million of reserves related to COVID-19 investigative and defense costs. Comparatively, the 2019 underwriting results included $2.1 million of favorable development on prior years’ loss and catastrophe reserves and $4.7 million of storm losses.

Underwriting results for the first half of 2020 translated into a combined ratio of 82.1, compared to 90.1 for the same period last year. The segment’s loss ratio was 41.8 in 2020, down from 45.1 in 2019 due to lower current accident year losses and more favorable development on prior years’ reserves. The segment’s expense ratio decreased to 40.3 in 2020 from 45.0 in the prior year, as increased levels of earned premium allowed the segment to better leverage expenses.

Surety

The surety segment recorded underwriting income of $16.9 million for the first half of 2020, compared to $17.3 million for the same period last year. Both periods reflected positive current accident year underwriting performance and benefited from favorable development on prior years’ loss reserves. Results for 2020 included favorable development on prior accident

29

years’ reserves, which decreased loss and settlement expenses for the segment by $7.8 million, and offset $1.1 million in current year reserves established for COVID-19 related losses. Comparatively, 2019 results included favorable development on prior accident years’ loss reserves, which decreased the segment’s loss and settlement expenses by $8.0 million.

The combined ratio for the surety segment totaled 69.8 for the first six months of 2020, compared to 70.4 for the same period in 2019. The segment’s loss ratio was 5.0 in 2020, up from 3.6 in 2019. The expense ratio was 64.8, down from 66.8 in the prior year.

Investment Income and Realized Capital Gains

Our investment portfolio generated net investment income of $34.7 million during the first half of 2020, an increase of 3.4 percent from that reported for the same period in 2019. The increase in investment income was largely due to a larger asset base relative to the prior year.

Yields on our fixed income investments for the first half of 2020 and 2019 were as follows:

    

2020

    

2019

Pretax Yield

Taxable

3.22

%  

3.44

Tax-Exempt

2.75

%

2.83

%

After-Tax Yield

Taxable

2.54

%

2.72

%

Tax-Exempt

2.61

%

2.68

%

We recognized $13.0 million of realized gains in the first half of 2020, which were comprised of $12.8 million of realized gains on equity securities from rebalancing our portfolio, $2.6 million of realized gains on the fixed income portfolio and $2.4 million of other realized losses. This compares to realized gains of $13.8 million in the first half of 2019, which were comprised of $12.3 million of realized gains on the equity portfolio, $1.3 million of realized gains on the fixed income portfolio and $0.2 million of other realized gains.

The following table depicts the composition of our investment portfolio at June 30, 2020 as compared to December 31, 2019:

June 30, 2020

December 31, 2019

Financial

Financial

(in thousands)

    

Stmt Value

    

%

    

 

Stmt Value

    

%

Fixed income

$

2,075,093

78.4

%

$

1,983,086

77.5

%

Equity securities

422,198

16.0

%

460,630

18.0

%

Other invested assets

63,440

2.4

%

70,441

2.7

%

Cash and short-term investments

84,797

3.2

%

46,203

1.8

%

Total

$

2,645,528

100.0

%

$

2,560,360

100.0

%

We believe our overall asset allocation best meets our strategy to preserve capital for policyholders, provide sufficient income to support insurance operations, and to effectively grow book value over a long-term investment horizon.

The fixed income portfolio increased by $92.0 million in the first six months of 2020. The increase was due to declines in interest rates during the first six months of the year, lifting the fair value of securities in the fixed income portfolio. Average fixed income duration was 4.6 years at June 30, 2020, reflecting our current liability structure and sound capital position. The equity portfolio decreased by $38.4 million during the first six months of 2020 as the equity market sold off sharply in the first quarter.

Income Taxes

Our effective tax rate for the first six months of 2020 was 13.0 percent, compared to 18.9 percent for the same period in 2019. Effective rates are dependent upon components of pretax earnings or losses and the related tax effects. The effective rate was lower for the first half of 2020 as lower levels of pre-tax earnings caused tax-favored adjustments to be larger on a percentage basis when compared to the prior year.

30

Three Months Ended June 30, 2020 Compared to Three Months Ended June 30, 2019

Consolidated revenue for the second quarter of 2020 increased $60.1 million from the second quarter of 2019. A partial recovery from the market declines experienced in the first quarter resulted in $74.7 million of unrealized gains on equity securities in the second quarter of 2020, compared to $8.8 million of unrealized gains in the second quarter of 2019. Net premiums earned for the Group increased 1 percent, driven by growth from our property segment, which offset declines in our surety segment. Investment income decreased 1 percent due to lower average yields relative to the prior year. Realized losses during the quarter were $2.1 million and were comprised of $2.3 million of realized losses on equity securities from rebalancing our portfolio, $0.3 million of realized gains on the fixed income portfolio and $0.1 million of other realized losses. This compares to realized gains of $4.8 million in the second quarter of 2019, which were comprised of $3.9 million of realized gains on the equity portfolio, $0.7 million of realized gains on the fixed income portfolio and $0.2 million of miscellaneous realized gains.

For the Three-Month Periods

Ended June 30,

    

2020

    

2019

Consolidated revenues (in thousands)

Net premiums earned

$

208,734

$

207,541

Net investment income

16,917

16,998

Net realized gains (losses)

(2,109)

4,764

Net unrealized gains (losses) on equity securities

74,705

8,810

Total consolidated revenue

$

298,247

$

238,113

Net earnings for the second quarter of 2020 totaled $92.2 million, compared to $40.5 million for the same period in 2019. The increase in earnings for 2020 was primarily attributed to $59.0 million of net after-tax unrealized gains on equity securities, compared to $7.0 million in 2019. Underwriting results for both periods reflect profitable current accident year results and favorable development from prior years’ loss reserves. Favorable development on prior years’ loss reserves provided additional pretax earnings of $25.6 million in the second quarter of 2020, compared to $21.2 million in 2019. Catastrophe activity consisted of $6.0 million of pretax storm and civil unrest losses in the second quarter of 2020, compared to $4.0 million of storm losses in 2019. Pretax bonus and profit sharing-related expenses associated with the net impact of prior years’ reserve development and catastrophe losses totaled $2.9 million in 2020, compared to $2.5 million in 2019. These performance-related expenses affected policy acquisition, insurance operating and general corporate expenses. Bonus and profit-sharing amounts earned by executives, managers and associates are predominately influenced by corporate performance including operating earnings, combined ratio and return on capital.

During the second quarter of 2020, equity in earnings of unconsolidated investees totaled $5.1 million. This amount includes $2.6 million from Maui Jim and $2.5 million from Prime. Comparatively, the second quarter of 2019 reflected $8.5 million of earnings, including $6.5 million from Maui Jim and $2.0 million from Prime. The decline in earnings from Maui Jim is reflective of the shutdown much of the traditional retail sector experienced as a result of the pandemic.

Comprehensive earnings totaled $145.7 million for the second quarter of 2020, compared to $68.3 million of comprehensive earnings for the second quarter of 2019. Other comprehensive earnings primarily included after-tax unrealized gains and losses from the fixed income portfolio. The second quarter’s $53.6 million of other comprehensive earnings was due to declines in interest rates, which increased the market value of the portfolio. This compares to $27.9 million of other comprehensive earnings for the same period in 2019.

Premiums

Gross premiums written for the Group increased $3.9 million for the second quarter of 2020 when compared to the same period of 2019. Rate increases across the property and casualty portfolios were the largest influence on growth. Net premiums earned increased $1.2 million, also driven by products in the property segment.

31

Gross Premiums Written

Net Premiums Earned

For the Three-Month Periods Ended June 30,

For the Three-Month Periods Ended June 30,

(in thousands)

2020

    

2019

% Change

    

2020

    

2019

% Change

Casualty

Commercial excess and personal umbrella

$

59,943

$

49,427

21

%

$

42,321

$

34,340

23

%

General liability

26,666

32,030

(17)

%

22,651

25,347

(11)

%

Commercial transportation

18,874

30,712

(39)

%

11,139

20,508

(46)

%

Professional services

24,469

23,958

2

%

21,384

19,275

11

%

Small commercial

17,140

16,244

6

%

15,791

13,315

19

%

Executive products

27,012

22,100

22

%

6,975

6,381

9

%

Other casualty

15,943

14,652

9

%

14,954

19,178

(22)

%

Total

$

190,047

$

189,123

0

%

$

135,215

$

138,344

(2)

%

Property

Marine

$

25,814

$

24,070

7

%

$

20,712

$

18,579

11

%

Commercial property

37,311

33,900

10

%

19,048

16,275

17

%

Specialty personal

5,305

5,878

(10)

%

4,936

4,792

3

%

Other property

856

512

67

%

691

326

112

%

Total

$

69,286

$

64,360

8

%

$

45,387

$

39,972

14

%

Surety

Commercial

$

9,622

$

10,569

(9)

%

$

10,806

$

10,975

(2)

%

Miscellaneous

10,312

10,572

(2)

%

10,499

11,280

(7)

%

Contract

7,886

8,647

(9)

%

6,827

6,970

(2)

%

Total

$

27,820

$

29,788

(7)

%

$

28,132

$

29,225

(4)

%

Grand Total

$

287,153

$

283,271

1

%

$

208,734

$

207,541

1

%

Casualty

Gross premiums written for the casualty segment were up $0.9 million in the second quarter of 2020. Premiums from commercial excess and personal umbrella increased $10.5 million, due to an expanded distribution base in personal umbrella, which supplemented rate increases. Substantial rate increases led to a 22 percent increase for our executive products group.

Transportation continues to be significantly affected by the stay at home orders associated with COVID-19. This is particularly impactful on our public transportation book that has a focus on charter or city buses, which stopped running to a large degree in March. A slowdown or suspension of construction activity in certain parts of the country also led to the decline in general liability.

Property

Gross premiums written for the property segment totaled $69.3 million for the second quarter of 2020, up $4.9 million from the same period last year. Our commercial property business was up $3.4 million, as rates on wind-prone and earthquake exposures continued to increase. Market disruption created new business opportunities and led to $1.7 million of growth for our marine product. Other property premium increased as a result of property exposed GBA business that continues to gain scale.

Surety

The surety segment recorded gross premiums written of $27.8 million for the second quarter of 2020, a decrease of $2.0 million from the same period last year. The surety market remains very competitive. Additionally, the economic downturn, decreased commodity pricing and less regulation has reduced demand for bonds.

Underwriting Income

Underwriting income for the Group totaled $24.2 million for the second quarter of 2020, compared to $14.9 million in the same period last year. Both periods reflect positive underwriting results for the current accident year and favorable reserve

32

development on prior accident years, with 2020 experiencing a larger benefit. The combined ratio for the Group totaled 88.4 in the second quarter of 2020, compared to 92.8 in the same period of 2019. The loss ratio decreased to 48.5 from 50.1, due to the increased level of favorable development in 2020. The Group’s expense ratio decreased to 39.9 from 42.7, as 2019 experienced stronger earnings and growth in book value in the six-month period ended June 30, which led to larger levels of bonus and profit-sharing expenses.

For the Three-Month Periods

Ended June 30,

    

2020

    

2019

Underwriting income (loss) (in thousands)

Casualty

$

9,733

$

6,939

Property

6,167

(436)

Surety

8,263

8,429

Total

$

24,163

$

14,932

Combined ratio

Casualty

92.8

95.0

Property

86.4

101.1

Surety

70.6

71.2

Total

88.4

92.8

Casualty

The casualty segment recorded underwriting income of $9.7 million in the second quarter of 2020, compared to $6.9 million for the same period last year. Reserve releases reduced loss and settlement expenses for the casualty segment by $21.1 million, primarily on accident years 2016 through 2018. Transportation, executive products, general liability and professional services were drivers of the favorable development. Partially offsetting these benefits, $4.7 million of current year reserves were established in the second quarter of 2020 for COVID-19 related loss and defense costs. In comparison, $17.5 million of reserves were released in the second quarter of 2019, with nearly every product contributing to the favorable development.

The combined ratio for the casualty segment was 92.8 in 2020, compared to 95.0 in 2019. The segment’s loss ratio was 57.4 in 2020, down from 57.9 in 2019. The loss ratio decreased in 2020 as a result of a shift in mix of business towards products with lower loss booking ratios and more favorable development on prior years’ reserves. The expense ratio for the casualty segment was 35.4, down from 37.1 for the same period last year, as reduced levels of bonus and profit-sharing expenses were incurred.

Property

The property segment recorded underwriting income of $6.2 million for the second quarter of 2020, compared to $0.4 million of underwriting loss for the same period last year. Underwriting results for 2020 included $0.7 million of favorable development on prior years’ loss and catastrophe reserves and $4.8 million of storm and civil unrest losses. Comparatively, the 2019 underwriting results included $0.1 million of adverse development on prior years’ loss and catastrophe reserves and $3.9 million of storm losses.

Underwriting results for the second quarter of 2020 translated into a combined ratio of 86.4, compared to 101.1 for the same period last year. The segment’s loss ratio was 47.5 in 2020, down from 56.5 in 2019 due to the combination of a larger amount of favorable development and decreased current accident year non-catastrophe losses. The segment’s expense ratio decreased to 38.9 in 2020 from 44.6 in the prior year, as increased levels of earned premium allowed the segment to better leverage expenses and reduced levels of bonus and profit-sharing expenses were incurred.

Surety

The surety segment recorded underwriting income of $8.3 million for the second quarter of 2020, compared to $8.4 million for the same period last year. Both periods reflected positive current accident year underwriting performance and benefited from favorable development on prior years’ loss reserves. Results for 2020 and 2019 included favorable development on prior accident years’ loss reserves across all products, which decreased the segment’s loss and settlement expenses by $3.8 million. Additionally, $1.1 million of reserves were established in 2020 for COVID-19 related losses.

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The combined ratio for the surety segment totaled 70.6 for the second quarter of 2020, compared to 71.2 for the same period in 2019. The segment’s loss ratio was 7.1 in 2020, up from 4.1 in 2019 due to the recognition of COVID-19 related losses. The expense ratio was 63.5, down from 67.1 in the prior year as stronger growth in book value led to increased bonus and profit-sharing expenses in 2019.

Investment Income and Realized Capital Gains

Our investment portfolio generated net investment income of $16.9 million during the second quarter of 2020, a decrease of 0.5 percent from that reported for the same period in 2019. The decrease in investment income was largely due to a decline in yields relative to the prior year.

Yields on our fixed income investments for the second quarter of 2020 and 2019 were as follows:

    

2Q 2020

    

2Q 2019

Pretax Yield

Taxable

3.17

%

3.43

%

Tax-Exempt

2.70

%

2.83

%

After-Tax Yield

Taxable

2.50

%

2.71

%

Tax-Exempt

2.56

%

2.68

%

We recognized $2.1 million of realized losses in the second quarter of 2020, which were comprised of $2.3 million of realized losses on equity securities from rebalancing our portfolio, $0.3 million of realized gains on the fixed income portfolio and $0.1 million of other realized losses. This compares to realized gains of $4.8 million in the second quarter of 2019, which were comprised of $3.9 million of realized gains on the equity portfolio, $0.7 million of realized gains on the fixed income portfolio and $0.2 million of other realized gains.

Income Taxes

Our effective tax rate for the second quarter of 2020 was 19.8 percent, compared to 17.1 percent for the same period in 2019. Effective rates are dependent upon components of pretax earnings or losses and the related tax effects. The effective rate was higher for the second quarter of 2020 due to higher levels of pre-tax earnings and lower levels of tax-favored adjustments compared to 2019.

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 shareholder dividend payments and changes in debt and shares outstanding.

The following table summarizes cash flows provided by (used in) our activities for the six-month periods ended June 30, 2020 and 2019:

(in thousands)

    

2020

    

2019

Operating cash flows

$

83,773

$

105,347

Investing cash flows

(26,666)

(100,654)

Financing cash flows

(18,513)

(9,999)

Total

$

38,594

$

(5,306)

Our largest source of cash is premiums received from customers and our largest cash outflow is claim payments on insured losses. Cash flows from operating activities can vary among periods due to the timing in which these payments are made or received. Operating cash flows in the first half of 2020 were impacted by increased levels of loss and settlement expense payments relative to the first six months of 2019. Additionally, improved financial performance in 2019 resulted in a higher level of bonus and profit-sharing contributions that were paid in the first quarter of 2020, which also reduced operating cash flows in 2020.

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We have $149.4 million in debt outstanding. On October 2, 2013, we completed a public debt offering, issuing $150.0 million in senior notes maturing September 15, 2023 (a 10-year maturity), and paying interest semi-annually at the rate of 4.875 percent per annum. The notes were issued at a discount resulting in proceeds, net of discount and commission, of $148.6 million. The estimated fair value for the senior note at June 30, 2020 was $162.7 million. The fair value of our debt is estimated based on the limited observable prices that reflect thinly traded securities.

As of June 30, 2020, we had cash and other investments maturing within one year of approximately $160.7 million and an additional $496.0 million maturing between one to five years. Whereas our strategy is to be fully invested at all times, short-term investments in excess of demand deposit balances are considered a component of investment activities, and thus are classified as investments in our consolidated balance sheets.

We also maintain a revolving line of credit with Bank of Montreal, Chicago Branch, which permits us to borrow up to an aggregate principal amount of $60.0 million. This facility was entered into during the first quarter of 2020 and replaced the previous $50.0 million facility with JP Morgan Chase Bank N.A., which was set to expire on May 24, 2020. Under certain conditions, the line may be increased up to an aggregate principal amount of $120.0 million. The facility has a three-year term that expires on March 27, 2023. As of and during the three-month period ended June 30, 2020, no amounts were outstanding on either facility.

Additionally, two of our insurance companies, RLI Ins. and Mt. Hawley, are members of the Federal Home Loan Bank of Chicago (FHLBC). Membership in the Federal Home Loan Bank System provides both companies access to an additional source of liquidity via a secured lending facility. Our membership allows each insurance subsidiary to determine tenor and structure at the time of borrowing. As of and during the six-month period ended June 30, 2020, there were no outstanding borrowing amounts with the FHLBC.

We believe that cash generated by operations and investments will provide sufficient sources of liquidity to meet our anticipated needs over the next 12 to 24 months. In the event they are not sufficient, we believe cash available from financing activities and other sources will provide sufficient additional liquidity.

We have not had any liquidity issues affecting our operations as we have sufficient cash flow to support operations. In addition to our bank credit facility and FHLBC membership, our highly liquid investment portfolio provides an additional source of liquidity.

We maintain a diversified investment portfolio representing policyholder funds that have not yet been paid out as claims, as well as the capital we hold for our shareholders. Invested assets at June 30, 2020 have increased $85.2 million from December 31, 2019. As of June 30, 2020, our investment portfolio had the following asset allocation breakdown:

Portfolio Allocation

(in thousands)

Cost or

Fair

Unrealized

% of Total

Asset class

    

Amortized Cost

    

Value

    

Gain/(Loss)

    

Fair Value

    

Quality*

U.S. government

$

171,174

$

186,838

$

15,664

7.1

%

AAA

U.S. agency

27,913

32,091

4,178

1.2

%

AAA

Non-U.S. govt. & agency

7,316

7,692

376

0.3

%

BBB

Agency MBS

388,036

409,167

21,131

15.5

%

AAA

ABS/CMBS**

214,548

218,507

3,959

8.2

%

AA+

Corporate

717,748

765,125

47,377

28.9

%

BBB+

Municipal

429,402

455,673

26,271

17.2

%

AA

Total Fixed Income

$

1,956,137

$

2,075,093

$

118,956

78.4

%

AA-

Equity

270,987

422,198

151,211

16.0

%

Other Invested Assets

72,291

63,440

(8,851)

2.4

%

Cash

84,797

84,797

3.2

%

Total Portfolio

$

2,384,212

$

2,645,528

$

261,316

100.0

%

*Quality ratings provided by Moody’s, S&P and Fitch

**Asset-backed and commercial mortgage-backed securities

Quality is an average of each bond’s credit rating, adjusted for its relative weighting in the portfolio. As of June 30, 2020, our fixed income portfolio had the following rating distribution:

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AAA

    

45.9

%

AA

17.9

%

A

20.4

%

BBB

9.3

%

BB

3.2

%

B

2.4

%

CCC

0.3

%

NR

0.6

%

Total

100.0

%

As of June 30, 2020, the duration of the fixed income portfolio was 4.6 years. Our fixed income portfolio remained well diversified, with 1,288 individual issues.

Our investment portfolio has limited exposure to structured asset-backed securities. As of June 30, 2020, we had $137.9 million in ABS which are pools of assets collateralized by cash flows from several types of loans, including home equity, credit cards, autos and structured bank loans in the form of collateralized loan obligations (CLOs).

As of June 30, 2020, we had $80.6 million in commercial mortgage backed securities and $409.2 million in mortgage backed securities backed by government sponsored enterprises (GSEs - Freddie Mac, Fannie Mae and Ginnie Mae). Excluding the GSE backed MBS, our exposure to ABS and CMBS was 8.2 percent of our investment portfolio at quarter end.

We had $765.1 million in corporate fixed income securities as of June 30, 2020, which includes $98.2 million invested in a high yield credit strategy. This high-yield portfolio consists of floating rate bank loans and bonds that are below investment grade in credit quality and offer incremental yield over our core fixed income portfolio.

We also maintain an allocation to municipal fixed income securities. As of June 30, 2020, we had $455.7 million in municipal securities. The municipal portfolio includes approximately 73 percent tax-exempt securities and 27 percent taxable securities. Approximately 86 percent of our municipal bond portfolio maintains an ‘AA’ or better rating, while 99 percent of the municipal bond portfolio is rated ‘A’ or better.

Our equity portfolio had a fair value of $422.2 million as of June 30, 2020 and is also a source of liquidity. The securities within the equity portfolio remain primarily invested in large-cap issues with a focus on dividend income. In the equity portfolio, the strategy remains one of value investing, with security selection taking precedence over market timing.

As of June 30, 2020, our equity portfolio had a dividend yield of 2.1 percent, compared to 1.9 percent 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 13.1 percent on dividends, compared to 21.0 percent on taxable interest and 5.3 percent on municipal bond interest income. The equity portfolio is managed in a diversified and granular manner, with 221 individual securities and three ETF positions. No single stock exposure is greater than 2 percent of the equity portfolio.

We had $63.4 million of other invested assets at June 30, 2020, including investments in low income housing tax credit partnerships, membership in the FHLBC, investments in private funds and investments in restricted stock. As of June 30, 2020, $14.6 million of investments were pledged as collateral with the FHLBC to ensure timely access to the secured lending facility that ownership of FHLBC stock provides. As of and during the six-month period ending June 30, 2020, there were no outstanding borrowings with the FHLBC.

Our investment portfolio does not have any exposure to derivatives.

Our capital structure is comprised of equity and debt outstanding. As of June 30, 2020, our capital structure consisted of $149.4 million in 10-year maturity senior notes maturing in 2023 (debt) and $1.1 billion of shareholders’ equity. Debt outstanding comprised 12.4 percent of total capital as of June 30, 2020. Interest and fees on debt obligations totaled $3.8 million during the first six months of 2020, compared to $3.7 million during the same period in 2019. We have incurred interest expense on debt at an average annual interest rate of 4.91 percent for the three-month periods ended June 30, 2020 and 2019.

We paid a regular quarterly cash dividend of $0.24 per share on June 19, 2020, a $0.01 increase over the prior quarter. We have increased dividends in each of the last 45 years.

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Our three insurance subsidiaries are subsidiaries of RLI Corp, with RLI Ins. as the first-level, or principal, insurance subsidiary. At the holding company (RLI Corp.) level, we rely largely on dividends from our insurance company subsidiaries to meet our obligations for paying principal and interest on outstanding debt, corporate expenses and dividends to RLI Corp. shareholders. As discussed further below, dividend payments to RLI Corp. from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the insurance regulatory authorities of Illinois. As a result, we may not be able to receive dividends from such subsidiary at times and in amounts necessary to pay desired dividends to RLI Corp. shareholders. On a GAAP basis, as of June 30, 2020, our holding company had $1.1 billion in equity. This includes amounts related to the equity of our insurance subsidiaries, which is subject to regulatory restrictions under state insurance laws. The unrestricted portion of holding company net assets is comprised primarily of investments and cash, including $43.4 million in liquid assets, which would cover the majority of our annual holding company expenditures. Unrestricted funds at the holding company are available to fund debt interest, general corporate obligations and dividend payments to our shareholders. If necessary, the holding company also has other potential sources of liquidity that could provide for additional funding to meet corporate obligations or pay shareholder dividends, which include a revolving line of credit, as well as access to capital markets.

Ordinary dividends, which may be paid by our principal insurance subsidiary without prior regulatory approval, are subject to certain limitations based upon statutory income, surplus and earned surplus. The maximum ordinary dividend distribution from our principal insurance subsidiary in a rolling 12-month period is limited by Illinois law to the greater of 10 percent of RLI Ins. policyholder surplus, as of December 31 of the preceding year, or the net income of RLI Ins. for the 12-month period ending December 31 of the preceding year. Ordinary dividends are further restricted by the requirement that they be paid from earned surplus. Any dividend distribution in excess of the ordinary dividend limits is deemed extraordinary and requires prior approval from the Illinois Department of Insurance (IDOI). In the first six months of 2020, RLI Ins. paid $22.0 million in ordinary dividends to RLI Corp. In 2019, our principal insurance subsidiary paid ordinary dividends totaling $59.0 million. As of June 30, 2020, $43.3 million of the net assets of our principal insurance subsidiary were not restricted and could be distributed to RLI Corp. as ordinary dividends without prior approval from the IDOI. Because the limitations are based upon a rolling 12-month period, the amount and impact of these restrictions vary over time. In addition to restrictions from our principal subsidiary’s insurance regulator, we also consider internal models and how capital adequacy is defined by our rating agencies in determining amounts available for distribution.

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 currency exchange rates and commodity prices. Historically, our primary market risks have been equity price risk associated with investments in equity securities and interest rate risk associated with investments in fixed maturities. We have limited exposure to both foreign currency risk and commodity risk.

Credit risk is the potential loss resulting from adverse changes in an issuer’s ability to repay its debt obligations. We monitor our portfolio to ensure that credit risk does not exceed prudent levels. We have consistently invested in high credit quality, investment grade securities. Our fixed maturity portfolio has an average rating of AA-, with 84 percent rated A or better by at least two nationally recognized rating organizations.

On an overall basis, our exposure to market risk has not significantly changed from that reported in our 2019 Annual Report on Form 10-K. The COVID-19 pandemic does present new and emerging uncertainty to the financial markets. See further discussion in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Part II, Item 1A., Risk Factors, of this Quarterly Report on Form 10-Q.

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.

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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.

PART II - OTHER INFORMATION

Item 1.

Legal Proceedings – There were no material changes to report.

Item 1A.  

Risk Factors

There have been no material changes from the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, as updated in the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds -

Items 2(a) and (b) are not applicable.

In 2010, our Board of Directors implemented a $100 million share repurchase program. We did not repurchase any shares during 2020. We have $87.5 million of remaining capacity from the repurchase program. The repurchase program may be suspended or discontinued at any time without prior notice.

Item 3.  

Defaults Upon Senior Securities - Not Applicable.

Item 4.

Mine Safety Disclosures - Not Applicable.

Item 5.

Other Information - Not Applicable.

Item 6.  

Exhibits

Exhibit No.

Description of Document

Reference

3.1

Amended and Restated Certificate of Incorporation

Incorporated by reference to the Company’s Current Report on Form 8-K filed May 8, 2020.

10.1

RLI Corp. 2015 Long-Term Incentive Plan

Attached as Exhibit 10.1.

10.2

RLI Corp. Annual Incentive Compensation Plan

Attached as Exhibit 10.2.

31.1

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Attached as Exhibit 31.1.

31.2

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

Attached as Exhibit 31.2.

32.1

Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Attached as Exhibit 32.1.

32.2

Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

Attached as Exhibit 32.2.

101

iXBRL-Related Documents

Attached as Exhibit 101.

104

Cover Page Interactive Data File

Embedded in Inline XBRL and contained in Exhibit 101.

38

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.

RLI Corp.

/s/ Todd W. Bryant

Todd W. Bryant

Vice President, Chief Financial Officer

(Principal Financial and Chief Accounting Officer)

Date: July 24, 2020

39