<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 For the fiscal year ended______________DECEMBER 31, 1998_________
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 ____________0-6612______________
RLI CORP.
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(Exact name of registrant as specified in its charter)
ILLINOIS 37-0889946
-------------------------------- -----------------------------------
(State or other jurisdiction of (I.R.S. Employers Identification No.)
incorporation or organization)
9025 NORTH LINDBERGH DRIVE, PEORIA, ILLINOIS 61615
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (309) 692-1000
---------------
Securities registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
Common Stock $1.00 par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: NONE
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.
_X_ Yes No___
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant, based upon the closing sale price of the Common Stock on
February 26, 1999 as reported on the New York Stock Exchange, was
$306,409,698. Shares of Common Stock held directly or indirectly by each
officer and director along with shares held by the Company ESOP have been
excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive
determination for other purposes.
The number of shares outstanding of the Registrant's Common Stock, $1 par
value, on February 26, 1999 was $10,408,822.
DOCUMENTS INCORPORATED BY REFERENCES.
Portions of the Annual Report to Shareholders for the past year ended
December 31, 1998, are incorporated by reference into Parts I and II of this
document.
Portions of the Registrant's definitive Proxy Statement for the 1999
annual meeting of security holders to be held May 6, 1999, are incorporated
herein by reference into Part III of this document.
Exhibit index is located on pages 34-35 of this document.
1
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PART I
Item 1. BUSINESS
(a) General Development of Business
As used in this Form 10-K, the term "Company" refers to RLI Corp. and
its subsidiaries and affiliates, unless the context otherwise indicates.
RLI Corp., which was incorporated in Illinois in 1965, merged into and
became a Delaware corporation in 1984. In May of 1993, RLI Corp. changed its
state of incorporation back to Illinois through a merger. RLI Corp. is a
holding company, which, through its subsidiaries, underwrites selected
property and casualty insurance.
SIGNIFICANT DEVELOPMENT
UNDERWRITERS INDEMNITY HOLDING COMPANY MERGER
On January 29, 1999, the Company acquired Underwriters Indemnity
Holdings, Inc., ("UIH") located in Houston, Texas. The Company paid $40.7
million in cash in exchange for all outstanding shares of UIH subject to
post-closing contingencies. Included in the transaction were both of UIH's
operating insurance subsidiaries, Underwriters Indemnity Company of Texas
("UIC") and Planet Indemnity Company of Colorado ("PIC"). UIC and PIC
specialize in the marketing and underwriting of surety products for oil, gas,
mining and other energy-related exposures. Both UIC and PIC are rated "A-"
(Excellent) by A.M. Best.
(b) Financial Information about Industry Segments
Selected information about industry segments is included herein as Item
8.
(c) Narrative Description of Business
RLI INSURANCE GROUP
RLI Insurance Group is composed primarily of two main insurance
companies. RLI Insurance Company, the principal subsidiary, writes multiple
lines of insurance on an admitted basis in all 50 states, the District of
Columbia and Puerto Rico. Mt. Hawley Insurance Company, a subsidiary of RLI
Insurance Company, writes multiple lines of insurance on an admitted basis in
Kansas and surplus lines insurance in the remaining 49 states, the District
of Columbia, Puerto Rico, the Virgin Islands and Guam. Other companies in the
RLI Insurance Group include: Replacement Lens Inc., RLI Insurance Agency,
Ltd., RLI Insurance Ltd., Underwriters Indemnity Company and Planet Indemnity
Company.
Since 1977, when the Company first began underwriting specialty property
and casualty coverages for commercial risks, highly cyclical market
conditions and a number of other factors have influenced the Company's growth
and underwriting profits. The Company, as a "niche" company rather than an
"all lines" company, seeks to develop expertise and large homogeneous books
of business in areas generally overlooked by traditional markets.
In response to the soft market conditions of the early 1980's, which
were characterized by severe rate competition and excess underwriting
capacity, the Company limited its writings in specialty property and casualty
lines and terminated certain lines and sources of production.
2
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Significant rate increases resulted when the insurance market hardened
in late 1984. The Company responded by expanding its premium volume in
targeted lines. Since 1987, the industry has experienced generally soft
market conditions featuring intensified competition for admitted and surplus
lines insurers, resulting in rate decreases. The Company has continually
monitored its rates and controlled its costs in an effort to maximize profits
during this entrenched soft market condition. As a result of catastrophic
losses, such as Hurricane Andrew and the Northridge Earthquake, property
rates hardened in California, Florida and the wind belt, but remained soft in
other areas of the country. In 1994 and 1995, rates hardened and premium
growth was achieved in the commercial property book of business. Otherwise,
rates for property and casualty lines have declined over time. To maintain
profitability, underwriters have tightened selection criteria, broadened
their focus to other market segments and given up business where rates
dropped too low.
The Company initially wrote specialty property and casualty insurance
through independent underwriting agents. The Company opened its first branch
office in 1984, and began to shift from independent underwriting agents to
wholly-owned branch offices which market to wholesale producers. The Company
also markets certain products to retail producers from its Specialty
Marketing Division located at the Home Office in Peoria, Illinois. The
Company produces business under agreements with underwriting general agents.
Additional underwriting agents are being accepted under the auspices of
Company product vice presidents. The majority of the specialty property and
casualty business is marketed through the Specialty Markets and Surety
divisions and branch offices located in Los Angeles, California; San Diego,
California; San Francisco, California; Glastonbury, Connecticut; Atlanta,
Georgia; Alpharetta, Georgia; Honolulu, Hawaii; Chicago, Illinois; Overland
Park, Kansas; Boston, Massachusetts; St. Paul, Minnesota; New York City, New
York; Dallas, Texas; Houston, Texas and Seattle, Washington.
The following table provides for the year ended December 31, 1998 the
geographic distribution of the Company's risks insured as represented by
direct premiums earned for all product lines. For the year ended December 31,
1998, no other state accounted for more than 2% of total direct premiums
earned for all product lines.
<TABLE>
<CAPTION>
DIRECT PREMIUMS
STATE EARNED PERCENT OF TOTAL
----- ---------------- ----------------
<S> <C> <C>
California $100,662,702 36.60%
Florida 24,036,160 8.74
New York 21,698,605 7.89
Texas 20,740,580 7.54
Hawaii 10,513,187 3.82
Ohio 8,867,799 3.23
New Jersey 8,090,247 2.94
Illinois 7,328,351 2.67
Michigan 5,644,425 2.05
Pennsylvania 5,627,816 2.05
All Other 61,785,825 22.47
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Total direct $274,995,697 100.00%
premiums ------------ -------
------------ -------
</TABLE>
The Company presently underwrites selected property and casualty
insurance primarily in the following lines:
3
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A. PROPERTY SEGMENT
1. COMMERCIAL PROPERTY. The Company's commercial property coverage
consists primarily of excess and surplus lines and specialty insurance such
as fire and difference in conditions which includes earthquake, flood and
collapse coverages. The Company writes coverage for a wide range of
commercial and industrial classes such as office buildings, apartments,
condominiums, certain industrial and mercantile structures, and buildings
under construction. The Company also writes boiler and machinery and ocean
marine insurance under the same management as commercial property. The
Alpharetta, Boston, Chicago, Dallas, Houston, Los Angeles, and, San Francisco
branch offices are responsible for underwriting this coverage. In 1998, 1997,
and 1996, net earned premiums totaled $42,281,000, $48,799,000, and
$47,822,000, or 25%, 29%, and 31% respectively, of the Company's consolidated
revenues.
2. HOMEOWNERS/RESIDENTIAL PROPERTY. In 1997, the Company assumed a
highly profitable book of homeowners and dwelling fire business for Hawaii
homeowners from the Hawaii Property Insurance Association. In the aftermath
of Hurricane Iniki in 1992, this business was available at reasonable rates
and terms. Net earned premiums totaled $9,689,000 and $13,229,000 or 6% and
8% of the Company's consolidated revenues for 1998 and 1997, respectively.
B. SURETY SEGMENT
3. SURETY. In 1993, the Company began writing surety business. This
product line is underwritten from the Home Office in Peoria and through the
Dallas, Houston and Seattle branch offices. The initial target market of the
Surety Division was a wide range of commercial surety bonds written primarily
through the independent agency system. In 1996, the Company expanded their
product offering to include contract bonds for small size contractors. Net
earned premiums totaled $18,307,000, $11,491,000, and $4,407,000, or 11%, 8%,
and 3% of the Company's consolidated revenues for 1998, 1997, and 1996,
respectively.
The acquisition of Underwriter's Indemnity Holdings, Inc., and its
operating insurance subsidiaries provide an ideal situation for our surety
line to grow in new directions. The facility is a leader in the oil and gas
field and will begin generating premium income in 1999.
C. CASUALTY SEGMENT
4. GENERAL LIABILITY. The Company writes general liability coverages
through its Los Angeles, Glastonbury, Chicago, Alpharetta, and Dallas branch
offices. The Company's general liability business consists primarily of
coverage for third party liability of commercial insureds including
manufacturers, contractors, apartments and mercantile risks. Net earned
premiums totaled $23,726,000, $26,332,000, and $34,834,000, or 14%, 16%, and
22% of the Company's consolidated revenues for the years 1998, 1997, and
1996, respectively.
5. COMMERCIAL AND PERSONAL UMBRELLA LIABILITY. The Company's commercial
umbrella coverage is produced through its Overland Park, St. Paul,
Alpharetta, Glastonbury, and Dallas branch offices, and through an
underwriting general agency in San Francisco. The coverage is principally
written in excess of primary liability insurance provided by other carriers
and, to a small degree, in excess of primary liability written by the
Company. The expansion into California and the introduction of internet based
production of smaller premium light hazard businesses contributed to
significant premium growth in 1998. The personal umbrella coverage, which is
produced through the Specialty Markets Division, is written in excess of the
homeowners and automobile liability coverage provided by other carriers. Net
earned premiums totaled $29,086,000, $22,566,000, and $21,282,000, or 17%,
12%, and 14% of the Company's consolidated revenues for the years 1998, 1997,
and 1996, respectively.
6. DIRECTORS' AND OFFICERS' LIABILITY/MISCELLANEOUS PROFESSIONAL
LIABILITY. The Company produces Directors' and Officers' Liability through
underwriting facilities in San Diego, Los Angeles, and New York City. The
Company also offers Miscellaneous Professional Liability for a variety of low
to moderate classes of risks. D&O is a relatively small component of the
overall P&C market, which has been subject to severe competition.
Underwriters have relinquished market share rather than accept inadequate
pricing. Net earned premiums totaled $3,054,000, $4,430,000, and $5,000,000,
or 2%, 3%, and 3%, of the Company's consolidated revenues for the years 1998,
1997, and 1996, respectively.
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<PAGE>
7. EMPLOYER'S EXCESS INDEMNITY. Since 1993, the Company has written
Employer's Excess Indemnity coverage for businesses which have opted out of
the Workers' Compensation plan in the state of Texas. The coverage is similar
to accident and health, in that it indemnifies the employer for expenses
resulting from a work related injury or disease, excess of a self-insured
retention (SIR). The SIR can range from $50,000 to $500,000. The product is
underwritten out of the Overland Park branch office. A return to excessive
competition for Texas workers' compensation business has reduced the market
for this product since 1996. Net earned premiums totaled $1,722,000,
$5,130,000, and $6,566,000, or 1%, 3%, and 4%, of the Company's consolidated
revenues for 1998, 1997, and 1996, respectively.
8. TRANSPORTATION. In 1997, the Company opened a transportation
insurance facility in Atlanta to offer automobile liability and physical
damage insurance to local, intermediate and long haul truckers, public
transportation risks and equipment dealers. Incidental, related insurance
coverages are also offered, including general liability, commercial umbrella
and excess liability, and motor truck cargo. The facility is staffed by
highly experienced transportation underwriters who produce business through
independent agents and brokers nationwide. Net earned premiums totaled
$3,806,000 or 2% of the Company's consolidated revenues for 1998.
9. OTHER. Smaller programs offered by the Company include: excess
medical, in-home business, personal automobile (Hawaii only), ocean marine
and occupational accident. Net earned premiums from these lines totaled
$10,653,000, $9,907,000, and $10,744,000, or 6%, 5%, and 7% of the Company's
consolidated revenues for the years, 1998, 1997, and 1996, respectively.
COMPETITION
The Company's specialty property and casualty insurance subsidiaries are
part of an extremely competitive industry which is cyclical and historically
characterized by periods of high premium rates and shortages of underwriting
capacity followed by periods of severe competition and excess underwriting
capacity. Within the United States alone, approximately 3,500 companies, both
stock and mutual, actively market property and casualty products. The
combination of products, service, pricing and other methods of competition
vary from line to line. The Company's principal methods of meeting this
competition are innovative products, marketing structure and quality service
to the agents and policyholders at a fair price. The Company competes
favorably in part because of its sound financial base and reputation, as well
as its broad geographic penetration into all 50 states, the District of
Columbia, Puerto Rico, the Virgin Islands, and Guam. In the property and
casualty area, the Company has acquired experienced underwriting specialists
in its branch and Home offices. In 1987, the insurance industry, in general,
entered into a "soft" or highly competitive period during which insurance
rates generally decreased. The specialty property and casualty market
continues to be soft with some rate increases experienced in the property
lines in California, Florida and the wind belt from 1993 through 1995. Since
1996, competition reasserted itself and the Company reduced rates somewhat.
The Company has, however, continued to maintain its underwriting and
marketing standards by not seeking market share at the expense of earnings.
New products and new programs are offered where the opportunity exists to
provide needed insurance coverage with exceptional service on a profitable
basis.
RATINGS
During 1992, the A.M. Best rating for RLI Insurance Company, the
principal subsidiary of the Company, was upgraded to "A" (Excellent). During
1993, Mt. Hawley Insurance Company's (an indirect subsidiary of the Company)
A.M. Best rating was upgraded to "A" (Excellent). During 1998, A.M. Best
reaffirmed "A" ratings for both RLI Insurance Company and Mt. Hawley
Insurance Company.
During 1997, the Company for the first time applied for and received a
claims-paying rating from Standard & Poor's. As a result, rating of "A"
(Good) was received for the combined insurance operation. In 1998, the "A"
rating was reaffirmed, with the addition of a "Positive Future Outlook". The
addition of the positive outlook to the rating indicates that Standard &
Poor's anticipates that there is a good chance that RLI's rating could
increase within the next year.
5
<PAGE>
A.M. Best ratings for the industry range from "A++" (Superior) to "F"
(In Liquidation) with some companies not being rated. Standard & Poor's
ratings for the industry range from "AAA" (Superior) to "CC" (Default
Expected). Publications of both A.M. Best and Standard & Poor's indicate that
"A" ratings are assigned to those companies that, in their opinion, have
achieved excellent overall performance when compared to the standards
established by these firms and have a strong ability to meet their
obligations to policyholders over a long period of time. In evaluating a
company's financial and operating performance, both firms reviews the
company's profitability, leverage and liquidity as well as the company's
spread of risk, the quality and appropriateness of its reinsurance, the
quality and diversification of its assets, the adequacy of its policy and
loss reserves, the adequacy of its surplus, its capital structure and the
experience and objectives of its management. These ratings are based on
factors relevant to policyholders, agents, insurance brokers and
intermediaries and are not directed to the protection of investors.
As of December 31, 1998, the Company had no public debt outstanding,
therefore, no debt rating existed.
REINSURANCE
The Company reinsures a significant portion of its property and casualty
insurance exposure, paying to the reinsurer a portion of the premiums
received on such policies. Earned premiums ceded to non-affiliated reinsurers
totaled $135,269,000, $138,198,000, and $140,928,000 in 1998, 1997, and 1996,
respectively. Insurance is ceded principally to reduce net liability on
individual risks and to protect against catastrophic losses. Although
reinsurance does not legally discharge an insurer from its primary liability
for the full amount of the policies, it does make the assuming reinsurer
liable to the insurer to the extent of the insurance ceded.
The Company attempts to purchase reinsurance from a limited number of
financially strong reinsurers. Retention levels are adjusted each year to
maintain a balance between the growth in surplus and the cost of reinsurance.
At December 31, 1998, the Company had prepaid reinsurance premiums and
reinsurance recoverables on paid and unpaid losses and settlement expenses
with American Re-Insurance Company (rated A++ "superior" by A.M. Best
Company) that amounted to 80,365,000. All other reinsurance balances
recoverable, when considered by individual reinsurer, are less than 10% of
shareholders' equity.
The following table sets forth the largest reinsurers in terms of
amounts recoverable before reinsurance payables from such reinsurers as of
December 31, 1998. Also shown are the amounts of written premium ceded by the
Company to such reinsurers during 1998.
<TABLE>
<CAPTION>
GROSS REINSURER CEDED
EXPOSURE AS OF PERCENT PREMIUMS PERCENT
DECEMBER 31, 1998 OF TOTAL WRITTEN OF TOTAL
------------------ -------- ------- --------
<S> <C> <C> <C> <C>
American Re-Insurance Co. $80,365,000 32.97% $30,916,000 21.27%
General Reins Corp. 23,469,000 9.63 12,631,000 8.69
Employer's Re 12,505,000 5.13 8,700,000 5.98
Transatlantic Reinsurance 11,439,000 4.69 10,047,000 6.91
NAC Reinsurance Corporation 7,057,000 2.89 4,516,000 3.11
Everest Re 7,043,000 2.89 6,163,000 4.24
TIG Insurance Co. 6,218,000 2.55 1,299,000 .89
St. Paul Fire & Marine 5,915,000 2.43 4,166,000 2.86
Old Lyme Ins. Co. of RI 5,543,000 2.27 6,394,000 4.40
Lloyd's of London 4,580,000 1.88 11,017,000 7.58
All other reinsurers 79,644,000 32.67 49,523,000 34.07
------------ ------ ------------ ------
Total ceded exposure $243,778,000 100.00% $145,372,000 100.00%
------------- ------ ------------ ------
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</TABLE>
As of December 31, 1998, the Company held $9,448,000 in irrevocable letters
of credit, $7,575,000 under trust agreements and $1,313,508 in cash to
collateralize a portion of the total amount recoverable.
6
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Since 1992, the Company has purchased non-proportional contracts. This
allows the Company to retain a larger percentage of the premium and a larger
portion of the initial loss risk. Under non-proportional reinsurance, the
ceding company retains losses on a risk up to a specified amount and the
reinsurers assume any losses above that amount. Since 1989, through its
various reinsurance programs, the Company has generally limited its maximum
retained exposure on any one risk to $1,000,000. The Company seeks to limit
its net aggregate exposure to a single catastrophic event to less than 10% of
shareholders' equity by purchasing various types of reinsurance.
In 1998, the Company's underwriting was supported by up to $220,000,000
in traditional reinsurance protection. In 1999, the Company has enhanced this
protection by adding an additional $30,000,000 in catastrophe reinsurance
protection at improved terms and conditions. Using computer-assisted
techniques, the Company quantifies and monitors its exposure to earthquake
risk, the most significant catastrophe exposure to the Company. Detail is
captured for each location covered for earthquake risk and the Probable
Maximum Loss (PML) for each risk is determined. The PML calculation for each
risk includes all faults to which the risk is exposed. Richter scale
magnitudes used in the PML calculations are determined and applied separately
for each fault. The Company uses the greater of the magnitude of an
earthquake which only occurs every 100 years or 6.5 on the Richter scale in
its PML calculations. Several widely accepted methods are used to estimate
the magnitude of the 100 year event for each fault. Underwriting decisions
are based on the PML as determined by the system, which calculates PML's on
over 200 faults. Portfolio runs are made regularly to determine the Company's
overall exposure on each fault from all risks covered. Total exposure after
facultative reinsurance is managed by the Company to fall within the limits
covered by the Company's chosen net retention, working layer treaty
reinsurance and catastrophe reinsurance.
In 1998, the Company continued its innovative catastrophe reinsurance
and loss financing program with Centre Reinsurance (Centre Re). The program,
called Catastrophe Equity Puts (CatEPuts)-SM-, augments the Company's
traditional reinsurance by integrating its loss financing needs with a
pre-negotiated sale of securities linked to exchange-traded shares. CatEPuts
allows the Company to put up to $50.0 million of its convertible preferred
shares to Centre Re at a pre-negotiated rate in the event of a catastrophic
loss provided the loss does not reduce GAAP equity to less than $55.0
million. CatEPuts is intended to be a three-year program and is designed to
enable the Company to continue operating after a loss of such magnitude that
its reinsurance capacity is exhausted. If the Company exercises its option to
put preferred shares to Centre Re, then Centre Re, in turn, has the option to
reinsure certain business written by the Company on a prospective basis.
FACTORS AFFECTING SPECIALTY PROPERTY AND CASUALTY PROFITABILITY
The profitability of the specialty property and casualty insurance
business is generally subject to many factors, including rate competition,
the severity and frequency of claims, natural disasters, state regulation of
premium rates, default of reinsurers, interest rates, general business
conditions, regulatory measures and court decisions that define and expand
the extent of coverage and the amount of compensation due for injuries or
losses. One of the distinguishing features of the property and casualty
insurance business is that its product must be priced before the ultimate
claims costs can be known. In addition, underwriting profitability has tended
to fluctuate over cycles of several years' duration. Insurers generally had
profitable underwriting results in the late 1970's, substantial underwriting
losses in the early 1980's and somewhat smaller underwriting losses in 1986
and 1987. During the years 1988 through 1992, underwriting losses increased
due to increased rate competition and the frequency and severity of
catastrophic losses, although pre-tax operating income remained profitable
due to investment income gains. Since 1993, the industry experienced
improvement in underwriting losses, particularly in years with fewer
catastrophe losses. The trends experienced during the late 1980s, however,
have continued, and companies continue to post underwriting losses but remain
profitable through investment income gains. As well, ongoing rate cuts are of
concern to financial analysts. For 1998, the industry's statutory combined
ratio is estimated to be 104.5. The Company believes that certain other
factors affect its ability to underwrite specialty lines successfully,
including:
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SPECIALIZED UNDERWRITING EXPERTISE. The Company employs experienced
professionals in its branch offices. Each office restricts its production and
underwriting of business to certain classes of insurance reflecting the
particular areas of expertise of its key underwriters. In accepting risks,
all independent and affiliated underwriters are required to comply with risk
parameters, retention limits and rates prescribed by the Company's home
office underwriting group, which reviews submissions and periodically audits
and monitors underwriting files and reports on losses over $100,000.
Compensation of senior underwriters is substantially dependent on the
profitability of the business for which they are responsible. The loss of any
of these professionals could have an adverse effect on the Company's
underwriting abilities and earnings in these lines.
The Company's Underwriting Policy limits extension of binding authority
to independent agents. The Company's product distribution falls into distinct
categories, with binding authority following the categorization.
BROKER BUSINESS. The largest volume of broker generated premium is
Commercial Property, General Liability, Commercial Umbrella and Commercial
Automobile. This business is produced through wholesale brokers who are not
affiliated with the Company. Only a Company underwriter has the authority to
bind the Company on such risks.
INDEPENDENT AGENT BUSINESS. The Surety Division offers its business
through a variety of independent agents. Additionally, the Specialty Markets
Division writes program business, such as Personal Umbrella and the In-Home
Business Policy, through independent agents. Homeowners Dwelling Fire and
Personal Auto are produced through independent agents in Hawaii. Each of
these programs involves detailed eligibility criteria which are incorporated
into strict underwriting guidelines. The programs involve prequalification of
each risk using the "smart" system accessible by the independent agent. The
independent agent cannot bind the risk unless they receive approval through
the Company's "smart" system.
UNDERWRITING AGENTS. The Surety Division has authorized two underwriting
general agencies to underwrite contract surety business on behalf of RLI,
primarily in the East and Southeast. An underwriting agency in San Francisco
is authorized to underwrite commercial umbrella business in select Western
states. An underwriting agency in New York is authorized to underwrite and
handle claims for low limit deductible buy-backs on program business,
primarily in the East. Other underwriting agencies have been designated to
underwrite programs involving ocean marine insurance, property and liability
insurance for apartment risks, farm insurance, miscellaneous professional
insurance and commercial automobile.
These underwriting general agencies receive some compensation through
contingent profit commission. Otherwise, producers of business who are not
Company employees are generally compensated on the basis of direct
commissions with no provision for any contingent profit commission. There are
a few volume incentives for producers handling association business, with the
increased commission involved being tied to the program's underwriting
profit. This represents less than 5% of the business.
RETENTION LIMITS. The Company limits its net retention of single and
aggregate risks through the purchase of reinsurance. See "Business --
Specialty Property and Casualty Insurance Segment -- Reinsurance." The amount
of reinsurance available fluctuates according to market conditions.
Reinsurance arrangements are subject to annual renewal. Any significant
reduction in the availability of reinsurance or increase in the cost of
reinsurance could adversely affect the Company's ability to insure specialty
property and casualty risks at current levels or to add to the amount thereof.
CLAIMS ADJUSTMENT ABILITY. The Company has a professional claims
management team with proven experience in all areas of multi-line claims
work. This team supervises and administers all claims and directs all outside
legal and adjustment specialists. Whether a claim is being handled by the
Company's claim specialist or has been assigned to a local attorney or
adjuster, detailed attention is given to each claim to minimize loss expenses
while providing for loss payments in a fair and equitable manner.
8
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EXPENSE CONTROL. Management continues to review all areas of the
Company's operations to streamline the organization, emphasizing quality and
customer service, while minimizing expenses. These strategies will help to
contain the growth of future costs. Maintaining and improving underwriting
and other key organizational systems continues to be paramount as a means of
supporting the Company's orderly growth in anticipation of a market rebound,
as it is the Company's philosophy to retain its talented insurance
professionals and to build infrastructure in spite of the soft market. Other
insurance operating expenses as a percent of gross written premiums for the
years 1998, 1997, and 1996, were 6%, 7%, and 6%, respectively.
ENVIRONMENTAL EXPOSURES. The Company is subject to environmental claims
and exposures through its commercial umbrella, general liability, and
discontinued assumed reinsurance lines of business. Within these lines, the
Company's environmental exposures include environmental site cleanup,
asbestos removal, and mass tort liability. The majority of the exposure is in
the excess layers of the Company's commercial umbrella and assumed
reinsurance books of business.
The following table represents inception-to-date paid and unpaid
environmental exposure data (including incurred but not reported losses) for
the periods ended 1998, 1997, and 1996:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------
Inception-to-date December 31
(in thousands) 1998 1997 1996
- -----------------------------------------------------------------------------------
<S> <C> <C> <C>
Loss and Loss Adjustment
Expense (LAE) payments
Gross $ 14,690 $11,570 $8,267
Ceded (9,140) (7,646) (5,761)
- -----------------------------------------------------------------------------------
Net $ 5,550 $ 3,924 $ 2,506
- -----------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------
Unpaid losses and LAE at end of year
Gross $ 12,360 $14,880 $17,596
Ceded ( 5,875) ( 8,842) (11,150)
- -----------------------------------------------------------------------------------
Net $ 6,485 $ 6,038 $ 6,446
- -----------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------
</TABLE>
Although the Company's environmental exposure is limited as a result of
entering the liability lines after the industry had already recognized it as
a problem, Management cannot determine the Company's precise ultimate
liability with any reasonable degree of certainty. This ultimate liability is
difficult to assess due to evolving legislation on such issues as joint and
several liability, retroactive liability, and standards of cleanup.
Additionally, the Company participates primarily in the excess layers, making
it even more difficult to assess the ultimate impact.
LOSSES AND SETTLEMENT EXPENSES
Many years may elapse between the occurrence of an insured loss, the
reporting of the loss to the insurer and the insurer's payment of that loss.
To recognize liabilities for unpaid losses, insurers establish reserves,
which are balance sheet liabilities. The reserves represent estimates of
future amounts needed to pay claims and related expenses with respect to
insured events which have occurred.
9
<PAGE>
When a claim is reported, the claims department establishes a "case
reserve" for the estimated amount of the ultimate payment. The estimate
reflects the informed judgment of professional claims personnel, based on the
Company's reserving practices and the experience and knowledge of such
personnel regarding the nature and value of the specific type of claim.
Estimates for losses incurred but not yet reported are determined on the
basis of statistical information, including the Company's past experience.
The Company does not use discounting (recognition of the time value of money)
in reporting its estimated reserves for losses and settlement expenses.
The reserves are closely monitored and reviewed by management, with
changes reflected as a component of earnings in the current accounting
period. For lines of business without sufficiently large numbers of policies
or that have not accumulated sufficient development statistics, industry
average development patterns are used. To the extent that the industry
average development experience improves or deteriorates, the Company adjusts
prior accident years' reserves for the change in development patterns.
Additionally, there may be future adjustments to reserves should the
Company's actual experience prove to be better or worse than industry
averages.
As part of the reserving process, historical data is reviewed and
consideration is given to the anticipated impact of various factors such as
legal developments and economic conditions, including the effects of
inflation. The reserving process provides implicit recognition of the impact
of inflation and other factors affecting claims payments by taking into
account changes in historic payment patterns and perceived probable trends.
Changes in reserves from the prior years' estimates are calculated based on
experience as of the end of each succeeding year (loss and settlement expense
development). The estimate is increased or decreased as more information
becomes known about the frequency and severity of losses for individual
years. A redundancy means the original estimate was higher than the current
estimate; a deficiency means that the current estimate is higher than the
original estimate.
Due to the inherent uncertainty in estimating reserves for losses and
settlement expenses, there can be no assurance that the ultimate liability
will not exceed amounts reserved, with a resulting adverse effect on the
Company. Based on the current assumptions used in calculating reserves,
Management believes the Company's overall reserve levels at December 31, 1998
are adequate to meet its future obligations.
10
<PAGE>
The table which follows is a reconciliation of the Company's unpaid
losses and settlement expenses for the years 1998, 1997, and 1996.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------
(Dollars in thousands) 1998 1997 1996
---- ----- -----
<S> <C> <C> <C>
Unpaid losses and settlement
expenses at beginning of year:
Gross $404,263 $405,801 $418,986
Ceded (155,711) (157,995) (186,678)
------- ------- --------
Net 248,552 247,806 232,308
------- ------- --------
Increase (decrease) in incurred losses and settlement expenses:
Current accident year 68,131 61,771 69,724
Prior accident years (3,403) (520) (1,463)
------- ------- --------
Total incurred 64,728 61,251 68,261
------- ------- --------
Loss and settlement expense payments for claims incurred:
Current accident year (14,762) (11,284) (11,026)
Prior accident years (54,927) (49,023) (41,143)
------- ------- -------
Total paid (69,689) (60,307) (52,169)
-------- ------ -------
Insolvent reinsurer charged off (recovered) 7,911 (627) 607
Loss reserves commuted (4,240) 429 (1,201)
------- ------- --------
Unpaid losses and settlement
expenses at end of year $247,262 $248,552 $247,806
------- ------- -------
------- ------- -------
Unpaid losses and settlement expenses at end of year:
Gross $415,523 $404,263 $405,801
Ceded (168,261) (155,711) (157,995)
--------- ------- --------
Net $247,262 $248,552 $247,806
------- ------- -------
------- ------- -------
</TABLE>
11
<PAGE>
Explanation of significant components of reserve development by calendar
year are as follows:
1996 During 1996, the Company experienced approximately $1,463,000 of
favorable development on loss reserves. This development resulted from
approximately $1,519,000 of favorable development in the property lines
of business. Various property claims closed during the year were settled
below recorded reserves. The remaining $56,000 of adverse development
relates to the net effect of changes made to casualty loss reserves.
This development is a result of reserve strengthening of $3,557,000 made
in the General Liability and Miscellaneous Professional business on
accident years 1987 through 1995. This increase was offset by favorable
development and reserve decreases of $3,501,000 in the Umbrella and
Excess Employer's Indemnity programs on accident years 1986 and 1993
through 1995.
1997 During 1997, the Company experienced approximately $520,000 of favorable
development on loss reserves. The development results from loss reserve
adjustments in various lines of business. Reserve strengthening was
necessary on the Property line of business due to development on the
Lender's Single Interest program. As a result, an increase of $1,465,000
was made to IBNR reserves. This increase, however, was offset by
$1,985,000 of favorable development on the Company's other casualty,
in-home business, and surety bonding programs.
1998 During 1998, the Company experienced $3,402,000 of favorable development
on loss reserves. This development was the net result from several
reserve adjustments amongst various programs. Reserve strengthening of
$2,600,000 to the surety line of business in the third quarter was
offset by favorable development in primarily the personal umbrella
product. Favorable development of approximately $3,000,000 on a
deductible buy-back program resulted in a reclass between loss reserves
and contingent commissions. This reclass was warranted by favorable loss
development and had no impact to earnings.
The table on the following page presents the development under generally
accepted accounting principles of the Company's balance sheet reserves
for 1989 through 1998. The top line of the table shows the reserves at
the balance sheet date for each of the indicated periods. This
represents the estimated amount of losses and settlement expenses
arising in all prior years that are unpaid at the balance sheet date,
including losses that had been incurred but not yet reported to the
Company. The lower portion of the table shows the re-estimated amount of
the previously recorded reserves based on experience as of the end of
each succeeding year. The estimate changes as more information becomes
known about the frequency and severity of claims for individual periods.
12
<PAGE>
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------------------
(Dollars in thousands) 1989 1990 1991 1992 1993
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Net Liability for unpaid losses and
settlement expenses at end of year $105,025 $111,152 $119,411 $140,248 $175,491
Paid (cumulative) as of:
One year later 15,525 18,579 22,332 24,589 36,416
Two years later 26,685 35,963 37,763 46,342 63,675
Three years later 40,341 44,088 49,462 64,364 84,614
Four years later 44,714 52,322 57,085 78,994 96,741
Five years later 51,153 56,413 65,318 85,746 106,631
Six years later 54,546 62,989 70,270 92,689
Seven years later 59,444 66,254 75,668
Eight years later 62,266 71,373
Nine years later 67,235
Liability re-estimated as of:
One year later 91,646 101,251 108,249 128,600 166,666
Two years later 89,112 98,505 105,747 132,850 164,218
Three years later 87,981 95,690 107,777 132,376 157,286
Four years later 87,403 97,041 106,326 127,426 168,782
Five years later 90,030 96,490 100,968 140,536 163,127
Six years later 88,982 93,159 117,529 134,950
Seven years later 85,381 96,973 107,103
Eight years later 90,154 99,622
Nine years later 94,151
Net cumulative redundancy
(deficiency) $10,874 $11,530 $12,308 $5,298 $12,364
Gross liability $268,043 $310,767
Reinsurance recoverable (127,795) (135,276)
-------- --------
Net liability $140,248 $175,491
Gross re-estimated liability $283,890
Re-estimated recoverable (120,763)
--------
Net re-estimated liability $163,127
Gross cumulative redundancy
(deficiency) $ 26,877
</TABLE>
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------------------------------
(Dollars in thousands) 1994 1995 1996 1997 1998
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Net Liability for unpaid losses and
settlement expenses at end of year $204,771 $232,308 $247,806 $248,552 $247,262
Paid (cumulative) as of:
One year later 46,905 37,505 47,999 54,927
Two years later 73,972 75,485 85,342
Three years later 100,936 103,482
Four years later 121,834
Five years later
Six years later
Seven year later
Eight years later
Nine years later
Liability re-estimated as of:
One year later 218,499 220,185 240,264 245,150
Two years later 214,352 228,636 242,865
Three years later 212,964 222,761
Four years later 217,790
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Net cumulative redundancy
(deficiency) $(13,019) $9,547 $4,941 $3,402
Gross liability $394,966 $418,986 $405,801 $404,263 $415,523
Reinsurance recoverable (190,195) (186,678) (157,995) (155,711) (168,261)
-------- -------- -------- -------- --------
Net liability $204,771 $232,308 $247,806 $248,552 $247,262
Gross re-estimated liability $408,715 $404,867 $407,051 $408,424
Re-estimated recoverable (190,925) (182,106) (164,186) (163,274)
-------- -------- -------- --------
Net re-estimated liability $217,790 $222,761 $242,865 $245,150
Gross cumulative redundancy
(deficiency) $(13,749) $ 14,119 $( 1,250) $ (4,161)
</TABLE>
13
<PAGE>
OPERATING RATIO
PREMIUMS TO SURPLUS RATIO
The following table shows, for the periods indicated, the Company's
insurance subsidiaries' statutory ratios of net premiums written to
policyholders' surplus. While there is no statutory requirement applicable to
the Company which establishes a permissible net premiums written to surplus
ratio, guidelines established by the National Association of Insurance
Commissioners provide that this ratio should generally be no greater than 3
to 1.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------
(Dollars in thousands) 1998 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Statutory net premiums written $145,701 $144,674 $130,908 $130,453 $131,164
Policyholders' surplus $314,484 $265,526 $207,787 $172,313 $136,125
Ratio .5 to 1 .5 to 1 .6 to 1 .8 to 1 1.0 to 1
GAAP AND STATUTORY COMBINED RATIOS
The underwriting experience of the Company is best indicated by its GAAP
combined ratio, which is the sum of (a) the ratio of incurred losses and
settlement expenses to net premiums earned (loss ratio) and (b) the ratio of
policy acquisition costs and other operating expenses to net premiums earned
(expense ratio).
YEAR ENDED DECEMBER 31,
------------------------------------------------------------------------
GAAP 1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Loss ratio 45.4 43.2 52.2 64.4 72.5
Expense ratio 42.8 43.6 35.2 43.1 44.4
---- ---- ---- ---- ----
Combined ratio 88.2 86.8 87.4 107.5(1) 116.9(1)
---- ---- ---- ---- ----
---- ---- ---- ---- ----
</TABLE>
(1) Excluding the effects of the Northridge Earthquake, the GAAP combined
ratio for the years ended 1995 and 1994 would have been 86.2 and 91.1,
respectively.
14
<PAGE>
The Company also calculates the statutory combined ratio, which is not
indicative of GAAP underwriting profits due to accounting for multiple-year
retrospectively-rated reinsurance contracts and policy acquisition costs
differently for statutory accounting purposes compared to GAAP. The statutory
combined ratio is the sum of (a) the ratio of statutory loss and settlement
expenses incurred to statutory net premiums earned (loss ratio) and (b) the
ratio of statutory policy acquisition costs and other underwriting expenses to
statutory net premiums written.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------------------
Statutory 1998 1997 1996 1995 1994
-------- ---- ---- ---- -----
<S> <C> <C> <C> <C> <C>
Loss ratio 48.0 43.0 52.3 63.6 73.4
Expense ratio 40.4 47.4 36.8 42.9 43.5
---- ---- ---- ---- ----
Combined ratio 88.4 90.4 89.1 106.5 (3) 116.9 (3)
---- ---- ---- ---- ----
---- ---- ---- ---- ----
Industry combined ratio 104.5 (1) 101.6 (2) 105.8 (2) 106.4 (2) 108.4 (2)
---- ---- ---- ---- ----
---- ---- ---- ---- ----
</TABLE>
(1) Source: Insurance Information Institute. Estimated for the year ended
December 31, 1998.
(2) Source: A.M. Best Aggregate & Averages -- Property-Casualty (1997 Edition).
(3) Excluding the effects of the Northridge Earthquake, the statutory combined
ratio for the years ended 1995 and 1994 would have been 85.3 and 89.7,
respectively.
INVESTMENTS
The investment portfolios of the Company are managed by an Investment
Committee of the Board of Directors. The Company follows an investment policy
that is reviewed quarterly and revised periodically.
The investment portfolio serves primarily as the funding source for loss
reserves and secondly as a source of income and appreciation. For these reasons,
RLI's primary investment criteria are quality and liquidity, followed by yield
and potential for appreciation. Investments of the highest quality and
marketability are critical for preserving the Company's claims paying ability.
Virtually all of RLI's fixed income investments are U.S. Government or AA-rated
or better taxable and tax- exempt securities. Common stock investments are
limited to securities listed on national exchanges and by the Securities
Valuation Office of the National Association of Insurance Commissioners.
During 1998, operating cash flows were used to acquire fixed income
instruments composed primarily of intermediate-term municipal and U.S.
Government and Agency securities. Additionally, a smaller portion of funds was
allocated to the equity portfolio and an investment grade convertible debenture
portfolio designed to provide diversification and yield enhancement to the
portfolio.
RLI's mix of fixed income securities continues to be biased toward U.S.
Government and Agency securities due to their high liquidity and almost
risk-free nature. The mix of tax-exempt and taxable instruments within the
portfolios is decided at the time of purchase on the basis of available
after-tax returns and overall taxability of all invested assets. Almost all
securities reviewed for purchase are either high grade municipal or U.S.
Government or Agency, debt instruments. As part of its investment philosophy,
the Company attempts to avoid exposure to default risk by holding, almost
exclusively, instruments ranked in the top two grades of investment security
quality by Standard & Poor's and Moody's (i.e. AAA and AA). As of December 31,
1998, 96% of the fixed income portfolio was rated AA or better. Interest rate
risk is limited by restricting and managing acceptable call provisions among new
security purchases.
15
<PAGE>
The municipal bond component of the fixed maturity portfolio increased
$28.2 million, to $172.1 million; and comprised 52.3% of the Company's total
fixed maturity portfolio, up 9.2% from year- end 1997. The taxable U.S.
Government and Agency portion of the fixed income portfolio declined by $34.3
million to $143.7 million, or 43.7% of the total versus 53.3% at year end 1997.
Investment grade corporate securities totaled $4.2 million compared to $5.0
million at year- end 1997, while convertible debenture securities totaled $8.9
million, an increase over last year's $6.5 million.
The Company follows a program of matching assets to anticipated liabilities
to ensure its ability to hold securities until maturity. The Company's long-term
accounts payable and other liabilities are added to the estimate of its unpaid
losses and settlement expenses, broken out by line of business. These
anticipated liabilities are then factored against ultimate payout patterns and
the resulting payout streams are fully funded with the purchase of fixed-income
securities of like maturity. Management believes that both liquidity and
interest rate risk can best be minimized by such asset/liability matching.
Aggregate maturities for the fixed maturity securities are as follows:
<TABLE>
<CAPTION>
MATURITY PAR AMORTIZED FAIR CARRYING
YEAR VALUE VALUE VALUE VALUE
- ------- ------------- ------------- ------------- --------------
<S> <C> <C> <C> <C>
1999 $32,600,000 $32,684,341 $33,229,363 $32,786,941
2000 32,685,000 33,064,261 34,055,168 33,229,235
2001 22,250,000 22,850,114 23,547,318 22,930,970
2002 28,930,000 29,964,671 30,991,320 30,225,787
2003 34,740,000 34,889,536 35,911,948 34,904,449
2004 20,345,000 20,429,631 21,182,564 20,438,600
2005 29,090,000 29,244,928 30,640,999 29,362,843
2006 21,540,000 21,606,893 22,525,427 21,538,659
2007 16,650,000 16,769,639 17,309,025 16,640,301
2008 20,355,000 20,235,585 20,995,265 20,131,847
2009 21,635,000 21,465,486 22,652,738 21,465,486
2010 23,280,000 23,582,486 24,334,504 23,582,486
2011 6,865,000 6,846,070 7,050,834 6,908,160
2012 7,415,000 7,401,994 7,632,658 7,401,994
2013 7,105,000 6,882,043 6,936,197 6,894,863
2014 0 0 0 0
2015 0 0 0 0
2016 0 0 0 0
2017 750,000 416,574 413,438 413,438
2018 0 0 0 0
TOTAL $326,235,000 $328,334,252 $339,408,766 $328,856,059
------------ ------------- ------------- ---------------
------------ ------------- ------------- ---------------
</TABLE>
At December 31, 1998, the Company's equity securities were valued at $296.5
million, an increase of $45.1 million from the $251.4 million held at the end of
1997. During 1998, net common equity investments totaling $8.6 million were
purchased and pretax unrealized appreciation of common equity securities totaled
$36.0 million. Equity securities represented 43.8% of cash and invested assets
at the end of 1998, an increase from the 41.6% at year-end 1997. As of the
year-end, total equity investments held at the operating companies represented
88.2% of the combined statutory surplus of the insurance subsidiaries.
Combined cash and short-term investments totaling $51.9 million at year-end
1998 represented 7.7% of cash and invested assets versus 3.1% last year. The
Company's short-term investments consist of U.S. Government and Agency backed
money market funds and the highest rated commercial paper.
16
<PAGE>
Under generally accepted accounting principles, equity and fixed income
securities are carried at fair market value, except that a company that can
demonstrate its ability to hold fixed income securities until their originally
scheduled maturity is permitted to carry such securities at amortized cost. RLI
Corp. has chosen to carry most of its fixed income securities at amortized cost
as it believes it has constructed its fixed income portfolios to match expected
liability payouts and thus has the ability and intention to hold such securities
until their originally scheduled maturity dates. Consequently, fluctuations in
the market value of most bonds are not reflected in the financial statements and
do not affect shareholders' equity.
The Company's investment results are summarized in the following table:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------------------------
(Dollars in thousands) 1998 1997 1996 1995 1994
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Average invested
assets (1) $640,576 $570,901 $504,773 $442,717 $407,722
Investment
income (2)(3) 23,937 24,558 23,681 22,029 20,133
Realized gains
(losses) (3) 1,853 2,982 1,017 457 (3,595)
Change in unreal-
ized appreciation/
depreciation (3)(4) 36,183 55,760 25,033 36,037 (5,749)
Annualized return
on average
invested assets 9.7% 14.6% 9.9% 13.2% 2.7%
</TABLE>
(1) Average of amounts at beginning and end of each year.
(2) Investment income, net of investment expenses, including non-debt interest
expense.
(3) Before income taxes.
(4) Relates to available-for-sale fixed income and equity securities.
REGULATION
STATE REGULATION
As an insurance holding company, RLI Corp., as well as its insurance
subsidiaries, are subject to regulation by the states in which the insurance
subsidiaries are domiciled or transact business. Holding company registration in
each insurer's state of domicile requires reporting to the state regulatory
authority the financial, operations and management data of the insurers within
the holding company system. All transactions within a holding company system
affecting insurers must be fair, and the insurer's policyholder surplus
following any transaction must be both reasonable in relation to its outstanding
liabilities and adequate for its needs. Notice to regulators is required prior
to the consummation of certain transactions affecting insurance subsidiaries of
the holding company system.
Other regulations limit the amount of dividends and other distributions the
subsidiaries can pay without prior approval of the insurance department in the
states in which they are physically and/or commercially domiciled, and impose
restrictions on the amount and type of investments they may have. Regulations
designed to ensure financial solvency of insurers and to require fair and
adequate treatment and service for policyholders are enforced by filing,
reporting and examination requirements. Market oversight is conducted by
monitoring trade practices, approving policy forms, licensing of agents and
brokers, and requiring fair and equitable premiums and commission rates.
Financial solvency is monitored by minimum reserve and capital requirements,
periodic reporting procedures (annually, quarterly, or more frequently if
necessary), and periodic examinations.
17
<PAGE>
The quarterly and annual financial reports to the states utilize accounting
principles which are different than the generally accepted accounting principles
that show the business as a going concern. The statutory accounting principles
used by regulators, in keeping with the intent to assure policyholder
protection, are generally based on a liquidation concept. The National
Association of Insurance Commissioners (NAIC) has recently developed a codified
version of these statutory accounting principles, and its deployment in the
states in the near future will foster more consistency among the states for
accounting guidelines and reporting.
State regulatory authorities have relatively broad discretion with respect
to granting, renewing and revoking brokers' and agents' licenses to transact
business in the state. The manner of operating in particular states may vary
according to the licensing requirements of the particular state, which may,
among other things, require a firm to operate in the state through a
corporation. In a few states, licenses are issued only to individual residents
and locally-owned business entities. In such cases, the Company has arrangements
with residents or business entities licensed to act in the state.
COMMERCIAL LINES DEREGULATION -- The NAIC and several state legislatures
have taken up the issue of commercial lines deregulation in an attempt to
streamline specific areas of insurance regulation. A growing contingent in the
regulatory community has acknowledged that some regulatory procedures and
practices may be cumbersome and inappropriate for commercial buyers of
insurance. Specifically, the large, sophisticated, multi-state or multi-national
businesses that employ their own teams of risk managers to evaluate, reduce and
finance their loss exposures are less likely to need the form and rate
protections that regulators provide consumers and small to medium business
endeavors. And, while these large businesses may receive some benefit from the
state financial regulation of licensed insurers, it has long been acknowledged
that they do not need the protections addressed by the barriers to the surplus
lines market and other nontraditional markets. Indisputably, deregulation of the
licensed market will have an impact on the surplus lines insurance carriers,
which have been free from form and rate requirements.
USE OF CREDIT REPORTS IN UNDERWRITING -- Gains in access to electronic
commerce, and the means to gather information more rapidly, have spurred
regulators to take a second look at the use of consumer credit reports in
underwriting and rate making. In some states, regulators charged with protecting
insurance consumers from unfair trade practices, are concerned that some
consumers' risks may be underwritten based solely on their credit standing, and
have sought to strengthen their laws and regulations to address this. This trend
comes on the heels of Congress' re-tooling of the Fair Credit Reporting Act in
1997, which specifically addresses this issue, and permits the use of consumer
credit reports in underwriting. The issue of federal preemption of state action
in this arena has not been judicially addressed.
LEGISLATION AT FEDERAL LEVEL
Although the federal government generally does not directly regulate the
insurance business, federal initiatives often have an impact on the business in
a variety of ways. Current and proposed federal measures which may significantly
affect the insurance business include federal preemption of state auto liability
laws, tax reform measures, and Year 2000 legislation. The Company is also
monitoring the following federal proposals:
NATURAL DISASTER ACT--Recent natural disasters including Hurricane Georges,
continue to fuel concern regarding the best way to provide affordable insurance
coverage for such events. Congress has yet to pass legislation, but proposals to
set up a system for excess federal reinsurance to provide relief to the industry
continue to be discussed. Two Initiatives, "The Natural Disaster Protection and
Insurance Act of 1997" (H.R. 230), and "The Homeowners Insurance Availability
Act of 1997" (H.R. 219), have been the primary tools for discussion and debate.
The Company will continue to monitor the progress of this issue.
18
<PAGE>
FINANCIAL SERVICES MODERNIZATION -- Both judicial decisions and action by
the Office of the Comptroller of the Currency (OCC) have combined to grant
national banks more authority to enter non-banking business, including
insurance. The Barnett Bank decision, which permits the Comptroller of the
Currency to preempt any state law which "significantly interferes" with a bank's
ability to sell insurance products, has spawned the "Financial Services
Competition Act of 1997" (H.R. 10), (also known as "Financial Services
Modernization Legislation"). This Act, designed to shrink the powers of the OCC,
has been the subject of various revisions that would result in both positive and
negative effects on the insurance industry. The bill also contains a provision
that would create a National Association of Registered Agents and Brokers, which
would permit insurance producers to obtain a national license, rather than a
number of state licenses. Obviously, this legislation could have an important
impact on many aspects of the insurance industry; the Company continues to
monitor its progress.
NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS
The National Association of Insurance Commissioners (NAIC) facilitates the
regulation of multi-state companies through uniform reporting requirements,
standardized procedures for financial examinations, and uniform regulatory
procedures embodied in model acts and regulations. Current developments address
the reporting and regulation of the adequacy of capital and surplus.
The NAIC has developed Property-Casualty Risk-Based Capital (RBC) standards
that relate an insurer's reported statutory surplus to the risks inherent in its
overall operations. The RBC formula uses the statutory annual statement to
calculate the minimum indicated capital level to support asset (investment and
credit) risk and underwriting (loss reserves, premiums written, and unearned
premium) risk. The NAIC model law calls for various levels of regulatory action
based on the magnitude of an indicated RBC capital deficiency, if any. The
Company continues to monitor its subsidiaries' internal capital requirements and
the NAIC's RBC developments. The Company has determined that its subsidiaries'
capital levels are well in excess of the minimum capital requirements for all
RBC action levels. Management believes that its capital levels are sufficient to
support the level of risk inherent in its operations.
CORPORATE COMPLIANCE
The Company has developed a Code of Conduct and Compliance Manual which
provides employees with guidance on complying with a variety of federal and
state laws.
AGENCY LICENSES AND TRADEMARKS
Replacement Lens Inc. or its designated employees, must be licensed to act
as resident or non-resident producers by regulatory authorities in the states in
which it operates.
RLI Insurance Company obtained service mark registration of the letters
"RLI" in 1998 in the U.S. Patent and Trademark Office. Such registration
protects the mark nationwide from deceptively similar use by the Company's
competitors. The duration of this registration is ten years unless renewed.
CLIENTELE
No significant part of the Company's or its subsidiaries' business is
dependent upon a single client or upon a very few clients, the loss of any one
of which would have a material adverse effect on the Company.
19
<PAGE>
EMPLOYEES
The Company employs a total of 405 associates. Of the 405 total associates,
47 are part-time and 358 are full-time.
(d) Financial Information about Foreign and Domestic Operations and Export
Sales.
For purposes of this discussion, foreign operations are not considered
material to the Company's overall operations.
Item 2. PROPERTIES
The Company owns a two-story, 80,000 square foot building in Peoria,
Illinois, which serves as the Corporate Headquarters for RLI Corp., RLI
Insurance Company and Mt. Hawley Insurance Company. Two RLI Insurance Company
Branch Offices also lease office space in this building.
Located on the same 15.0 acre campus is a 12,800 square foot building.
Nearly 9,800 square feet of this building are used as warehouse storage for
records and equipment. The remaining 3,000 square feet are used as office space.
Additionally, the Company owns two other buildings located near the
headquarter building. One, a 19,000 square foot building, is leased to Maui
Jim, Inc. and is used as their headquarters. The other, a 20,000 square foot
building, was purchased in December of 1996. Currently used for warehousing
and record storage, this building will provide space for future office
expansion.
All other operations of RLI Corp. lease the office space which they need in
various locations throughout the country.
Item 3. LEGAL PROCEEDINGS
The Company is involved in certain legal proceedings and disputes
considered by management to be ordinary and incidental to the business or which
have no foundation in fact. Management believes that valid defenses exist as to
all such litigation and disputes, and is of the opinion that these will not have
a material effect on the Company's consolidated financial statements.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted by the Company to a vote of security holders
during the fourth quarter of the fiscal year covered by this report.
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Refer to the Corporate Data on page 52 of the Annual Report to Shareholders
for the year ended December 31, 1998 attached in Exhibit 13.
Item 6. SELECTED FINANCIAL DATA
Refer to the Selected Financial Data on pages 52 through 53 of the Annual
Report to Shareholders for the year ended December 31, 1998 attached in Exhibit
13.
20
<PAGE>
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Refer to the Management's Discussion and Analysis of Financial Condition
and Results of Operations on pages 16 through 28 of the Annual Report to
Shareholders for the year ended December 31, 1998 attached in Exhibit 13.
Item 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Refer to the Management's Discussion and Analysis of Financial Condition
and Results of Operations on pages 16 through 28 of the Annual Report to
Shareholders for the year ended December 31, 1998 attached in Exhibit 13.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Refer to the consolidated financial statements and supplementary data
included on pages 29 through 48 of the Annual Report to Shareholders for the
year ended December 31, 1998 attached in Exhibit 13. (See Index to Financial
Statements and Schedules attached on page 24.)
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There were no changes in accountants or disagreements with accountants on
any matters of accounting principles or practices or financial statement
disclosure.
PART III
Items 10 to 13.
Pursuant to General Instructions G(3) of Form 10-K, Items 10 to 13,
inclusive, have not been restated or answered since the Company intends to file
within 120 days after the close of its fiscal year with the Securities and
Exchange Commission a definitive proxy statement pursuant to Regulation 14A
under the Securities Exchange Act of 1934, which proxy statement involves the
election of directors. The information required in these items 10 to 13,
inclusive, is incorporated by reference to that proxy statement.
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (l-2) Consolidated Financial Statements and Schedules. See Index to
Financial Statements and Schedules attached.
(3) Exhibits. See Exhibit Index on pages 34-35.
(b) No reports on Form 8-K were filed during the last quarter of 1998.
(c) Exhibits. See Exhibit Index on pages 34-35.
(d) Financial Statement Schedules. The schedules included on attached pages 24
through 32 as required by Regulation S-X are excluded from the Company's
Annual Report to Shareholders. See Index to Financial Statements and
Schedules on page 24. There is no other financial information required by
Regulation S-X which is excluded from the Company's Annual Report to
Shareholders.
21
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
(Registrant)
By: /s/Joseph E. Dondanville
-----------------------------------------------
J. E. Dondanville
Vice President, Chief Financial Officer
(Principal Financial and Accounting Officer)
Date: MARCH 3, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
By: /s/Gerald D. Stephens
-----------------------------------------------
G. D. Stephens, President
(Principal Executive Officer)
Date: March 3, 1999
---------------------------------------------
* * * * *
By: /s/Joseph E. Dondanville
-----------------------------------------------
J. E. Dondanville, Vice President,
Chief Financial Officer
(Principal Financial and Accounting Officer)
Date: March 3, 1999
---------------------------------------------
* * * * *
By: /s/Gerald D. Stephens
-----------------------------------------------
G. D. Stephens, Director
Date: March 3, 1999
---------------------------------------------
* * * * *
By: /s/ Bernard J. Daenzer
-----------------------------------------------
B. J. Daenzer, Director
Date: March 3, 1999
---------------------------------------------
* * * * *
By: /s/Richard J. Haayen
-----------------------------------------------
R. J. Haayen, Director
Date: March 3, 1999
---------------------------------------------
* * * * *
By: /s/William R. Keane
-----------------------------------------------
W. R. Keane, Director
Date: March 3, 1999
---------------------------------------------
* * * * *
22
<PAGE>
By: /s/Gerald I. Lenrow
-----------------------------------------------
G. I. Lenrow, Director
Date: MARCH 3, 1999
---------------------------------------------
* * * * *
By: /s/Jonathan E. Michael
-----------------------------------------------
J.E. Michael, Director
Date: MARCH 3, 1999
---------------------------------------------
* * * * *
By: /s/Edwin S. Overman
-----------------------------------------------
E. S. Overman, Director
Date: March 3, 1999
---------------------------------------------
* * * * *
By: /s/Edward F. Sutkowski
-----------------------------------------------
E. F. Sutkowski, Director
Date: March 3, 1999
---------------------------------------------
* * * * *
By: /s/Robert O. Viets
-----------------------------------------------
R. O. Viets, Director
Date: March 3, 1999
---------------------------------------------
* * * * *
23
<PAGE>
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
<TABLE>
<CAPTION>
Reference (Page)
<S> <C>
DATA SUBMITTED HEREWITH:
Report of Independent Auditors 25
Schedules:
I. Summary of Investments - Other than Investments in Related Parties
at December 31, 1998. 26
II. Condensed Financial Information of Registrant for the three years
ended December 31, 1998. 27 - 29
III. Supplementary Insurance Information for the three years ended
December 31, 1998. 30 - 31
IV. Reinsurance for the three years ended December 31, 1998. 32
V. Valuation and Qualifying Accounts 33
</TABLE>
Schedules other than those listed are omitted for the reason that they are not
required, are not applicable or that equivalent information has been included in
the financial statements, and notes thereto, or elsewhere herein.
24
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders
RLI Corp.:
Under date of January 14, 1999, we reported on the consolidated balance sheets
of RLI Corp. and subsidiaries as of December 31, 1998 and 1997, and the related
consolidated statements of earnings and comprehensive earnings, shareholders'
equity, and cash flows for each of the years in the three-year period ended
December 31, 1998, as contained in the 1998 annual report to shareholders. These
consolidated financial statements and our report thereon are incorporated by
reference in the annual report on Form 10-K for the year 1998. In connection
with our audits of the aforementioned consolidated financial statements, we also
have audited the related financial statement schedules as listed in the
accompanying index. These financial statement schedules are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statement schedules based on our audits.
In our opinion, the financial statement schedules, when considered in relation
to the basic consolidated financial statements taken as a whole, present fairly,
in all material respects, the information set forth therein.
KPMG LLP
Chicago, Illinois
January 14, 1999
25
<PAGE>
RLI CORP. AND SUBSIDIARIES
SCHEDULE I--SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS
IN RELATED PARTIES
DECEMBER 31, 1998
<TABLE>
<CAPTION>
Column A Column B Column C Column D
Amount
at Which
Shown in
Fair the Balance
Type of Investment Cost(1) Value Sheet
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Fixed maturities:
Bonds:
Held-to-maturity
United States government and government agencies
and authorities $124,418,833 $128,814,165 $124,418,833
States, political subdivisions, and revenues 159,572,691 165,730,065 159,572,691
- ------------------------------------------------------------------------------------------------------------------------------------
Total held-to-maturity 283,991,524 294,544,230 283,991,524
- ------------------------------------------------------------------------------------------------------------------------------------
Trading
U.S. governments 3,652,869 3,726,006 3,726,006
Foreign governments 0 0 0
Corporate 4,102,579 4,215,737 4,215,737
States, political subdivisions & revenues 401,934 406,398 406,398
- ------------------------------------------------------------------------------------------------------------------------------------
Total trading 8,157,382 8,348,141 8,348,141
- ------------------------------------------------------------------------------------------------------------------------------------
Available-for-sale
U.S. governments 15,177,280 15,527,980 15,527,980
Corporates 9,149,952 8,892,633 8,892,633
States, political subdivisions, and revenues 11,858,113 12,095,780 12,095,780
- ------------------------------------------------------------------------------------------------------------------------------------
Total available-for-sale 36,185,345 36,516,393 36,516,393
- ------------------------------------------------------------------------------------------------------------------------------------
Total fixed maturities 328,334,251 339,408,764 328,856,058
- ------------------------------------------------------------------------------------------------------------------------------------
Equity securities, available-for-sale:
Common stock:
Public utilities 41,687,469 80,064,940 80,064,940
Banks, trusts and insurance companies 11,957,163 36,701,934 36,701,934
Industrial, miscellaneous and all other 73,563,360 179,260,083 179,260,083
Preferred stock 159,495 493,412 493,412
- ------------------------------------------------------------------------------------------------------------------------------------
Total equity securities 127,367,487 296,520,369 296,520,369
- ------------------------------------------------------------------------------------------------------------------------------------
Short-term investments 51,917,333 51,917,333 51,917,333
- ------------------------------------------------------------------------------------------------------------------------------------
Total investments $507,619,071 $687,846,466 $677,293,760
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
Note: See notes 1D and 2 of Notes to Consolidated Financial Statements, as
attached in Exhibit 13.
(1) Original cost of equity securities and, as to fixed maturities, original
cost reduced by repayments and adjusted for amortization of premiums or accrual
of discounts.
26
<PAGE>
RLI CORP. AND SUBSIDIARIES
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY)
CONDENSED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
<TABLE>
<CAPTION>
1998 1997
- -----------------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
Cash $ 258,436 $ 135,663
Investments in subsidiaries/investees, at equity 304,713,805 264,146,254
Equity securities available-for-sale, at fair value
(Cost--$6,528,441 in 1998 and $6,677,285 in 1997) 13,823,699 12,288,528
Investment in Rabbi Trust 6,432,355
Property and equipment 998,780 1,045,298
Other assets 736,815 418,040
- -----------------------------------------------------------------------------------------------------------
Total assets $320,531,535 $284,466,138
- -----------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Accounts payable, current $ 4,249,318 $ 1,996,859
Notes payable, short-term 19,575,000 7,500,000
Deferred compensation--Rabbi Trust 6,432,355
Income taxes payable--current 465,203 332,621
Income taxes payable--deferred 2,229,622 1,523,663
Other liabilities 53,738 128,200
- -----------------------------------------------------------------------------------------------------------
Total liabilities 26,572,881 17,913,698
- -----------------------------------------------------------------------------------------------------------
Shareholders' equity:
Common stock ($1 par value, authorized 50,000,000 shares,
issued 12,790,428 shares in 1998 and 10,229,673 shares in 1997) 12,790,428 10,229,673
Paid in Capital 71,092,631 74,587,595
Accumulated other comprehensive earnings net of tax 110,371,461 86,852,663
Retained earnings 163,324,161 140,431,791
Deferred compensation 3,460,606
Unearned ESOP shares (2,500,999)
Treasury shares at cost (2,384,736 shares in 1998
and 1,994,272 shares in 1997) (64,579,634) (45,549,282)
- -----------------------------------------------------------------------------------------------------------
Total shareholders' equity 293,958,654 266,552,440
- -----------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $320,531,535 $284,466,138
- -----------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------
</TABLE>
See Notes to Consolidated Financial Statements, as attached in Exhibit 13.
27
<PAGE>
RLI CORP. AND SUBSIDIARIES
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY)--(CONTINUED)
CONDENSED STATEMENTS OF EARNINGS AND COMPREHENSIVE EARNINGS
YEARS ENDED DECEMBER 31,
<TABLE>
<CAPTION>
1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Net investment income $ 453,843 $ 454,906 $ 164,181
Selling, general, and administrative expenses (3,914,954) (4,118,010) (3,559,113)
Interest expense on debt (1,122,358) (1,547,542) (2,808,470)
- -----------------------------------------------------------------------------------------------------------------------------
(4,583,469) (5,210,646) (6,203,402)
Income tax benefit (1,383,099) (1,675,135) (2,186,013)
- -----------------------------------------------------------------------------------------------------------------------------
Net loss before equity
in net earnings of subsidiaries (3,200,370) (3,535,511) (4,017,389)
Equity in net earnings of subsidiaries/investees 31,438,961 33,706,994 29,713,110
- -----------------------------------------------------------------------------------------------------------------------------
Net earnings $28,238,591 $30,171,483 $25,695,721
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
Other Comprehensive Earnings, net of tax
Unrealized gains on securities:
Unrealized holding gains arising
during the period $ 1,217,174 $ 1,859,712 $901,569
Less: Reclassification adjustment for
(gains) losses included in
Net Earnings (122,659) (81,383) 10,846
- -----------------------------------------------------------------------------------------------------------------------------
Other Comprehensive Earnings--parent only 1,094,515 1,778,329 912,415
Equity in Other Comprehensive
Earnings of Subsidiaries/Investees 22,424,283 4,465,638 15,361,757
- -----------------------------------------------------------------------------------------------------------------------------
Other Comprehensive Earnings 23,518,798 36,243,967 16,274,172
- -----------------------------------------------------------------------------------------------------------------------------
Comprehensive Earnings $ 51,797,389 $66,415,450 $41,969,893
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
See Notes to Consolidated Financial Statements, as attached in Exhibit 13
28
<PAGE>
RLI CORP. AND SUBSIDIARIES
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY)--(CONTINUED)
CONDENSED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,
<TABLE>
<CAPTION>
1998 1997
1996
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Cash Flows from Operating Activities
Losses before equity in net earnings of subsidiaries/investees $(3,200,370) $(3,535,511) $(4,017,389)
Adjustments to reconcile net losses to net cash provided by operating
activities:
Other items, net (576,103) (1,792,215) (55,262)
Change in:
Affiliate balances payable 2,187,132 451,029 (207,668)
Interest Payable (1,265,000)
Federal income taxes 97,641 140,485 437,303
Deferred debt costs 805,701 123,164
- -----------------------------------------------------------------------------------------------------------------------------------
Net cash used in operating activities (1,491,700) (5,195,511) (3,719,852)
- -----------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchase of:
Equity securities, available-for-sale (31,122) (135,001) (387,395)
Property and equipment (37,210)
Unconsolidated investee ownership interest (88,750) (3,694,118)
Sale of:
Equity securities, available-for-sale 368,672 383,838 236,986
Cash dividends received-subsidiaries/investees 13,384,443 16,998,248 21,125,783
- -----------------------------------------------------------------------------------------------------------------------------------
Net cash provided by investing activities 13,633,243 13,515,757 20,975,374
- -----------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Proceeds from issuance of debt 12,075,000 7,500,000
Payments on debt (2,800,000)
Fractional share paid (16,099) (1,211)
CatEPut Payment (1,212,500)
Shares issued under stock option plan 60,638 161,356
Unearned ESOP shares (2,500,999)
Treasury shares purchased (14,858,394) (20,738,547) (3,040,671)
Treasury shares reissued 2,207,526
Cash dividends paid (5,566,416) (4,704,015) (4,261,445)
- -----------------------------------------------------------------------------------------------------------------------------------
Net cash used in financing activities (12,018,770) (17,782,417) (7,894,590)
- -----------------------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash 122,773 (9,462,171) 9,360,932
Cash at beginning of year 135,663 9,597,834 236,902
- -----------------------------------------------------------------------------------------------------------------------------------
Cash at end of year $258,436 $135,663 $ 9,597,834
- -----------------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
Interest paid on outstanding debt for 1998, 1997, and 1996 amounted to
$2,327,113, $2,809,903, and $2,834,192, respectively.
See Notes to Consolidated Financial Statements, as attached in Exhibit 13.
29
<PAGE>
RLI CORP. AND SUBSIDIARIES
SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
SCHEDULE VI--SUPPLEMENTARY INFORMATION CONCERNING
PROPERTY-CASUALTY INSURANCE OPERATIONS
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
<TABLE>
<CAPTION>
Column A Column B Column C (1) Column E (1) Column F Column H
Incurred
Deferred Unpaid Losses and
policy losses and settlement
acquisition settlement Unearned Premiums expenses
Segment costs expenses, net premiums, net earned Current year
- -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Year ended
December 31, 1998
Property segment $8,783,705 $29,634,175 $34,977,862 $52,281,163 $12,050,748
Surety segment 5,263,476 5,397,144 8,944,616 18,307,259 4,198,692
Casualty segment 8,462,960 212,230,257 38,320,680 71,735,513 51,882,019
RLI Insurance Group $ 22,510,141 $247,261,576 $ 82,243,158 $142,323,935 $ 68,131,459
- -----------------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------------
Year ended
December 31, 1997
Property segment $10,484,486 35,794,786 41,230,427 62,028,216 $11,998,750
Surety segment 4,818,957 2,214,233 8,119,275 11,491,172 2,507,153
Casualty segment 6,681,142 210,543,568 29,516,110 68,365,057 47,265,353
RLI Insurance Group $ 21,984,585 $248,552,587 $ 78,865,812 $141,884,445 $61,771,256
- -----------------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------------
Year ended
December 31, 1996
Property segment $ 6,182,136 44,045,187 37,776,691 48,181,678 $11,030,823
Surety segment 3,421,403 1,715,328 5,483,068 4,406,633 1,195,897
Casualty segment 7,060,064 202,045,556 32,816,802 78,067,784 57,498,010
RLI Insurance Group $ 16,663,603 $247,806,071 $ 76,076,561 $130,656,095 $69,724,730
- -----------------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
NOTE 1: Investment income is not allocated to the segments, therefore net
investment income (column G) has not been provided.
30
<PAGE>
RLI CORP. AND SUBSIDIARIES
SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
SCHEDULE VI--SUPPLEMENTARY INFORMATION CONCERNING
PROPERTY-CASUALTY INSURANCE OPERATIONS
(CONTINUED)
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
<TABLE>
<CAPTION>
Column A Column H Column I Column J Column K
Incurred
Losses and
settlement Policy Other Net
expenses acquisition operating Premiums
Segment Prior year costs expenses written
- -----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Year ended
December 31, 1998
Property segment $ (300,799) $14,394,458 $6,335,787 $46,029,088
Surety segment 2,430,308 10,990,793 1,406,353 19,133,037
Casualty segment (5,532,667) 18,895,582 8,783,745 80,539,155
RLI Insurance Group $ (3,403,158) $44,280,833 $16,525,885 $145,701,280
- -----------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------
Year ended
December 31, 1997
Property segment $ (95,228) $20,366,636 $8,347,252 $65,482,315
Surety segment (19,898) 7,304,618 1,173,349 14,127,068
Casualty segment (404,696) 15,469,127 9,220,776 65,064,313
RLI Insurance Group $ (519,822) $43,140,381 $18,741,377 $144,673,696
- -----------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------
Year ended
December 31, 1996
Property segment $ (226,883) $11,442,412 $ 7,104,879 $ 48,809,514
Surety segment (24,597) 3,028,034 613,023 4,463,383
Casualty segment (1,211,943) 15,085,944 8,723,430 79,084,743
RLI Insurance Group $(1,463,423) $29,556,390 $16,441,332 $132,357,640
- -----------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------
</TABLE>
31
<PAGE>
RLI CORP. AND SUBSIDIARIES
SCHEDULE IV--REINSURANCE
FOR THE YEARS ENDED 1998, 1997, AND 1996
<TABLE>
<CAPTION>
Column A Column B Column C Column D Column E Column F
Percentage
Ceded to Assumed of Amount
Direct Other From Other Net Assumed to
Amount Companies Companies Amount Net
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
1998
Property $115,926,412 $ 65,712,932 $2,067,683 $ 52,281,163 3.95%
Surety 29,149,915 11,157,925 315,269 18,307,259 1.72%
Casualty 129,919,370 58,398,009 214,152 71,735,513 .30%
RLI Insurance Group
premiums earned $274,995,697 $135,268,866 $2,597,104 $142,323,935 1.82%
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
1997
Property $132,599,094 $ 81,810,126 $11,239,248 $ 62,028,216 18.12%
Surety 20,311,217 9,079,051 259,006 11,491,172 2.25%
Casualty 115,658,960 47,308,406 14,503 68,365,057 .02%
RLI Insurance Group
premiums earned $268,569,271 $138,197,583 $11,512,757 $141,884,445 8.11%
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
1996
Property $135,260,684 $87,079,006 0 48,181,678 0%
Surety 6,222,892 1,857,187 40,928 4,406,633 .93%
Casualty 130,068,132 51,992,133 (8,215) 78,067,784 (.01)%
RLI Insurance Group
premiums earned $271,551,708 $140,928,326 $ 32,713 $130,656,095 .02%
- -----------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
NOTES: Column B, "Gross Amount" includes only direct premiums earned.
32
<PAGE>
RLI CORP. AND SUBSIDIARIES
SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
Column A Column B Column C Column D Column E
Balance at Amounts Amounts Balance
beginning of charged to recovered Amounts at end
period expense (written-off) commuted of period
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
1998 Allowance for
insolvent reinsurers $17,057,194 -- $(574,934) $(6,839,313) $9,642,947
1997 Allowance for
insolvent reinsurers $16,897,798 -- $ 159,396 -- $17,057,194
1996 Allowance for
insolvent reinsurers $16,336,146 $1,006,140 $ (444,488) -- $16,897,798
</TABLE>
33
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT REFERENCE (PAGE)
- ----------- ----------------------- ----------------
<S> <C> <C>
2.1 Plan of Reorganization and Agreement Incorporated by reference to the Company's
of Merger Quarterly Form 10-Q for the First
Quarter ended March 31, 1993.
2.2 Articles of Merger Incorporated by reference to the Company's
Quarterly Form 10-Q for the Second Quarter
ended June 30, 1993.
3.1 Articles of incorporation Incorporated by reference to the Company's
Quarterly Form 10-Q for the Second Quarter
ended June 30, 1997.
3.2 By-Laws Incorporated by reference to the Company's
Quarterly Form 10-Q for the Second Quarter
ended June 30, 1997.
4.1 Indenture dated July 28, 1993 between Incorporated by reference to the Company's
the Company and Norwest Bank Registration Statement on Form S-3 filed on July
Minnesota, National Association as 21, 1993
Trustee
10.1 Market Value Potential Plan Incorporated by reference to the Company's
Quarterly Form 10-Q for the Second Quarter
ended June 30, 1997.
10.2 RLI Corp. Director Deferred Incorporated by reference to the Company's
Compensation Plan Registration Statement on Form 10-Q for the
Second Quarter ended June 30, 1993.
10.3 The RLI Corp. Directors' Irrevocable Incorporated by reference to the Company's
Trust Agreement Registation Statement on Form 10-Q for the
Second Quarter ended June 30, 1993.
10.4 Key Employee Excess Benefit Plan Incorporated by reference to the Company's
Annual Form 10-K/A for the year ended
December 31, 1992.
10.5 RLI Corp. Incentive Stock Incorporated by reference to Company's
Option Plan Registration Statement on Form S-8 filed on
March 11, 1996, File No. 333-01637
10.6 Directors' Stock Option Plan Incorporated by reference to the Company's
Registration Statement on Form S-8
filed on June 6, 1997,
File No. 333-28625.
10.7 RLI Corp. Executive Deferred Attached Exhibit 10.
Compensation Agreement
10.9 Reinsurance Agreements between the Incorporated by reference to the Company's
Company and American Re-Insurance Annual Form 10-K/A for the year ended
Company December 31, 1992.
</TABLE>
34
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT REFERENCE (PAGE)
- ----------- ----------------------- ----------------
<S> <C> <C>
10.10 Reinsurance Agreements between the Incorporated by reference to the Company's
Company and Lloyd's of London Annual Form 10-K/A
for the year ended December 31, 1992.
10.11 Reinsurance Agreements between the Incorporated by reference to the Company's
Company and NAC Reinsurance Corp. Annual Form 10-K/A
for the year ended December 31, 1992.
11.0 Statement re computation of per Refer to the Notes to Consolidated Financial
share earnings Statements--Note 1K
"Earnings per share", on page 35 of the
Annual Report to Shareholders attached in Exhibit 13.
13.1 Refer to the Annual Report to Share- Attached Exhibit 13.
holders for the year ended
December 31, 1998, pages 20-49 and 53.
21.1 Subsidiaries of the Registrant Attached page 36.
23.1 Consent of KPMG LLP Attached page 47.
23.2 Consent of Kirkland & Ellis Incorporated by reference to the Company's
Registration Statement on Form S-3 filed
July 21, 1993.
24.1 Powers of Attorney Incorporated by reference to the Company's
Registration Statement on Form S-3 filed
on July 21, 1993.
27 Financial Data Schedule Attached Exhibit 27.
28.1 Information from reports furnished to Attached page 48.
state insurance regulatory authorities
</TABLE>
35
<PAGE>
Exhibit 10.7
RLI CORP. EXECUTIVE DEFERRED COMPENSATION AGREEMENT
THIS RLI CORP./EXECUTIVE DEFERRED COMPENSATION AGREEMENT is made in duplicate
at Peoria, Illinois, effective on the Execution Date by and between RLI and
the Executive.
I. RECITALS
A. BACKGROUND: THE CORPORATION
RLI is a holding company which, through its subsidiaries, is engaged in the
Business, is possessed of the Accounting Year and reports its income and
expense on the Accounting Basis.
B. MVP EXECUTIVE PLAN
The Executive is a participant under the Market Value Potential Executive
Incentive Plan ("MVP Plan") incident to which the Executive may defer all or
any part of the cash bonus ("MVP Bonus") otherwise distributable to the
Executive. The Parties wish to supplement the MVP Plan with this Agreement
which shall control the distribution of any MVP Bonus otherwise distributable
to the Executive.
C. EXEMPTION FROM THE EXECUTIVE
INCOME RETIREMENT SECURITY ACT
RLI has established the RLI Corp. Executive Deferred Compensation Irrevocable
Trust ("Trust") with an independent trustee ("Trustee") to which RLI may
periodically transfer shares of RLI and other assets designed to fund the
obligation of RLI to the Executive under this Agreement. Even though the Plan
Benefit may be satisfied from property transferred to the Trustee under the
Trust, this Agreement and the Plan Benefit are unfunded and are maintained
primarily for the purpose of providing deferred compensation for the Executive.
If this Agreement is subject to the provisions of Title I of the Employee
Retirement Income Security Act of 1974 ("ERISA"), then subject to the filing
of the statement described in ERISA Labor Reg. Section 2520.104-23, this
Agreement shall be exempt from the participation, vesting, benefit accrual,
funding and fiduciary provisions of ERISA.
II. AGREEMENTS
NOW, THEREFORE, the Parties agree as follows:
1. REMUNERATION: DIRECT
RLI shall pay upon demand all reasonable expenses incurred by the Executive
incident to the Business.
<PAGE>
Except as otherwise provided in the following sections, RLI shall pay the
Executive for services rendered as an employee of RLI or an Affiliate a base
salary ("Base Compensation") in an amount periodically determined to be
appropriate by the Parties, payable not less often than annually.
2. REMUNERATION: BASE COMPENSATION DEFERRED
2.1 AMOUNT OF AND LIMITATIONS ON DEFERRED COMPENSATION
Subject to the limitations and the satisfaction of the conditions expressed in
the following sections, the Executive may defer not to exceed one hundred
percent (100%) of the Executive's Base Compensation attributable to services to
be rendered in respect of the period beginning on the Execution Date.
2.1(a) CURRENT ACCOUNTING YEAR: DELIVERY AND IRREVOCABILITY
OF DEFERRED COMPENSATION DIRECTION
Any Deferred Compensation Direction with respect to the period beginning on the
Execution Date and ending on December 31, 1998, must be delivered to RLI prior
to the expiration of the thirty (30) day period beginning on the Execution Date
and shall be irrevocable.
2.1(b) SUBSEQUENT ACCOUNTING YEAR: DELIVERY AND
IRREVOCABILITY OF DEFERRED COMPENSATION
DIRECTION
Any Deferred Compensation Direction with respect to any Accounting Year
beginning on or after January 1, 1999, must be delivered to RLI prior to January
1 of the subject Accounting Year and shall be irrevocable effective December 31
of the preceding Accounting Year.
2.1(c) INVESTMENT OF BASE COMPENSATION DEFERRED
RLI shall transfer to the Trustee either cash or such number of shares of RLI as
shall be equal in value to the amount of the Base Compensation deferred not less
often than monthly and in any event within the thirty (30) day period beginning
on the close of the subject Accounting Year. RLI shall direct the Trustee to
purchase additional shares of RLI with any cash dividend. The value of each
share of RLI to be transferred shall be equal to the closing price of a share of
RLI as of the close of the last business day of the referent month.
3. REMUNERATION: MVP BONUS DEFERRED
3.1 AMOUNT OF AND LIMITATIONS ON DEFERRED COMPENSATION
Subject to the limitations and the satisfaction of the conditions expressed in
the following sections, the Executive may defer not to exceed one hundred
percent (100%) of the Executive's MVP Bonus to the extent not then
ascertainable, subject to forfeiture or attributable to services to be rendered
in respect of the period beginning on the Execution Date.
3.1(a) CURRENT ACCOUNTING YEAR: DELIVERY AND IRREVOCABILITY
OF DEFERRED COMPENSATION DIRECTION
Any Deferred Compensation Direction with respect to the period beginning on the
Execution Date and ending on December 31, 1998, must be delivered to RLI prior
to the expiration of the thirty (30) day period beginning on the Execution Date
and shall be irrevocable.
<PAGE>
3.1(b) SUBSEQUENT ACCOUNTING YEAR: DELIVERY AND
IRREVOCABILITY OF DEFERRED COMPENSATION
DIRECTION
Any Deferred Compensation Direction with respect to any Accounting Year
beginning on or after January 1, 1999, must be delivered to RLI prior to
January 1 of the subject Accounting Year and shall be irrevocable effective
December 31 of the preceding Accounting Year.
3.1(c) INVESTMENT OF MVP BONUS DEFERRED
RLI shall transfer to the Trustee either cash or such number of shares of RLI
as shall be equal in value to the amount of the MVP Bonus within the thirty
(30) day period beginning on the date the amount of the MVP Bonus is finally
determined. RLI shall direct the Trustee to purchase additional shares of RLI
with any cash dividend. The value of each share of RLI to be transferred
shall be equal to the closing price of a share of RLI as of the close of the
last business day of the referent month.
3. DISTRIBUTION OF PLAN BENEFIT
3.2(a) PLAN BENEFIT DISTRIBUTION COMMENCEMENT DATE
Except as otherwise provided in the following paragraphs, the Plan Benefit
shall commence to be distributed to the Executive not earlier than thirty
(30) days after a Distribution Event.
If the Executive is the subject of an Unforeseeable Emergency that is caused
by an event beyond the control of the Executive which Unforeseeable Emergency
would result in severe financial hardship to the Executive but for the
distribution of the Plan Benefit before the Distribution Event, then, subject
to the satisfaction of the conditions expressed in the following paragraph,
the Plan Benefit may be distributed to the Executive as, when and to the
extent specified by the Executive Resources Committee.
The Executive Resources Committee must approve the payment period in respect
of any distribution. No payment shall be made to the extent that a hardship
may be relieved (i) through reimbursement or compensation by insurance or
otherwise, (ii) by liquidation of the participant's assets, to the extent the
liquidation of such assets would not itself cause severe financial hardship,
or (iii) by cessation of deferrals under the Plan. No payment shall be made
in excess of the amount reasonably required to satisfy the Unforeseeable
Emergency determined with regard to any Federal or state income tax payable
with respect to any distribution.
3.2(b) DISTRIBUTION PERIOD
Except as otherwise provided in Section 3.2(a) Plan Benefit Distribution
Commencement Date with respect to an Unforeseeable Emergency and the
following paragraphs, the Plan Benefit shall be distributed in sixty (60)
substantially equal monthly installments.
If the Executive is the subject of a fraud, a theft, or an embezzlement from
or with respect to either RLI or an Affiliate, RLI may suspend, reduce or
otherwise alter any payment of the Executive's Plan Benefit in full or
partial satisfaction of any direct or indirect damage sustained or reasonably
foreseeable by RLI or any Affiliate with respect to any such act or omission.
If any dispute arising with respect to this paragraph shall not be resolved
by the Parties, such dispute shall be subject to arbitration in accordance
with the Federal Arbitration Act 9 U.S.C. Section 1, et seq. from a location
in the City of Peoria designated by the Parties.
Subject to the satisfaction of the conditions expressed in the following
sentences, the Executive Resources Committee may, in its sole and
unrestricted discretion, upon application of the Executive, or the
Executive's beneficiary, periodically alter or amend the period over which
the Plan Benefit shall be distributed. The Executive Resources Committee may
require the presentation of such evidence as the Executive Resources
Committee periodically determines to be appropriate. The decision of the
Executive Resources Committee or the decision of the Executive Resources
Committee not to review the application of the Executive or the Executive's
beneficiary, shall not be the subject of any review by the Executive.
<PAGE>
3.2(c) FORM OF DISTRIBUTION
The Plan Benefit shall be distributed in the form of RLI shares. Unless the
shares have been registered under the Act, are otherwise exempt from the
registration requirements of such Act, are the subject of a favorable no action
letter issued by the Securities and Exchange Commission, or are the subject of
an opinion of counsel acceptable to RLI to the effect that such shares are
exempt from the registration requirements of the Act, certificates representing
such shares shall contain a legend precluding the transfer of such shares except
in accordance with the provisions of Rule 144 of the Act.
3.2(d) BENEFICIARY
The Plan Benefit shall be distributed to the Executive and then to such
beneficiary as the Executive may periodically designate during the lifetime of
such beneficiary. If the Executive fails to designate a beneficiary or the
designated beneficiary dies before the Executive's Plan Benefit is fully
distributed, the undistributed balance shall be distributed to the Executive's
spouse, if living, and upon the death of the Executive's spouse, to the
Executive's then living descendants, per stirpes, and upon the death of the last
surviving descendant to the estate of the Executive.
4. CLAIM PROCEDURE
This Agreement shall be administered by the Executive Resources Committee.
4.1 FILING OF A CLAIM FOR A PLAN BENEFIT
The Executive may present a claim for any Plan Benefit in writing to the
Executive Resources Committee. The Executive Resources Committee shall
determine the validity of any claim. If all or any part of the claim is
denied, a written notice of the denial will be provided to the Executive not
later than sixty (60) days following the receipt or filing of such claim. The
notice of denial must be expressed in a manner calculated to be understood by
the Executive and include the following: (a) the specific reason or reasons
for denial; (b) a specific reference to the pertinent Plan provisions on
which the denial is based; (c) description of any additional material or
information necessary for the Executive to perfect the claim; (d) an
explanation of why such material or information is necessary; and, (e) an
explanation of this review procedure.
4.2 APPEAL
Within ninety (90) days of the receipt by the Executive of written notice of
denial, or such later time as will be deemed reasonable, taking into account
the nature of any Plan Benefit claimed and any other circumstance, or if the
claim has not been granted within a reasonable period of time, the Executive
may file for a full review of the denial of the claim, including a hearing if
deemed necessary by the Board of Directors of RLI. In connection with such
review, the Executive may inspect pertinent documents and may submit issues
and comments in writing.
<PAGE>
The Board of Directors of RLI will deliver to the Executive a written
decision on the review of the claim not later than sixty (60) days after the
receipt of the request for such review, except that if there are special
circumstances which require an extension of time for processing, the sixty
(60) day period will be extended to one hundred twenty (120) days. A decision
on review will be in writing and will include specific reasons for the
decision, written in a manner calculated to be understood by the Executive
and with specific references to the applicable provisions of this Agreement.
5. GENERAL CONDITIONS
5.1 ABSENCE OF FUNDING AND CREDITOR CLAIMS
Except as otherwise provided in the following sentence, this Agreement and
the Plan Benefit are unfunded, are subject to the claims of the general
creditors of RLI, may not be assigned, sold, anticipated, pledged or
otherwise transferred and shall not be subject to any claim of the Executive,
the Executive's spouse, their respective creditors, or their respective
successors or assigns. The foregoing sentence shall not relieve RLI of its
obligation to pay the Plan Benefit as, when and to the extent distributable
pursuant to this Agreement.
5.2 ADDITIONAL DOCUMENTS REQUIRED
Each Party shall execute, acknowledge and deliver such additional documents,
writings or assurances as the other may periodically require so as to give
full force and effect to the terms and provisions of this Agreement.
5.3 AMENDMENT AND TERMINATION
Subject to the limitation expressed in the following sentence, this Agreement
may be altered, amended or terminated by RLI upon the vote of its directors
other than the Executive. No alteration, amendment or termination of this
Agreement shall reduce any Plan Benefit existent prior to the date of any
such alteration, amendment or termination.
5.4 BINDING EFFECT
The terms and provisions of this Agreement shall be binding upon and shall
inure to the benefit of the Parties and their respective successors and
assigns.
5.5 CHOICE OF LAW
The laws of the State of Illinois shall govern the validity, interpretation
and administration of this Agreement.
5.6 COUNTERPARTS
This Agreement may be executed in any number of counterparts, each of which
shall be deemed an original and all of which shall constitute but one and the
same instrument.
5.7 INCAPACITATED BENEFICIARY
If any beneficiary is Incapacitated, the Trustee may distribute such
beneficiary's Plan Benefit to such beneficiary's parent, guardian,
conservator, or to any individual with whom such beneficiary is residing
without responsibility for its expenditure.
<PAGE>
5.8 INCORPORATION BY REFERENCE; SCHEDULES
The paragraphs under the heading "I. RECITALS:" and any Schedule referred to in
this Agreement are a part of this Agreement.
5.9 INTERPRETIVE GUIDELINES
The words and phrases set off by quotation marks in the GLOSSARY have the
meanings therein indicated. Any word or phrase which appears in this Agreement
in parenthesis, set off by quotation marks and capitalized has the meaning
denoted by its context. Whenever the words and phrases defined either in the
GLOSSARY or elsewhere in this Agreement are intended to have their defined
meanings, the first letter of such word or the first letters of all substantive
words in such phrase shall be capitalized. When the context permits, a word or
phrase used in the singular includes the plural, and when used in any gender,
its meaning also includes all genders. Captions of Sections are inserted as a
matter of convenience only and do not define, limit or extend the scope or
intent of this Agreement or any provision hereof.
5.10 NOTICES
Any notice, request, communication and demand hereunder shall be in writing and
shall be deemed to have been duly given if delivered in person or sent by
registered or certified mail, postage prepaid, to RLI at its principal place of
business, or to such other address as RLI shall periodically designate by
written notice, and in the case of the Executive, to the Executive's last known
principal place of residence or to such other address as the Executive shall
periodically designate by written notice.
5.11 RECEIPT AND RELEASE FOR PAYMENTS
Any payment to the Executive, any beneficiary or any guardian for either shall,
to the extent thereof, be in full satisfaction of any claim hereunder against
RLI. RLI may require the distributee, as a condition precedent to such payment,
to execute a receipt and release thereof in such form as shall be determined by
RLI.
5.12 WAIVER
The waiver by either Party of any breach of this Agreement, whether in a single
instance or repeatedly, shall not be construed as a waiver of rights under this
Agreement to terminate the same because of similar or additional breaches.
Further such waiver shall not in any manner be construed as a waiver by any
Party to strictly adhere to the terms and conditions of this Agreement, nor as a
waiver of any claim for damages or other remedy by reason of any such breach.
6. DISPUTE RESOLUTION
Any claim, due, demand or dispute arising out of or with respect to this
Agreement not otherwise resolved, shall be subject to arbitration in
accordance with the Federal Arbitration Act 9 U.S.C, Section 1, et seq. from
a location in the City of Peoria designated by RLI.
7. GLOSSARY
"Accounting Basis" means the accrual basis method of accounting.
"Accounting Year" means the twelve (12) consecutive month period beginning
January 1, which shall change as, when and to the extent the fiscal year of RLI
shall change.
<PAGE>
"Act" means the Securities Act of 1933, as periodically amended.
"Affiliate" of any particular Person means any other Person controlling,
controlled by or under common control with such particular Person, where
"control" means the possession, directly or indirectly, of the power to direct
the management and policies of a Person whether through the ownership of voting
securities, contract or otherwise.
"Base Compensation" is defined under Section 1 REMUNERATION: DIRECT.
"Business" means the underwriting of specialty property and casualty insurance,
and providing licensing services for agents and brokers.
"Business Organization" means a partnership, limited partnership, limited
liability company, estate, trust, or any other form of for-profit activity or
any combination of the foregoing.
"Capital Structure Change" means any stock dividend, stock split, reverse stock
split, or any other change in the number of outstanding RLI shares occasioned by
any reorganization, merger, consolidation, split-up, combination or exchange, or
any combination of the foregoing.
"Change in Control" means:
(a) any transfer, sale of substantially all of the shares or assets of
RLI, any exchange, reorganization, merger, recapitalization or other
capital adjustment, or any combination of the foregoing, incident to
which the shareholders before any such event shall own after such event
less than fifty-one percent (51%) of the issued and outstanding shares
of the surviving corporation, or less than fifty-one percent (51%) of
the capital or profits interest of any surviving Business Organization;
or
(b) any transaction or series of transactions after which a majority of
the board of directors of the surviving corporation or a majority of
the voting members of the surviving Business Organization may be
elected or appointed without the consent of the Executive or any
combination of the foregoing.
"Deferred Compensation Direction" means an instrument executed by the Executive
specifying
(a) the amount, expressed in either a fixed dollar amount or a percentage, of
the Base Compensation which the Executive elects to defer; (b) the amount,
expressed in either a fixed dollar amount or a percentage, of the MVP Bonus
which the Executive elects to defer; and (c) any other information as RLI may
periodically request.
"Disability" means the inability of the Executive, by reason of accident or
mental or physical illness reasonably expected to be of indefinite duration, to
continue to provide the services expressed in this Agreement as conclusively
determined by RLI.
"Distribution Event" means (a) the death of the Executive, (b) the Disability of
the Executive, (c) the termination of the Executive's employment with either RLI
or an Affiliate, or (d) a Change in Control.
"ERISA" is defined under I. RECITALS: C. EXEMPTION FROM THE EXECUTIVE INCOME
RETIREMENT SECURITY ACT.
"Execution Date" means the date upon which this Agreement is signed by the last
Party to sign this Agreement.
"Executive" means the undersigned.
"Executive Resources Committee" means a committee of the members of the Board of
Directors of RLI other than the Executive.
<PAGE>
"MVP Bonus" is defined under I. RECITALS: B. MVP EXECUTIVE PLAN.
"MVP Plan" is defined under I. RECITALS: B. MVP EXECUTIVE PLAN.
"Parties" means RLI and the Executive.
"Person" means any individual, partnership, corporation, unincorporated
organization, limited liability company, a government or any department or
agency thereof, or any combination of the foregoing.
"Plan Benefit" means the sum of (a) such number of shares of RLI transferred to
the Trustee pursuant to the Executive's Deferred Compensation Direction,
equitably adjusted for any Capital Structure Change; (b) any uninvested
dividends; and (c) any cash or cash equivalents.
"RLI" means RLI Corp.
"Securities Act" means any provision of Section 10(b) of the Securities
Exchange Act of 1934, as periodically amended.
"Trust" is defined under I. RECITALS: C. EXEMPTION FROM THE EXECUTIVE INCOME
RETIREMENT SECURITY ACT.
"Trustee" is defined under I. RECITALS: C. EXEMPTION FROM THE EXECUTIVE
INCOME RETIREMENT SECURITY ACT.
"Unforeseeable Emergency" means severe financial hardship to the Executive
resulting from a sudden illness or accident of the Executive or of a dependent
of the Executive, loss of the Executive's property due to a casualty, or other
similar extraordinary or unforeseeable circumstance arising as a result of
events beyond the control of a participant.
[The balance of this page is intentionally left blank. The next page begins
with Section III. EXECUTION:.]
<PAGE>
III. EXECUTION
Dated at Peoria, Illinois as of the day and year noted above, on the Execution
Date noted below.
RLI: Executive:
RLI Corp. _______________________________
By:___________________________
Its:_____________________ Dated:_________________________
Dated:________________________
---------------------------------------------
<PAGE>
DEFERRED COMPENSATION ELECTION
---------------------------------------------
1998 BASE COMPENSATION: I elect to defer:
(a) ___% (or $________) of my Base Compensation attributable to the
period beginning on the Execution Date and otherwise payable to me
during 1998; and,
(b) ___% (or $________) of my MVP Bonus, if any, attributable to the
period beginning on the Execution Date and otherwise payable to me
during 1999.
(c) ___% of my MVP Bonus, if any, attributable to the period beginning
on the Execution Date and otherwise payable to me during 1999,
exceeding $______________, not to exceed $_______________.
Dated:_____________, 1998. ___________________________________
Executive
Received this ____ day of _________, 1998
RLI Corp.
By:__________________________________
Its:__________________________
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
OVERVIEW
RLI Corp. (the Company) is a holding company that underwrites selected property
and casualty insurance through its major subsidiaries collectively known as RLI
Insurance Group (the Group). The Group has accounted for approximately 84% of
consolidated revenue over the last two years by providing property and casualty
coverages primarily for commercial risks. As a niche insurer, the Group offers
products targeted to the needs of those insureds generally overlooked by
traditional insurance markets.
The property and casualty insurance business is cyclical and influenced by
many factors, including price competition, economic conditions, natural
disasters, interest rates, state regulations, court decisions, and changes in
the law. One of the unique and challenging features of the property and casualty
insurance business is that products must be priced before costs are fully known,
because premiums are charged before claims are incurred.
Property insurance results are subject to the variability introduced by
natural and man-made disasters such as earthquakes, fires and hurricanes. The
Company's major catastrophe exposure is to losses caused by earthquakes, since
over 61% of the Company's 1998 total property premiums were written in
California. The Company limits its net aggregate exposure to a catastrophic
event by purchasing reinsurance and through extensive use of computer-assisted
modeling techniques. These techniques provide estimates of the concentration of
risks exposed to catastrophic events. Utilizing this approach, the Company
attempts to limit its net aggregate exposure to a single catastrophic event to
less than 10% of total shareholders' equity.
The casualty portion of the Company's business consists largely of
commercial and personal umbrella, general liability, and commercial auto
coverages. In addition, the Group provides directors & officers liability,
employers' indemnity, and in-home business owners coverage. The casualty book of
business is subject to the risk of accurately estimating losses and related loss
reserves since the ultimate settlement of a casualty claim may take several
years to fully develop. The casualty line may also be affected by evolving
legislation and court decisions that define the extent of coverage and the
amount of compensation due for injuries or losses.
The surety segment of RLI specializes in writing small- and medium-sized
commercial and contract surety products, as well as those for the energy,
petrochemical and refining industries. The commercial surety products usually
involve a statutory requirement for bonds. This industry has historically
maintained a relatively low loss ratio. Losses may fluctuate, however, due to
adverse economic conditions that may affect the financial viability of an
insured.
The contract surety market guarantees the construction work of a commercial
contractor for a specific project. As such, this line has historically produced
marginally higher loss ratios than the commercial surety line. Generally, losses
occur due to adverse economic conditions, inclement weather conditions, or the
deterioration of a contractor's financial condition.
The consolidated financial statements and related notes found on pages
29-48, and the "Forward Looking Statements" on page 28, should be read in
conjunction with the following discussion.
SIGNIFICANT DEVELOPMENTS
In January 1999, RLI Insurance Company acquired Underwriters Indemnity Holdings,
Inc. (UIH), located in Houston, Texas. UIH specializes in the marketing and
underwriting of surety products for oil, gas, mining and other energy-related
exposures.
RLI paid $40.7 million in cash in exchange for all outstanding shares of
UIH subject to post-closing contingencies. Included in the transaction are both
of UIH's operating subsidiaries, Underwriters Indemnity Company of Texas and
Planet Indemnity Company of Colorado. The transaction was financed through
short-term borrowings and will be accounted for under the purchase method of
accounting. In 1998, UIH wrote $16.4 million of gross written premiums, with
$7.2 million in surety writings and $9.2 million of assumed and direct property
business. The organization has a history
16
<PAGE>
of profitable underwriting, witnessed by its 79.4 combined ratio in 1998 and
three-year average combined ratio of 79.9. Prior to the closing, UIH wrote
business in 34 states. Book value at December 31, 1998, is estimated at $16
million. Both of UIH's operating companies are rated "A-" (Excellent) by A.M.
Best.
YEAR ENDED DECEMBER 31, 1998, COMPARED TO YEAR ENDED DECEMBER 31, 1997
Consolidated gross sales -- gross premiums written, net investment income and
realized investment gains --totaled $316.9 million, a 3.4% increase from 1997.
Consolidated revenue for 1998 was $168.1 million, down 0.8% from the previous
year. Revenue was relatively flat due to a decrease in net realized investment
gains of 37.9% as well as a 2.5% decline in net investment income.
<TABLE>
<CAPTION>
Year Ended December 31,
<S> <C> <C> <C>
Gross sales (in thousands) 1998 1997 1996
Gross premiums written $291,073 $278,843 $276,802
Net investment income 23,937 24,558 23,681
Realized investment gains 1,853 2,982 1,017
Total gross sales $316,863 $306,383 $301,500
</TABLE>
Net after-tax earnings for the Company were $28.2 million ($2.65 per
diluted share) in 1998, compared to $30.2 million ($2.66 per share) in 1997.
<TABLE>
<CAPTION>
<S> <C> <C>
Pretax earnings (in thousands) 1998 1997
Insurance Group $ 16,789 $ 18,751
Net investment income 23,937 24,558
Net realized investment gains 1,853 2,982
Equity in investee earnings 1,337 951
</TABLE>
In accordance with Financial Accounting Standards Board (FASB) Statement
No. 130, the Company reports comprehensive earnings as prominently as GAAP
earnings information. Comprehensive earnings include not only traditional net
income, but other changes to equity. The material adjustment applicable to the
Company's net earnings is the inclusion of net unrealized gains and losses,
after tax.
<TABLE>
<CAPTION>
Diluted earnings per share
Net Comprehensive
<S> <C> <C>
1994 (0.49) (0.87)
1995 0.81 2.77
1996 2.28 3.62
1997 2.66 5.76
1998 2.65 4.87
Total $7.91 $16.15
</TABLE>
As this chart indicates, comprehensive earnings per share for the last five
years exceeded reported net earnings by 104.2% on a diluted basis. After adding
back dividends and stock repurchases, shareholders' equity reached an
unprecedented level of nearly $315 million, up more than 18% from 1997.
RLI INSURANCE GROUP
Gross written premiums in 1998 were $291.1 million, compared to $278.8 million
in 1997. This modest increase reflected the Company's firm commitment to sound
underwriting practices during an ongoing period of difficult pricing and market
conditions in certain lines. The Group's pretax underwriting earnings for 1998
were $16.8 million, a 10.5% decrease from the $18.8 million reported in 1997.
This decline can be attributed to losses from Hurricane Georges of $1.1 million
and reserve strengthening of $2.6 million on the surety line, both third quarter
events.
The Company's property segment gross written premiums were lower in 1998,
at $113.6 million, compared to $139.5 million in 1997. Non-recurring premiums
associated with the acquisition of the Hawaii residential insurance business in
March of 1997 accounted for $10.7 million of this decline. While fire premiums
were flat, difference in conditions premiums were down 19.1% from 1997. This
decrease can be attributed to rate reductions on these lines of business while
the Company continues to focus on controlling its total exposure to catastrophe
risks.
The property segment contributed the largest share of the Group's pretax
profits, generating $19.8 million in 1998, compared to
17
<PAGE>
$21.4 million in 1997. These results were reflected in the property segment
GAAP combined ratio of 62.1 for 1998, compared to 65.5 in 1997. Despite the
drop in the combined ratio, Group profits decreased slightly due to $1.1
million in Hurricane Georges losses as well as a decline in revenue
associated with Hawaii residential insurance.
Casualty gross written premiums improved 31.0% from 1997, reaching $148.7
million in 1998. This overall increase was the result of gains in the following
products: commercial umbrella - $19.3 million; transportation - $16.1 million;
and general liability - $3.6 million. The GAAP combined ratio for the casualty
segment was 103.2, compared to 104.6 in 1997. This resulted from premium
increases in the more profitable lines. Despite the lower ratio in 1998,
management believes that loss reserves for this segment will be adequate and the
investment income derived from reserved funds will provide significant future
earnings potential. This belief is supported by favorable total reserve
development over the last three years, as reported in note 6 of the financial
statements.
The surety segment continued a trend of solid growth as gross written
premiums increased to $28.8 million, which was an 11.5% improvement over 1997.
The segment's combined ratio of 103.9 included a charge of $2.6 million related
to unfavorable loss development from one specific contract surety producer. This
particular book of business constituted only 8% of the total surety book.
Excluding this adjustment, the combined ratio for the year would have fallen to
89.7, compared to 95.4 in 1997. Contri-buting to this decline was an improved
expense ratio, which dropped to 67.7 in 1998, from 73.8 a year ago. Increased
premium volumes paid back earlier infrastructure investments.
INVESTMENT INCOME
Net dividend and interest income decreased by 2.5% during 1998. Despite the
growth in invested assets during the year, a focus on investing new cash flow in
tax-exempt securities, as well as the general downturn in interest rates, caused
the decline. On an after-tax basis, investment income actually increased
slightly (0.3%). The Company realized $1.9 million in capital gains in 1998,
compared to $3.0 million in 1997. Operating cash flows were $23.6 million in
1998. All cash flows in excess of current needs were used to fund the stock
repurchase program and purchase both fixed income and equity securities.
Fixed-income purchases continue to be comprised of high-grade, tax-exempt, U.S.
government and agency and convertible debenture securities. Equity purchases
remain consistent with the long-term strategy of investing in large-cap, value
investments with attractive dividend yields.
<TABLE>
<CAPTION>
<S> <C> <C> <C>
Pretax yield 1998 1997 1996
Taxable (on book value) 6.58% 6.91% 6.87%
Tax-exempt (on book value) 4.95% 5.00% 4.97%
Equities (on market value) 2.49% 2.96% 3.38%
After-tax yield 1998 1997 1996
Taxable (on book value) 4.27% 4.49% 4.47%
Tax-exempt (on book value) 4.69% 4.74% 4.71%
Equities (on market value) 2.14% 2.54% 2.90%
</TABLE>
Overall yields continued to decline during 1998, reflecting the general
trend in the fixed income markets. At year end, the yields on the tax-exempt
side were relatively unchanged from last year, while taxable yields fell rather
significantly. As a result, the after-tax spread between these securities has
widened, making the tax-exempt selections increasingly more attractive. Given
the Company's tax position, the majority of fixed income purchases were made in
this sector.
The Company's investment results for the last five years are shown in the
following table:
<TABLE>
<CAPTION>
(in thousands) Tax Equivalent
Change in Annualized Annualized
Unrealized Return on Return on
Average Realized Appreciation/ Average Average
Invested Investment Gains Depreciation Invested Invested
Year Assets(1) Income(2)(3) (Losses)(3) (3)(4) Assets Assets
<S> <C> <C> <C> <C> <C> <C>
1994 407,722 20,133 (3,595) (5,749) 2.7% 3.6%
1995 442,717 22,029 457 36,037 13.2% 14.1%
1996 504,773 23,681 1,017 25,033 9.9% 10.7%
1997 570,901 24,558 2,982 55,760 14.6% 15.5%
1998 640,576 23,937 1,853 36,183 9.7% 10.6%
5-yr. avg. $513,338 22,868 543 29,453 10.3% 11.2%
</TABLE>
(1) Average of amounts at beginning and end of year.
(2) Investment income, net of investment expenses, including non-debt interest
expense.
(3) Before income taxes.
(4) Relates to available-for-sale fixed maturity and equity securities.
The annualized return for 1998 was again enhanced by the strong performance
of the equity portfolio, which generated pretax unrealized appreciation of $36.3
million.
18
<PAGE>
INTEREST AND GENERAL CORPORATE EXPENSE
Interest expense on debt was $2.3 million in 1998, up from $1.5 million in 1997.
This increase was largely the result of the Company's increased use of
short-term borrowings to finance the stock repurchase program. General corporate
expenses decreased 6.2% in 1998 as a result of lower executive compensation
costs relating to the MVP program.
INCOME TAXES
The Company's effective tax rates for 1998 and 1997 were 25.1% and 27.3%,
respectively. Effective rates are dependent upon components of pretax earnings
and the related tax effects. The Company's pretax earnings included $10.5
million of investment income in 1998 that is wholly or partially exempt from
federal income tax, compared to $9.1 million in 1997.
INVESTEE EARNINGS
The Company maintains a 44% interest in the earnings of Maui Jim, Inc.,
primarily a manufacturer of high-quality polarized sunglasses. In 1998, the
Company recorded $1.3 million in earnings compared to $951,000 in 1997. Sales
for Maui Jim grew 50% in 1998 on the strength of increased sunglass marketing
efforts in several international territories. Profit margins also improved in
1998 as the cost of goods sold was favorably impacted by the dollar's
performance against the yen.
MARKET RISK DISCLOSURE
Market risk is a general term describing the potential economic loss associated
with adverse changes in the fair market value of financial instruments.
Management of market risk is a critical component of the Company's investment
decisions and objectives. The Company manages its exposure to market risk by
using the following tools:
1. Continually monitoring the fair market value of all financial assets;
2. Changing the character of future investment purchases as needed, and;
3. Maintaining a balance between its existing asset and liability
portfolios.
The Company's primary risk exposures are to changes in interest rates and
equity prices, as it had no derivative or foreign exchange risk as of December
31, 1998.
INTEREST RATE RISK
The Company's primary exposure to interest rate risk is with its fixed income
investment portfolio, but on a smaller scale, it also incurs similar risk with
its short-term debt instruments.
Modified duration analysis is used to measure the sensitivity of the fixed
income portfolio to changes in interest rates, providing a measure of price
percentage volatility. The Company attempts to minimize interest rate risk by
matching the duration of its assets to that of its liabilities. The Company
limits the impact of changes in interest rates on its financial statements by
designating a majority of the fixed income holdings as held-to-maturity. This
designation is chosen for the securities for which the Company has the intent
and ability to hold to stated maturity. These securities are carried at
amortized cost and, except for declines that are other than temporary, changes
in fair market value are not reflected on the financial statements. As of
December 31, 1998, the Company had classified 86% of its fixed income portfolio
as held-to-maturity.
The balance of the Company's fixed income portfolio is classified in a
manner that affects its financial statements. As of December 31, 1998, 14% of
the Company's fixed income portfolio was classified as either available-for-sale
or trading (see note 2).
Interest rate risk could also impact the Company's income statement due to
its impact on interest expense. The Company's debt obligations are short term in
nature, with no long-term debt outstanding as of December 31, 1998. As a result,
the Company assumes interest rate risk in its ability to refinance these
short-term debt obligations. Any rise in interest rates will cause interest
expense to increase, assuming debt is maintained at current levels.
EQUITY PRICE RISK
Equity price risk is the potential that the Company will incur economic loss due
to a decline of common stock prices. Beta analysis is used to measure the
sensitivity of the Company's equity portfolio to changes in the value of the S&P
500 index (an index representative of the broad equity market). As measured from
December 31, 1981 to December 31, 1998, the Company's equity portfolio has a
beta of approximately 0.70 in comparison to the S&P 500. This low beta statistic
reflects the Company's long-term emphasis on maintaining a conservative,
value-oriented, dividend-driven investment philosophy for its
19
<PAGE>
equity portfolio. Historically, dividend-paying common stocks have
demonstrated superior down-market performance characteristics.
Additional risk management techniques include:
1. Restricting individual security weightings to less than 3% of the
equity portfolio's market value, and;
2. Reducing exposure to sector risk by limiting the market value to be
invested in any one industry sector to 25% of the equity portfolio.
Equity securities are classified as available-for-sale, with unrealized
gains and losses excluded from net earnings, but recorded as a component of
comprehensive earnings and shareholders' equity, net of deferred income taxes.
SENSITIVITY ANALYSIS
The tables at right detail information on the market risk exposure for the
Company's financial instruments as of December 31, 1998. Listed on each table is
year-end market value for the Company's assets and the expected reduction in
market value, given the stated hypothetical events. This sensitivity analysis
assumes that the composition of the Company's assets remains constant over the
period being measured and that interest rate changes are reflected uniformly
across the yield curve. The analysis does not consider any action the Company
would undertake in response to changes in market conditions. For purposes of
this disclosure, securities are divided into two categories: those held for
trading purposes and those held for non-trading purposes. The examples given are
not predictions of future market events, but rather illustrations of the impact
such events may have on the market value of the Company's investment portfolio.
As of December 31, 1998, the Company's fixed income portfolio had a market
value of $339.4 million. This sensitivity analysis uses scenarios of interest
rates increasing 100 and 200 basis points from their December 31, 1998 levels,
with all other variables held constant. Such scenarios would result in decreases
in the market value of the fixed income portfolio of $12.8 million and $24.7
million, respectively. Due to the Company's use of the held-to-maturity
designation for a majority of the fixed income portfolio, the balance sheet
impact of these scenarios would be much lower. The income statement would only
be affected by holdings designated as trading.
As of December 31, 1998, the Company's equity portfolio had a market value
of $296.5 million. This base sensitivity analysis uses market scenarios of the
S&P 500 index declining 10 percent and 20 percent. These scenarios would result
in approximate decreases in the market value of the equity portfolio of $20.2
million and $40.3 million, respectively. As the Company designates all common
stocks as available-for-sale, these market value declines would impact the
Company's balance sheet.
Counter to the base scenarios shown in Tables 1 and 2, Tables 3 and 4
quantify the opposite impact. Under the assumptions of falling interest rates
and an increasing S&P 500 index, the market value of the Company's assets will
increase from their present levels by the indicated amounts.
<TABLE>
<CAPTION>
Table 1 (in thousands)
Effect of a 100 basis point increase in interest rates and a 10% decline in
the S&P 500:
12/31/98 Interest Rate Equity
Market Value Risk Risk
<S> <C> <C> <C>
Held for trading purposes
Fixed maturity securities $ 8,348 $ (241) -
Total trading 8,348 (241) -
Held for non-trading purposes
Fixed income securities 331,060 (12,518) -
Equity securities 296,521 - (20,163)
Total non-trading 627,581 (12,518) (20,163)
Total trading & non-trading $635,929 $(12,759) ($20,163)
</TABLE>
<TABLE>
<CAPTION>
Table 2 (in thousands)
Effect of a 200 basis point increase in interest rates and a 20% decline in
the S&P 500:
12/31/98 Interest Rate Equity
Market Value Risk Risk
<S> <C> <C> <C>
Held for trading purposes
Fixed maturity securities $ 8,348 $ (455) -
Total trading 8,348 (455) -
Held for non-trading purposes
Fixed maturity securities 331,060 (24,280) -
Equity securities 296,521 - (40,327)
Total non-trading 627,581 (24,280) (40,327)
Total trading & non-trading $635,929 (24,735) (40,327)
</TABLE>
<TABLE>
<CAPTION>
Table 3 (in thousands)
Effect of a 100 basis point decrease in interest rates and a 10% increase in
the S&P 500:
12/31/98 Interest Rate Equity
Market Value Risk Risk
<S> <C> <C> <C>
Held for trading purposes
Fixed maturity securities $ 8,348 $224 -
Total trading 8,348 224 -
Held for non-trading purposes
Fixed maturity securities 331,060 10,148 -
Equity securities 296,521 - 20,163
Total non-trading 627,581 10,148 20,163
Total trading & non-trading $635,929 10,372 20,163
</TABLE>
20
<PAGE>
<TABLE>
<CAPTION>
Table 4 (in thousands)
Effect of a 200 basis point decrease in interest rates and a 20% increase in
the S&P 500:
12/31/98 Interest Rate Equity
Market Value Risk Risk
<S> <C> <C> <C>
Held for trading purposes
Fixed maturity securities $ 8,348 $ 473 -
Total trading 8,348 473 -
Held for non-trading purposes
Fixed maturity securities 331,060 21,644 -
Equity securities 296,521 - 40,327
Total non-trading 627,581 21,644 40,327
Total trading & non-trading $635,929 $22,117 $40,327
</TABLE>
The income statement will also be impacted by interest expense. As of
December 31, 1998, the Company had $39.6 million in short-term debt obligations.
Assuming this debt level remains constant, a hypothetical 100 basis point
increase in interest rates would increase the Company's annual pretax interest
expense by $0.4 million and a 200 basis point increase would increase annual
pretax interest expense by $0.8 million. Conversely, falling interest rates
would result in equivalent reductions in interest expense. These numbers are not
included in the previous tables.
OUTLOOK FOR 1999
In 1999, the Company will continue to pursue profitable opportunities for
top-line growth. There is an ongoing process of evaluating various avenues for
growth such as the acquisition of underwriting talent in certain product lines,
strategic alliances with producers on existing products, or through acquisition.
The implementation of the combined casualty reinsurance program is expected to
bolster investment earnings as well as improve underwriting results over time.
The materiality or viability of future new ventures or products is not known at
this time. Specific details regarding events in the Group's various business
segments follow.
PROPERTY
The Company expects further softening of earthquake rates during 1999. Exposure
will remain constant while reduced reinsurance costs will serve to mitigate the
bottom-line impact of lost premiums.
The Company's fire book of business posted improved results in the final
two quarters of 1998, which management believes to reflect the effect of new
leadership established in that line last year.
CASUALTY
Several initiatives launched in 1997 began to generate substantial revenue in
1998. Offices for writing commercial casualty business in Dallas, Los Angeles,
New York, Atlanta and San Francisco led the growth.
Management is confident that these initiatives involving product lines such
as commercial umbrella, general liability, executive products, and commercial
auto, will produce satisfactory growth results into the near future.
Profitability has improved as the product mix has shifted more heavily
toward the lines with lower combined ratios. The Company's assiduous attention
towards underwriting profit will continue and be supported by the recently
implemented combined casualty treaty.
SURETY
Gross written premiums are expected to continue to increase, primarily due to
the acquisition of Underwriters Indemnity, a producer of surety bonds for the
energy, petrochemical and refining industries. The transaction is also expected
to create cross-selling opportunities for existing RLI products. Increased
revenues should continue to drive down the expense ratio during 1999.
CAPITAL MANAGEMENT
In July 1997, the Company implemented a 1.8 million share common stock
repurchase program. In 1998, the Company repurchased 390,464 shares at a total
cost of $15.5 million. Including 1997, 1,349,402 shares were purchased at a
total cost of $48.2 million. Adjusting for the June 1998 5-for-4 stock split,
over 650,000 shares remain authorized for repurchase at year-end 1998. It is
anticipated that the program will continue as market conditions and the
Company's capital requirements warrant.
The repurchase program has been funded by the use of the Company's line of
credit facility, reverse repurchase agreements, and operating cash flow. It is
anticipated that future repurchases will be funded in a similar fashion.
Depending upon the Company's capital needs and prevailing market conditions, the
Company may issue a longer-term debt instrument, and repay the outstanding
short-term debt.
21
<PAGE>
In the fourth quarter of 1998, RLI declared a cash dividend to be paid in
January 1999 of $0.13 per share, representing the 90th consecutive dividend
payment for the Company. Since the inception of cash dividends in 1976, the
Company has increased the annual dividend every year. In its annual "Handbook of
Dividend Achievers," Moody's ranks RLI 177th in dividend growth out of 10,000
U.S. public companies over the last decade. No changes in the Company's dividend
policy is anticipated in 1999.
YEAR ENDED DECEMBER 31, 1997, COMPARED TO YEAR ENDED DECEMBER 31, 1996
Consolidated gross sales -- gross premiums written, net investment income and
realized investment gains--totaled $306.4 million, a 1.6% increase from 1996.
Consolidated revenue for 1997 was $169.4 million, up 9.1% from the previous
year. The increase in revenue was attributable in part to increased
realized investment gains of nearly $3.0 million, compared to $1.0 million in
1996. Also, an 8.6% increase in net earned premiums reflected the addition of
the Hawaii residential insurance program at a higher net retention than many
of the Company's other lines.
<TABLE>
<CAPTION>
Year Ended December 31,
<S> <C> <C>
Gross sales (in thousands) 1997 1996
Gross premiums written $278,843 $276,802
Net investment income 24,558 23,681
Realized investment gains 2,982 1,017
Total gross sales $306,383 $301,500
</TABLE>
Net after-tax earnings for the Company were a record $30.2 million ($2.66
per diluted share) in 1997, compared to $25.7 million ($2.28 per share) in 1996.
<TABLE>
<CAPTION>
<S> <C> <C>
Pretax earnings (in thousands) 1997 1996
Insurance Group $18,751 $16,397
Net investment income 24,558 23,681
Net realized investment gains 2,982 1,017
Equity in investee earnings 951 231
</TABLE>
RLI INSURANCE GROUP
Gross written premiums in 1997 were $278.8 million, compared to $276.8 million
in 1996. This modest increase reflected the Company's firm commitment to sound
underwriting practices during this period of unusually arduous pricing and
market conditions. The Group's pretax underwriting earnings for 1997 were $18.8
million, a 14.6% increase over the $16.4 million reported in 1996 as a result of
this focus on underwriting profit.
The Company's property segment gross written premiums were basically flat
in 1997 at $139.5 million, compared to $138.1 million in 1996. There were,
however, significant changes in the product mix of this segment. While existing
product gross premiums were down due to rate reductions and increased competitor
capacity, the reductions in net written premiums were mitigated through better
use of reinsurance. Fire and difference in conditions gross written premiums
were down 16% and 12% respectively from 1996, compared to declines in net
written premiums of only 3% and 7%. Meanwhile, the Group bolstered its overall
premium production in this segment with the addition of the Hawaii residential
insurance program. Including the assumption of $10.7 million of unearned premium
upon acquisition, gross and net premiums written for this program were $19.5
million and $19.1 million, respectively, for the year ended 1997.
The property segment contributed the largest share of the Group's pretax
profits, increasing to $21.4 million in 1997, compared to $18.8 million in 1996.
These results were reflected in the property segment GAAP combined ratio of 65.5
for 1997. The combined ratio increase from 60.9 in 1996 reflected the
incremental acquisition costs associated with the assumption of Hawaii homeowner
in-force business from the Hawaii Property Insurance Association. Such costs
were not associated with the continued production of these premiums in 1998.
These increased expenses were offset by a lower property segment loss ratio of
19.2 in 1997, compared to 22.4 in the previous year.
22
<PAGE>
Casualty gross written premiums declined 10.7% from 1996, to $113.5 million
in 1997. Much of this decline was due to discontinuing certain production source
relationships in the general liability area as a result of prolonged declines in
profitability. Despite premium declines, the casualty segment GAAP combined
ratio was 104.6 for 1997. While lower premiums have negatively influenced the
expense ratio component of this indicator, the loss ratio for 1997 was 68.5,
compared to 72.1 in 1996. Even at this level, management believes that loss
reserves for this segment will be adequate and that the investment income
derived from these reserved funds will provide significant future earnings
potential. Such optimism was warranted by the favorable total reserve
development in 1997 on prior accident years' reserves, as indicated in note 6 of
the financial statements.
The surety segment provided the most notable premium growth among existing
products, increasing to $25.8 million, a 123% increase over the $11.6 million
for the prior year. Much of this growth was achieved specifically through the
increased writing of contract bonds, which added $12.5 million of additional
premium in 1997. The surety segment profit picture also improved dramatically
as pretax underwriting profits came in at $0.5 million, compared to an
underwriting loss of $0.4 million in 1996. This was largely the result of the
anticipated payoff in premium writings from production investments made over
the last several years. The combined ratio for this segment fell to 95.4 in
1997 from 109.2 in 1996, mostly from the expense ratio improvement of 8.8
points.
INVESTMENT INCOME
Net dividend and interest income increased 3.7% during 1997 due to growth in
invested assets. The Company realized $3.0 million in capital gains in 1997,
compared to $1.0 million in 1996. Operating cash flows were $35.0 million in
1997, compared to $48.9 million in 1996. All cash flows in excess of current
needs were used to fund our common stock repurchase program, purchase equity
securities, and acquire fixed-income instruments composed of high grade,
tax-exempt, U.S. government and agency and convertible debenture securities.
Yields for 1997 rose during the first half of the year and remained fairly
stable throughout the third quarter. A significant bond price rally during the
fourth quarter brought yields in the Treasury market close to their historic
lows. Tax-exempt yields were up slightly as the Company extended its portfolio
duration to gain additional yield and minimize the effect of declining interest
rates. The taxable segment of the portfolio remained fairly stable during the
year with the overall yield unchanged.
INTEREST AND GENERAL CORPORATE EXPENSE
Interest expense on debt was $1.5 million in 1997, down 44.9% from $2.8 million
in 1996. This decline was the direct result of the Company's call for redemption
and subsequent conversion of all of its outstanding convertible debentures
during July 1997. General corporate expenses increased 27.3% in 1997, as a
result of accrued executive bonuses relating to the MVP program and recognition
of the expense of issuing directors' stock options.
INCOME TAXES
The Company's effective tax rates for 1997 and 1996 were 27.3% and 27.1%,
respectively. Effective rates are dependent upon components of pretax earnings
and the related tax effects. The Company's pretax earnings included $9.1 million
of investment income in 1997 that was wholly or partially exempt from federal
income tax, compared to $8.0 million in 1996.
ACCOUNTING STANDARDS
In June 1997, the FASB issued Statement No. 131, "Disclosures about Segments of
an Enterprise and Related Information" (Statement 131). Statement 131
establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements according to
a management approach. The Company has adopted Statement 131 and applied the
criteria for segment identification and follows the requirements of the
pronouncement in the MD&A as well as note 11 to the financial statements.
In February 1998, the FASB issued Statement No. 132, "Employers'
Disclosures about Pensions and Other Postretirement Benefits" (Statement 132).
Statement 132 revises employers' disclosures about pension and other
post-retirement benefit plans. It does not change the measurement or recognition
of those plans. Statement 132 standardizes the disclosure requirements for
pensions and other postretire-ment benefits to the extent practicable, requires
additional information on changes in the benefit
23
<PAGE>
obligations and fair values of plan assets that will facilitate financial
analysis, and eliminates certain other disclosures that are no longer useful.
This Statement was adopted in 1998.
In June 1998, the FASB issued Statement No. 133, "Accounting for Derivative
Instruments and Hedging Activities" (Statement 133). Statement 133 addresses the
accounting for and disclosure of derivative instruments. This Statement
standardizes the accounting for derivative instruments by requiring that an
entity recognize those items as assets or liabilities in the statement of
financial position and measure them at fair value. This Statement is effective
for all fiscal quarters of fiscal years beginning after June 15, 1999.
LEGISLATION
STATE REGULATION
As an insurance holding company, RLI Corp. and its insurance subsidiaries are
subject to regulation by the states in which they are domiciled or transact
business. Holding company registration in each insurer's state of domicile
requires reporting to the state regulatory authority the financial, operations
and management data of the insurers within the holding company system. All
transactions within a holding company system affecting insurers must be fair,
and the insurer's policyholder surplus following any transaction must be both
reasonable in relation to its outstanding liabilities and adequate for its
needs. Notice to regulators is required prior to the consummation of certain
transactions affecting insurance subsidiaries of the holding company system.
Other regulations limit the amount of dividends and other distributions the
subsidiaries can pay without prior approval of the insurance department in the
states in which they are physically and/or commercially domiciled, and impose
restrictions on the amount and type of investments they may have. Regulations
designed to ensure financial solvency of insurers and to require fair and
adequate treatment and service for policyholders are enforced by filing,
reporting and examination requirements. Market oversight is conducted by
monitoring trade practices, approving policy rates and forms, licensing of
agents and brokers, and requiring fair and equitable premiums and commission
rates. Financial solvency is monitored by minimum reserve and capital
requirements, periodic reporting procedures (annually, quarterly, or more
frequently if necessary), and periodic examinations.
The quarterly and annual financial reports to the states utilize accounting
principles which are different than the generally accepted accounting principles
that show the business as a going concern. The statutory accounting principles
used by regulators, in keeping with the intent to assure policyholder
protection, are generally based on a liquidation concept. The National
Association of Insurance Commissioners (NAIC) has recently developed a codified
version of these statutory accounting principles, and its deployment in the
states in the near future will foster more consistency among the states for
accounting guidelines and reporting.
State regulatory authorities have relatively broad discretion with respect
to granting, renewing and revoking brokers' and agents' licenses to transact
business in the state. The manner of operating in particular states may vary
according to the licensing requirements of the particular state, which may,
among other things, require a firm to operate in the state through a
corporation. In a few states, licenses are issued only to individual residents
and locally-owned business entities. In such cases, the Company has arrangements
with residents or business entities licensed to act in the state.
COMMERCIAL LINES DEREGULATION -- The NAIC and several state legislatures
have taken up the issue of commercial lines deregulation in an attempt to
streamline specific areas of insurance regulation. A growing contingent in the
regulatory community has acknowledged that some regulatory procedures and
practices may be cumbersome and inappropriate for commercial buyers of
insurance. Specifically, the large, sophisticated, multi-state or multi-national
businesses that employ their own teams of risk managers to evaluate, reduce and
finance their loss exposures are less likely to need the form and rate
protections that regulators provide consumers and small- to medium-sized
businesses. And while these large businesses may receive some benefit from the
state financial regulation of licensed insurers, it has long been acknowledged
that they do not need the protections addressed by the barriers to the surplus
lines market and other nontraditional markets. Indisputably, deregulation of the
licensed market will have an impact on the surplus lines insurance carriers,
which have been free from form and rate requirements.
24
<PAGE>
USE OF CREDIT REPORTS IN UNDERWRITING -- Gains in access to electronic
commerce, and the means to gather information more rapidly, have spurred
regulators to take a second look at the use of consumer credit reports in
underwriting and rate making. In some states, regulators charged with protecting
insurance consumers from unfair trade practices are concerned that some
consumers' risks may be underwritten based solely on their credit standing, and
have sought to strengthen their laws and regulations to address this. This trend
comes on the heels of Congress' retooling of the Fair Credit Reporting Act in
1997, which specifically addresses this issue, and permits the use of consumer
credit reports in underwriting. The issue of federal preemption of state action
in this arena has not been judicially addressed.
FEDERAL LEGISLATION
Although the federal government generally does not directly regulate the
insurance business, federal initiatives often have an impact on the business in
a variety of ways. Current and proposed federal measures that may significantly
affect the insurance business include federal preemption of state auto liability
laws, tax reform measures, and Y2K legislation. The Company is also monitoring
the following federal proposals:
NATURAL DISASTER ACT -- Recent natural disasters, including Hurricane
Georges, continue to fuel concern regarding the best way to provide affordable
insurance coverage for such events. Congress has yet to pass legislation, but
proposals to set up a system for excess federal reinsurance to provide relief to
the industry continue to be discussed. Two initiatives, "The Natural Disaster
Protection and Insurance Act of 1997" (H.R. 230), and "The Homeowners Insurance
Availability Act of 1997" (H.R. 219), have been the primary tools for discussion
and debate. The Company will continue to monitor the progress of this issue.
FINANCIAL SERVICES MODERNIZATION -- Both judicial decisions and action by
the Office of the Comptroller of the Currency (OCC) have combined to grant
national banks more authority to enter non-banking business, including
insurance. The Barnett Bank decision, which permits the Comptroller of the
Currency to preempt any state law that "significantly interferes" with a bank's
ability to sell insurance products, has spawned the "Financial Services
Competition Act of 1997" (H.R. 10, also known as "Financial Services
Modernization Legislation"). This Act, designed to shrink the powers of the OCC,
has been the subject of various revisions that would result in both positive and
negative effects on the insurance industry. The Act also contains a provision
that would create a National Association of Registered Agents and Brokers, which
would permit insurance producers to obtain a national license rather than a
number of state licenses. This legislation could have an important impact on
many aspects of the insurance industry; the Company continues to monitor its
progress.
LIQUIDITY AND CAPITAL RESOURCES
Historically, the primary sources of the Company's liquidity have been funds
generated from insurance premiums (operating activities) and investment income
and maturing investments (investment activities). In addition, the Company has
occasionally received funds from financing activities, such as short-term
borrowings, the sale of Company treasury stock to its Employee Stock Ownership
Plan, and the issuance of common stock or convertible debentures.
The Company maintains a $30.0 million secured revolving line of credit with
one financial institution. The facility has a three-year term. At December 31,
1998, the Company had $19.6 million in outstanding debt from this facility.
Additionally, the Company was party to two reverse repurchase transactions
totaling $20.0 million. All funds were used to repurchase RLI stock. Management
believes that cash generated from operations, investments, and cash available
from financing activities will provide sufficient liquidity to meet the
Company's anticipated needs over the next 12 to 24 months.
In 1996, the Company entered into an innovative catastrophe reinsurance and
loss financing program with Centre Reinsurance (Centre Re). The program, called
Catastrophe Equity Puts (CatEPuts-SM-), augments the Company's traditional
reinsurance by integrating its loss financing needs with a pre-negotiated sale
of securities linked to exchange-traded shares. For a more detailed description
of CatEPuts, see note 5.
During 1998, the Company generated net operating cash flow of $23.6
million. Financing activities included the borrowing of $9.6 million from the
line of credit and an additional $5.1
25
<PAGE>
million from reverse repurchase agreements. All borrowings, as well as a
portion of operational cash flow, were utilized to repurchase shares of the
Company's stock. During 1998, 390,464 shares were repurchased at a total cost
of $15.5 million. The remainder of excess operating cash flow was added to
the Company's investment portfolio.
The Company's fixed income portfolio continues to be biased toward U.S.
government and agency securities due to their high liquidity and almost
risk-free nature. As part of its investment strategy, the Company attempts to
avoid exposure to default risk by holding, almost exclusively, securities ranked
in the top two grades of investment quality by Standard & Poor's and Moody's
(i.e., AAA or AA). Virtually all of the Company's fixed income portfolio
consists of securities rated A or better, with 96% rated AA or better. Most of
the Company's fixed-income portfolio is noncallable. Those securities containing
call features have been factored into the overall duration objectives of the
portfolio and will not affect efforts to match assets with anticipated
liabilities.
The Company follows a program of matching assets to anticipated liabilities
to ensure its ability to hold securities until maturity. Anticipated liabilities
are factored against ultimate payout patterns and the resulting payout streams
are funded with the purchase of fixed-income securities of like maturity.
Management believes that both liquidity and interest rate risk can best be
minimized by such asset/liability matching.
The Company intends to hold approximately 86% of the securities in its
fixed income port-folio until their contractual maturity. These securities are
classified as held-to-maturity and are carried at amortized cost. Smaller
portions of the fixed income portfolio are classified as available-for-sale
(11%) or trading (3%) and are carried at fair market value. As of December 31,
1998, the Company maintained $44.9 million in fixed income securities within the
available-for-sale and trading classifications. Although it is likely that the
majority of these securities will be held by the Company to maturity, they
provide an additional source of liquidity and can be used to address potential
future changes in the Company's asset/liability structure.
The Company's equity portfolio increased by $45.1 million during 1998, to
$296.5 million. The Company had net purchases during the year of $8.6 million of
common stock, with a pretax portfolio appreciation of $36.0 million. Capital
gains of $1.2 million on this portfolio were realized during the year. The
securities within the equity portfolio remain invested in large-cap issues with
strong dividend performance. The strategy remains one of value investing, with
security selection taking precedence over market timing. A buy-and-hold strategy
is used, minimizing the impact of both transactional costs and taxes.
The National Association of Insurance Commissioners (NAIC) continues its
work on developing a model investment law. This law would regulate insurance
Company investments. The Company's current investment portfolio appears to be in
compliance with the proposed model investment law. Management does not feel the
proposed model law will affect its current strategies.
OTHER MATTERS
The Year 2000 (Y2K) issue is a result of computerized systems, including both
hardware and software systems, using a two-digit format, as opposed to four
digits, to indicate the year in date fields. Such computer systems may be unable
to interpret dates beyond the year 1999, which could cause a system failure or
other computer errors, leading to disruptions in operations.
In 1997, the Company began work on a five-phase program for Y2K compliance.
Phase I was to identify those primary and mission-critical business systems,
those essential to continuing operations, which presented Y2K issues. This phase
was a four-month process beginning in August 1997. Phase II was to form a
committee by business unit to identify all secondary and general infrastructure
issues which would need
26
<PAGE>
to be addressed for Y2K compliance. This phase began in December 1997 and was
completed in April 1998, with the evaluation and initial identification of
secondary Y2K exposures which needed attention. Phase III was the
modification and testing of mission-critical systems identified in Phase I.
Phase III included changes to the Company's property and casualty systems,
accounts receivable, custom business processing, general ledger, accounts
payable, external business interfaces, digital image processing and
accounting interface systems. The status of Phase III completion is discussed
below. Phase IV, which began in May 1998, included the development of plans
to address secondary infrastructure issues, line of business strategies to
address exposures associated with the Company's insurance products and a
process to survey key vendors and business partners. This phase is scheduled
to be completed within the first quarter of 1999. Phase V is designed to
refine operational and contingency plans for Y2K cut-over. This phase is
scheduled to begin in the first quarter of 1999 and carry through the first
quarter of the year 2000. Items carried through the first quarter of the year
2000 are considered non-critical and incidental to the Company's operations.
The Company has identified three major areas as critical for successful
Y2K compliance: (1) accounting and premium processing systems, (2) terms and
conditions of existing insurance contracts, and (3) third-party
relationships. Y2K compliance and progress is regularly reviewed by the
Company's MIS steering committee, audit committee and the board of directors.
In accordance with Phase I of the program, the Company completed an
internal review of all primary and mission-critical systems and contacted
related software suppliers to determine major areas of exposure by December
1997. As an element of Phase III, in November 1998 the Company successfully
completed the modification, testing and implementation of Y2K-compliant core
property and casualty systems, accounts receivable, custom business
processing, general ledger, accounts payable and accounting interfaces. The
Company's new reinsurance system, implemented in early 1998, was already
identified as Y2K compliant. Business transactions are presently being
processed and premiums are being earned on in-force policies with Y2K
expiration dates. Digital image processing upgrades were completed in January
1999. External business interfaces have been addressed within core systems
efforts but may require additional modification for any subsequent changes
implemented by external parties. These activities concluded Phase III
efforts.
As a component of Phase IV, the Company completed the development of
strategies by line of business, which it feels will effectively manage Y2K
related exposures and coverages. This exposure is divided into two distinct
areas: business partners and insurance coverage issues for our
policyholders/customers.
In August 1998, all significant vendors and business partners were
surveyed for compliance efforts and responses are being evaluated by the
Company's internal audit and compliance unit for further steps and action,
prior to the end of the first quarter of 1999. Of the responses received from
vendors and business partners, a significant number state that they are Y2K
compliant or intend to be Y2K compliant by December 31, 1999. The Company
will continue to make efforts to ensure its business partners and vendors are
Y2K compliant; however, the ultimate state of compliance of these providers
is beyond the Company's control and could impact the Company's operations and
financial results in future periods.
The types of insurance that may be the subject of claims arising from
Y2K losses include property, directors & officers liability, miscellaneous
professional liability, and other casualty coverages. Although uncertainty
exists with respect to the nature and intent of Y2K liability, it is
anticipated that if Y2K claims are received, the majority will stem from
directors & officers and miscellaneous professional liability policies, in
terms of both frequency and severity. The Company has formulated a Y2K
questionnaire to be completed at the time of initial policy application and
renewal. Each application is individually underwritten, and responses on the
Y2K questionnaire are a component of the underwriter's determination whether
to offer coverage and, if so, to what extent. A Y2K exclusion is available
for underwriters' use if needed. Additionally, a Y2K team of underwriters and
claims personnel has been assembled to prepare for the proper handling of Y2K
claims. All claims will be handled on an individual basis in accordance with
policy terms and conditions.
As an element of Phase V, the Company has system-contingency services
contracted through a major third-party provider and is presently refining
support related to potential Y2K issues.
27
<PAGE>
In addition, the Company plans to develop a Y2K operational support plan for
the millennium weekend, including on-site staff and on-call support, by the
third quarter of 1999. Exposure and risk management of new or developing Y2K
exposures will continue through the first quarter of 2000.
The Company has incurred $1.2 million in expenses over the last two
years to complete the core system modifications for Y2K. It required over
26,000 hours of technical staff effort and changes to systems representing
12.5 million lines of program code. It is estimated that the Company will
incur an additional $300,000 of expense in 1999 to upgrade telephone systems,
corporate e-mail solutions, and to ensure the necessary services are in place
for contingency efforts.
FORWARD LOOKING STATEMENTS
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 the Company's expectations,
hopes, beliefs, intentions, goals or strategies regarding the future and are
based on certain underlying assumptions by the Company. 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 industry, claims development and the impact
thereof on the Company's loss reserves, the adequacy of the Company's
reinsurance programs, developments in the securities market and the impact on
the Company's investment portfolio, regulatory changes and conditions, and other
factors. Actual results could differ materially from those in forward-looking
statements. The Company assumes no obligation to update any such statements. You
should review the various risks, uncertainties and other factors listed from
time to time in the Company's Securities and Exchange Commission filings.
28
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED BALANCE SHEETS
December 31,
(in thousands, except share data) 1998 1997
<S> <C> <C>
Assets
Investments:
Fixed maturities:
Held-to-maturity, at amortized cost
(fair value--$294,544 in 1998 and $296,808 in 1997) $283,992 $290,034
Trading, at fair value
(amortized cost-- $8,157 in 1998 and $9,419 in 1997) 8,348 9,546
Available-for-sale, at fair value
(amortized cost-- $36,185 in 1998 and $33,642 in 1997) 36,516 34,120
Equity securities available-for-sale, at fair value
(cost-- $127,367 in 1998 and $118,637 in 1997) 296,521 251,460
Short-term investments, at cost which approximates fair value 51,917 18,697
Total investments 677,294 603,857
Cash -- --
Accrued investment income 6,457 6,348
Premiums and reinsurance balances receivable, net of allowances for
insolvent reinsurers of $6,669 in 1998 and $10,728 in 1997 46,667 36,718
Ceded unearned premiums 59,780 49,677
Reinsurance balances recoverable on unpaid losses and settlement expenses, net of
allowances for insolvent reinsurers of $3,096 in 1998 and $5,998 in 1997 168,261 155,711
Deferred policy acquisition costs, net 22,510 21,985
Property and equipment, at cost, net of accumulated depreciation
of $20,954 in 1998 and $20,735 in 1997 12,200 12,388
Investment in unconsolidated investee 13,457 13,615
Other assets 6,059 11,442
Total assets $1,012,685 $911,741
Liabilities and shareholders' equity
Liabilities:
Unpaid losses and settlement expenses $415,523 $404,263
Unearned premiums 142,023 128,543
Reinsurance balances payable 32,161 24,390
Income taxes-- current 2,124 2,702
Income taxes-- deferred 48,421 36,340
Notes payable, short-term 39,644 24,901
Other liabilities 38,830 24,050
Total liabilities 718,726 645,189
Shareholders' equity:
Common stock ($1 par value, authorized 50,000,000 shares,
issued 12,790,428 shares in 1998 and 10,229,673 shares in 1997) 12,790 10,230
Paid-in capital 71,093 74,586
Accumulated other comprehensive earnings net of tax 110,372 86,853
Retained earnings 163,324 140,432
Deferred compensation 3,461 --
Unearned ESOP shares, at cost (70,400 shares) (2,501) --
Treasury stock, at cost (2,384,736 shares in 1998 and 1,994,272 shares in 1997) (64,580) (45,549)
Total shareholders' equity 293,959 266,552
Total liabilities and shareholders' equity $1,012,685 $911,741
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
29
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF EARNINGS
AND COMPREHENSIVE EARNINGS
Years ended December 31,
(in thousands, except per share data) 1998 1997 1996
<S> <C> <C> <C>
Net premiums earned $142,324 $141,884 $130,656
Net investment income 23,937 24,558 23,681
Net realized investment gains 1,853 2,982 1,017
168,114 169,424 155,354
Losses and settlement expenses 64,728 61,251 68,261
Policy acquisition costs 44,281 43,140 29,556
Insurance operating expenses 16,526 18,742 16,442
Interest expense on debt 2,280 1,548 2,808
General corporate expenses 3,915 4,172 3,278
131,730 128,853 120,345
Equity in earnings of unconsolidated investee 1,337 951 231
Earnings before income taxes 37,721 41,522 35,240
Income tax expense (benefit):
Current 10,065 11,698 6,038
Deferred (583) (347) 3,506
9,482 11,351 9,544
Net earnings $ 28,239 $ 30,171 $ 25,696
Other comprehensive earnings, net of tax $24,259 $37,682 $16,525
Unrealized gains on securities:
Unrealized holding gains arising during the period 23,519 36,244 16,274
Less: Reclassification adjustment for gains included
in net earnings (740) (1,438) (251)
Other comprehensive earnings 23,519 36,244 16,274
Comprehensive earnings 51,758 66,415 41,970
Earnings per share:
Basic
Net earnings per share from operations $2.58 $2.71 $2.54
Realized gains, net of tax 0.11 0.19 0.06
Basic net earnings per share $2.69 $2.90 $2.60
Basic comprehensive earnings per share $4.92 $6.38 $4.25
Diluted
Net earnings per share from operations $2.54 $2.50 $2.22
Realized gains, net of tax 0.11 0.16 0.06
Diluted net earnings per share $2.65 $2.66 $2.28
Diluted comprehensive earnings per share $4.87 $5.76 $3.62
Weighted average number of common shares outstanding:
Basic 10,514 10,402 9,871
Diluted 10,638 11,714 12,105
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
30
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF
SHAREHOLDERS' EQUITY
Accumulated
Other
Compre- Unearned Treasury Total
(in thousands, Common Paid-in hensive Retained Deferred ESOP Stock Shareholders'
except per share data) Stock Capital Earnings Earnings Compensation shares at Cost Equity
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1996 $ 8,453 $ 23,832 $ 34,335 $ 95,378 $ (3,390) $ 158,608
Net earnings 25,696 25,696
Other comprehensive
earnings, net of tax 16,274 16,274
Treasury shares reissued
(108,825 shares) 1,656 552 2,208
Treasury shares purchased
(145,265 shares) (3,041) (3,041)
Adjustment to accounting
for business combination
(see note 1B) 6,204 (1,571) 4,633
Dividends declared
($.44 per share) (4,339) (4,339)
Balance, December 31, 1996 $ 8,453 $ 31,692 $ 50,609 $ 115,164 $ (5,879) $ 200,039
Net earnings 30,171 30,171
Other comprehensive
earnings, net of tax 36,244 36,244
Net change from conversion
of convertible debentures 1,769 43,485 45,254
Treasury shares purchased
(1,204,625 shares) (39,670) (39,670)
Shares issued from exercise
of stock options 8 154 162
Other capital items, including
CatEPuts amortization (745) (745)
Dividends declared
($.47 per share) (4,903) (4,903)
Balance, December 31, 1997 $ 10,230 $ 74,586 $ 86,853 $ 140,432 $ (45,549) $ 266,552
Net earnings 28,239 28,239
Other comprehensive
earnings, net of tax 23,519 23,519
Treasury shares purchased
(390,464 shares) (15,570) (15,570)
5-for-4 stock split 2,558 (2,574) (16)
Adjustment to accounting for
deferred compensation plans 3,461 (3,461) 0
Shares issued from exercise
of stock options 2 60 62
Other capital items, including
CatEPuts amortization (979) (979)
Unearned ESOP shares
purchased (2,501) (2,501)
Dividends declared
($.51 per share) (5,347) (5,347)
Balance, December 31, 1998 $12,790 $71,093 $110,372 $163,324 $3,461 $(2,501) $(64,580) $293,959
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
31
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31,
(in thousands) 1998 1997 1996
<S> <C> <C> <C>
Cash Flows from Operating Activities
Net earnings $28,239 $30,171 $25,696
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Provision for insolvencies -- -- 1,006
Net realized investment losses (gains) (1,853) (2,982) (1,018)
Depreciation 2,070 2,290 2,455
Other items, net (4,525) (327) 6,379
Change in:
Accrued investment income (109) (512) 19
Premiums and reinsurance balances receivable
(net of direct write-offs and commutations) (9,949) 7,470 1,913
Reinsurance balances payable 7,771 691 (14,045)
Ceded unearned premium (10,103) 4,028 (3,515)
Reinsurance balances recoverable on unpaid losses (12,550) 2,284 28,682
Deferred policy acquisition costs (526) (5,321) (857)
Unpaid losses and settlement expenses 11,260 (1,538) (13,185)
Unearned premiums 13,480 (1,239) 3,768
Income taxes:
Current (578) 567 4,624
Deferred (583) (347) 3,506
Changes in investment in unconsolidated investee:
Undistributed earnings (1,337) (951) (231)
Dividends received 1,495 -- 3,750
Net proceeds from trading portfolio activity 1,376 738 --
Net cash provided by operating activities 23,578 35,022 48,947
Cash Flows from Investing Activities
Purchase of:
Fixed maturities, held-to-maturity (29,793) (56,645) (29,682)
Fixed maturities, available-for-sale (8,898) (8,890) (11,792)
Equity securities, available-for-sale (15,790) (10,609) (11,649)
Short-term investments, net (7,799) -- (19,940)
Property and equipment (2,529) (2,745) (3,409)
Unconsolidated investee ownership interest -- (3,694) --
Proceeds from sale of:
Fixed maturities, available-for-sale 772 8,386 8,298
Equity securities, available-for-sale 8,207 5,780 2,579
Short-term investments, net -- 22,127 --
Property and equipment 646 195 795
Proceeds from call or maturity of:
Fixed maturities, held-to-maturity 34,596 29,083 17,381
Fixed maturities, available-for-sale 5,511 1,304 2,860
Net cash used in investing activities (15,077) (15,708) (44,559)
Cash Flows from Financing Activities
Proceeds from issuance of debt 14,744 24,900 --
Payments on debt -- -- (2,800)
Fractional shares paid (16) (1) --
Shares issued under stock option plan 62 162 --
Treasury shares reissued -- -- ,208
Unearned ESOP shares (2,501) -- --
Treasury shares purchased (15,570) (39,670) (3,041)
Cash dividends paid (5,220) (4,705) (4,262)
Net cash used in financing activities (8,501) (19,314) (7,895)
Net decrease in cash 0 0 (3,507)
Cash at beginning of year 0 0 3,507
Cash at end of year $ 0 $ 0 $ 0
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
32
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A. DESCRIPTION OF BUSINESS: RLI Corp. is a holding company that, through its
subsidiaries, underwrites selected property and casualty insurance products.
The property and casualty insurance segment, RLI Insurance Group (the
Group), is composed of two insurance companies. RLI Insurance Company, the
principal subsidiary, writes multiple lines of insurance on an admitted basis in
all 50 states, the District of Columbia and Puerto Rico. Mt. Hawley Insurance
Company, a subsidiary of RLI Insurance Company, writes multiple lines of
insurance on an admitted basis in Kansas and surplus lines insurance in the
remaining 49 states, the District of Columbia, Puerto Rico, the Virgin Islands
and Guam.
B. PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION: The accompanying
consolidated financial statements were prepared in conformity with generally
accepted accounting principles (GAAP), which differ in some respects from those
followed in reports to insurance regulatory authorities. The consolidated
financial statements include the accounts of RLI Corp. and its subsidiaries (the
Company). All significant intercompany balances and transactions have been
eliminated. Certain reclassifications were made to the prior years' financial
statements to conform with the classifications used in 1998.
On December 1, 1996, RLI Vision Corp., the Company's wholly-owned optical
goods distributor, merged with Hester Enterprises, Inc., the manufacturer of
Maui Jim sunglasses. The Company retained a 34% minority interest in the
combined entity, renamed Maui Jim, Inc. The Company accounted for this merger as
a non-monetary exchange of ownership interests with no gain or loss recognized.
As a result of the merger, the Company began presenting its minority
interest in Maui Jim, Inc. under the equity method of accounting beginning
December 1, 1996. Additionally in 1996, for comparative purposes, the Company
restated prior period financial information to present its 100% ownership in RLI
Vision Corp. under the equity method. This restatement was a change in
presentation only and had no impact on earnings. In January 1997, the Company
paid $3.7 million for an additional 10% ownership interest in Maui Jim, Inc.,
bringing the Company's total minority interest in Maui Jim, Inc. to 44%.
On May 4, 1995, RLI Vision Corp. acquired through merger Target Industries,
Inc., a wholesale optical goods distributor of contact lenses, Rx spectacles,
frames and sunglasses, located in Cohasset, Mass. As consideration, RLI Corp.
issued 391,875 shares of its common stock. This business combination was
accounted for as a pooling-of-interests. The consolidated financial statements
and related financial information for periods prior to the combination were, at
the time, restated to include the accounts and results of operations of Target
Industries, Inc., including Target Industries, Inc. stand-alone net income for
the year ended December 31, 1994, of $0.2 million.
As a result of the aforementioned merger with Hester Enterprises, Inc., the
accounting for the merger with Target Industries, Inc. as a pooling-of-interests
was no longer applicable. Accordingly, the 1996 financial statements reflect an
adjustment to shareholders' equity of $4.6 million to recognize the change from
pooling-of-interests to purchase accounting, and a charge to earnings of $0.7
million, or $.04 per diluted share, for cumulative goodwill amortization from
May 4, 1995, through November 30, 1996. Prior period financial information was
not restated to reflect this change in accounting due to immateriality.
Prior years' share and per share data have been restated to reflect the
5-for-4 stock split that occurred on June 19, 1998.
C. SUBSEQUENT EVENT: In January 1999, RLI Insurance Company acquired
Underwriters Indemnity Holdings, Inc. (UIH), located in Houston, Texas. UIH
specializes in the marketing and underwriting of surety products for oil, gas,
mining and other energy-related exposures.
RLI paid $40.7 million in cash in exchange for all outstanding shares of
UIH, subject to post-closing contingencies. Included in the transaction
33
<PAGE>
are both of UIH's operating subsidiaries, Underwriters Indemnity Company of
Texas and Planet Indemnity Company of Colorado. The transaction was financed
through short-term borrowings and will be accounted for under the purchase
method of accounting.
D. INVESTMENTS: In compliance with FASB Statement No. 115, "Accounting for
Certain Investments in Debt and Equity Securities," the Company classifies its
investments in all debt securities and those equity securities with readily
determinable fair values into one of three categories: held-to-maturity,
trading, or available-for-sale.
HELD-TO-MATURITY SECURITIES
Debt securities that the Company has the positive intent and ability to hold to
maturity are classified as held-to-maturity and carried at amortized cost.
Except for declines that are other than temporary, changes in the fair value of
these securities are not reflected in the financial statements. The Company has
classified approximately 86% of its portfolio of debt securities as
held-to-maturity.
TRADING SECURITIES
Debt and equity securities purchased for short-term resale are classified as
trading securities. These securities are reported at fair value with unrealized
gains and losses included in earnings. The Company has classified approximately
3% of its portfolio of debt securities as trading.
AVAILABLE-FOR-SALE SECURITIES
All other debt and equity securities not included in the above categories are
classified as available-for-sale and reported at fair value. Unrealized gains
and losses on these securities are excluded from net earnings but are recorded
as a separate component of comprehensive earnings and shareholders' equity, net
of deferred income taxes. All of the Company's equity securities and
approximately 11% of debt securities are classified as available-for-sale.
Short-term investments are carried at cost, which approximates fair value.
The Company continuously monitors the values of its investments in fixed
maturities and equity securities on an ongoing basis. If this review shows that
a decline in fair value is other than temporary, the Company's carrying value in
the investment is reduced to its estimated realizable value through an
adjustment to earnings. Realized gains and losses on disposition of investments
are based on specific identification of the investments sold.
Interest on fixed maturities and short-term investments is credited to
earnings as it accrues. Dividends on equity securities are credited to earnings
on the ex-dividend date.
E. REINSURANCE: Ceded unearned premiums and reinsurance balances
recoverable on unpaid losses and settlement expenses are reported separately as
assets, instead of being netted with the appropriate liabilities, since
reinsurance does not relieve the Company of its legal liability to its
policyholders.
The Company continuously monitors the financial condition of its
reinsurers. The Company's policy is to periodically charge to earnings an
estimate of unrecoverable amounts from troubled or insolvent reinsurers. During
1996, the Company provided $1,006,140 for uncollectible reinsurance balances. No
additional charges occurred in 1997 or 1998. The Company believes that current
reserve levels for uncollectible reinsurance are sufficient to cover the related
exposure.
F. UNPAID LOSSES AND SETTLEMENT EXPENSES: The liability for unpaid losses
and settlement expenses represents estimates of amounts needed to pay reported
and unreported claims and related expenses. The estimates are based on certain
actuarial and other assumptions related to the ultimate cost to settle such
claims. Such assumptions are subject to occasional changes due to evolving
economic, social and political conditions. All estimates are periodically
reviewed and, as experience develops and new information becomes known, the
reserves are adjusted as necessary. Such adjustments are reflected in the
results of operations in the period in which they are determined. Due to the
inherent uncertainty in estimating reserves for losses and settlement expenses,
there can be no assurance that the ultimate liability will not exceed recorded
amounts, with a resulting adverse effect on the Company. Based on the current
assumptions used in calculating reserves, management believes that the Company's
overall reserve levels at December 31, 1998, are adequate to meet its future
obligations.
G. REVENUE RECOGNITION: Insurance premiums are recognized ratably over the
term of the contracts, net of ceded reinsurance. Unearned premiums are
calculated on the monthly pro rata basis.
34
<PAGE>
H. POLICY ACQUISITION COSTS: The costs of acquiring insurance premiums --
principally commissions and brokerage, sales compensation, premium taxes, and
other direct underwriting expenses -- net of reinsurance commissions received,
are amortized over the life of the policies in order to properly match policy
acquisition costs to the related premium revenue. The method followed in
computing deferred policy acquisition costs limits the amount of such deferred
costs to their estimated realizable value, which gives effect to the premium to
be earned, related investment income, losses and settlement expenses and certain
other costs expected to be incurred as the premium is earned.
I. PROPERTY AND EQUIPMENT: Property and equipment are depreciated on a
straight-line basis for financial statement purposes over periods ranging from
three to 10 years for equipment and up to 40 years for buildings and
improvements.
J. INCOME TAXES: The Company files a consolidated income tax return. Tax
provisions are computed and apportioned to the subsidiaries on the basis of
their taxable income.
K. EARNINGS PER SHARE: Pursuant to disclosure requirements contained in
FASB Statement 128, the following represents a reconciliation of the numerator
and denominator of the basic and diluted EPS computations contained in the
financial statements:
(in thousands, except per share data)
For the year ended December 31, 1998
<TABLE>
<CAPTION>
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------ --------
<S> <C> <C> <C>
Basic EPS
Income available to
common shareholders 28,239 10,514 2.69
Incentive stock options -- 124
Diluted EPS
Income available to common share-
holders and assumed conversions 28,239 10,638 2.65
</TABLE>
Conversion of the Company's $46.0 million convertible debenture occurred in
July 1997. See note 4 for further discussion and related disclosures.
(in thousands, except per share data)
For the year ended December 31, 1997
<TABLE>
<CAPTION>
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------ --------
<S> <C> <C> <C>
Basic EPS
Income available to
common shareholders 30,171 10,402 2.90
Effect of dilutive securities
Convertible debentures 1,012 1,230
Incentive stock options -- 82
Diluted EPS
Income available to common share-
holders and assumed conversions 31,183 11,714 2.66
</TABLE>
(in thousands, except per share data)
For the year ended December 31, 1996
<TABLE>
<CAPTION>
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------ --------
<S> <C> <C> <C>
Basic EPS
Income available to
common shareholders 25,696 9,871 2.60
Effect of dilutive securities
Convertible debentures 1,874 2,212
Incentive stock options -- 22
Diluted EPS
Income available to common share-
holders and assumed conversions 27,570 12,105 2.28
</TABLE>
L. COMPREHENSIVE EARNINGS: FASB Statement No. 130, "Reporting Comprehensive
Income," was adopted by the Company in 1997. The primary difference between
reporting the Company's net and comprehensive earnings is that comprehensive
earnings include unrealized gains/losses net of tax. Traditional reporting of
net earnings directly credits or charges shareholders' equity with unrealized
gains/losses, rather than including them in earnings. In reporting the
components of comprehensive earnings on a net basis in the income statement, the
Company has used a 35% tax rate. Other comprehensive income, as shown, is net of
tax expense of $12.7 million, $19.5 million, and $8.8 million, respectively, for
1998, 1997, and 1996.
M. FAIR VALUE DISCLOSURES: The following methods were used to estimate the
fair value of each class of financial instruments for which it was practicable
to estimate that value. Fixed maturities and equity securities are valued using
quoted market prices, if available. If a quoted market price is not available,
fair value is estimated using independent pricing services or quoted market
prices of similar securities. Fair value disclosures for investments are
included in note 2. Due to the relatively short-term nature of cash, short-term
35
<PAGE>
investments, accounts receivable, accounts payable and short-term debt, their
carrying amounts are reasonable estimates of fair value. Fair value of long-term
debt is based on quoted market prices if available or quoted market prices of
similar issues.
N. STOCK BASED COMPENSATION: The Company grants to officers and directors
stock options for a fixed number of shares with an exercise price equal to the
fair market value of the shares at the date of grant. The Company accounts for
stock option grants in accordance with APB Opinion No. 25, "Accounting for Stock
Issued to Employees," and accordingly recognizes no compensation expense for the
stock option grants. See note 8 for further discussion and related disclosures.
O. RISKS AND UNCERTAINTIES: Certain risks and uncertainties are inherent to
the Company's day-to-day operations and to the process of preparing its
financial statements. The more significant risks and uncertainties, as well as
the Company's methods for mitigating, quantifying, and minimizing such, are
presented below and throughout the notes to the consolidated financial
statements.
CATASTROPHE EXPOSURES
The Company's past and present insurance coverages include exposure to
catastrophic events. Catastrophic events such as earthquakes, floods, and
windstorms are covered by certain of the Company's property policies. The
Company has a concentration of such coverages in California (61.0% of gross
property premiums written during 1998). Using computer-assisted modeling
techniques, the Company quantifies and monitors its exposure to catastrophic
events. The Company limits its risk to such catastrophes through the purchase of
reinsurance. Utilizing the above, the Company attempts to limit its net
aggregate exposure to a single catastrophic event to less than 10% of
shareholders' equity.
ENVIRONMENTAL EXPOSURES
The Company is subject to environmental claims and exposures through its
commercial umbrella, general liability and discontinued assumed reinsurance
lines of business. Although exposure to environmental claims exists in these
lines of business, management has sought to mitigate or control the extent of
this exposure through the following methods: 1) the Company's policies include
pollution exclusions that have been continually updated to further strengthen
the exclusion; 2) the Company's policies primarily cover moderate hazard risks;
and 3) the Company began writing this business after the industry became aware
of the potential pollution liability exposure.
The Company has made loss and settlement expense payments on environmental
liability claims and has loss and settlement expense reserves for others. The
Company includes this historical environmental loss experience with the
remaining loss experience in the applicable line of business to project ultimate
incurred losses and settlement expenses and related "incurred but not reported"
loss and settlement expense reserves.
Although historical experience on environmental claims may not accurately
reflect future environmental exposures, the Company has used this experience to
record loss and settlement expense reserves in the exposed lines of business.
See further discussion of environmental exposures in note 6.
REINSURANCE
Reinsurance does not discharge the Company from its primary liability to
policyholders, and to the extent that a reinsurer is unable to meet its
obligations, the Company would be liable. The Company continuously monitors the
financial condition of prospective and existing reinsurers. As a result, the
Company currently attempts to purchase reinsurance from a limited number of
financially strong reinsurers. The Company provides a reserve for reinsurance
balances deemed uncollectible.
FINANCIAL STATEMENTS
The preparation of the consolidated financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the reported
financial statement balances as well as the disclosure of contingent assets and
liabilities. Actual results could differ from those estimates. The most
significant of these amounts is the liability for unpaid losses and settlement
expenses. Management continually updates its estimates as additional data
becomes available and adjusts the financial statements as deemed necessary.
Other estimates such as the recoverability of reinsurance balances, deferred tax
assets and deferred policy acquisition costs are constantly monitored,
evaluated, and adjusted. Although recorded estimates are supported by actuarial
computations and other supportive data, the estimates are ultimately based on
management's expectations of future events.
36
<PAGE>
EXTERNAL FACTORS
The Company's insurance subsidiaries are highly regulated by the states in which
they are incorporated, and by the states in which they do business. Such
regulations, among other things, limit the amount of dividends, impose
restrictions on the amount and types of investments, and regulate rates insurers
may charge for various products. The Company is also subject to insolvency and
guarantee fund assessments for various programs designed to ensure policyholder
indemnification. The Company generally accrues the full amount of the assessment
upon notification.
The National Association of Insurance Commissioners (NAIC) has developed
Property-Casualty Risk-Based Capital (RBC) standards that relate an insurer's
reported statutory surplus to the risks inherent in its overall operations. The
RBC formula uses the statutory annual statement to calculate the minimum
indicated capital level to support asset (investment and credit) risk and
underwriting (loss reserves, premiums written, and unearned premium) risk. The
NAIC model law calls for various levels of regulatory action based on the
magnitude of an indicated RBC capital deficiency, if any. The Company
continuously monitors its subsidiaries' internal capital requirements and the
NAIC's RBC developments. The Company has determined that its capital levels are
well in excess of the minimum capital requirements for all RBC action levels,
and that its capital levels are sufficient to support the level of risk inherent
in its operations.
2. INVESTMENTS
A summary of net investment income is as follows:
<TABLE>
<CAPTION>
Investment Income (in thousands) 1998 1997 1996
<S> <C> <C> <C>
Interest on fixed maturities $ 19,479 $ 19,659 $18,862
Dividends on equity securities 6,718 6,361 5,715
Interest on short-term investments 1,296 1,531 1,573
Gross investment income 27,493 27,551 26,150
Less investment expenses 3,556 2,993 2,469
Net investment income $23,937 $24,558 $23,681
</TABLE>
Pretax net realized investment gains (losses) and net changes in unrealized
gains (losses) on investments for the years ended December 31 are summarized as
follows:
<TABLE>
<CAPTION>
Realized/unrealized gains (in thousands) 1998 1997 1996
<S> <C> <C> <C>
Net realized investment gains (losses)
Fixed maturities
Held-to-maturity $ 34 $ 27 $ 11
Trading 179 117 --
Available-for-sale (9) 175 24
Equity securities 1,148 2,037 361
Other 501 626 621
1,853 2,982 1,017
Net changes in unrealized gains
(losses) on investments
Fixed maturities
Held-to-maturity 3,779 4,030 (6,577)
Available-for-sale (147) 100 (751)
Equity securities 36,330 55,660 25,785
39,962 59,790 18,457
Net realized investment gains and
changes in unrealized gains
(losses) on investments $41,815 $62,772 $19,474
</TABLE>
Following is a summary of the disposition of fixed maturities for the years
ended December 31, with separate presentations for sales and calls/maturities.
Sales
<TABLE>
<CAPTION>
Proceeds Gross Realized Net Realized
(in thousands) From Sales Gains Losses Gain (Loss)
1998
<S> <C> <C> <C> <C>
Available-for-sale 772 -- -- --
Trading 9,358 131 (17) 114
1997
Available-for-sale 8,386 259 (84) 175
Trading 4,354 16 (25) (9)
1996
Available-for-sale 8,298 84 (59) 25
</TABLE>
Calls/Maturities
<TABLE>
<CAPTION>
Proceeds Gross Realized Net Realized
(in thousands) From Sales Gains Losses Gain (Loss)
1998
<S> <C> <C> <C> <C>
Held-to-maturity 34,596 46 (12) 34
Available-for-sale 5,511 1 (10) (9)
Trading 70 -- -- --
1997
Held-to-maturity 29,083 48 (20) 28
Available-for-sale 1,304 -- -- --
Trading 55 -- -- --
1996
Held-to-maturity 17,381 11 (1) 10
Available-for-sale 2,860 -- (1) (1)
</TABLE>
The following is a schedule of amortized costs and estimated fair values of
investments in fixed maturities and equity securities as of December 31, 1998
and 1997.
37
<PAGE>
<TABLE>
<CAPTION>
Amortized Estimated Gross Unrealized
(in thousands) Cost Fair Value Gains Losses
1998
<S> <C> <C> <C> <C>
Held-to-maturity
U.S. governments $ 124,419 $ 128,814 $ 4,395 --
States, political subdi-
visions & revenues 159,573 165,730 6,173 (16)
Total held-to-maturity $ 283,992 $ 294,544 $ 10,568 $ (16)
Trading
U.S. governments $ 3,652 $ 3,726 $ 80 $ (6)
Corporate 4,103 4,216 113 --
States, political subdi-
visions & revenues 402 406 4 --
Total trading $ 8,157 $ 8,348 $ 197 $ (6)
Available-for-sale
U.S. governments $ 15,177 $ 15,528 $ 351 --
Corporate 9,150 8,893 255 (512)
States, political subdi-
visions & revenues 11,858 12,095 241 (4)
Fixed maturities 36,185 36,516 847 (516)
Equity securities 127,367 296,521 170,357 (1,203)
Total available-for-sale $ 163,552 $ 333,037 $ 171,204 $ (1,719)
Total $ 455,701 $ 635,929 $ 181,969 $ (1,741)
</TABLE>
<TABLE>
<CAPTION>
Amortized Estimated Gross Unrealized
(in thousands) Cost Fair Value Gains Losses
1997
<S> <C> <C> <C> <C>
Held-to-maturity
U.S. governments $ 153,767 $ 156,388 $ 2,963 $ (342)
States, political subdi-
visions & revenues 136,267 140,420 4,167 (14)
Total held-to-maturity $ 290,034 $ 296,808 $ 7,130 $ (356)
Trading
U.S. governments $ 3,655 $ 3,713 $ 61 $ (3)
Foreign governments 441 448 7 --
Corporate 4,919 4,978 59 --
States, political subdi-
visions & revenues 404 407 3 --
Total trading $ 9,419 $ 9,546 $ 130 $ (3)
Available-for-sale
U.S. governments $ 20,248 $ 20,465 $ 299 $ (82)
Corporate 6,342 6,473 308 (177)
States, political subdi-
visions & revenues 7,052 7,182 137 (7)
Fixed maturities 33,642 34,120 744 (266)
Equity securities 118,637 251,460 133,273 (450)
Total available-for-sale $ 152,279 $ 285,580 $ 134,017 $ (716)
Total $ 451,732 $ 591,934 $ 141,277 $ (1,075)
</TABLE>
The amortized cost and estimated fair value of fixed-maturity securities at
December 31, 1998, by contractual maturity, are shown as follows.
<TABLE>
<CAPTION>
Amortized Estimated
(in thousands) Cost Fair Value
<S> <C> <C>
Held-to-maturity
Due in one year or less $ 26,479 $ 26,921
Due after one year through five years 94,322 97,537
Due after five years through ten years 99,686 104,227
Due after ten years 63,505 65,859
$ 283,992 $ 294,544
Trading
Due in one year or less $ 201 $ 203
Due after one year through five years 5,666 5,748
Due after five years through ten years 2,290 2,397
Due after ten years -- --
$ 8,157 $ 8,348
Available-for-sale
Due in one year or less $ 6,004 $ 6,105
Due after one year through five years 20,781 21,221
Due after five years through ten years 6,310 6,028
Due after ten years 3,090 3,162
$ 36,185 $ 36,516
</TABLE>
Expected maturities may differ from contractual maturities due to call
provisions present on some existing securities. Management believes the impact
of any calls should be slight and intends to follow its policy of matching
assets against anticipated liabilities.
At December 31, 1998, the net unrealized appreciation of available-for-sale
fixed maturities and equity securities totaled $110.4 million. This amount was
net of deferred taxes of $59.1 million. At December 31, 1997, the net unrealized
appreciation of available-for-sale fixed maturities and equity securities
totaled $86.9 million. This amount is net of deferred taxes of $46.4 million.
The Company is party to a securities lending program whereby fixed-income
securities are loaned to third parties, primarily major brokerage firms. As of
December 31, 1998 and 1997, fixed maturities with a fair value of $25.1 million
and $91.1 million, respectively, were loaned. Agreements with custodian banks
facilitating such lending generally require 102% of the value of the loaned
securities to be separately maintained as collateral for each loan. Pursuant to
FASB Statements 125 and 127, an invested asset and a corresponding liability
have been recognized for this collateral amount. To further minimize the credit
risks related to this lending program, the Company monitors the financial
condition of counter parties to these agreements.
As required by law, certain fixed maturities and short-term investments
amounting to $13.8 million at December 31, 1998, were on deposit with either
regulatory authorities or banks.
38
<PAGE>
Additionally, the Company has certain fixed maturities held in trust amounting
to $8.3 million at December 31, 1998. These funds cover net premiums, losses,
and expenses related to a property and casualty insurance program.
The Company does not invest in derivative securities or collateralized
mortgage obligations (CMOs).
3. POLICY ACQUISITION COSTS
Policy acquisition costs deferred and amortized to income for the years ended
December 31 are summarized as follows:
<TABLE>
<CAPTION>
(in thousands) 1998 1997 1996
<S> <C> <C> <C>
Deferred policy acquisition costs,
beginning of year $21,985 $16,664 $ 15,807
Deferred:
Direct commissions 55,035 57,034 46,740
Premium taxes 4,489 4,382 4,034
Other direct underwriting expenses 20,335 16,340 14,194
Ceding commissions (33,644) (27,812) (31,055)
Net deferred 46,215 49,944 33,913
Amortized 45,690 44,623 33,056
Deferred policy acquisition costs,
end of year $22,510 $21,985 $ 16,664
Policy acquisition costs:
Amortized to expense 45,690 44,623 33,056
Period costs:
Ceding commission - contingent (6,604) (4,400) (5,275)
Other 5,195 2,917 1,775
Total policy acquisition costs $44,281 $43,140 $ 29,556
</TABLE>
4. DEBT
On July 28, 1993, the Company issued $46.0 million of 6.0% convertible
debentures that were to mature July 15, 2003, and pay interest semi-annually.
The Company received $45.1 million in net proceeds from the issue ($46.0
million principal less $0.9 million of underwriting costs incurred) of which
$30.5 million was contributed to the insurance subsidiaries to increase
underwriting capacity and facilitate expansion of their business. The balance
was retained for general corporate purposes, including debt service and the
payment of dividends. All convertible debentures, unless previously redeemed,
were convertible at the option of the holder at any time before maturity into
RLI Corp. common stock at an adjusted conversion price of $20.80 per share.
The Company retained the option to redeem the convertible debentures, in
whole or in part, on or after July 15, 1997, at specified redemption prices,
plus accrued interest to redemption date. On June 20, 1997, the Company
announced that it was calling for redemption all convertible debentures. The
entire issue was to be redeemed for cash on July 22, 1997, at 103% of its
principal amount, plus accrued interest. Holders of the debenture had the
option to convert, at any time prior to the close of business on July 21,
1997, the debentures at an exchange rate of 48.0769 shares of RLI common
stock for each $1,000 principal amount of convertible debt. On July 22, 1997,
the entire $46.0 million was converted into RLI common stock. This conversion
created an additional 2,211,499 new shares of RLI common stock.
During the first quarter of 1996, the Company paid off its short-term
borrowings of $2.8 million, using excess funds from operations.
During 1997 and 1998, the Company utilized its short-term credit facilities
and engaged in three reverse repurchase transactions to partially fund the
Company's common stock repurchase program.
Interest paid on outstanding debt for 1998, 1997, and 1996 amounted to $2.3
million, $2.8 million, and $2.8 million, respectively.
The Company maintains a $30.0 million secured, revolving line of credit
from one financial institution. As of December 31, 1998, the Company had $19.6
million in outstanding short-term borrowings. Additionally, the Company was
party to three reverse repurchase transactions totaling $20.0 million.
5. REINSURANCE
In the ordinary course of business, the insurance subsidiaries assume and cede
premiums with other insurance companies. A large portion of the reinsurance is
effected under reinsurance contracts known as treaties and, in some instances,
by negotiation on each individual risk. In addition, there are excess of loss
and catastrophe reinsurance contracts that protect against losses over
stipulated amounts arising from any one occurrence or event. The arrangements
provide greater diversification of business and serve to limit the maximum net
loss on catastrophes and large and unusually hazardous risks.
Through the purchase of reinsurance, the Company generally limits the loss
on any individual risk to $1.0 million. Additionally, through extensive use of
computer-assisted modeling techniques, the Company monitors the
39
<PAGE>
concentration of risks exposed to catastrophic events (predominantly
earthquakes). The Company seeks to limit its estimated net aggregate exposure to
a single catastrophic event to less than 10% of shareholders' equity.
In 1996, the Company entered into an innovative catastrophe reinsurance and
loss financing program with Centre Reinsurance (Centre Re). The program, called
Catastrophe Equity Puts (CatEPuts), augments the Company's traditional
reinsurance by integrating its loss financing needs with a pre-negotiated sale
of securities linked to exchange-traded shares. CatEPuts allows the Company to
put up to $50.0 million of its convertible preferred shares to Centre Re at a
pre-negotiated rate in the event of a catastrophic loss, provided the loss does
not reduce GAAP equity to less than $55.0 million. CatEPuts is a three-year
program and is designed to enable the Company to continue operating after a loss
of such magnitude that its reinsurance capacity is exhausted. If the Company
exercises its option to put preferred shares to Centre Re, then Centre Re, in
turn, has the option to reinsure certain business written by the Company on a
prospective basis. This agreement is scheduled for renewal in October 1999.
Premiums written and earned along with losses and settlement expenses
incurred for the years ended December 31 are summarized as follows:
<TABLE>
<CAPTION>
(in thousands) 1998 1997 1996
<S> <C> <C> <C>
Written
Direct $ 288,135 $ 265,850 $ 276,707
Reinsurance assumed 2,938 12,993 94
Reinsurance ceded (145,372) (134,170) (144,444)
Net $ 145,701 $ 144,673 $ 132,357
Earned
Direct $ 274,996 $ 268,569 $ 271,552
Reinsurance assumed 2,597 11,513 33
Reinsurance ceded (135,269) (138,198) (140,929)
Net $ 142,324 $ 141,884 $ 130,656
Losses and settlement
expenses incurred
Direct $ 112,325 $ 96,379 $ 109,528
Reinsurance assumed 6,887 5,960 10
Reinsurance ceded (54,484) (41,088) (41,277)
Net $ 64,728 $ 61,251 $ 68,261
</TABLE>
At December 31, 1998, the Company had prepaid reinsurance premiums and
reinsurance recoverables on paid and unpaid losses and settlement expenses with
American Re-Insurance Company (rated A+ "Superior" by A.M. Best Company) that
amounted to $80.4 million. All other reinsurance balances recoverable, when
considered by individual reinsurer, are less than 10% of shareholders' equity.
6. UNPAID LOSSES AND SETTLEMENT EXPENSES
The following table reconciles the Company's liability for unpaid losses and
settlement expenses (LAE) for the three years ended December 31, 1998. Since
reserves are based on estimates, the ultimate net cost may vary from the
original estimate. As adjustments to these estimates become necessary, they are
reflected in current operations. As part of the reserving process, historical
data is reviewed and consideration is given to the anticipated impact of various
factors such as legal developments and economic conditions, including the
effects of inflation. Changes in reserves from the prior years' estimates are
calculated based on experience as of the end of each succeeding year (loss and
LAE development).
<TABLE>
<CAPTION>
(in thousands) 1998 1997 1996
<S> <C> <C> <C>
Unpaid losses and LAE
at beginning of year:
Gross $404,263 $ 405,801 $418,986
Ceded (155,711) (157,995) (186,678)
Net 248,552 247,806 232,308
Increase (decrease) in incurred
losses and LAE:
Current accident year 68,131 61,771 69,724
Prior accident years (3,403) (520) (1,463)
Total incurred 64,728 61,251 68,261
Loss and LAE payments for
claims incurred:
Current accident year (14,762) (11,284) (11,026)
Prior accident years (54,927) (49,023) (41,143)
Total paid (69,689) (60,307) (52,169)
Insolvent reinsurer charge off 7,911 (627) 607
Loss reserves commuted (4,240) 429 (1,201)
Net unpaid losses and LAE
at end of year $247,262 $ 248,552 $247,806
Unpaid losses and LAE
at end of year:
Gross 415,523 404,263 405,801
Ceded (168,261) (155,711) (157,995)
Net $247,262 $ 248,552 $247,806
</TABLE>
During the three years, overall development on prior accident-year loss and
settlement expense reserves was insignificant to operating results and recorded
loss and settlement expense reserves.
40
<PAGE>
The Company is subject to environmental claims and exposures through its
commercial umbrella, general liability, and discontinued assumed reinsurance
lines of business. Within these lines, the Company's environmental exposures
include environmental site cleanup, asbestos removal, and mass tort liability.
The majority of the exposure is in the excess layers of the Company's commercial
umbrella and assumed reinsurance books of business.
The following table represents inception-to-date paid and unpaid
environmental claims data (including incurred but not reported losses) for the
periods ended 1998, 1997 and 1996:
<TABLE>
<CAPTION>
Inception-to-date December 31,
(In thousands) 1998 1997 1996
<S> <C> <C> <C>
Loss and LAE payments for
claims incurred
Gross $14,690 $ 11,570 $ 8,267
Ceded (9,140) (7,646) (5,761)
Net $ 5,550 $ 3,924 $ 2,506
Unpaid losses and LAE at end of year
Gross $12,360 $ 14,880 $17,596
Ceded (5,876) (8,842) (11,150)
Net $ 6,485 $ 6,038 $ 6,446
</TABLE>
Although the Company's environmental exposure is limited as a result of
entering the liability lines after the industry had already recognized it as a
problem, management cannot determine the Company's ultimate liability with any
reasonable degree of certainty. This ultimate liability is difficult to assess
due to evolving legislation on such issues as joint and several liability,
retroactive liability, and standards of cleanup. Additionally, the Company
participates primarily in the excess layers, making it even more difficult to
assess the ultimate impact.
7. INCOME TAXES
The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and deferred tax liabilities are summarized in the
following table.
<TABLE>
<CAPTION>
(In thousands) 1998 1997 1996
<S> <C> <C> <C>
Deferred tax assets:
Tax discounting of claim reserves $ 15,388 $ 14,775 $ 12,875
Unearned premium offset 5,757 5,521 5,326
Other, net 2,551 3,016 492
23,696 23,312 18,693
Less valuation allowance (300) (300) (300)
Total deferred tax assets $ 23,396 $ 23,012 $ 18,393
Deferred tax liabilities:
Net unrealized appreciation
of securities $ 59,113 $ 46,448 $ 26,932
Deferred policy acquisition costs 7,879 7,695 5,832
Books/tax depreciation 1,328 1,606 1,350
Other, net 3,497 3,603 1,450
Total deferred tax liabilities 71,817 59,352 35,564
Net deferred tax asset (liability) $ (48,421) $ (36,340) $ (17,171)
</TABLE>
Management feels it is more likely than not that a portion of the Company's
deferred tax assets will not be realized. Therefore, an allowance has been
established for certain deferred tax assets that have an indefinite reversal
pattern. Management also believes the Company's remaining deferred tax assets
will be fully realized through deductions against future taxable income.
Income tax expense attributable to income from operations for the years
ended December 31, 1998, 1997, and 1996 differed from the amounts computed by
applying the U.S. federal tax rate of 35% to pretax income from continuing
operations as demonstrated in the following table.
<TABLE>
<CAPTION>
(In thousands) 1998 1997 1996
<S> <C> <C> <C>
Provision for income taxes at
the statutory federal tax rates $ 13,202 $ 14,533 $ 12,334
Increase (reduction) in taxes
resulting from:
Dividends received deduction (1,409) (1,322) (1,216)
Dividends paid deduction (231) (236) (258)
Tax exempt interest income (2,271) (1,876) (1,567)
State income tax provision 170 160 132
Other items, net 21 92 119
$ 9,482 $ 11,351 $ 9,544
</TABLE>
The Company has recorded its deferred tax assets and liabilities using the
statutory federal tax rate of 35%. Management believes when these deferred items
reverse in future years, the Company's taxable income will be taxed at an
effective rate of 35%.
Net federal and state income taxes paid in 1998, 1997, and 1996 amounted to
$10.6 million, $11.1 million, and $1.4 million, respectively.
The Internal Revenue Service (IRS) has examined the Company's income tax
returns
41
<PAGE>
through the tax year ended December 31, 1990. The IRS is currently examining the
Company's income tax returns through the tax year ended December 31, 1994.
Management believes any tax implication from examinations of these years should
not materially impact the Company's consolidated financial position or results
of operations.
8. EMPLOYEE BENEFITS
PENSION PLAN
The Company maintains a noncontributory defined benefit pension plan covering
substantially all employees meeting age and service requirements. The plan
provides a benefit based on a participant's service and the highest five
consecutive years' average compensation out of the last 10 years. The Company
funds pension costs as accrued, except that in no case will the Company
contribute amounts less than the minimum contribution required under the
Employee Retirement Income Security Act of 1974 or more than the maximum tax
deductible contribution for the year. The plan reached the full funding
limitation in 1986 and remained fully funded through 1993. During 1998, 1997,
and 1996, the Company made the maximum tax deductible contribution allowed,
totaling $422,489, $453,146, and $413,977, respectively, to adequately meet the
funding requirements of the plan.
The Company has made various amendments to the plan in order to comply with
certain Internal Revenue Code changes.
The financial status of the plan for each of the three years ended December
31 is illustrated in the following tables:
<TABLE>
<CAPTION>
For the year ended December 31,
1998 1997 1996
<S> <C> <C> <C>
Components of pension cost
Service cost $ 530,886 $ 414,301 $ 419,349
Interest cost 336,573 291,324 270,965
Expected return on
plan assets (427,320) (354,166) (320,036)
Recognized prior
service cost 3,051 3,051 3,051
Recognized net loss -- 1,353 14,608
Amortization of transition
(asset) obligation (32,566) (32,566) (32,566)
Pension cost $ 410,624 $ 323,297 $ 355,371
Accumulated benefit
obligation $3,854,111 $ 3,222,460 $3,096,953
</TABLE>
<TABLE>
<CAPTION>
For the year ended December 31,
1998 1997 1996
<S> <C> <C> <C>
Change in plan assets
Fair value of plan assets
at January 1 $4,157,321 $ 3,328,525 $3,253,386
Actual return on plan assets 600,966 852,855 403,266
Employer contribution 422,489 453,146 413,977
Benefit payments (463,901) (477,205) (742,104)
Fair value of plan assets
at December 31 $4,716,875 $ 4,157,321 $3,328,525
Change in projected
benefit obligation
Projected benefit obligation
at January 1 $4,416,028 $ 4,039,460 $3,835,535
Service cost 530,886 414,301 419,349
Interest cost 336,573 291,324 270,965
Actuarial losses 518,388 148,148 255,715
Benefit payments (463,901) (477,205) (742,104)
Projected benefit obligation
at December 31 $5,337,974 $ 4,416,028 $4,039,460
Funded status $ (621,099) $ (258,707) $ (710,935)
Unrecognized net loss 458,391 113,649 465,543
Unamortized prior
service cost 3,214 6,265 9,316
Unrecognized transition
(asset) obligation (169,347) (201,913) (234,479)
(Accrued) prepaid at
December 31 $ (328,841) $ (340,706) $ (470,555)
Amounts recognized in the
statement of financial
position consist of:
Accrued benefit liability $(328,841) $ (340,706) $ (470,555)
Net amount recognized $(328,841) $ (340,706) $ (470,555)
Rates
Discount rate 7.00% 7.25% 7.50%
Compensation increase 6.00% 6.00% 6.00%
Expected return on
plan assets 10.00% 10.00% 10.00%
</TABLE>
At December 31, 1998, plan assets at fair value are comprised of
approximately 95% equity securities and 5% invested cash.
EMPLOYEE STOCK OWNERSHIP AND BONUS AND INCENTIVE PLANS
The Company has both an Employee Stock Ownership Plan (ESOP) and an officer
performance incentive plan. In 1996, the Company adopted a new approach for
evaluating the funding of these plans. Called the Market Value Potential (MVP)
plan, the new program is designed to ensure that the interests of the Company's
associates correspond with those of our shareholders. Beginning in 1997, the
Company established an additional provision allowing for employee bonus
participation.
42
<PAGE>
MVP requires that the Company generate a return on equity in excess of its
cost of capital before either the funding of the ESOP or the payment of
associate bonuses. Under MVP, funds in excess of the cost of capital are first
designated to fund the Company's ESOP up to the maximum allowable contribution
of 15% of eligible wages. MVP in excess of the ESOP funding is then shared by
the associates.
Associates can receive a maximum of 1% of the excess on an after-tax basis,
while officers can receive a maximum of approximately 8% of the excess on an
after-tax basis. All remaining funds are reinvested in the Company for the
benefit of the shareholders. MVP further limits the officer payout in a given
year to 50% (60% prior to 1998) of the combination of bonuses earned in the
previous fiscal year plus any unpaid balance carried forward from prior years.
The remaining balance is at risk and is retained by the Company. This amount is
posted to a participant's "bank account" and is subject to achieving the MVP
target return in the succeeding fiscal year.
The following table illustrates the amount earned, the percentage of MVP
earned, and the subsequent amount paid for each year:
<TABLE>
<CAPTION>
(In thousands) 1998 1997 1996
<S> <C> <C> <C>
Earned (current year)
Executives $ 2,960 $ 5,390 $ 2,810
Percent of MVP 7.70% 7.91% 7.07%
Employees $ 388 $ 689 --
Percent of MVP 1.00% 1.00%
Paid (subsequent year)
Executives $ 2,127 $ 3,858 $ 1,686
Employees $ 388 $ 689 --
</TABLE>
In addition to the executive amount paid in 1998, an additional $547,000
was deferred towards Company stock plans as discussed below.
The Company's ESOP covers substantially all employees meeting eligibility
requirements. ESOP contributions are determined annually by the Company's board
of directors, subject to the achievement of MVP targets, and are expensed in the
year earned. During 1998, the Company leveraged the ESOP and purchased a total
of 70,400 shares at an average price of $35.58 per share ($2.5 million) in the
third quarter in advance of the actual contribution to the plan. These purchases
were internally financed with the Company and resulted in ESOP-related expense
of $2.9 million for the year compared to $2.6 million in 1997 and $2.8 million
in 1996. At its December 1998 meeting, the board approved a contribution subject
to a favorable MVP result. Contributions were authorized in 1997 and 1996, as
well.
During 1998, the ESOP purchased 61,802 shares on the open market at an
average price of $38.54 ($2.4 million) During 1997, the ESOP purchased 79,801
shares of the Company's common stock on the open market at an average price of
$26.62 ($2.1 million). During 1996, the ESOP purchased 95,625 shares of the
Company's treasury stock at an average price of $20.30 ($1.9 million). In 1997
and 1996, shares held by the ESOP were treated as outstanding in computing the
Company's earnings per share. At December 31, 1998, unearned leveraged shares
were not considered outstanding for calculating earnings per share. Dividends on
earned ESOP shares are passed through to the participants.
DEFERRED COMPENSATION
The Company maintains a Rabbi Trust for deferred compensation plans for
directors, key employees and executive officers through which company shares are
purchased. During 1998, the Emerging Issues Task Force reached its consensus on
issue 97-14 relative to Rabbi Trusts. This prescribed an accounting treatment
where the employer stock in the plan is classified and accounted for in equity,
in a manner consistent with the accounting for treasury stock. This increased
the Company's treasury stock by $3.5 million in 1998. The deferred compensation
obligation is classified as an equity instrument. This treatment was applied
prospectively by the Company in 1998.
The expense associated with funding these plans is recognized through
salary, bonus, and ESOP expenses for key employees and executive officers as
disclosed in prior notes. The expense recognized from the directors deferred
plan was $175,900, $158,600, and $139,075 in 1998, 1997 and 1996, respectively.
In 1998, the Rabbi Trusts purchased 15,521 shares of the Company's common stock
on the open market at an average price of $37.20 ($577,409). In 1997, the Rabbi
Trusts purchased 9,679 shares of the Company's common stock on the open market
at an average price of $31.62 ($306,027). In 1996, the Rabbi Trusts purchased
13,200 shares of the Company's treasury stock, at an average price of $20.18
($266,339) and 5,375 shares of the Company's common stock on the open market at
an average price of $25.70 ($138,138). At December 31, 1998, the Trusts' assets
were valued at $5.9 million.
43
<PAGE>
STOCK OPTION PLAN
During 1995, the Company adopted and the shareholders approved a tax-favored
incentive stock option plan (the Incentive Plan). During 1997, the shareholders
approved the Outside Directors' Stock Option Plan (the Directors' Plan). The
Company accounts for the plan in accordance with APB Opinion No. 25, under which
no compensation cost has been recognized.
Had compensation cost for the plan been determined consistent with FASB
Statement No. 123, "Accounting for Stock-Based Compensation," the Company's net
income and earnings per share would have been reduced to the following pro forma
amounts:
<TABLE>
<CAPTION>
(in thousands, except per share data) 1998 1997 1996
<S> <C> <C> <C>
Net income: As reported $ 28,239 $ 30,171 $ 25,696
Pro forma 27,592 29,789 25,462
Diluted EPS:As reported $ 2.65 $ 2.66 $ 2.28
Pro forma $ 2.59 2.63 2.26
</TABLE>
These pro forma amounts may not be representative of the effects of FASB
Statement No. 123 on pro forma net income for future years because options vest
over several years and additional awards may be granted in the future.
Under the Incentive Plan, an officer may be granted an option to purchase
shares at 100% of the grant date fair market value (110% if the optionee and
affiliates own 10% or more of the shares), payable as determined by the
Company's board of directors. An option may be granted only during the 10-year
period ending in May 2005. An optionee must exercise an option within 10 years
(five years if the optionee and affiliates own 10% or more of the shares) from
the grant date. Full vesting of options granted occurs at the end of five years.
Under the Directors' Plan, shares granted do not qualify as tax-favored
incentive stock options. Directors may be granted non-qualified options to
purchase shares at 100% of the grant date fair market value. An optionee must
exercise an option within 10 years from the grant date. Full vesting occurs at
the end of three years, except in the case of death, disability, or termination
of Director status, at which time all options become fully vested and
exercisable.
Additionally, subject to the Directors' Plan's approval by shareholders,
the Directors' Plan included a grant of 30,000 shares (3,750 per Director)
effective on May 2, 1996. Shareholder approval occurred at the May 1997
shareholder meeting. As a result, 1996 plan data, as provided, has been restated
to include the impact of this grant.
The Company may grant options for up to 1,562,500 shares under the
Incentive Plan and 250,000 shares under the Directors' Plan. Through December
31, 1998, the Company has granted 425,351 options under these plans. Under both
plans, the option exercise price equals the stock's fair market value on the
date of grant.
A summary of the status of the plans at December 31, 1998, 1997 and 1996,
and changes during the years then ended are presented in the following table and
narrative:
<TABLE>
<CAPTION>
1998 1997 1996
Weighted- Weighted- Weighted-
Average Average Average
Number Exercise Number Exercise Number Exercise
of Shares Price of Shares Price of Shares Price
<S> <C> <C> <C> <C> <C> <C>
Outstanding
at beginning
of year 277,347 $21.15 181,626 $17.72 82,032 $16.48
Granted 134,252 42.06 104,500 26.87 104,563 18.63
Exercised 3,231 18.77 8,779 18.38 -- --
Forfeited 23,294 32.22 -- -- 4,969 16.48
Outstanding at
end of year 385,074 27.78 277,347 21.14 181,626 17.72
Exercisable at
end of year 112,652 19.46 50,413 17.45 15,688 16.48
Weighted-avg.
fair value of
options
granted
during year $12.49 $ 8.78 $ 6.25
</TABLE>
The fair market value of each option grant is estimated on the date of
grant using the Black-Scholes option pricing model with the following
weighted-average assumptions used for grants in 1998, 1997 and 1996,
respectively: risk-free interest rates of 5.66%, 6.64% and 6.82%; expected
dividend yields of 2.87%, 3.10% and 3.15%; expected lives of 10 years; and
expected volatility of 23.79%, 26.30% and 27.35%.
Information on the range of exercise prices for options outstanding as of
December 31, 1998, is as follows:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
Weighted-
Average Weighted- Weighted-
Outstanding Remaining Average Exercisable Average
Range of as of Contractual Exercise as of Exercise
Exercise Price 12/31/98 Life Price 12/31/98 Price
<S> <C> <C> <C> <C> <C>
$ 0.00 - $16.88 69,595 6.1 $16.48 42,840 $16.48
$16.89 - $21.10 90,926 7.2 $18.36 45,462 $18.35
$21.11 - $37.98 102,801 8.3 $26.88 24,350 $26.79
$37.99 - $42.20 121,752 9.3 $42.04 -- --
385,074 8.0 $27.78 112,652 $19.46
</TABLE>
44
<PAGE>
POST-RETIREMENT BENEFITS OTHER THAN PENSION
The Company does not provide post-retirement or post-employment benefits to
employees and therefore does not have any liability under FASB Statement No.
106, "Employer's Accounting for Postretirement Benefits Other Than Pensions" or
FASB Statement No. 112, "Employers' Accounting for Post-employment Benefits."
9. STATUTORY INFORMATION AND DIVIDEND RESTRICTIONS
The Company's insurance subsidiaries maintain their accounts in conformity with
accounting practices prescribed or permitted by state insurance regulatory
authorities that vary in certain respects from GAAP. Reconciliations of net
income and shareholders' equity (statutory surplus), as reported in conformity
with statutory reporting practices to that reported in the accompanying
financial statements on the basis of GAAP, are shown as follows:
<TABLE>
<CAPTION>
Year ended December 31,
Net Income (Loss) (in thousands) 1998 1997 1996
<S> <C> <C> <C>
Consolidated net income (loss),
statutory basis $29,404 $26,897 $29,486
Proposition 103 liability -- -- 2,500
Deferred policy acquisition costs 526 5,321 857
Deferred income
tax benefit (expense) 583 347 (3,506)
Net income of non-insurance operations,
interest expense on debt and
general corporate expense (1,859) (2,328) (3,605)
Other (415) (66) (36)
As reported in accompanying
financial statements $28,239 $30,171 $25,696
</TABLE>
<TABLE>
<CAPTION>
December 31,
Shareholders' Equity (in thousands) 1998 1997
<S> <C> <C>
Consolidated surplus, statutory basis $314,484 $265,526
Deferred policy acquisition costs 22,510 21,985
Non-admitted assets 3,399 2,738
Subsidiary ownership in RLI Corp. (9,894) (11,412)
Deferred tax liability (48,421) (36,340)
Statutory liability for reinsurance 525 881
Equity of non-insurance companies 10,504 22,427
Other 852 747
As reported in accompanying
financial statements $293,959 $266,552
</TABLE>
Dividend payments to the Company from its principal insurance subsidiary
are restricted by state insurance laws as to the amount that may be paid without
prior notice or approval of the regulatory authorities of Illinois and
California. The maximum dividend distribution is limited by Illinois and
California law to the greater of: 10% of RLI Insurance Company's policyholder
surplus as of December 31 of the preceding year, or the net income of RLI
Insurance Company for the 12-month period ending December 31 of the preceding
year. Therefore, the maximum dividend distribution that can be paid by RLI
Insurance Company during 1999 without prior notice or approval amounts to $31.4
million -- 10% of RLI Insurance Company's 1998 policyholder surplus. The actual
amount paid to the Company during 1998 was $11.8 million.
10. COMMITMENTS AND CONTINGENT LIABILITIES
The Company is involved in certain legal proceedings and disputes considered by
management to be ordinary and incidental to the business, or which have no
foundation in fact. Management believes that valid defenses exist as to all such
litigation and disputes and is of the opinion that these will not have a
material effect on the Company's financial statements.
In November 1988, California voters approved Proposition 103, which
requires insurance rates for certain lines of business to be rolled back 20%
from the rates in effect in November 1987. During 1996, the Company reached a
settlement with the California Department of Insurance resolving its total
liability for refunds and interest under Proposition 103. The settlement
required the Company to pay $3.0 million in refunds and interest. In the second
quarter of 1996, the Company recorded a pretax charge of $0.5 million to record
the difference between the actual settlement and the amount previously accrued.
During 1998 and 1997, the Company issued refund checks to policyholders. As of
December 31, 1998, there was no liability and all remaining funds have been
remitted to the state of California.
The Company leases regional office facilities and automobiles under
operating leases expiring in various years through 2003. Minimum future rental
payments under noncancellable operating leases are as follows:
<TABLE>
<CAPTION>
<S> <C>
1999 $1,359,072
2000 1,149,961
2001 1,044,436
2002 692,817
2003 229,251
Total minimum future rental payments $4,475,537
</TABLE>
45
<PAGE>
11. INDUSTRY SEGMENT INFORMATION
The following table summarizes the Company's segment data as specified by FASB
Statement No. 131, "Disclosures about Segments of an Enterprise and Related
Information." As prescribed by the pronouncement, reporting is based on the
internal structure and reporting of information as it is used by Company
management.
The segments of the property/casualty operations of the Company include
property, casualty and surety. The property segment is comprised of insurance
products providing physical damage coverage for commercial risks. These risks
are exposed to a variety of perils including earthquakes, fires and hurricanes.
Losses are developed in a relatively short period of time. The casualty segment
includes liability products where loss and related settlement expenses must be
estimated, as the ultimate disposition of claims may take several years to fully
develop. Policy coverage is more significantly impacted by evolving legislation
and court decisions. The surety segment offers a selection of small- and
medium-sized commercial products related to the statutory requirement for bonds
on construction projects. The results of this segment are characterized by
relatively low loss ratios. However, expense ratios tend to be higher due to the
high volume of transactions at lower premium levels. The investment income
segment is the by-product of the interest and dividend income streams from the
Company's investments in fixed income and equity securities. Interest and
general corporate expenses include the cost of debt and other director and
shareholder relation costs incurred for the benefit of the corporation, but not
attributable to the operations of other segments. Investee earnings represent
the Company's share in Maui Jim, Inc. earnings. The Company owns approximately
44% of the unconsolidated investee, which operates in sunglass and optical goods
industries.
The following table provides data on each of the Company's segments as used
by company management. The net earnings of each segment are before taxes, and
include revenues (if applicable), direct product or segment costs (such as
commissions, claims costs, etc.), as well as allocated support costs from
various overhead departments. While depreciation and amortization charges have
been included in these measures, the related assets are not allocated for
management use and, therefore, are not included in this schedule.
<TABLE>
<CAPTION>
Depreciation
(in thousands) Net Earnings Revenues and Amortization
1998 1997 1996 1998 1997 1996 1998 1997 1996
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Property $19,800 $21,410 $ 18,831 $ 52,281 $ 62,028 $ 48,182 $1,048 $ 927 $739
Casualty (2,292) (3,185) (2,028) 71,736 68,365 78,068 993 904 1,427
Surety (719) 526 (406) 18,307 11,491 4,406 280 169 113
Net investment income 23,937 24,558 23,681 23,937 24,558 23,681 81 91 69
Realized gains 1,853 2,982 1,017 1,853 2,982 1,018
General corporate
and interest on debt (6,195) (5,720) (6,086) 113 99 831
Equity in earnings of
unconsolidated investee 1,337 951 231
Total segment earnings
before income taxes 37,721 41,522 35,240
Income taxes 9,482 11,351 9,544
Total $28,239 $30,171 $25,696 $168,114 $169,424 $155,355 $2,515 $2,190 $3,179
</TABLE>
46
<PAGE>
12. UNAUDITED INTERIM FINANCIAL INFORMATION
Selected quarterly information is as follows:
<TABLE>
<CAPTION>
(in thousands, except per share data) First Second Third Fourth Year
<S> <C> <C> <C> <C> <C>
1998
Net premiums earned $34,915 $35,085 $35,951 $36,373 $142,324
Net investment income 5,945 5,741 6,180 6,071 23,937
Net realized investment gains 573 66 32 1,182 1,853
Earnings before income taxes 9,422 10,393 7,137 10,769 37,721
Net earnings 6,976 7,625 5,578 8,060 28,239
Basic earnings per share(1) $0.66 $0.72 $0.53 $0.78 $2.69
Basic operating earnings per share(1)(2) $0.62 $0.72 $0.53 $0.71 $2.58
Diluted earnings per share(1) $0.65 $0.71 $0.53 $0.77 $2.65
Diluted operating earnings per share(1)(2) $0.62 $0.71 $0.53 $0.70 $2.54
1997
Net premiums earned $33,066 $35,974 $35,895 $36,949 $141,884
Net investment income 6,022 5,999 6,247 6,290 24,558
Net realized investment gains 560 1,734 545 143 2,982
Earnings before income taxes 8,870 11,005 10,850 10,797 41,522
Net earnings 6,557 7,982 7,898 7,734 30,171
Basic earnings per share(1) $0.68 $0.84 $0.71 $0.69 $2.90
Basic operating earnings per share(1)(2) $0.64 $0.72 $0.67 $0.68 $2.71
Diluted earnings per share(1) $0.59 $0.72 $0.68 $0.68 $2.66
Diluted operating earnings per share(1)(2) $0.56 $0.62 $0.65 $0.67 $2.50
</TABLE>
(1)Since the weighted-average shares for the quarters are calculated
independently of the weighted-average shares for the year, and due to the
exclusion of the antidilutive effects as discussed in note 1K, quarterly
earnings per share may not total to annual earnings per share.
(2)Operating earnings per share is calculated by reducing net earnings by the
after-tax impact of net realized investment gains.
47
<PAGE>
REPORT OF INDEPENDENT AUDITORS
THE BOARD OF DIRECTORS AND SHAREHOLDERS
RLI Corp.
We have audited the accompanying consolidated balance sheets of RLI Corp.
and Subsidiaries as of December 31, 1998 and 1997, and the related consolidated
statements of earnings and comprehensive earnings, shareholders' equity, and
cash flows for each of the years in the three-year period ended December 31,
1998. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of RLI Corp.
and Subsidiaries at December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 1998, in conformity with generally accepted accounting
principles.
January 14, 1999
KPMG
Certified Public Accountants
303 East Wacker Drive
Chicago, Illinois 60601
<PAGE>
STATEMENT OF FINANCIAL REPORTING RESPONSIBILITY
The management of RLI Corp. and Subsidiaries is responsible for the
preparation and for the integrity and objectivity of the accompanying financial
statements and other financial information in this report. The financial
statements have been prepared in accordance with generally accepted accounting
principles and include amounts that are based on management's estimates and
judgments.
The accompanying financial statements have been audited by KPMG LLP (KPMG),
independent certified public accountants, selected by the audit committee and
approved by the shareholders. Management has made available to KPMG all the
Company's financial records and related data, including minutes of directors'
meetings. Furthermore, management believes that all representations made to KPMG
during its audit were valid and appropriate.
Management has established and maintains a system of internal controls
throughout its operations that are designed to provide assurance as to the
integrity and reliability of the financial statements, the protection of assets
from unauthorized use, and the execution and recording of transactions in
accordance with management's authorization. The system of internal controls
provides for appropriate division of responsibility and is documented by written
policies and procedures that are updated by management as necessary. Certain
aspects of these systems and controls are tested periodically by the Company's
internal auditor. As part of its audit of the financial statements, which is
performed in accordance with generally accepted auditing standards, KPMG
considers certain aspects of the system of internal controls to the extent
necessary to form an opinion on the financial statements and not to provide
assurance on the system of internal controls. Management considers the
recommendations of its internal auditor and independent public accountants
concerning the Company's internal controls and takes the necessary actions that
are cost effective in the circumstances to respond appropriately to the
recommendations presented. Management believes that as of December 31, 1998, the
Company's system of internal controls was adequate to accomplish the objectives
described herein.
The audit committee is comprised solely of four non-employee directors and
is charged with general supervision of the audits, examinations and inspections
of the books and accounts of RLI Corp. and Subsidiaries. It also recommends to
the board of directors the firm of independent public accountants to be engaged
to audit the annual consolidated financial statements, and it meets regularly
with those independent public accountants and with management, both separately
and together. The independent public accountants and the internal auditor have
ready access to the audit committee.
Gerald D. Stephens, CPCU
President, RLI Corp.
Joseph E. Dondanville, CPA
Vice President, Chief Financial Officer, RLI Corp.
48
<PAGE>
GLOSSARY
CAPACITY -- The amount of insurance that a company can write on a single
risk.
CATEPUTS-SM- -- An innovative financing arrangement that provides for
the issuance of the company's convertible preferred shares at a
pre-negotiated rate to restore surplus to a sufficient level and to continue
writing business in the event of a catastrophic loss.
CEDE -- To buy or effect reinsurance.
COMBINED RATIO -- A measurement commonly used to express underwriting
profit (less than 100) or loss (more than 100). It is a combination of the
expense ratio and the loss ratio.
COMMERCIAL PROPERTY INSURANCE -- Coverage for commercial or business
entities for financial loss from damage to real and personal property, and
interruption of the business resulting from such damage.
COMPREHENSIVE EARNINGS -- As defined at RLI, this equates to the sum of net
after-tax earnings and net after-tax unrealized gains (losses) on investments.
COMPREHENSIVE GENERAL LIABILITY INSURANCE -- Liability coverage for all
premises and operations, other than personal, for all general liability hazards,
unless excluded.
CONSOLIDATED REVENUE -- As defined at RLI, consists of net premiums earned,
net investment income and realized gains (losses).
CONTRACT BOND -- A guarantee of the faithful performance of a construction
contract and the payment of all related labor and material bills.
DIFFERENCE IN CONDITIONS (DIC) INSURANCE --Coverage for property causes of
loss normally excluded in standard commercial or personal property policies,
particularly flood and earthquake.
DIRECTORS AND OFFICERS LIABILITY INSURANCE -- Insurance that protects the
personal assets of an organization's directors and officers from claims brought
by employees, shareholders, regulatory agencies or other outside third parties
alleging wrongful acts in the discharge of their duties.
EXCESS INSURANCE -- A policy or bond covering the insured against certain
hazards, which applies only to loss or damage in excess of a stated amount.
EXPENSE RATIO -- The percentage of the premium used to pay all the costs of
acquiring, writing and servicing business.
FIRE INSURANCE -- Property insurance on which the predominant peril is
fire, but also includes wind and other allied lines.
FOCUSED PRODUCT MANAGEMENT -- A business approach to managing individual
products by assigning responsibility for each product to a dedicated team of
individuals drawn from the various support functions based on their expertise in
that product.
GROSS SALES -- As defined at RLI, consists of gross premiums written, net
investment income and realized gains (losses).
IBNR -- Incurred But Not Reported losses; as defined at RLI, is the
difference between actuarially determined expected ultimate losses and loss
adjustment expenses and currently reported loss and loss adjustment expenses.
INLAND MARINE INSURANCE -- Property coverage for perils arising from
transportation of goods or covering types of property that are more mobile in
nature, as well as other unusual property hazards.
LOSS RATIO -- The proportion which losses incurred bear to the earned
premiums.
MARKET VALUE POTENTIAL (MVP) -- An internal asset allocation plan. The
amount by which an investment, acquisition or program generates a return in
excess of the cost of assigned capital is defined as MVP.
POLICYHOLDER SURPLUS -- The residual difference between assets and
liabilities for the benefit of policyholders.
PRIMARY INSURER -- A company providing coverage up to a specified amount
against specific perils. Other insurers may write coverage above, or IN EXCESS,
of the specified amount.
PRODUCER -- Term commonly applied to an agent, solicitor, broker, or entity
marketing insurance coverages, such as wholesale brokers (who market to retail
agents) and retail agents (who market to insureds).
PRODUCTS LIABILITY INSURANCE -- Protection provided against claims arising
from the use of covered products manufactured, sold, handled or distributed by
the insured.
<PAGE>
PROFESSIONAL LIABILITY INSURANCE -- Insures against claims for damages
because of professional misconduct or failure to exercise ordinary care in the
performance of a professional service.
PROPERTY AND CASUALTY INSURANCE -- All forms of insurance coverage except
for life insurance and accident/health insurance.
REINSURER/REINSURANCE -- A company that accepts part or all of the risk of
loss covered by another insurer. Insurance for insurers.
RESERVES -- Funds set aside by an insurer for meeting obligations when due.
RETENTION -- The amount of liability retained on a given risk. If an
insurer buys $40,000 of reinsurance on a $50,000 risk, it has RETAINED a
$10,000 potential liability.
RISK MANAGEMENT -- The use of appropriate insurance, avoidance of risk,
loss control, risk retention, self-insuring, and other techniques that minimize
the risks of a business, individual or organization.
STANDARD LINES VS. SPECIALTY LINES -- Those insurance coverages or target
market segments which are commonly insured through large, admitted insurers
using standard forms and pricing are in contrast to unique insurance coverages
or selected market niches that are only served by a single insurer or a select
group of insurers, often with unique coverage forms and pricing approach.
SURETY BOND -- An instrument providing for compensation should there be a
failure to perform any specific acts within a stated period.
TRANSPORTATION INSURANCE -- Coverage provided to entities in the business
of transporting people or goods by land conveyance. For RLI, this specifically
involves motor vehicle transportation and focuses on automobile liability and
physical damage, with incidental public liability, umbrella and excess
liability, and motor truck cargo insurance.
UMBRELLA LIABILITY POLICY -- Either a commercial or personal policy which
provides liability coverage for limits in excess of those covered by underlying
or primary liability insurance policies, as well as coverage for some claims not
covered by those policies.
UNDERWRITING PROFIT -- That portion of the earnings after deducting
incurred losses and expenses from earned premiums.
UNREALIZED GAINS -- The result of an increase in market value of an asset
which is not recognized in the traditional statement of income. The difference
between an asset's market and book values.
WEST COAST PROPERTY -- As defined at RLI, consists of property insurance
business written by the Company's branch offices in San Francisco and Los
Angeles.
49
<PAGE>
INVESTOR INFORMATION
ANNUAL MEETING
The annual meeting of shareholders will be held at 2:00 p.m., CST, on May 6,
1999, at the company's offices at 9025 North Lindbergh Drive, Peoria, Ill.
TRADING AND DIVIDEND INFORMATION
RLI common stock trades on the New York Stock Exchange under the symbol RLI. The
following table sets forth the high and low sale prices, as well as the closing
prices, for the common stock for the indicated periods as reported by the NYSE.
The table also indicates cash dividends as declared by the company.
<TABLE>
<CAPTION>
Stock Price Dividends
1998 High Low Close Declared
<S> <C> <C> <C> <C>
1st Quarter 44.20 36.60 43.20 $.12
2nd Quarter 45.45 39.30 40.69 .13
3rd Quarter 45.63 31.56 38.00 .13
4th Quarter 38.06 30.69 33.25 .13
Stock Price Dividends
1997 High Low Close Declared
<S> <C> <C> <C> <C>
1st Quarter 29.30 25.50 25.50 $.11
2nd Quarter 29.40 24.40 29.15 .12
3rd Quarter 36.05 27.60 36.00 .12
4th Quarter 40.20 32.60 39.85 .12
</TABLE>
RLI Corp. normally pays dividends four times a year, usually on January 15,
April 15, July 15 and October 15. The company has paid and increased dividends
for 23 consecutive years. RLI dividends qualify for the enterprise zone dividend
subtraction modification for Illinois state income tax returns.
STOCK OWNERSHIP
At December 31, 1998, RLI stock ownership was as follows:
<TABLE>
<CAPTION>
Shares %
<S> <C> <C>
Insiders 904,694 8.8
ESOP 1,274,279 12.3
Institutions 6,328,116 61.2
Other public 1,828,203 17.7
Total Outstanding 10,335,292 100.0
</TABLE>
DIVIDEND REINVESTMENT PLANS
An Automatic Dividend Reinvestment and Stock Purchase Plan is offered to
shareholders of RLI on a voluntary basis. Shareholders may also have their
dividends deposited directly into their checking, savings or money market
accounts. If you wish to sign up for either Plan, send your request to
"Shareholder Services" at the following transfer agent and registrar address.
SHAREHOLDER INQUIRIES
Shareholders of record requesting information concerning individual account
balances, stock certificates, dividends, stock transfers, tax information or
address corrections should contact the transfer agent and registrar at:
Norwest Bank Minnesota, N.A.
Shareholder Services
P.O. Box 64854
St. Paul, MN 55164-0854
Phone: (800) 468-9716 or (651) 450-4064
Fax: (651) 450-4033
50
<PAGE>
Email: [email protected]
REQUESTS FOR ADDITIONAL INFORMATION
Additional copies of this report and the Annual Report to the Securities and
Exchange Commission, Form 10-K, are available without charge to any shareholder.
Additionally, "Street Name" shareholders can have their names placed on a
mailing list to receive copies of annual reports, quarterly reports, and other
shareholder materials. Simply contact the treasurer at our corporate
headquarters.
CONTACTING RLI
CORPORATE HEADQUARTERS
9025 North Lindbergh Drive
Peoria, IL 61615-1431
(309) 692-1000
(800) 331-4929
Fax: (309) 692-1068
Internet: http://www.rlicorp.com
FINANCIAL INFORMATION
For investor relations requests and management's perspective on
specific issues, contact RLI Treasurer Mike Price at (309) 693-5880 or
at [email protected].
<PAGE>
SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
The following is selected financial data of RLI Corp. and Subsidiaries for the
eleven years ended December 31, 1998:
(amounts in thousands, except per share data) 1998 1997 1996 1995 1994 1993
Operating Results
<S> <C> <C> <C> <C> <C> <C>
Gross sales $ 316,863 306,383 301,500 293,922 295,966 266,480
Total revenue $ 168,114 169,424 155,354 155,954 156,722 143,100
Net operating earnings (loss)(1) $ 27,035 28,233 25,035 7,648 (2,403) 14,118
Net earnings (loss) $ 28,239 30,171 25,696 7,950 (4,776) 15,948
Comprehensive earnings (loss)(2) $ 51,758 66,415 41,970 31,374 (8,513) 21,175
Net cash provided from operating activities $ 23,578 35,022 48,947 24,649 27,041 73,629
Net premiums written to statutory surplus 46% 54% 64% 76% 108% 94%
GAAP combined ratio 88.2 86.8 87.4 107.5 116.9 97.2
Statutory combined ratio 88.4 90.4 89.1 106.5 116.9 87.9(7)
Financial condition
Total investments $ 677,294 603,857 537,946 471,599 413,835 401,609
Total assets $1,012,685 911,741 845,474 810,200 751,086 667,650
Unpaid losses and settlement expenses $ 415,523 404,263 405,801 418,986 394,966 310,767
Long-term debt $ -- -- 46,000 46,000 52,255 53,000
Total shareholders' equity $ 293,959 266,552 200,039 158,608 131,170 140,706
Statutory surplus $ 314,484 265,526 207,787 172,313 136,125 152,262
Share Information
Net operating earnings (loss) per share:
Basic (4) $ 2.58 2.71 2.54 0.78(6) (0.25)(6) 1.49
Diluted(4) $ 2.54 2.50 2.22 0.78(6) (0.25)(6) 1.42
Net earnings (loss) per share:
Basic(4) $ 2.69 2.90 2.60 0.81(6) (0.49)(6) 1.68(8)
Diluted(4) $ 2.65 2.66 2.28 0.81(6) (0.49)(6) 1.60(8)
Comprehensive earnings (loss) per share(2)
Basic(4) $ 4.92 6.38 4.25 3.20(6) (0.87)(6) 2.23(8)
Diluted(4) $ 4.87 5.76 3.62 2.77(5)(6) (0.87)(6) 2.10(8)
Cash dividends declared per share $ 0.51 0.47 0.44 0.41 0.36 0.34
Book value per share $ 28.44 24.70 20.46 16.16 13.37 14.60
Closing stock price $ 33.25 39.85 26.70 20.00 13.12 16.96
Stock split 125% 125%
Weighted average shares outstanding:
Basic(4) 10,514 10,402 9,871 9,812 9,733 9,499
Diluted(4) 10,638 11,714 12,105 9,812 9,732 10,451
Common shares outstanding 10,335 10,793 9,777 9,814 9,812 9,639
(amounts in thousands, except per share data) 1992 1991 1990 1989 1988
Operating Results
<S> <C> <C> <C> <C> <C>
Gross sales $ 220,048 215,498 181,216 149,230 143,785
Total revenue $ 117,582 102,343 92,958 89,984 104,279
Net operating earnings (loss)(1) $ 15,599 15,986 14,998 7,960 6,927
Net earnings (loss) $ 16,207 16,800 14,267 8,200 7,254
Comprehensive earnings (loss)(2) $ 18,548 22,430 11,952 11,105 8,296
Net cash provided from operating activities $ 43,619 22,918 45,388 22,801 27,742
Net premiums written to statutory surplus 110% 95% 112% 96% 131%
GAAP combined ratio 91.4 85.2 85.1 97.8 96.1
Statutory combined ratio 95.8 91.6 92.2 99.5 98.3
Financial condition
Total investments $ 281,113 237,932 213,160 177,025 165,957
Total assets $ 526,351 483,572 432,380 402,906 372,492
Unpaid losses and settlement expenses $ 268,043 244,667 235,807 230,524 217,231
Long-term debt $ 7,000 7,000 7,000 7,000 7,000
Total shareholders' equity $ 117,393 99,678 79,851 70,276 64,026
Statutory surplus $ 100,585 88,605 70,410 68,571 60,152
Share Information
Net operating earnings (loss) per share:
Basic (4) $ 1.74 1.81 1.70 0.89 0.74
Diluted(4) $ 1.74 1.81 1.70 0.89 0.74
Net earnings (loss) per share:
Basic(4) $ 1.81 1.90 1.61 0.91 0.78
Diluted(4) $ 1.81 1.90 1.61 0.91 0.78
Comprehensive earnings (loss) per share(2)
<PAGE>
Basic(4) $ 2.07 2.54 1.35 1.24 0.89
Diluted(4) $ 2.07 2.54 1.35 1.24 0.89
Cash dividends declared per share $ 0.32 0.30 0.27 0.24 0.22
Book value per share $ 13.04 11.27 9.03 7.95 6.85
Closing stock price $ 15.84 10.56 9.28 5.44 4.88
Stock split
Weighted average shares outstanding:
Basic(4) 8,949 8,842 8,842 8,986 9,344
Diluted(4) 8,949 8,842 8,842 8,986 9,344
Common shares outstanding 9,002 8,842 8,842 8,842 9,344
(1) For all periods presented, net operating earnings represent the Company's net earnings reduced by after-tax realized gains.
For 1993, the financial impact of FASB Statement No. 109 has also been deducted in arriving at operating earnings.
(2) See note 1.L to the consolidated financial statements.
(3) Share and per share data have been restated to reflect the 5-for-4 stock split that occurred June 19, 1998.
(4) See note 1.K to the consolidated financial statements.
(5) For 1995, diluted earnings per share on a GAAP basis were anti-dilutive. As such, GAAP diluted and basic earnings per share
were equal. Diluted comprehensive earnings per share, however, were not anti-dilutive. The number of diluted shares used
for this calculation was 9,619.
(6) The combined effects of the Northridge Earthquake -- including losses, expenses and the reduction in revenue due to the
reinstatement of reinsurance coverages -- reduced 1994 after-tax earnings by $25.0 million ($2.57 per basic share, $2.10
per diluted share) and 1995 after-tax earnings by $18.6 million ($1.90 per basic share, $1.54 per diluted share). See note
1.C to the consolidated financial statements for further details.
(7) Contingent commission income recorded during 1993, from the cancellation of a multiple-year, retrospectively-rated
reinsurance contract, reduced the statutory expense and combined ratio 10.3 points.
(8) Basic and diluted earnings per share include $.18 and $.16 per share, respectively, from the initial application of FASB
Statement No. 109 "Accounting for Income Taxes."
</TABLE>
51
<PAGE>
Exhibit 21.1
Subsidiaries of the Registrant
The following companies are subsidiaries of the Registrant as of December 31,
1998.
<TABLE>
<CAPTION>
JURISDICTION OF PERCENTAGE
NAME INCORPORATION OWNERSHIP
- ----- ---------------- -----------
<S> <C> <C>
Illinois 100%
RLI Aviation, Inc. Illinois 100%
Replacement Lens Inc. Illinois 100%
Mt. Hawley Insurance Company Kansas 100%
RLI Insurance Ltd. Bermuda 100%
RLI Insurance Agency Ltd. Canada 100%
RLI Mortgage Services, LLC Illinois 50%
RLI Texas Corp. Texas 100%
</TABLE>
<PAGE>
Exhibit 23.1
CONSENT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders
RLI Corp.:
We consent to incorporation by reference in the registration statement on Form
S-8 (No. 333-1637), Form S-8 (No. 333-28625) and Form S-3 (No. 33-61788) of RLI
Corp. of our reports dated January 14, 1999, relating to the consolidated
balance sheets of RLI Corp. and subsidiaries as of December 31, 1998 and 1997,
and the related consolidated statements of earnings and comprehensive earnings,
shareholders' equity, and cash flows for each of the years in the three-year
period ended December 31, 1998, and all related schedules, which reports aaare
incorporated by reference in, or appear in (with respect to the schedules), and
1998 annual report on Form 10-K of RLI Corp.
KPMG, LLP
Chicago, Illinois
March 24, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS FINANCIAL DATA SCHEDULE CONTAINS THE CONSOLIDATED FINANCIAL STATEMENTS IN
THE RLI CORP. ANNUAL REPORT TO SHAREHOLDERS FOR THE PERIOD ENDED DECEMBER 31,
1998, ATTACHED AS EXHIBIT 13 TO RLI CORP.'S FORM 10K AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 0
<SECURITIES> 677,294
<RECEIVABLES> 221,385
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 1,000,485
<PP&E> 20,954
<DEPRECIATION> (8,754)
<TOTAL-ASSETS> 1,012,685
<CURRENT-LIABILITIES> 670,305
<BONDS> 0
0
0
<COMMON> 12,790
<OTHER-SE> 281,169
<TOTAL-LIABILITY-AND-EQUITY> 1,012,685
<SALES> 0
<TOTAL-REVENUES> 168,114
<CGS> 0
<TOTAL-COSTS> 125,535
<OTHER-EXPENSES> 3,915
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 2,280
<INCOME-PRETAX> 37,721
<INCOME-TAX> 9,482
<INCOME-CONTINUING> 28,239
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 28,239
<EPS-PRIMARY> 2.69
<EPS-DILUTED> 2.65
</TABLE>
<PAGE>
Exhibit 28.1
Information from reports furnished to state insurance regulatory authorities -
Reconciliation of reserves for unpaid losses and settlement expenses.
The domestic insurance subsidiaries of the Company are required to file annual
statements with state insurance regulatory authorities prepared on an accounting
basis prescribed or permitted by such authorities (statutory basis). The
differences between the net liability reported in the accompanying consolidated
financial statements in accordance with generally accepted accounting principles
(GAAP) and that reported in the annual statutory statements are as follows:
<TABLE>
<CAPTION>
At December 31, 1998
(In Thousands)
------------------
<S> <C>
Net liability reported on a statutory basis $247,498
Adjustments:
Interest imputed on commutation settlements (236)
----------
Net liability reported on a GAAP basis $247,262
----------
----------
Reconciliation of the GAAP net liability:
Gross unpaid losses and settlement expenses $415,523
Reinsurance balances recoverable on unpaid losses
and settlement expenses (168,261)
----------
Net liability reported on a GAAP basis $247,262
----------
----------
</TABLE>
