8. EMPLOYEE BENEFITS

EMPLOYEE STOCK OWNERSHIP, 401(K) AND INCENTIVE PLANS

We maintain ESOP, 401(k) and incentive plans covering executives, managers and associates. Funding of these plans is primarily dependent upon reaching predetermined levels of operating return on equity, combined ratio and Market Value Potential (MVP). MVP is a compensation model that measures components of comprehensive earnings against a minimum required return on our capital. Bonuses are earned as we generate earnings in excess of this required return. While some management incentive plans may be affected somewhat by other performance factors, the larger influence of corporate performance ensures that the interests of our executives, managers and associates correspond with those of our shareholders.

Our 401(k) plan allows voluntary contributions by employees and permits ESOP diversification transfers for employees meeting certain age and service requirements. We provide a basic 401(k) contribution of 3 percent of eligible compensation. Participants are 100 percent vested in both voluntary and basic contributions. Additionally, an annual discretionary profit-sharing contribution may be made to the ESOP and 401(k), subject to the achievement of certain overall financial goals and board approval. Profit-sharing contributions vest after three years of plan service.

Our ESOP and 401(k) cover all employees meeting eligibility requirements. ESOP and 401(k) profit-sharing contributions are determined annually by our board of directors and are expensed in the year earned. ESOP and 401(k)-related expenses (basic and profit-sharing) were $12.5 million, $11.7 million and $11.6 million, for 2017, 2016 and 2015, respectively.

During 2017, the ESOP purchased 124,186 shares of RLI stock on the open market at an average price of $58.02 ($7.2 million) relating to the contribution for plan year 2016. Shares held by the ESOP as of December 31, 2017, totaled 3,206,518 and are treated as outstanding in computing our earnings per share. During 2016, the ESOP purchased 112,608 shares of RLI stock on the open market at an average price of $64.20 ($7.2 million) relating to the contribution for plan year 2015. During 2015, the ESOP purchased 178,492 shares of RLI stock on the open market at an average price of $49.98 ($8.9 million) relating to the contribution for plan year 2014. The above mentioned ESOP purchases relate only to our annual contributions to the plan and do not include amounts or shares resulting from the reinvestment of dividends.

Annual awards are provided to executives, managers and associates through our incentive plans, provided certain financial and operational goals are met. Annual expenses for these incentive plans totaled $19.7 million, $19.2 million and $20.4 million for 2017, 2016 and 2015, respectively.

DEFERRED COMPENSATION

We maintain rabbi trusts for deferred compensation plans for directors, key employees and executive officers through which our shares are purchased. The employer stock in the plan is classified and accounted for as equity, in a manner consistent with the accounting for treasury stock.

In 2017, the trusts purchased 7,464 shares of our common stock on the open market at an average price of $58.66 ($0.4 million). In 2016, the trusts purchased 6,702 shares of our common stock on the open market at an average price of $61.61 ($0.4 million). In 2015, the trusts purchased 9,348 shares of our common stock on the open market at an average price of $53.15 ($0.5 million). At December 31, 2017, the trusts’ assets were valued at $33.2 million.

STOCK PLANS

Our RLI Corp. Omnibus Stock Plan (omnibus plan) was in place from 2005 to 2010. The omnibus plan provided for equity-based compensation, including stock options, up to a maximum of 3,000,000 shares (subject to adjustment for changes in our capitalization and other events). Between 2005 and 2010, we granted 2,458,059 stock options under this plan, including incentive stock options (ISOs). The omnibus plan was replaced in 2010.

In 2010, our shareholders approved the RLI Corp. Long-Term Incentive Plan (2010 LTIP), which provides for equity-based compensation and replaced the omnibus plan. In conjunction with the adoption of the 2010 LTIP, effective May 6, 2010, options were no longer granted under the omnibus plan. The 2010 LTIP provided for equity-based compensation, including stock options, up to a maximum of 4,000,000 shares of common stock (subject to adjustment for changes in our capitalization and other events). Between 2010 and 2015, we granted 2,878,000 stock options under the 2010 LTIP. The 2010 LTIP was replaced in 2015.

In 2015, our shareholders approved the 2015 RLI Corp. Long-Term Incentive Plan (2015 LTIP), which provides for equity-based compensation and replaced the 2010 LTIP. In conjunction with the adoption of the 2015 LTIP, effective May 7, 2015, options were no longer granted under the 2010 LTIP. Awards under the 2015 LTIP may be in the form of restricted stock, stock options (non-qualified only), stock appreciation rights, performance units as well as other stock-based awards. Eligibility under the 2015 LTIP is limited to employees and directors of the company or any affiliate. The granting of awards under the 2015 LTIP is solely at the discretion of the board of directors. The maximum number of shares of common stock available for distribution under the 2015 LTIP is 4,000,000 shares (subject to adjustment for changes in our capitalization and other events). Since the plan’s approval in 2015, we have granted 1,448,575 awards under the 2015 LTIP, including 497,825 in 2017.

Stock Options

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

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

Shares issued may be less than the number of shares actually exercised, as our plan allows net settlement to cover the option exercise price and taxes due upon option exercise. Shares netted are valued at the closing stock price at the time of option exercise. In these instances, the actual number of shares issued will be less than the options exercised and can result in a decrease to shareholders’ equity. Specifically, when options are exercised with significant intrinsic value (i.e. market value in excess of exercise price) and the exercise is facilitated via net settlement, amounts withheld for taxes result in a decrease in shareholders’ equity. During 2016 and 2015, the aggregate intrinsic value of options exercised was $31.3 million and $32.1 million, respectively. A majority of these options were exercised via net settlement with taxes withheld at the statutory minimum rate. As shown in the consolidated statements of shareholders’ equity, the exercise of options in 2016 and 2015 resulted in a decrease to paid-in-capital, as the taxes withheld pursuant to net settlement exceeded amounts paid in for options that were exercised using cash. This was not the case in 2017 as the intrinsic value of the options exercised was not as significant ($12.8 million). Therefore, the exercise of options in 2017 resulted in an increase to paid-in-capital. Prior to the adoption of FASB ASU 2016-09 in 2017, shareholders’ equity was also impacted by corporate tax deductions allowed as a result of option exercises. This tax benefit offset our current tax liability and was recorded as an increase to paid-in-capital. Beginning in 2017, all tax effects related to share-based payments are required to be recorded in net earnings and will directly impact our effective tax rate. See note 7 for the impact in 2017. For 2016 and 2015, refer to our consolidated statements of shareholders’ equity for the impact to paid-in capital from this tax benefit in those years.

On November 9, 2017, the board of directors declared a $1.75 per share special cash dividend to be paid on December 27, 2017, to shareholders of record at the close of business on November 30, 2017. Similarly, on November 10, 2016, the board of directors declared a $2.00 per share special cash dividend to be paid on December 23, 2016, to shareholders of record at the close of business on November 30, 2016. On November 12, 2015, the board of directors declared a $2.00 per share special cash dividend to be paid on December 22, 2015, to shareholders of record at the close of business on November 30, 2015. To preserve the intrinsic value of the options, the board also approved, pursuant to the terms of our various stock option plans, a proportional adjustment to the exercise price (equivalent to the special dividend) for all outstanding non-qualified options in relation to the 2015 special dividend. This adjustment did not result in any incremental compensation expense as the aggregate fair value, aggregate intrinsic value and the ratio of the exercise price to the market price were approximately equal immediately before and after the adjustments. No adjustments were made in 2017 or 2016.

The following tables summarize option activity in 2017, 2016 and 2015:


				Weighted
		Weighted		Average	Aggregate
	Number of	Average		Remaining	Intrinsic
	Options	Exercise		Contractual	Value
	Outstanding	Price		Life	(in 000’s)
Outstanding options at January 1, 2017	2,207,110	$	40.90
Options granted	482,375	$	57.12
Options exercised	(390,870)	$	26.07		$	12,779
Options canceled/forfeited	(41,600)	$	48.30
Outstanding options at December 31, 2017	2,257,015	$	46.80	4.88	$	32,620
Exercisable options at December 31, 2017	975,055	$	38.66	3.25	$	21,780


				Weighted
		Weighted		Average	Aggregate
	Number of	Average		Remaining	Intrinsic
	Options	Exercise		Contractual	Value
	Outstanding	Price		Life	(in 000’s)
Outstanding options at January 1, 2016	2,582,220	$	32.42
Options granted	440,750	$	63.54
Options exercised	(756,380)	$	24.87		$	31,328
Options canceled/forfeited	(59,480)	$	44.39
Outstanding options at December 31, 2016	2,207,110	$	40.90	4.93	$	49,531
Exercisable options at December 31, 2016	862,605	$	31.23	3.27	$	27,523


				Weighted
		Weighted		Average	Aggregate
	Number of	Average		Remaining	Intrinsic
	Options	Exercise		Contractual	Value
	Outstanding	Price		Life	(in 000’s)
Outstanding options at January 1, 2015	2,892,717	$	26.65
Options granted	563,500	$	49.01
Options exercised	(865,957)	$	19.23		$	32,135
Options canceled/forfeited	(8,040)	$	32.12
Outstanding options at December 31, 2015	2,582,220	$	32.42	5.32	$	75,725
Exercisable options at December 31, 2015	899,680	$	23.60	3.98	$	34,327

The majority of our stock options are granted annually at our regular board meeting in May. In addition, options are approved at the May meeting for quarterly grants to certain retirement eligible employees. Since stock option grants to retirement eligible employees are fully expensed when granted, the approach allows for a more even expense distribution throughout the year.

In 2017, 482,375 options were granted with an average exercise price of $57.12 and an average fair value of $8.00. Of these grants, 384,750 were granted at the board meeting in May with a calculated fair value of $7.91. We recognized $4.4 million of expense during 2017 related to options vesting. Since options granted under our plan are non-qualified, we recorded a deferred tax benefit of $1.5 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $5.7 million, which will be recognized over the remainder of the vesting period.

In 2016, 440,750 options were granted with an average exercise price of $63.54 and an average fair value of $11.38. Of these grants, 345,750 were granted at the board meeting in May with a calculated fair value of $11.42. We recognized $4.1 million of expense during 2016 related to options vesting. Since options granted under our plan are non-qualified, we recorded a deferred tax benefit of $1.4 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $6.2 million, which will be recognized over the remainder of the vesting period.

In 2015, 563,500 options were granted with an average exercise price of $49.01 and an average fair value of $9.25. Of these grants, 412,000 were granted at the board meeting in May with a calculated fair value of $8.94. We recognized $4.1 million of expense during 2015 related to options vesting. Since options granted under our plan are non-qualified, we recorded a deferred tax benefit of $1.4 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $5.7 million, which will be recognized over the remainder of the vesting period.

The fair value of options were estimated using a Black-Scholes based option pricing model with the following weighted-average grant-date assumptions and weighted-average fair values as of December 31:


	2017			2016			2015
Weighted-average fair value of grants	$	8.00		$	11.38		$	9.25
Risk-free interest rates		1.90	%		1.21	%		1.54	%
Dividend yield		3.60	%		1.61	%		1.81	%
Expected volatility		22.95	%		23.06	%		22.91	%
Expected option life		5.05	years		5.04	years		5.21	years

The risk-free rate was determined based on U.S. treasury yields that most closely approximated the option’s expected life. The dividend yield for 2017 was determined based on the average annualized quarterly dividends paid during the most recent five-year period and incorporated a consideration for special dividends paid in recent history. The dividend yield in 2016 and 2015 was calculated based on the average annualized dividends paid during the most recent five-year period, exclusive of consideration for special dividends. The expected volatility was calculated based on the median of the rolling volatilities for the expected life of the options. The expected option life was determined based on historical exercise behavior and the assumption that all outstanding options will be exercised at the midpoint of the current date and remaining contractual term, adjusted for the demographics of the current year’s grant.

Restricted Stock Units

In addition to stock options, restricted stock units (RSUs) were granted for the first time in May 2017. RSUs have a grant date value equal to the closing stock price of the Company’s stock on the dates the shares are granted. Generally, these units have a three-year cliff vesting. For participants who become retirement eligible, defined by the plan as those individuals whose age and years of service equals 75, the units become fully vested. In addition, the RSUs have dividend participation which accrues and is settled in additional shares with all granted stock units at the end of the three-year period.

As of December 31, 2017, 15,450 RSUs have been granted and 15,300 remain outstanding. The weighted average grant date fair value was $56.71. We recognized $0.4 million of expense on these units during 2017. Total unrecognized compensation expense relating to outstanding and unvested RSUs was $0.5 million, which will be recognized over the remainder of the three-year vesting period.