-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, WGmG+TDToLwcRYeEIJyT/+BYBOJTbEUUByhkm2u0RDd/ut15u/6LIA4z9dX095iE XsKdcPL9G28vrsFvK0zTPQ== 0000912057-96-005193.txt : 19960327 0000912057-96-005193.hdr.sgml : 19960327 ACCESSION NUMBER: 0000912057-96-005193 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19951231 FILED AS OF DATE: 19960326 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: RLI CORP CENTRAL INDEX KEY: 0000084246 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 370889946 STATE OF INCORPORATION: IL FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-09463 FILM NUMBER: 96538717 BUSINESS ADDRESS: STREET 1: 9025 N LINDBERGH DR CITY: PEORIA STATE: IL ZIP: 61615 BUSINESS PHONE: 3096921000 10-K 1 FORM 10-K 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, 1995 ----------------------------------------------------- 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. ----------------------------------------------------------------------------- (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 --------------------------------------------------- ----------------------- (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 6% Convertible Subordinated Debentures due 2003 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 29, 1996 as reported on the New York Stock Exchange, was $147,806,135. 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 29, 1996 was 7,935,776. DOCUMENTS INCORPORATED BY REFERENCES. Portions of the Annual Report to Shareholders for the past year ended December 31, 1995, are incorporated by reference into Parts I and II of this document. Portions of the Registrant's definitive Proxy Statement for the 1996 annual meeting of security holders to be held May 2, 1996, are incorporated herein by reference into Part III of this document. Exhibit index is located on page 27 of this document. Page 1 of 44 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 specialty property and casualty insurance, administers extended service programs, markets computers and automated practice management software to the ophthalmic industry, distributes contact and other lenses, spectacle frames and sunglasses, manufactures made-to-order spectacle and rigid gas permeable (RGP) lenses and writes miscellaneous surety bonds. SIGNIFICANT EVENT NORTHRIDGE EARTHQUAKE Refer to pages 24 through 31, Management's Discussion and Analysis from the Company's Annual Report to Shareholders, as attached in Exhibit 13. (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., License Express Services, Inc., RLI Aviation, Inc. and RLI Insurance Ltd. 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 Significant rate increases resulted when the insurance market hardened in late 1984. The Company responded by expanding its premium volume in targeted lines. In 1987, and continuing through 1995, the industry again experienced 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 current soft market period. As a result of Hurricane Andrew and other catastrophic losses, especially the Northridge Earthquake of January 17, 1994, property rates hardened in California, Florida and the wind belt, but remain soft in other areas of the country. During 1994 the Company did see rate increases of over 30% on the commercial property book of business. The casualty book of business incurred flat to moderate decreases. This trend continued during 1995. During 1995, rates for catastrophic driven property business, especially in California, remained hard. Some softening is expected for 1996. The Company initially began to write specialty property and casualty insurance primarily through independent underwriting agents. However, with the opening of its first branch office in 1984, the Company began to shift its marketing efforts 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. Although the Company still maintains agreements with two underwriting agents, the majority of its specialty property and casualty business is marketed through its Specialty Marketing and Surety divisions and eight branch offices located in Los Angeles, California; San Diego, California; San Francisco, California; St. Paul, Minnesota; Kansas City, Kansas; Hartford, Connecticut; Atlanta, Georgia; and Chicago, Illinois. During 1995, an office was established in Columbus, Ohio to underwrite Lenders' Single Interest inland marine property insurance. The following table provides for the year ended December 31, 1995 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, 1995, no other state accounted for more than 2% of total direct premiums earned for all product lines.
Direct Premiums State Earned Percent of Total ----- --------------- ----------------- California $103,619,169 39.2% Texas 39,562,154 15.0 Florida 16,757,701 6.3 New York 14,683,741 5.6 Illinois 7,215,762 2.7 Michigan 6,475,145 2.4 Pennsylvania 5,817,933 2.2 All other 70,519,765 26.6% ------------ ------ Total direct premiums $264,651,370 100.00% ------------ ------
The Company presently underwrites specialty property and casualty insurance primarily in the following lines: 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 St. Paul, Los Angeles, Hartford, Kansas City, San Francisco, Chicago, Columbus and Atlanta branch offices are responsible for underwriting this coverage. In 1993, 1994, and 1995, net earned premiums totaled $24,370,000, $42,646,000, and $49,430,000, or 14%, 22%, and 26%, respectively, of the Company's consolidated revenues. 3 GENERAL LIABILITY. The Company writes general liability coverages through its St. Paul, Hartford, Chicago and Atlanta branch offices and through one of its unaffiliated underwriting agents. The Company's general liability business consists primarily of coverage for third party liability of commercial insureds including manufacturers, contractors, apartments and mercantile. Net earned premiums totaled $35,025,000, $35,160,000, and $36,499,000, or 20%, 18%, and 19% of the Company's consolidated revenues for the years 1993, 1994, and 1995, respectively. COMMERCIAL AND PERSONAL UMBRELLA LIABILITY. The Company's commercial umbrella coverage is produced through its Kansas City, St. Paul, Atlanta, and Hartford branch offices. 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 personal umbrella coverage, which is produced through the Specialty Marketing Division, is written in excess of the homeowners and automobile liability coverage provided by other carriers. Net earned premiums totaled $16,764,000, $17,638,000, and $18,092,000, or 10%, 9%, and 10% of the Company's consolidated revenues for the years 1993, 1994, and 1995, respectively. DIRECTORS' AND OFFICERS' LIABILITY. In December, 1990, the Company established a new Directors' and Officers' Liability underwriting facility in San Diego, California. Net earned premiums totaled $3,487,000, $5,680,000, and $6,025,000, or 2%, 3%, and 3% of the Company's consolidated revenues for the years 1993, 1994, and 1995, respectively. EMPLOYER'S EXCESS INDEMNITY. In 1993, the Company began offering 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 Kansas City branch office. Net earned premiums totaled $1,670,000, $7,953,000, and $8,257,000, or 1%, 4%, and 4% of the Company's consolidated revenues for 1993, 1994, and 1995, respectively. CONTACT LENS. Up until January of 1994, contact lens insurance was underwritten and marketed by the Company in the United States. In Canada, up until January of 1994,the Company marketed contact lens policies underwritten by Security National Insurance Company, an unaffiliated insurer, which business was, in turn, reinsured by RLI Insurance Company. The Company generally retained all risks associated with this coverage. This product has been phased out and replaced by a "non-insurance" product in an effort to better serve the needs of the Company's customers and to reduce expenses. The contact lens insurance is processed by RLI Vision Corp. Net earned premiums totaled $10,327,000, $4,833,000, and $743,000, or 7%, 3% and .4% of the Company's consolidated revenues for the years 1993, 1994, and 1995, respectively. OTHER. Smaller programs offered by the Company include: miscellaneous professional liability, fidelity and surety, commercial multi-peril and accident and health insurance. Net earned premiums from these lines totaled $34,346,000, $26,274,000, and $14,422,000, or 20%, 14%, and 8% of the Company's consolidated revenues for the years 1993, 1994, and 1995, respectively. The target market for the Surety Division continues to be a wide range of miscellaneous surety bonds which can be developed quickly and at relatively little additional risk. By providing a high level of quick, efficient service, the Company's newest venture will target business now handled by slow, inflexible multi-line companies. In June of 1995, a new facility was opened in Columbus, Ohio. This facility specializes in writing single interest inland marine property insurance for major lending institutions. This insurance covers the institution's interest in property used as collateral for loans, in the event of the borrower's default. In March of 1992, License Express Services, Inc., an agent/agency/broker licensing service subsidiary, was formed. Revenues for the period ended December 31, 1995 amounted to $103,000. Review of this division's viability during the 1996 planning cycle included recognition of strategic efforts by the National Association of 4 Insurance Commissioners to streamline and automate agent licensing efforts. The uncertainty of the future and limited prospects of near-term profitability resulted in the decision to withdraw this service from the agent licensing market. An agreement has been negotiated to refer the customers of this division to a competitor service in exchange for a stipulated royalty payment. COMPETITION The Company's specialty property and casualty insurance subsidiaries are part of an extremely competitive industry which is cyclical and 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 and Puerto Rico. 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 increase in the property lines in California, Florida and the wind belt during 1993 and 1994. The Company is maintaining its underwriting and marketing standards by not seeking market share at the expense of earnings. 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 from "A-" (Excellent) to "A" (Excellent). During 1995, A.M. Best reaffirmed "A" (Excellent) ratings for both RLI Insurance Company and Mt. Hawley Insurance Company. Ratings for the industry range from "A++" (Superior) to "F" (In Liquidation) and some companies are not rated. Publications of A.M. Best indicate that the "A" and "A-" (Excellent) ratings are assigned to those companies that in A.M. Best's opinion have achieved excellent overall performance when compared to the standards established by A.M. Best 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, A.M. Best 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 or loss reserves, the adequacy of its surplus, its capital structure and the experience and objectives of its management. A.M. Best's ratings are based on factors relevant to policyholders, agents, insurance brokers and intermediaries and are not directed to the protection of investors. In conjunction with RLI Corp.'s July, 1993 issuance of $46 million of 6.00% Convertible Debentures due 2003, the Company applied for and received a debt rating from two of the major debt rating agencies - Standard & Poor's Ratings Group and Moody's Investor Service. Each of these security review firms assigned investment grade ratings to the new debt issue. Moody's reviews corporations and assigns ratings exclusively for the purpose of grading bonds according to investment quality. Their rating symbols range from "Aaa" (highest) to "C" (lowest). The Company's new debt issue received a rating of "Baa3" classifying them as medium grade obligations, i.e. they are neither highly protected nor poorly secured. Moody's assigns this rating to companies when interest payments and principal security appear adequate for the present but certain protective elements may be lacking, or may be characteristically unreliable over any great length of time. 5 Standard & Poor's assigns ratings to corporate debt that range from "AAA" (highest) to "CCC" (lowest). Standard & Poor's assigned RLI's Convertible Debentures a rating of "BBB-" based on the Company's adequate capitalization and its disciplined underwriting approach. This classification deems the issuer to have adequate capacity to pay interest and repay principal. Standard & Poor's assigns this rating when the issuer normally exhibits adequate protection to debtholders, yet adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this capacity than in higher rated categories. REINSURANCE The Company reinsures a significant portion of its specialty 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 $108,272,000, $125,458,000 and $131,772,000 in 1993, 1994, and 1995, 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. During the period 1993 through 1995, certain of the Company's reinsurers were unable to meet their obligations to the Company under reinsurance treaties. As reserves were previously established for the uncollectible amounts, the effects of the insolvent reinsurers on net earnings for 1993 through 1995 were immaterial. The Company continually monitors the financial stability of its reinsurers and establishes reserves for uncollectible reinsurance balances on a regular basis. As a result of these reviews, the Company reevaluates its position with respect to its reinsurance. During 1993, 1994, and 1995, the Company provided $1,163,278, $1,000,000, and $613,296 for uncollectible reinsurance balances. Currently 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, 1995, 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) and Lloyds of London that amounted to $50,886,661 and $19,593,757, respectively. 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, the total amounts recoverable net of reinsurance payables from such reinsurers as of December 31, 1995 and the amounts of written premium ceded by the Company to such reinsurers during 1995.
Gross Reinsurer Ceded Exposure as of Percent Premiums Percent December 31, 1995 of Total Written of Total ----------------- -------- ------- -------- American Re-Insurance Co. $50,886,661 20.93% $19,567,724 13.89% Lloyds of London 19,593,757 8.06 17,658,920 12.47 Employers Re 12,763,642 5.25 7,203,799 5.11 General Reins Corp. 8,835,778 3.63 5,567,212 3.95 TransAtlantic Reinsurance 12,505,000 4.82 15,954,368 11.32 NAC Reinsurance Corporation 9,367,974 3.85 4,388,507 3.11 Security Ins Co of Hartford 5,869,269 2.41 4,279,075 3.04 TIG Insurance Co 6,182,575 2.54 1,042,859 0.74 All other reinsurers 117,936,468 48.51 65,320,789 46.37 ------------ ------ ------------ ------- Total ceded exposure $243,155,123 100.00% $140,983,253 100.00% ------------ ------ ------------ ------- ------------ ------ ------------ -------
6 As of December 31, 1995, the Company held $24,925,074 in irrevocable letters of credit, $5,026,740 under trust agreements and $2,865,012 in cash to collateralize a portion of the total amount recoverable. 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 sought to limit its net aggregate exposure to a single catastrophic event in 1995 to less than 10% of shareholders' equity by purchasing various types of reinsurance. The Company increased its commercial property reinsurance protection in 1995. Through implementation of this change, the Company reduced its net aggregate exposure on a single catastrophic event from 20% to 10% of shareholders' equity. 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. 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. During 1995 the industry's statutory combined ratio is estimated to be 107.2. The Company believes that certain other factors affect its ability to underwrite specialty lines successfully, including: 7 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 Employer's Excess Indemnity. 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 Specialty Marketing Division writes program business such as Personal Umbrella, Residential Earthquake, and the In-Home Business Policy. 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. One independent agent is authorized to underwrite and bind business on behalf of the Company within limited underwriting guidelines as follows: General Liability business up to a limit of $1,000,000 written for a variety of risks, primarily in Texas and Louisiana. With rare exceptions, producers of business who are not Company employees are 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 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 operating expenses as a percent of gross written premiums for the years 1993, 1994 and 1995 were 6%, 5%, and 5%, respectively. ENVIRONMENTAL EXPOSURES. The Company is subject to environmental claims and exposures through its commercial umbrella, general liability, and 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 1994 and 1995:
- ------------------------------------------------------------------------------- Inception-to-date December 31 (in thousands) 1994 1995 - ------------------------------------------------------------------------------- Loss and LAE payments Gross $ 3,549 $ 5,117 Ceded ( 2,933) ( 3,842) - ------------------------------------------------------------------------------- Net $ 616 $ 1,275 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Unpaid losses and LAE at end of year Gross $15,519 $20,154 Ceded ( 9,875) ( 13,398) - ------------------------------------------------------------------------------- Net $ 5,644 $ 6,756 - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
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 within 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 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 will adjust 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 loss adjustment 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, 1995 are adequate to meet its future obligations. 10 The table which follows is a reconciliation of the Company's unpaid losses and settlement expenses for the years 1993, 1994, and 1995.
Year Ended December 31, -------------------------------- (Dollars in thousands) 1993 1994 1995 ---- ---- ---- Unpaid losses and settlement expenses at beginning of year: Gross $268,043 $310,767 $394,966 Ceded (137,591) (145,208) (199,737) ------- ------- ------- Net 130,452 165,559 195,229 ------- ------- ------- Increase (decrease) in incurred losses and settlement expenses: Current accident year 81,589 100,535 62,619 Prior accident years (1,852) 1,107 23,271 ----- ----- ------ Total incurred 79,737 101,642 85,890 ------ ------ ------ Loss and settlement expense payments for claims incurred: Current accident year (18,743) (36,501) (10,600) Prior accident years (24,726) (36,026) (48,023) ------ ------ ------ Total paid (43,469) (72,527) (58,623) ------ ------ ------ Insolvent reinsurer charge off (221) 643 514 Loss reserves commuted (940) (88) (1,376) ----- ----- ----- Unpaid losses and settlement expenses at end of year $165,559 $195,229 $221,648 -------- -------- -------- -------- -------- -------- Unpaid losses and settlement expenses at end of year: Gross $310,767 $394,966 $418,986 Ceded (145,208) (199,737) (197,338) ------- -------- ------- Net $165,559 $195,229 $221,648 -------- -------- -------- -------- -------- --------
Explanation of significant components of reserve development by calendar year are as follows: 1993 During 1993 favorable development was reported in the other and products liability lines. These lines showed overall favorable development of $1,349,000. The favorable development was primarily isolated to the 1988 and 1990 accident years due to a reduction in the estimated ultimate loss. This was offset by unfavorable development in the 1982 and 1983 accident years due to development of a products liability claim. Unfavorable development also occurred in the 1992 accident year due to increases in the estimated ultimate loss for this accident year. 11 Favorable development also resulted from a reduction in the Company's estimate of unpaid unallocated loss adjustment expenses. 1994 During 1994, the Company experienced approximately $1,107,000 of adverse development on loss reserves. This development resulted from approximately $2,512,000 of adverse development in the other liability and products liability lines of business. Approximately $1,000,000 of this development related to one individual claim. The remainder of the adverse development is related to changes in loss reserves on prior years related to the professional liability business written by RLI from 1987 through 1993. The Company has withdrawn from this line of business. Offsetting the adverse development experience in the other liability and products liability lines of business was approximately $1,644,000 of favorable development on the property line of business. This favorable development resulted from individual claim estimates where the claims closed for less than the recorded reserves. 1995 During 1995, the Company experienced approximately $23,300,000 of adverse development on loss reserves. This development resulted from approximately $27,300,000 of adverse development in the property line due to the 1994 Northridge earthquake. Excluding the earthquake development, the Company experienced approximately $4,000,000 of favorable development. Approximately $1,000,000 of this favorable development occurred in the property line excluding the earthquake, with the remaining $3,000,000 occurring in the other liability and products liability lines. The liability development was the result of IBNR reserve decreases made possible by lower than expected tail development on two liability programs. The table on the following page presents the development under generally accepted accounting principles of the Company's balance sheet reserves for 1986 through 1995. 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
Year Ended December 31, ------------------------------------------------------------------------------------------------------- (Dollars in thousands) 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- Liability for unpaid losses and settlement expenses at end of year $57,088 $66,169 $89,197 $95,953 $103,302 $110,844 $130,452 $165,559 $195,229 $221,648 Paid (cumulative) as of: One year later 18,631 10,170 17,312 14,302 19,297 23,561 24,725 36,026 48,023 Two years later 23,341 21,860 26,093 26,685 35,963 37,763 46,342 63,675 Three years later 29,874 28,052 37,137 40,341 44,088 49,462 64,364 Four years later 30,071 35,459 47,617 44,714 52,322 57,085 Five years later 33,785 42,010 48,937 51,153 56,413 Six years later 38,536 41,698 53,670 54,546 Seven years later 37,661 44,995 56,254 Eight years later 39,216 46,113 Nine years later 40,080 Liability re-estimated as of: One year later 56,793 67,033 86,230 91,646 101,251 108,249 128,600 166,666 218,499 Two years later 59,797 67,939 85,120 89,112 98,505 105,747 132,850 164,218 Three years later 59,338 68,697 84,426 87,981 95,690 107,777 132,377 Four years later 58,847 69,904 84,931 87,403 97,041 106,326 Five years later 60,794 69,670 84,217 90,030 96,490 Six years later 60,547 70,486 87,585 88,982 Seven years later 61,329 72,074 86,593 Eight years later 63,327 72,540 Nine years later 63,719 Net cumulative redundancy (deficiency) $(6,631) $(6,371) $ 2,604 $ 6,971 $ 6,812 $ 4,518 $(1,925) $ 1,341 $(23,271) Gross liability $310,767 $394,966 $418,986 Reinsurance recoverable (145,208) (199,737) (197,338) --------- --------- --------- Net liability $165,559 $195,229 $221,648 Gross re-estimated liability $309,716 $437,649 Re-estimated recoverable (145,498) (219,150) --------- -------- Net re-estimated liability $164,218 $218,499 Gross cumulative redundancy (deficiency) $1,051 $(42,683)
13 The Company's loss reserves at the end of any particular calendar year are based upon the premiums received and earned as of the end of that particular year. Reinsurance premiums and losses, especially foreign, are not, in many cases, received and recorded until after the calendar year. The loss development as displayed includes losses incurred in a particular calendar year that relate to premiums reported, recorded and earned subsequent to that year. The following table adjusts the cumulative redundancy (deficiency), as shown in the foregoing table, for the estimated losses associated with such late reported premiums.
Year Ended December 31, ------------------------------------------------------------------------------------------------- 1986 1987 1988 1989 1990 1991 1992 1993 1994 ---- ---- ---- ---- ---- ---- ---- ---- ---- Cumulative redundancy (deficiency) per above $( 6,631) $( 6,371) $ 2,604 $6,971 $6,812 $4,518 $(1,925) $ 1,341 $(23,271) Estimated losses associated with late reported premiums 1,600 1,356 ------- ------- ------- ------- ------ ------ ------- ------ ------- Adjusted cumulative redundancy (deficiency) $ (5,031) $( 5,015) $ 2,604 $ 6,971 $6,812 $4,518 $(1,925) $ 1,341 $(23,271) -------- -------- ------- ------- ------ ------ ------- ------- ------- -------- -------- ------- ------- ------ ------ ------- ------- -------
See discussion of calendar year development for 1992, 1993, and 1994 on pages 11 and 12. 14 OPERATING RATIOS 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.
Year Ended December 31, ----------------------------------------------------------- (Dollars in thousands) 1991 1992 1993 1994 1995 ---- ---- ---- ---- ---- Statutory net premiums written $84,188 $110,895 $136,728 $131,164 $130,453 Policyholders' surplus $88,605 $100,585 $152,262 $136,125 $172,313 Ratio .9 to 1 1.1 to 1 .9 to 1 1.0 to 1 .8 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 1991 1992 1993 1994 1995 ---- ---- ---- ---- ----- Loss ratio 60.6 60.3 63.3 72.5 64.4 Expense ratio 24.6 31.1 33.9 44.4 43.1 ---- ---- ---- ----- ----- Combined ratio 85.2 91.4 97.2 116.9 107.5 ---- ---- ---- ----- ----- ---- ---- ---- ----- -----
(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. 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.
Year Ended December 31, ----------------------------------------------- Statutory 1991 1992 1993 1994 1995 ---- ---- ---- ---- ---- Loss ratio 56.8 58.9 65.8 73.4 63.6 Expense ratio 34.8 36.9 22.1 (3) 43.5 42.9 ---- ---- ---- ---- ---- Combined ratio 91.6 95.8 87.9 (3) 116.9 (4) 106.5 (4) ---- ---- ---- ----- ----- ---- ---- ---- ----- ----- Industry combined ratio 108.8 (2) 115.7 (2) 106.9 (2) 108.4 (2) 105.3 (1) ----- ----- ----- ----- ----- ----- ----- ----- ----- -----
15 (1) Source: Insurance Information Institute. Estimated for the year ended December 31, 1995. (2) Source: A.M. Best Aggregate & Averages -- Property-Casualty (1995 Edition). (3) Contingent commission income recorded during 1993, from the cancellation of a multiple-year retrospectively-rated reinsurance contract, reduced the statutory combined and expense ratio by 10.3 points. (4) 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. RLI VISION CORP. The Company believes that it was the world's largest provider of contact lens insurance between 1965 and 1993. In 1993, due to changes in the ophthalmic market place, the Company began converting its contact lens insurance book of business over to a non-insurance contact lens purchase plan called Total Lens Care. Beginning January 1, 1994, the Company no longer offered contact lens insurance. In the late 1970's, the Company became a third party administrator of ophthalmic practitioners' extended service programs. The Company further expanded its operations in 1985 when it developed and marketed an office automation computer system for eyecare professionals. The Company became a contact lens wholesale distributor in 1990. On May 4, 1995, RLI Vision Corp. (formerly known as RLI Professional Technologies, Inc.), a wholly-owned subsidiary of RLI Corp., acquired through merger, Target Industries, Inc., a wholesale optical goods distributor of contract lenses, Rx spectacles, frames and sunglasses, located in Cohasset, Massachusetts. As consideration, RLI Corp. issued 313,500 shares of its common stock. The combined enterprise is now doing business under the name of RLI Vision Corp. This business combination has been accounted for as a pooling-of- interests. The consolidated financial statements and related financial information for periods prior to the combination have been restated to include the accounts and results of operations of Target Industries, Inc. RLI Vision Corp.'s revenues, as restated to include Target Industries, Inc. revenues, of $29,195,000, $33,974,000 and $34,595,000, in 1993, 1994, and 1995, respectively, represented 17%, 18% and 18% of the Company's consolidated revenues after eliminations in such years. CONTACT LENS INSURANCE PROCESSING While the Company no longer offers contact lens insurance, policies will be in effect and honored through February, 1996. Claims will be processed by RLI Vision Corp. under an agreement with RLI Insurance Company. TOTAL LENS CARE Total Lens Care is a contact lens purchase plan which offers patients discounted prices on contact lenses in exchange for an annual membership fee. As of December 31, 1995, approximately 200,000 patients had enrolled in Total Lens Care, generating $4,576,601 in fees for the year ended December 31, 1995. Presently, 65% of the patients renew their TLC memberships as they expire. EXTENDED SERVICE PROGRAMS The Company administers approximately 6,900 individual ophthalmic practitioners' extended service programs which entitle enrolled patients to receive certain goods and services at discounted costs. At December 31, 1995, approximately 310,000 patients were enrolled in such programs. Revenues for the same period amounted to $1,874,111. In 1990, the Company introduced Vision Care Advantage (VCA), an eye care cost containment program offered nationwide to employers, unions and groups. In exchange for an enrollment fee, VCA members receive specified ophthalmic goods and services at discounted costs from a panel of approximately 4,500 participating practitioners. For the period ended December 31, 1995, revenues amounted to $132,976. 16 CONTACT LENSES In order to take advantage of its purchasing power, in 1990 the Company opened the RLI Service Center which purchases contact lenses at wholesale costs for distribution to RLI Insurance Company and private practitioners. In 1992, the Company opened a distribution center in southern California to better compete in the west-coast market. Consolidated revenue from contact lens distribution out of all sites was $19,268,768 in soft lenses and $1,285,730 in RGP lenses in 1995. OPHTHALMIC LENS LAB As a result of the acquisition of Target Industries, RLI Vision now operates its own spectacle Rx laboratories. In 1995, spectacle Rx revenue was $3,376,972, up 9% over 1994. RLISYS PRACTICE AUTOMATION SYSTEMS The Company's office automation software, formally known as RLISYS, is designed to assist ophthalmic practitioners in the management of their patient, accounting, insurance and marketing records. In 1993, the Company ceased offering hardware to complement the software and adopted a monthly licensing pricing structure. The Company is the single largest provider of ophthalmic software and has installed over 3,000 systems in eyecare professionals' offices throughout the United States. The Company provides users with training, support and supplies for their systems. In addition, the Company continually evaluates the system and develops enhancements designed to meet the changing needs of the ophthalmic community. COMPETITION AND INDUSTRY POSITION In regards to TLC and Extended Service, competition stems from ophthalmic practitioners who offer their own membership plans. These independently-operated programs are believed by the Company to be the largest source of competition. The contact lens distribution facilities operate in a very competitive market, with the cost of goods sold comprising nearly 79% of lens sales revenue. With such low margins, volume affects profitability. The Company believes that the total wholesale contact lens distribution market generates approximately $600 million in annual sales, $150 million (25%) of which is sold through distributors. The Company is one of approximately 50 distribution facilities in the United States. The Company's 1995 contact lens sales totaled $20,553,000. The Company considers itself the leader in office automation software, having captured 23% of the automated optometrist market. It is believed that the elimination of the large up-front purchase price and a switch to a monthly- licensing pricing structure, will make the RLISYS system much more affordable and enable the Company to increase its market share both through practitioners automating for the first time and practitioners converting to RLISYS from other software vendors. 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. 17 Investments of the highest quality and marketability are critical for preserving claims paying ability. Virtually all of RLI's fixed income investments are U.S. Government securities or AA or better rated taxable and tax exempt issues. Common stock portfolios are limited to securities listed on national exchanges and listed by the Securities Valuation Office of the National Association of Insurance Commissioners. The investment portfolio serves primarily as the funding source of loss reserves and secondly as a source of income. For these reasons, RLI's primary investment criteria are quality and liquidity, followed by yield. During 1995, operating cash flows were used to acquire fixed income instruments composed almost entirely of intermediate-term U.S. Government and Agency securities and municipal securities. The tax-exempt component of the fixed maturity portfolios increased $14.7 million, to $106.8 million; and comprises 36.1% of the Company's fixed maturity portfolios, unchanged from year end 1994. Net purchases of taxable U.S. Government and Government Agency securities amounted to $22.2 million in 1995; these taxable securities comprise 63.0% ($186.2 million) of the fixed income portfolios. Investment grade corporate securities in the fixed income portfolios totaled $2.7 million at the end of 1995, up slightly from the 1994 level of $2.5 million. Equity portfolios increased $49.9 million from $104.1 million at the end of last year to $154.0 million at the end of 1995. During 1995, net common equity investments totaling $15.5 million were purchased and pretax unrealized appreciation of equity securities totaled $34.4 million. Equity securities as a percentage of cash and invested assets increased to 32.4% at the end of 1995 from 24.5% at year end 1994. Combined cash and short-term investments decreased $35.5 million in 1995 to 5.3% of cash and total invested assets from 14.3% in 1994. The Company's short-term investments consist of U.S. Government and Agency backed money market funds and the highest rated commercial paper. RLI's mix of fixed income securities continues to be biased in favor of U.S. Government and Agency securities due to their high liquidity and almost risk-free nature. The mixture of tax-exempt and taxable instruments within the fixed income 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 U.S. Government, Agency, or high grade municipal 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). Interest rate risk is minimized by the Company's policy of purchasing securities with limited call provisions. The Company follows a program of matching assets to anticipated liabilities to ensure its ability to hold securities until maturity. The Company's known debt and long-term accounts payable are added to the estimate of its unpaid losses and settlement expenses, 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 interest rate risk can best be minimized by such asset/liability matching.
Aggregate maturities for the fixed maturity securities are as follows: Maturity Par Amortized Fair Carrying Year Value Cost Value Value -------- -------- ---------- ---------- ----------- 1996 $17,670,000 $17,630,139 $17,788,259 $17,638,672 1997 19,640,000 19,618,969 19,950,236 19,637,385 1998 30,950,000 31,246,389 32,423,703 31,388,458 1999 37,885,000 38,367,149 40,744,005 38,942,963 2000 31,580,000 32,423,834 34,100,788 32,784,417 2001 19,350,000 20,233,445 20,947,597 20,227,870 2002 24,460,000 25,662,858 26,353,026 25,667,448 2003 41,155,000 41,408,041 41,872,419 41,427,626 2004 18,295,000 18,317,544 18,627,591 18,306,272 2005 28,790,000 29,295,646 30,782,099 29,312,375 2006 4,185,000 4,124,770 4,241,337 4,124,770 18 2007 3,100,000 3,105,254 3,612,205 3,105,255 2008 525,000 525,000 556,432 525,000 2009 5,000,000 5,256,988 5,476,470 5,256,988 2010 8,000,000 8,411,848 8,601,440 8,411,848 --------- --------- --------- --------- $290,585,000 $295,627,874 $306,077,607 $296,757,347 ------------ ------------ ------------ ------------ ------------ ------------ ------------ ------------
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 originally scheduled maturity. Consequently, fluctuations in the market value of most bonds are not reflected in the financial statements and do not affect shareholders' equity. At December 31, 1995, the Company's equity securities valued at $154.0 million, accounted for 32.4% of total cash and invested assets and 89.4% of the combined statutory surplus of its insurance subsidiaries. At December 31, 1995, net pretax unrealized capital appreciation of equity securities was $51.4 million. The Company's investment results are summarized in the following table:
Year ended December 31, ------------------------------------------- (Dollars in thousands) 1991 1992 1993 1994 1995 ---- ---- ---- ---- ---- Average invested assets (1) $225,546 $260,616 $343,441 $410,058 $445,562 Investment income (2)(3) 12,742 13,483 16,857 20,133 22,029 Realized gains (losses) (3) 1,234 921 254 (3,595) 457 Change in unreal- ized appreciation/ depreciation (3)(4) 8,528 3,546 7,945 (5,749) 36,037 Annualized return on average invested assets 10.0% 6.9% 7.3% 2.6% 13.1%
(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 maturities and equity securities. REGULATION STATE REGULATION The Company's insurance subsidiaries are highly regulated by insurance regulators in their states of incorporation as well as the states in which they do business. Such regulations, among other things, 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. Certain states also regulate the rates insurers may charge for certain property/casualty products. 19 These regulations are designed to ensure financial solvency of insurance companies and to require fair and adequate service and treatment for policyholders. They are enforced through the granting and revoking of licenses to do business, licensing of agents and brokers, monitoring of trade practices, policy form approval, fair and equitable premium and commission rates, and minimum reserve and capital requirements. The procedures are administered by the various state departments of insurance and are supplemented by periodic reporting procedures and periodic examinations. The quarterly and annual financial reports to the states utilize accounting principles which are different than the generally accepted accounting principles used in shareholders' reports. The statutory accounting principles, in keeping with the intent to assure policyholder protection, are based, in general, on a liquidation concept while generally accepted accounting principles are based on a going concern concept. Under the laws of most states and provinces, 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 operate in the state through a corporation. In a few states and provinces, licenses are issued only to individual residents or locally-owned business entities. In such cases, the Company has arrangements with residents or business entities licensed to act in the state. As an insurance holding company, RLI Corp. is subject to regulation by the states in which its insurance subsidiaries are domiciled or transact business. Most states have enacted legislation that requires each insurance company in a holding company system to register with the insurance regulatory authority of its state of domicile and furnish to it financial and other information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the 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 applicable regulators is required prior to the consummation of certain transactions affecting insurance subsidiaries of the holding company system. CALIFORNIA EARTHQUAKE AUTHORITY--The California Insurance Commissioner has been authorized to establish a state residential earthquake program. The most recent proposals for the program include industry participation, investment of private capital and reinsurance commitments. As the Company writes an insignificant amount of residential homeowner's insurance, it does not appear that the legislation will impact the Company in any significant manner. PROPOSITION 103 (RATE ROLLBACK INITIATIVE)--In November 1988, California voters approved Proposition 103, which requires insurance premium rates for certain lines of business to be rolled back twenty percent (20%) from the rates in effect in November 1987. As a result, in 1994 and 1993, the Company reduced pretax earnings by $71,280 and $416,400, respectively. No additional provision was made during 1995. The above amounts include interest for 1994 and 1993 in the amount of $71,280 and $259,200, respectively. The total amount of deferred premiums and interest accrued as of December 31, 1995, was $2.5 million. The state of California maintains that the Company is not in compliance with Proposition 103 and that the required amount of premiums to be returned is $6.5 million plus accrued interest. The Company maintains it had reduced rates by 20% or more on its most significant lines of business. This reduction is at issue with the California Department of Insurance. While it is impossible to predict the outcome, Management believes that the amount accrued is adequate to cover the ultimate rollback, if any. The matter has been set for hearing in March of 1996. 20 ASSESSMENTS AGAINST INSURERS Under insurance insolvency or guaranty laws in most states in which the Company operates, insurers doing business therein can be assessed for policyholder losses covered by insolvent insurance companies. The amount and timing of any future assessments on the Company under these laws cannot be reasonably estimated and are beyond the control of the Company. Recent financial difficulties of insurance companies increase the probability of assessments under these laws. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer's financial strength. The Company generally accrues the full amount of the assessment upon notification. 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 employee benefits regulation, limitation on anti-trust immunity, minimum solvency requirements and removal of barriers preventing banks from engaging in the insurance business. The Company is monitoring the following federal proposals: NATURAL DISASTER ACT--Recent natural disasters such as Hurricane Andrew, the Midwestern floods and the Northridge Earthquake have sparked debate on the best way to provide affordable insurance coverage for such events. At this time, the Company supports the proposed Natural Disaster Act as the most desirable alternative. MCCARRAN-FERGUSON ACT--The repeal of the McCarran-Ferguson Act has long been a topic of considerable debate. Congress has conducted numerous hearings on the issue, but has taken no action. The current legislature is inclined to drop the proposal. SUPERFUND REFORM (ENVIRONMENTAL LIABILITY)--Environmental liability and the methods of funding the cleanup of polluted sites received considerable attention in Congress during 1995. The Superfund Reform '95 Coalition lobbied for reform of the original law including full repeal of the retroactive liability standard. In the past, insurance industry supporters have suggested a general tax on all insurers to pay for the cleanup rather than requiring retroactive liability. The Company would not be significantly affected by any retroactive tax assessments since the Company did not write a large volume of liability insurance prior to 1984. However, if a tax is levied against current liability writers for prior pollution losses, the Company could have some tax exposure. 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 RBC standards became effective for 1994 annual statement filings. The Company continues to monitor 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. Management believes that its capital levels are sufficient to support the level of risk inherent in its operations. 21 AGENCY LICENSES AND TRADEMARKS Replacement Lens Inc. and RLI Insurance Agency Ltd., or their designated employees, must be licensed to act as resident or non-resident brokers or agents by regulatory authorities in the states or provinces in which they operate. Replacement Lens Inc. obtained service mark registration of the letters "RLI" in 1978 and currently maintains such registration in 47 states. Such registration protects the mark from deceptively similar use by the Company's competitors. The duration of this registration is ten years for all states except three in which registration is limited to five years unless renewed. Duration of the registration in the State of Wisconsin is twenty years. 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. EMPLOYEES The Company employs a total of 570 associates. Of that total, 222 work for RLI Vision Corp. and 348 work for RLI Insurance Company. Of the 570 total associates, 57 are part-time and 513 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. 22 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 29.2 acre campus, is a 2,500 square foot facility leased to a day care facility, and a 600 square foot condominium, attached to the day care building. The Company also owns a 12,800 square foot building near the headquarters building. Nearly 9,800 square feet of this building are used as warehouse storage for records and equipment. The remaining 3,000 square feet is leased to RLI Vision Corp., as a part of its contact lens distribution center. In addition, the Company owns a 19,000 square foot building near the headquarter building that is leased to RLI Vision Corp., which is used as the subsidiary's headquarters. RLI Vision Corp. also owns a 16,000 square foot building located in Cohasset, Massachusetts, a 2,700 square foot office condominium building located in Bedford, Massachusetts, and a 3,000 square foot building located in Lewistown, Maine, as well as the 10 acres on which these buildings are located. 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 53 of the Annual Report to Shareholders for the year ended December 31, 1995 attached in Exhibit 13. Item 6. SELECTED FINANCIAL DATA Refer to the Selected Financial Data on pages 22 through 23 of the Annual Report to Shareholders for the year ended December 31, 1995 attached in Exhibit 13. 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 24 through 31 of the Annual Report to Shareholders for the year ended December 31, 1995 attached in Exhibit 13. 23 Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Refer to the consolidated financial statements and supplementary data included on pages 32 through 49 of the Annual Report to Shareholders for the year ended December 31, 1995 attached in Exhibit 13. (See Index to Financial Statements and Schedules attached on page 27.) 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 page 27. (b) No reports on Form 8-K were filed during the last quarter of 1995. (c) Exhibits. See Exhibit Index on page 27. (d) Financial Statement Schedules. The schedules included on attached pages 28 through 38 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 27. There is no other financial information required by Regulation S-X which is excluded from the Company's Annual Report to Shareholders. 24 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 7, 1996 ---------------------------------- 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 7, 1996 ---------------------------------- * * * * * By: /s/Joseph E. Dondanville ------------------------------------ J. E. Dondanville, Vice President, Chief Financial Officer (Principal Financial and Accounting Officer) Date: March 7, 1996 ---------------------------------- * * * * * By: /s/Gerald D. Stephens ------------------------------------ G. D. Stephens, Director Date: March 7, 1996 ---------------------------------- * * * * * By: /s/Bernard J. Daenzer ------------------------------------ B. J. Daenzer, Director Date: March 7, 1996 ---------------------------------- * * * * * By: /s/Richard J. Haayen ------------------------------------ R. J. Haayen, Director Date: March 7, 1996 ---------------------------------- * * * * * By: /s/William R. Keane ------------------------------------ W. R. Keane, Director Date: March 7, 1996 ---------------------------------- * * * * * 25 By: /s/Gerald I. Lenrow ------------------------------------ G. I. Lenrow, Director Date: March 7, 1996 ---------------------------------- * * * * * By: /s/John S. McGuinness ------------------------------------ J. S. McGuinness, Director Date: March 7, 1996 ---------------------------------- * * * * * By: /s/Edwin S. Overman ------------------------------------ E. S. Overman, Director Date: March , 1996 ---------------------------------- * * * * * By: /s/Edward F. Sutkowski ------------------------------------ E. F. Sutkowski, Director Date: March 7, 1996 ---------------------------------- * * * * * By: /s/Robert O. Viets ------------------------------------ R. O. Viets, Director Date: March 7, 1996 ---------------------------------- * * * * * 26 INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Reference (Page) DATA SUBMITTED HEREWITH: Report of Independent Auditors 28 Schedules: I. Summary of Investments - Other than Investments in Related Parties at December 31, 1995. 29 II. Condensed Financial Information of Registrant for the three years ended December 31, 1995. 30 - 34 III. Supplementary Insurance Information for the three years ended December 31, 1995. 35 - 36 IV. Reinsurance for the three years ended December 31, 1995. 37 V. Valuation and Qualifying Accounts 38 VI. Supplemental Information Concerning Property- Casualty Insurance Operations for the three years ended December 31, 1995. 35 - 36
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. 27 INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders RLI Corp.: Under date of January 25, 1996, we reported on the consolidated balance sheets of RLI Corp. and subsidiaries as of December 31, 1995 and 1994, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1995, as contained in the 1995 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 1995. 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. As discussed in Note 1 to the consolidated financial statements, in 1994 the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and in 1993 the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." KPMG Peat Marwick LLP Chicago, Illinois January 25, 1996 28 RLI CORP. AND SUBSIDIARIES SCHEDULE I--SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1995
Column A Column B Column C Column D Amount at Which Shown in Fair the Balance Type of Investment Cost(1) Value Sheet - ------------------------------------------------------------------------------------------------------------------------- Fixed maturities: Bonds: Held-to-maturity United States government and government agencies and authorities $148,846,846 $156,517,125 $148,846,846 States, municipalities and political subdivisions 102,292,482 103,931,411 102,292,482 Foreign governments 498,208 509,260 498,208 - ------------------------------------------------------------------------------------------------------------------------- Total held-to-maturity 251,637,536 260,957,796 251,637,536 - ------------------------------------------------------------------------------------------------------------------------- Available-for-sale United States government and government agencies and authorities 33,730,335 34,767,197 34,767,197 All other corporate bonds 10,260,003 10,352,614 10,352,614 - ------------------------------------------------------------------------------------------------------------------------- Total available-for-sale 43,990,338 45,119,811 45,119,811 - ------------------------------------------------------------------------------------------------------------------------- Total fixed maturities 295,627,874 306,077,607 296,757,347 - ------------------------------------------------------------------------------------------------------------------------- Equity securities, available-for-sale: Common stock: Public utilities 34,002,905 47,747,375 47,747,375 Banks, trusts and insurance companies 9,353,637 15,684,039 15,684,039 Industrial, miscellaneous and all other 59,224,292 90,526,121 90,526,121 - ------------------------------------------------------------------------------------------------------------------------- Total equity securities 102,580,834 153,957,535 153,957,535 - ------------------------------------------------------------------------------------------------------------------------- Short-term investments 23,874,732 23,874,732 23,874,732 - ------------------------------------------------------------------------------------------------------------------------- Total investments $422,083,440 $483,909,874 $474,589,614 - -------------------------------------------------------------------------------------------------------------------------
Note: See notes 1D and 2 of Notes to Consolidated Financial Statements. (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. 29 RLI CORP. AND SUBSIDIARIES SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS DECEMBER 31, 1994 AND 1995
1994 1995 (restated) - ------------------------------------------------------------------------------------ ASSETS Cash $ 1,426,075 $ 236,902 Investments in consolidated subsidiaries, at equity 173,544,318 199,299,589 Equity securities available-for-sale, at fair value (Cost--$6,897,359 in 1994 and $6,667,195 in 1995) 6,369,104 8,138,847 Investment in Rabbi Trust 1,717,187 2,817,965 Deferred debt costs 1,052,030 928,865 Income taxes recoverable 2,556,129 537,838 Property and equipment 1,119,976 1,090,713 Other assets 288,507 238,615 - ------------------------------------------------------------------------------------ Total assets $188,073,326 $213,289,334 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Accounts payable, current $ 911,666 $ 1,163,723 Notes payable, short-term 2,800,000 Long-term debt: Convertible debentures 46,000,000 46,000,000 Industrial development bonds 6,255,000 Deferred compensation--Rabbi Trust 1,717,187 2,817,965 Interest payable--Convertible debentures 1,265,000 1,265,000 Other liabilities 754,512 634,930 - ------------------------------------------------------------------------------------ Total liabilities 56,903,365 54,681,618 - ------------------------------------------------------------------------------------ Shareholders' equity: Common stock ($1 par value, authorized 12,000,000 shares, issued 6,762,905 shares in 1994 and 8,453,449 in 1995) 6,762,905 8,453,449 Other shareholders' equity 127,807,805 153,544,590 Treasury shares at cost (604,015 shares in 1994 and 602,567 shares in 1995) (3,400,749) (3,390,323) - ------------------------------------------------------------------------------------ Total shareholders' equity 131,169,961 158,607,716 - ------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $188,073,326 $213,289,334 - ----------------------------------------------------------------------------------- - -----------------------------------------------------------------------------------
See notes to condensed financial information. NOTE: See also Notes to Consolidated Financial Statements. 30 RLI CORP. AND SUBSIDIARIES SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) CONDENSED STATEMENTS OF EARNINGS YEARS ENDED DECEMBER 31,
1993 1994 1995 (restated) (restated) - ------------------------------------------------------------------------------------------------------------------------- Net investment income (expense) $ 62,362 $ 146,815 $ 69,603 Selling, general, and administrative expenses 1,679,686 2,845,289 2,093,019 Interest expense on debt 1,855,697 3,431,464 3,347,378 - --------------------------------------------------------------------------------------------------------------------------- (3,473,021) (6,129,938) (5,541,278) Income tax benefit (1,499,612) (2,312,907) (2,147,995) - --------------------------------------------------------------------------------------------------------------------------- Net loss before equity in net earnings of subsidiaries and cumulative effect of accounting change (1,973,409) (3,817,031) (3,393,283) Equity in net earnings (loss) of subsidiaries 17,014,460 (958,840) 11,342,824 - ---------------------------------------------------------------------------------------------------------------------------- Net earnings (loss) before cumulative effect of accounting change 15,041,051 (4,775,871) 7,949,541 Cumulative effect to January 1, 1993 of initial application of SFAS 109 "Accounting for Income Taxes" 906,576 - ---------------------------------------------------------------------------------------------------------------------------- Net earnings (loss) $15,947,627 $(4,775,871) $7,949,541 - ---------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------
See notes to condensed financial information. NOTE: See also Notes to Consolidated Financial Statements. 31 RLI CORP. AND SUBSIDIARIES SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) CONDENSED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31,
1993 1994 1995 (restated) (restated) - -------------------------------------------------------------------------------------------------------------------------- Cash Flows from Operating Activities Losses before equity in net earnings of subsidiaries $ (1,066,833) $ (3,817,031) $(3,393,283) Adjustments to reconcile net losses to net cash provided by operating activities: Write-down of investments 10,000 9,597 Other items, net (9,988) 445,597 (407,586) Change in: Affiliate balances payable (33,356) (10,058) 135,916 Federal income taxes (1,349,388) (1,034,695) 1,658,597 Deferred debt costs (1,187,938) 135,908 123,165 - --------------------------------------------------------------------------------------------------------------------------- Net cash used in operating activities (3,637,503) (4,270,682) (1,883,191) - --------------------------------------------------------------------------------------------------------------------------- Cash Flows from Investing Activities Purchase of: Equity securities, available-for-sale (5,380,075) (1,995,106) (857,883) Property and equipment (85,888) (1,054,894) (9,600) Sale of: Equity securities, available-for-sale 300,000 433,263 1,004,380 Capital contributions to subsidiaries (32,500,000) Cost of investment in related parties (4,765,619) Cash dividends received-subsidiaries 2,768,947 6,340,282 7,823,965 - ---------------------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) investing activities (39,662,635) 3,723,545 7,690,862 - ---------------------------------------------------------------------------------------------------------------------------- Cash Flows from Financing Activities Payments on debt (745,000) (6,255,000) Proceeds from issuance of debt 46,000,000 2,800,000 Fractional share paid 4,010 Treasury shares reissued 4,043,970 2,513,375 33,667 Cash dividends paid (3,132,338) (3,461,217) (3,849,521) - ---------------------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities 46,911,632 (1,692,842) (7,266,844) - ---------------------------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash 3,611,494 (2,239,979) (1,189,173) Cash at beginning of year 54,560 3,666,054 1,426,075 - ---------------------------------------------------------------------------------------------------------------------------- Cash at end of year $ 3,666,054 $ 1,426,075 $ 236,902 - ---------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------
Interest paid on outstanding debt for 1993, 1994, and 1995 amounted to $682,500, $3,345,714, and $3,372,479, respectively. See notes to condensed financial information. NOTE: See also Notes to Consolidated Financial Statements. 32 RLI CORP. AND SUBSIDIARIES SCHEDULE II CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of RLI Corp. and subsidiaries (the Company). (1) Significant Event In September 1995, the Company strengthened loss reserves related to the January 17, 1994 Northridge Earthquake. While relatively minor development had occurred throughout the first six months of 1995, the third quarter claim-by-claim review indicated that greater future development was likely. The overall 1995 impact from the Northridge Earthquake was a reduction to after-tax earnings by $18.6 million or $2.37 per share. The additional development resulted, in part, from hidden damages and increased business interruption losses on the Company's excess policies which, in 1994, were estimated by adjusters to be well within coverage limits of the primary and underlying excess layers. Also contributing to the increased development were unanticipated building code enactments, escalating construction costs, and the impact of reopened claims as a result of the involvement of public adjusters. (2) Convertible Debentures On July 28, 1993, RLI Corp. issued $46.0 million of 6.0% convertible debentures which mature July 15, 2003 and pay interest semi-annually. RLI Corp. received $45,080,000 in net proceeds from the issue of which $30,500,000 was contributed to the insurance subsidiaries and $2,000,000 to RLI Vision Corp., the ophthalmic subsidiary. The balance has been retained for general corporate purposes. RLI Corp. incurred underwriting and related costs associated with the issuance of the debentures of $1,245,000 which will be amortized over a 120-month period. (3) Acquisition On May 4, 1995, RLI Vision Corp. (formerly known as RLI Professional Technologies, Inc.), a wholly-owned subsidiary of RLI Corp., acquired through merger, Target Industries, Inc., a wholesale optical goods distributor of contact lenses, Rx spectacles, frames and sunglasses, located in Cohasset, Massachusetts. As consideration, RLI Corp. issued 313,500 shares of its common stock. The combined enterprise is now doing business under the name of RLI Vision Corp. This business combination has been accounted for as a pooling-of-interests. The consolidated financial statements and related financial information for periods prior to the combination have been restated to include the accounts and results of operations of Target Industries, Inc. (4) Income Taxes The Company files a consolidated income tax return. Tax provisions for 1993, 1994, and 1995 were computed and apportioned to the subsidiaries on the basis of separate tax return liabilities. The Company adopted SFAS 109, "Accounting for Income Taxes" as of January 1, 1993. The cumulative effect of this change allocated to RLI Corp. of $906,576 is shown as a separate component on the RLI Corp. income statement. The cumulative effect of the charge allocated to the subsidiaries of $758,424 is included in the "Equity in net earnings of subsidiaries." (continued) 33 RLI CORP. AND SUBSIDIARIES SCHEDULE II CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) NOTES TO CONDENSED FINANCIAL STATEMENTS (5) Deferred Compensation The Company has a directors deferred compensation plan, and excess ESOP plan for key employees, through which shares of RLI Corp. common stock are purchased by the Company for the directors and key employees. In 1993, the Company funded these plans by establishing Rabbi Trusts. Since the assets of the Rabbi Trusts are subject to claims of the Company's general creditors, such assets are recorded as "Investment in Rabbi Trusts" in the accompanying balance sheet. A corresponding liability for the same amount, which represents the Company's liability to its directors and key employees, is reflected as "Deferred Compensation--Rabbi Trusts." (6) Stock Split In the second quarter of 1995, the Company announced a 5-for-4 stock split. Share and per share data have been restated to reflect the impact of the split. 34 RLI CORP. AND SUBSIDIARIES SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION SCHEDULE VI--SUPPLEMENTARY INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1994, AND 1995
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 - ------------------------------------------------------------------------------------------------------------ Year ended December 31, 1993 RLI Insurance Group $18,722,395 $165,558,994 $72,362,259 $125,989,278 $ 81,589,111 - -------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------- Year ended December 31, 1994 RLI Insurance Group $19,208,212 $195,229,244 $78,839,454 $140,184,488 $100,534,321 - -------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------- Year ended December 31, 1995 RLI Insurance Group $15,806,911 $221,648,494 $75,824,217 $133,468,133 $ 62,618,745 - -------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------
NOTE 1: The Company adopted Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" ("SFAS 113"), in the first quarter of 1993. This resulted in grossing up assets and liabilities for ceded reinsurance recoverables on unpaid losses and ceded unearned premiums with no impact on earnings or shareholders' equity. Included above is unpaid losses and settlement expenses and unearned premiums net of applicable ceded amounts. See the consolidated balance sheets for gross and ceded amounts. NOTE 2: Investment income is not allocated to the segments, therefore net investment income (column G) has not been provided. 35 RLI CORP. AND SUBSIDIARIES SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION SCHEDULE VI--SUPPLEMENTARY INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1994, AND 1995
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 - --------------------------------------------------------------------------------------------------- Year ended December 31, 1993 RLI Insurance Group $(1,851,708) $27,640,459 $15,062,838 $143,531,051 - -------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------- Year ended December 31, 1994 RLI Insurance Group $ 1,107,345 $47,106,098 $15,142,384 $146,661,684 - --------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------- Year ended December 31, 1995 RLI Insurance Group $23,271,250 $43,042,045 $14,470,053 $130,452,895 - --------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------
36 RLI CORP. AND SUBSIDIARIES SCHEDULE IV--REINSURANCE FOR THE YEARS 1993, 1994, AND 1995
Column A Column B Column C Column D Column E Column F Percentage Ceded to Assumed of Amount Gross Other From Other Net Assumed to Amount Companies Companies Amount Net - -------------------------------------------------------------------------------------------------------------------------------- 1993 - -------------------------------------------------------------------------------------------------------------------------------- RLI Insurance Group premiums earned $233,757,304 $108,272,489 $504,463 $125,989,278 .4% - -------------------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------------------- 1994 - -------------------------------------------------------------------------------------------------------------------------------- RLI Insurance Group premiums earned $265,453,514 $125,458,397 $189,371 $140,184,488 .1% - -------------------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------------------- 1995 - -------------------------------------------------------------------------------------------------------------------------------- RLI Insurance Group premiums earned $264,651,370 $131,771,599 $588,362 $133,468,133 .4% - -------------------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------------------
NOTES: Column B, "Gross Amount" includes only direct premiums earned. 37 RLI CORP. AND SUBSIDIARIES SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 3, 1993, 1994, AND 1995
Column A Column B Column C Column D Column E Balance at Amounts Balance beginning of charged to Amounts Amounts at end period expense written-off commuted of period - ------------------------------------------------------------------------------------------------------------------------------------ 1993 Allowance for insolvent reinsurers $15,380,668 $1,163,278 $ (2,234) $ (939,564) $15,602,148 1994 Allowance for insolvent reinsurers $15,602,148 $1,000,000 $(1,054,748) -- $15,547,400 1995 Allowance for insolvent reinsurers $15,547,400 $ 613,296 $261,373 $ (85,923) $16,336,146
38 EXHIBIT INDEX EXHIBIT NO. DESCRIPTION OF DOCUMENT REFERENCE (PAGE) 2.1 Plan of Reorganization Incorporated by reference to the and Agreement of Merger Company's 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 Report on Form 10-Q for the Second Quarter ended June 30, 1993. 3.2 By-Laws Incorporated by reference to the Company's Quarterly Report on Form 10-Q for the Second Quarter ended June 30, 1993. 4.1 Indenture dated July Incorporated by reference to the 28, 1993 between the Company's Registration Company and Norwest Bank Statement on Form S-3 filed on July 21, 1993. Minnesota, National Association as Trustee 10.1 Executive Achievement Incorporated by reference to the Target Salary Plan Company's Registration Statement on Form S-2 filed on August 22, 1985, File No. 0-6612. 10.2 The William R. Keane/ Incorporated by reference to the RLI Corp. Director Company's Registration Deferred Compensation Statement on Form 10-Q for the Second Plan Quarter ended June 30, 1993. 10.3 The RLI Corp. Directors' Incorporated by reference to the Irrevocable Trust Company's Registration Agreement Statement on Form 10-Q for the Second Quarter ended June 30, 1993. 10.4 Key Employee Excess Incorporated by reference to the Benefit Plan for Company's Annual Form 10-K/A for the Gerald D. Stephens year ended December 31, 1992. 10.5 RLI Corp. Incentive Incorporated by reference to Company's Stock Option Plan Registration Statement on Form S-8 filed on March 11, 1996, File No. 333-01637 10.9 Reinsurance Agreements Incorporated by reference to the between the Company and Company's Annual Form 10-K/A for the American Re-Insurance year ended December 31, 1992. Company 10.10 Reinsurance Agreements Incorporated by reference to the between the Company and Company's Annual Form 10-K/A Lloyds of London for the year ended December 31, 1992. 10.11 Reinsurance Agreements Incorporated by reference to the between the Company Company's Annual Form 10-K/A for the and NAC Reinsurance Corp. year ended December 31, 1992. 11.0 Statement re computation Attached page 41. of per share earnings 13.1 Refer to the Annual Attached Exhibit 13. Report to Shareholders for the year ended December 31, 1995, pages 22-49 and 53. 39 EXHIBIT NO. DESCRIPTION OF DOCUMENT REFERENCE (PAGE) 21.1 Subsidiaries of the Attached page 42. Registrant 23.1 Consent of KPMG Peat Attached page 43. Marwick LLP 23.2 Consent of KPMG Peat Incorporated by reference to the Marwick LLP Company's Registration Statement on Form S-3 filed July 21, 1993. 23.3 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 29.1 Information from reports Attached page 44 furnished to state insurance regulatory authorities 40 EX-11.0 2 EXHIBIT 11.0 EXHIBIT 11.0 RLI CORP. AND SUBSIDIARIES COMPUTATION OF PER SHARE EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1994, AND 1995
1993 1994 1995 (restated) (restated) - ------------------------------------------------------------------------------------------------------------------------ Primary Net earnings (loss) $15,947,627 $(4,775,871) $ 7,949,541 - ----------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------- Earnings (loss) per share $2.10 $(0.61) $1.01 - ----------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------- Weighted average shares outstanding 7,599,563 7,786,004 7,849,799 - ----------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------- Fully Diluted Net earnings (loss) $15,947,627 $(4,775,871) $ 7,949,541 Reduction of interest expense on assumed conversion of convertible debentures (net of tax) 762,450 Note (1) Note (1) Reduced amortization of deferred loan costs on assumed conversion of convertible debentures (net of tax) 37,091 Note (1) Note (1) - ----------------------------------------------------------------------------------------------------------------------- Adjusted net earnings (loss) $16,747,168 $(4,775,871) $ 7,949,541 - ----------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------- Earnings (loss) per share (1) $2.00 $(0.61) $1.01 - ----------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------- Weighted average shares outstanding (1) 7,599,563 7,786,004 7,849,799 Dilutive effect of convertible debentures (2) 761,012 Note (1) Note (1) Adjusted weighted average shares outstanding 8,360,575 7,786,004 7,849,799 - ----------------------------------------------------------------------------------------------------------------------- - -----------------------------------------------------------------------------------------------------------------------
NOTES: (1) Fully diluted earnings per share calculations are based on the weighted average number of shares of common stock and common stock equivalents outstanding for the period, assuming full conversion of all convertible debentures into common stock. Net earnings are adjusted for purposes of this calculation to eliminate interest and amortization of debt issuance costs on the convertible debentures net of related income taxes. When the conversion of convertible debentures increases the earnings per share or reduces the loss per share, the effect on earnings is antidilutive. Under these circumstances the fully diluted net earnings or net loss per share is computed assuming no conversion of the convertible debentures. (2) On July 28, 1993, RLI Corp. issued $46 million in 6.0% convertible debentures which mature July 15, 2003. These debentures, unless previously redeemed, are convertible at the option of the holder at any time prior to maturity into RLI Corp. common stock at an adjusted conversion price of $26.00 per share, subject to adjustment in certain events. (See Note 4 in the "Notes to Consolidated Financial Statements" for additional information.) 41 EX-13 3 EXHIBIT 13 EXHIBIT 13 SELECTED FINANCIAL DATA The following is selected financial data of RLI Corp. and Subsidiaries for the eleven years ended December 31, 1995:
1985 1986 1987 1988 1989 - -------------------------------------------------------------------------------------------------------------------------------- OPERATING RESULTS Gross sales $161,273,603 195,805,801 151,492,336 143,785,384 149,230,331 Total revenue $69,619,102 111,029,407 106,846,379 104,279,172 89,984,262 Net earnings (loss) $4,321,537 10,978,773 13,965,174 7,253,913 8,200,264 Growth in shareholder value 14.6% 30.1% 26.2% 14.4% 18.1% Net cash provided from operating activities $43,186,139 31,600,447 9,151,857 27,742,205 22,801,043 Net premiums written to statutory surplus 194% 190% 156% 131% 96% GAAP combined ratio 101.3 93.5 84.4 96.1 97.8 Statutory combined ratio 102.5 89.5 84.7 98.3 99.5 FINANCIAL CONDITION Total investments $100,410,988 131,902,026 152,777,063 165,956,870 177,025,151 Total assets $283,575,812 321,883,748 364,740,628 372,492,257 402,906,191 Unpaid losses and settlement expenses $119,457,576 159,383,894 194,707,865 217,230,839 230,523,717 Long-term debt $7,000,000 7,000,000 7,000,000 7,000,000 7,000,000 Total shareholders' equity $36,310,127 49,291,745 57,763,851 64,026,271 70,276,175 Statutory surplus $37,037,118 54,063,188 57,453,264 60,151,725 68,571,173 SHARE INFORMATION (1) Earnings (loss) per share: Primary $.68 1.46 1.82 .97 1.14 Fully-diluted (2) $.68 1.46 1.82 .97 1.14 Cash dividends declared per common share $.18 .22 .25 .27 .30 Book value $4.84 6.37 7.73 8.57 9.94 Closing stock price $10.10 11.00 7.70 6.10 6.80 Stock split 167% 150% Weighted average number of common shares outstanding: Primary 6,348,426 7,526,375 7,704,938 7,475,369 7,189,076 Fully-diluted (2) 6,348,426 7,526,375 7,704,938 7,475,369 7,189,076 Common shares outstanding 7,500,000 7,738,619 7,475,369 7,475,369 7,073,718 ===============================================================================================
(1) Share and per share data have been restated to reflect the 5-for-4 stock split that occurred on June 21, 1995. (2) See note 1K to the consolidated financial statements. (3) 1993 and 1994 information has been restated to include the accounts and results of Target Industries, Inc., acquired through merger in 1995. Years prior to 1993 have not been restated due to their immateriality. See note 1B to the consolidated financial statements. 22 SELECTED FINANCIAL DATA The following is selected financial data of RLI Corp. and Subsidiaries for the eleven years ended December 31, 1995:
1990 1991 1992 1993 (3) 1994 (3) 1995 (restated) (restated) - ------------------------------------------------------------------------------------------------------------------------------------ OPERATING RESULTS Gross sales $181,215,877 215,497,602 232,223,865 295,675,237 330,895,139 328,440,941 Total revenue 92,957,578 102,342,998 129,757,326 172,295,163 190,695,564 190,549,112 Net earnings (loss) 14,267,002 16,800,050 16,207,127 15,947,627 (4,775,871) 7,949,541 Growth in shareholder value 17.0% 28.1% 18.2% 21.2% (5.9)% 23.9% Net cash provided from operating activities 45,388,065 22,918,206 42,885,435 72,290,506 27,277,853 24,298,768 Net premiums written to statutory surplus 112% 95% 110% 94% 108% 76% GAAP combined ratio 85.1 85.2 91.4 97.2 116.9 107.5 Statutory combined ratio 92.2 91.6 95.8 87.9 (4) 116.9 106.5 FINANCIAL CONDITION Total investments 213,160,198 237,932,089 283,299,088 403,642,919 416,532,508 474,589,614 Total assets 432,379,562 483,571,862 529,660,099 673,866,304 757,803,069 814,647,141 Unpaid losses and settlement expenses 235,806,989 244,666,938 268,042,761 310,767,026 394,966,040 418,985,960 Long-term debt 7,000,000 7,000,000 7,000,000 53,000,000 52,255,000 46,000,000 Total shareholders' equity 79,850,942 99,677,983 117,392,751 140,706,372 131,169,961 158,607,716 Statutory surplus 70,409,590 88,605,319 100,584,758 152,261,509 136,124,530 172,312,961 SHARE INFORMATION (1) Earnings (loss) per share: Primary 2.02 2.38 2.26 2.10 (5) (0.61) 1.01 Fully-diluted (2) 2.02 2.38 2.26 2.00 (5) (0.61) 1.01 Cash dividends declared per common share .34 .37 .40 .42 .45 .51 Book value 11.29 14.09 16.30 18.25 16.71 20.20 Closing stock price 11.60 13.20 19.80 21.20 16.40 25.00 Stock split 125% Weighted average number of common shares outstanding: Primary 7,073,718 7,073,718 7,158,890 7,599,563 7,786,186 7,849,799 Fully-diluted (2) 7,073,718 7,073,718 7,158,890 8,360,575 7,786,186 7,849,799 Common shares outstanding 7,073,718 7,073,718 7,201,343 7,711,065 7,849,443 7,850,882 ================================================================================================================================
(1) Share and per share data have been restated to reflect the 5-for-4 stock split that occurred on June 21, 1995. (2) See note 1K to the consolidated financial statements. (3) 1993 and 1994 information has been restated to include the accounts and results of Target Industries, Inc., acquired through merger in 1995. Years prior to 1993 have not been restated due to their immateriality. See note 1B to the consolidated financial statements. (4) 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. (5) Primary and fully-diluted earnings per share include $.22 per share and $.20 per share, respectively, related to the initial application of SFAS 109 "Accounting for Income Taxes." 23 MANAGEMENT'S DISCUSSION AND ANALYSIS OVERVIEW RLI Corp. (the Company) is a holding company which, through its subsidiaries, underwrites specialty property and casualty insurance and provides a wide range of services and products to the ophthalmic industry. The most significant segment of the Company is RLI Insurance Group (the Group), which provides specialty property and casualty coverages primarily for commercial risks. This segment accounted for 70.0% of the Company's total revenue for 1995. As a niche insurer, the Group offers products geared to the needs of those insureds generally overlooked by traditional insurance markets. The Group's product mix is split almost evenly between property and casualty coverages. 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 75.1% of the Company's 1995 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 Group's business consists largely of Commercial and Personal Umbrella and General Liability coverages. In addition, the Group provides In-Home Business Owners coverage, Directors & Officers Liability, Employers Excess Indemnity (EEI-an alternative to the Texas state-run workers' compensation system) and Surety Bonds. The casualty book of business is subject to the risk of accurately estimating loss reserves since the ultimate disposition of a casualty claim may take several years to fully develop. The casualty line is additionally affected by evolving legislation and court decisions that define and expand the extent of coverage and the amount of compensation due for injuries or losses. The ophthalmic segment, RLI Vision Corp. (RLI Vision), provides eyecare professionals with products and services to meet the needs of their practice. These include: wholesale distribution of soft contact lenses, spectacle frames and sunglasses; third party administration of extended service programs; manufacturing rigid gas permeable (RGP) contact lenses and spectacle lenses; and RLISYS practice management software. The ophthalmic industry is extremely competitive and constantly evolving. In addition, it experiences some seasonal declines during the first and fourth quarters of the year. Recent advancements in technology have dramatically improved the outlook for consumers with vision problems. In order to thrive in this industry, a company must be highly efficient and extremely sensitive to the needs of the consumer. The consolidated financial statements and related notes found on pages 32-49 should be read in conjunction with the following discussion. SIGNIFICANT DEVELOPMENTS NORTHRIDGE EARTHQUAKE In September 1995, the Company strengthened loss reserves related to the January 17, 1994 Northridge Earthquake. While relatively minor development had occurred throughout the first six months of 1995, the third quarter claim-by-claim review indicated that greater future development was likely. The overall 1995 impact from the Northridge Earthquake was a reduction to after-tax earnings by $18.6 million or $2.37 per share. This additional development resulted, in part, from hidden damages and increased business interruption losses on the Company's excess policies which, in 1994, were estimated by adjusters to be well within coverage limits of the primary and underlying excess layers. Also contributing to the increased development were unanticipated building code enactments, escalating construction costs, and the impact of reopened claims as a result of the involvement of public adjusters. AVIATION DIVISION SALE On February 1, 1995, the Company completed the sale of its aviation division, Aviation Underwriting Specialists (AUS), to AVEMCO Corporation of Frederick, Maryland, resulting in an immaterial gain to the Company. Soft market conditions, which are anticipated to continue, were the major cause of the division's downturn. AUS had generated $13.5 million in aviation insurance premiums in 1994, a portion of which the AVEMCO Group assumed through a reinsurance arrangement between AVEMCO Insurance Company and RLI Insurance Company. OPHTHALMIC ACQUISITION On May 4, 1995, the Company's subsidiary, RLI Professional Technologies, Inc., announced the acquisition through merger of Target Indus- 24 tries, Inc., a wholesale optical goods distributor of contact lenses, Rx spectacles, frames, and sunglasses. As consideration, the Company issued 313,500 shares of its common stock and, accordingly, the transaction was accounted for as a pooling-of-interests. The combined entity operates under the name of RLI Vision Corp. The resulting operating and product synergies, along with the combined ability to provide $35 million in products and services, bode well for the future success of RLI Vision Corp. STOCK SPLIT In the second quarter of 1995, the Company announced a 5-for-4 stock split. RESTATEMENT As a result of the merger with Target Industries, Inc., financial information for 1993, 1994 and 1995 has been restated. Additionally, all share and per share data has been restated as a result of the stock split. YEAR ENDED DECEMBER 31, 1995, COMPARED TO YEAR ENDED DECEMBER 31, 1994 Consolidated gross sales -- which consist of gross premiums written, RLI Vision sales, net investment income and realized investment gains (losses) -- totaled $328.4 million, a 0.7% decline from 1994. Consolidated revenue for 1995 was $190.5 million, down 0.1% from 1994. These decreases were due to the discontinuation of lines of business and a re-underwriting of the property book of business resulting in a temporary decline in premiums. The specific declines from discontinued business were $4.1 million from contact lens and $11.3 million from Aviation. These decreases were partially offset by increases in investment income and capital gains.
- -------------------------------------------------------------------------------- Year Ended December 31, - -------------------------------------------------------------------------------- Gross sales (in thousands) 1993 1994 1995 - -------------------------------------------------------------------------------- Gross premiums written $249,369 $279,428 $271,436 RLI Vision Corp. sales 29,195 34,930 34,519 Net investment income 16,857 20,132 22,029 Realized investment gains (losses) 254 (3,595) 457 - -------------------------------------------------------------------------------- Total gross sales $295,675 $330,895 $328,441 - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
Net after-tax earnings for the Company were $8.0 million ($1.01 per share) in 1995 compared to a net after-tax loss in 1994 of $4.8 million ($.61 per share). The net after-tax impact of the Northridge Earthquake was a loss of $18.6 million ($2.37 per share) in 1995. The effect of the earthquake in 1994 was an after-tax loss of $25.0 million ($3.21 per share). The following table compares the Company's operating results for 1995 and 1994. Results are shown as actually reported as well as adjusted for the Northridge Earthquake. All amounts are shown in thousands, except per share data.
- -------------------------------------------------------------------------------- Without Earthquake - -------------------------------------------------------------------------------- 1994 1995 1994 1995 Premiums earned $140,184 $133,468 $158,197 $134,695 Other revenue 50,512 57,081 50,512 57,081 - -------------------------------------------------------------------------------- Consolidated revenue 190,696 190,549 208,709 191,776 - -------------------------------------------------------------------------------- Loss and settlement expenses 101,642 85,890 80,466 58,552 Policy acquisition costs 47,106 43,042 48,416 43,042 All other expenses 53,534 53,348 53,534 53,348 - -------------------------------------------------------------------------------- Total expenses 202,282 182,280 182,416 154,942 - -------------------------------------------------------------------------------- Earnings (loss) before income taxes (11,586) 8,269 26,293 36,834 Net earnings (loss) (4,775) 7,950 20,246 26,517 Primary net earnings (loss) per share (0.61) 1.01 2.60 3.38 Operating earnings (loss) per share $ (0.31) $0.97 $2.90 $3.34 - -------------------------------------------------------------------------------- - --------------------------------------------------------------------------------
In 1994, the Company's Board of Directors did not authorize a contribution to the RLI Corp. Employee Stock Ownership Plan and Trust (ESOP). This decision reduced expenses and thereby enhanced 1994 after-tax earnings by $1.6 million ($.21 per share). Realized capital losses recognized in 1994 reduced after-tax earnings by $2.4 million ($.30 per share). Realized capital gains in 1995 increased after-tax earnings by $297,000 ($.04 per share). RLI INSURANCE GROUP While the effects of the Northridge Earthquake were still being felt in 1995, they were offset to a large extent by the outstanding results from ongoing operations of the Group. Including results from the earthquake, the Group's pretax loss was $9.9 million, which was an improvement of $13.8 million over the same period in 1994. The Group's overall property loss ratio, including Northridge, improved 23 points to 75 in 1995 compared to 1994, largely due to the elimination of unprofitable fire risks. Gross written premiums of $271.4 million were down 2.9%, off slightly from 1994 results. This was due to the Group's re-underwriting efforts designed to reduce Difference In Conditions (DIC) exposure through reduced limits, fewer heavily exposed policies and attachment at higher levels on large risks. As this re-underwriting phase was completed toward the end of 1995, property premiums began to increase accordingly. The Group also reduced its fire book of business in selected areas by focusing on more profitable risks. Net premiums earned also declined 4.8% to $133.5 million. The discontinued Aviation and contact lens lines contributed to this decline. Excluding the impact of the earthquake, the Group's pretax earnings increased 31.5% to $18.6 million from $14.2 million a year ago. This 25 improvement was also reflected in the pre-quake combined ratio, calculated according to GAAP, which was 86.2 in 1995 compared to 91.1 in 1994. Favorable property loss experience contributed to this trend. While the pre-quake expense ratio increased slightly in 1995 due to the decline in earned premiums, actual operating expenses for the Group declined $6.0 million in 1995 compared to 1994. Of this amount, $5.3 million was attributable to policy acquisition costs where gross commission dropped $3.0 million due to the decline in gross written premiums for 1995. Other insurance expenses were lower due mostly to the sale of AUS, which resulted in 1995 expense savings of $2.1 million. As described in note 6 of the consolidated financial statements, prior-year loss reserves developed unfavorably by $23.3 million. This reflects $27.3 million of development on the Northridge Earthquake claims alone. After adjusting for the earthquake, favorable development of $4.0 million would have occurred, compared to unfavorable development of $1.1 million in 1994. The 1995 pre-quake development constitutes 2.0% of the total reserves for net loss and settlement expenses. RLI VISION CORP. RLI Vision's 1995 revenue of $34.6 million was 1.8% higher than the $34.0 million attained in 1994. Revenue from ophthalmic products increased $892,000, or 3.5%. This includes contact lenses and other distribution products, which increased $754,000, or 3.5%, and the manufacturing of spectacle and RGP lenses, which increased $137,000, or 3.8%. License fees from RLISYS practice management software increased $370,000, or 36.3%, over 1994. Revenue for Vision Care Advantage (VCA), RLI Vision's managed care product, increased $109,000, or 457.9%, due to a heavy marketing emphasis during the latter half of 1995. Revenue from third party administration products, including Total Lens Care (TLC) and Clear Advantage, decreased $609,000, or 8.5%, from 1994. This decrease was due to the downward trend of these services throughout the ophthalmic industry. RLI Vision's pretax earnings for 1995 decreased 37.7% to $1.2 million from $1.9 million in 1994. Operating expenses increased by $1.3 million, or 4.1%, during 1995. This increase was largely attributable to the increase in cost of goods sold of $876,000, or 4.7%, related to the increase in sales of ophthalmic products. The operating expense increase was partially due to an increase of $214,000 in collection costs; and increase of $107,000 due to the increased marketing of VCA; and an increase of $221,000 in employee benefits from the participation in the subsidiary's newly formed 401(k). No comparable employee benefit contribution was made in 1994. Partially offsetting these increases was a reduction of $176,000 in marketing expenses, primarily due to TLC. INVESTMENT INCOME Net dividend and interest income increased 9.4% during 1995. The increase was due to the growth of assets throughout 1995 and from the reallocation of shorter term securities into higher yielding, longer term fixed-income securities. The Company realized $457,000 in capital gains in 1995 compared to $3.6 million in realized losses in 1994. During 1994, certain equity securities were sold at a net loss in order to recover $1.3 million in taxes paid on prior-year capital gains. The opportunity to recover a portion of these tax dollars would have expired at the end of 1994. Operating cash flows were down slightly for 1995, declining to $24.3 million from $27.3 million in 1994. All cash flows in excess of current needs were used to acquire fixed-income instruments, composed of intermediate term, high grade tax-exempt securities and U.S. government and agency securities. The yields on the Company's fixed-income investments for the years ended December 31, 1994 and 1995, respectively, were as follows:
1994 1995 - ----------------------------------- Taxable 6.82% 6.84% Tax-exempt 5.25% 5.06%
Yields for 1995 declined as the bond market saw yields tumble nearly 200 basis points. As a result, cash flows invested in tax-exempt securities were invested at lower yields. The taxable segment of the portfolio saw a slight increase in yield through the inclusion of callable agencies in the portfolio. The investment results of the Company for the last five years are shown in the following table. All amounts are shown 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 - ----------------------------------------------------------------------------------------------------- 1991 $225,546 $12,742 $1,234 $ 8,528 10.0% 11.0% 1992 260,616 13,483 921 3,546 6.9% 8.0% 1993 343,441 16,857 254 7,945 7.3% 8.3% 1994 410,058 20,133 (3,595) (5,749) 2.6% 3.6% 1995 445,562 22,029 457 36,037 13.1% 14.0% 5-yr. $338,133 $17,049 $ (146) $10,061 8.0% 9.0%
(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 maturities and equity securities. - -------------------------------------------------------------------------------- 26 The annualized return for 1995 was greatly enhanced by the strong performance of our equity portfolio. During 1995, the equity portfolio had unrealized appreciation of $34.4 million. INTEREST AND GENERAL CORPORATE EXPENSE Interest expense on debt for 1995 was $3.3 million, down slightly from 1994. General corporate expenses dropped $753,000 in 1995 due primarily to the 1994 contribution of $1.0 million to Bradley University to establish an insurance chair as part of its curriculum. INCOME TAXES The Company's effective tax rate in 1995 was 3.9% on pretax earnings of $8.3 million. These earnings include $7.4 million of investment income which is wholly or partially exempt from federal income tax. In 1994, the loss before taxes was $11.6 million, with a tax benefit of $6.8 million, producing an effective rate of 58%. Non-taxable investment income for 1994 was $7.8 million. The Company had a net operating loss for tax purposes in 1994. The loss was carried back to 1991 to recover federal and state income taxes paid. In addition, the Company realized capital losses to be carried back as an offset to capital gains in previous years. As a result, the Company carried back $3.6 million in capital losses realized in 1994 and recovered $1.3 million of taxes paid in 1991, 1992, and 1993. OUTLOOK FOR 1996 Aside from the recognition of additional earthquake development, the Company demonstrated strong ongoing earnings potential which bodes well for the coming year. PROPERTY INSURANCE The property line is projected to continue to represent about half of the total gross premium written by the Group. The Group anticipates that rates will remain steady throughout 1996. During 1995, exposure reduction and improvements in the overall reinsurance program were emphasized. Reinsurance rate reductions of 15% were achieved late in the year as the 1996 reinsurance placements were made. These savings were utilized to increase protection above existing layers, purchase a reinstatement cover, and buy lower level per risk coverage. These strategies are designed to reduce earnings volatility and better control the impact of earthquake and wind events in total. To illustrate, the total pretax loss from Northridge for 1994 and 1995 combined was $66.4 million. With the reduced exposure and improved reinsurance structure, the same event today would produce a total pretax loss of only $12.5 million. CASUALTY AND OTHER LINES The Commercial Umbrella, Directors and Officers Liability, and Personal Umbrella products are all expected to show continued increases in gross premium writings during 1996, before consideration of acquisition or addition of new product lines. Intense competition in the casualty market will likely discourage much rate improvement. General Liability business is expected to show modest growth on current branch office products. However, new product development is expected to foster the bulk of overall growth in this line. Although the Group's Surety business has, to date, comprised a small amount of the overall premium volume, the reported loss experience has been excellent. In 1996, to complement the existing distribution system, new ventures will be pursued to significantly increase the written premiums on this program. RLI VISION CORP. During 1996, RLI Vision expects to see revenue grow through the distribution of all ophthalmic products, including soft contact lenses, Rx spectacles, frames, sunglasses, RGP lenses and license fees from the RLISYS practice management software. Also, a recent increase in the marketing of the Vision Care Advantage (VCA) product should produce an increase in revenue beginning in 1996. The division continues to seek out possible acquisitions to enhance its current product line and overall profitability. YEAR ENDED DECEMBER 31, 1994, COMPARED TO YEAR ENDED DECEMBER 31, 1993 RLI INSURANCE GROUP The effects of the Northridge Earthquake overshadowed what was otherwise an exceptional year for the Group. Gross premiums written surged to $279.4 million in 1994, a 12.1% increase over 1993. Net premiums earned in 1994 increased to $140.2 million, an 11.3% jump, despite the recognition of $18.0 million in ceded reinsurance reinstatement premiums as a result of the earthquake. The Group recorded a pretax loss of $23.7 million in 1994 compared to pretax earnings of $3.5 million in 1993. Losses and expenses caused by the earthquake reduced pretax earnings by $37.9 million. As a result of the earthquake, the combined ratio, calculated according to GAAP, hit 116.9, making 1994 the only year of the prior nine in which the ratio exceeded 100. Net premiums earned, before the effects of the earthquake (pre-quake), increased 25.6%. The Company's property coverages saw rate increases of over 30% during 1994, with Difference In Conditions coverage regis- 27 tering a rise of over 45% and Fire, a gain of approximately 10%. Also contributing to the growth in premiums earned was EEI, a new line of business in 1993, that made excellent progress during 1994. Lastly, the Company revised its property reinsurance program in 1994 and did not renew its multiple-year, retrospectively-rated reinsurance contracts. This essentially reduced both ceded premiums and ceded contingent commissions by $13.0 million. The Group's pre-quake, pretax earnings increased to $14.2 million, more than four times the level reported in 1993. Earned premium growth and favorable loss experience were the primary reasons for the vast improvement. As a result, the pre-quake GAAP combined ratio declined to 91.1 in 1994 from 97.2 in 1993, the pre-quake loss ratio dropped to 50.9 in 1994 from 63.3 in 1993, and the pre-quake expense ratio increased to 40.2 in 1994 compared to 33.9 in 1993. The shift in the loss and expense ratios was caused by the revision of the property reinsurance program noted above. Had the same reinsurance program been in place during 1993, the 1993 loss and expense ratios would have approximated 57.4 and 40.1, respectively. Pre-quake policy acquisition costs increased 75.2%, primarily because of the $13.0 million reduction in ceding contingent commissions. Excluding the impact from the change in the reinsurance program, pre-quake policy acquisition costs would have increased 19.2% in 1994. This increase was largely due to the increase in premiums earned along with changes in other ceding commissions. See note 3 of the consolidated financial statements for additional details on policy acquisition costs. Other insurance expenses were virtually unchanged from 1993. The reserves for loss and settlement expenses held strong, minimizing the impact of reserve development on current operations. As described in note 6 of the consolidated financial statements, prior-year loss reserves developed unfavorably by $1.1 million in 1994, and favorably by $1.9 million in 1993. The 1994 development represents approximately half of one percent of the reserves for net loss and settlement expenses. The Company has been successful in minimizing loss and settlement expense reserve development by writing predominantly short-to-medium-tail liability business, limiting its exposure to environmental liability, and constantly reviewing and monitoring loss reserve levels. RLI VISION CORP. RLI Vision's 1994 revenue of $34.0 million was 16.4% higher than the $29.2 million attained in 1993. A significant part of the increase was due to growth in TLC revenue. During 1994, TLC revenue increased by approximately $4.0 million as RLI Vision converted customers from the contact lens insurance product to TLC. Revenue from all ophthalmic distribution products and RLISYS licensing fees increased 10.0% in 1994, while revenue from other RLISYS products and extended services decreased 35.3% from 1993. This decrease was due primarily to the discontinuation of the unprofitable computer hardware product. RLI Vision's pretax earnings for 1994 increased 54.1% to $1.9 million from $1.2 million in 1993. Operating expenses increased by $4.1 million, or 14.8%, during 1994. This increase was largely due to expenses related to the TLC product. Partially offsetting the increase in TLC expenses were decreased expenses on other products. Cost-control measures and the restructuring of the sales force during the third quarter of 1993 contributed significantly to these decreases. Realignment and reduction of the sales territories decreased the number of sales representatives and regional managers by 28.6%. While revenue generated by products marketed through the sales force remained level in 1994, travel costs declined by $180,000. Commissions and other direct selling expenses incurred on the sale of computer hardware products decreased $610,000 during 1994. This decrease coincided with the reduction in revenue generated by this discontinued product. Also, since no ESOP contribution was made for 1994, RLI Vision's employee benefits were reduced by approximately $360,000. INVESTMENT INCOME Net dividend and interest income increased 19.4% during 1994. The increase was partly due to growth in invested assets during the second half of 1993 and throughout 1994. Proceeds from a $46.0 million convertible debt offering in July 1993, along with increased premium writings during 1993 and 1994, were the key contributors to this growth. The Company also recognized $3.6 million of realized capital losses in 1994 compared to $254,000 of realized gains in 1993. In the fourth quarter of 1994, the Company sold certain equity securities at a net loss in order to recover $1.3 million in taxes paid on prior-year capital gains. The opportunity to recover a portion of these tax dollars expired on December 31, 1994. Operating cash flows were $27.3 million for 1994, even though the Company paid over $100 million to insureds for earthquake claims. Although cash flow was positive, it decreased by $45.0 million from 1993, thereby diminishing the potential growth of the Company's investment portfolio. Reinsurance recoveries on earthquake losses were being collected on a timely basis. These recoveries--coupled with increased premium production and short-term investments--provided adequate funding for all current obligations, thus eliminating any need to sell long-term securities to cover claim payments. All operating cash flows in excess of current needs were used to acquire fixed-income instruments, composed almost entirely of intermediate-term U.S. government and agency securities. 28 The yields on the Company's fixed-income investments for the years ended December 31, 1993 and 1994, were as follows:
1993 1994 - ---------------------------------------------------------- Taxable 6.94% 6.82% Nontaxable 5.46% 5.25%
Yields for 1994 decreased due to several factors. Fourth quarter 1993 cash flows were invested in fixed-income securities prior to February 1994, when interest rates started increasing. Short-term investments and practically all operating cash flows generated during the first nine months of 1994 were used to pay losses and expenses from the Northridge Earthquake. As a result, purchases of higher-rate, fixed-income securities were reduced. In addition, the fixed-income securities which matured during 1994 carried higher interest rates; consequently, the portfolio had a lower effective yield. INTEREST AND GENERAL CORPORATE EXPENSE Interest expense on debt for 1994 totaled $3.4 million, up $1.6 million from 1993. The increase was caused by the Company's issuance of convertible debentures on July 28, 1993. Interest expense on these debentures totaled $2.8 million in 1994 compared to $1.2 million in 1993. General corporate expenses rose $1.2 million in 1994. The redefinition of general corporate expenses and a $1.0 million contribution to Bradley University were the primary contributors to the increase. INCOME TAXES During 1994, the Company had a loss before taxes of $11.9 million and a tax benefit of $6.9 million, or a 58.0% effective rate. This loss was net of investment income of $20.1 million. For federal income tax purposes, municipal bond interest and dividend income from equity securities are wholly or partially exempt. In 1994, $7.8 million of the investment income was exempt from federal income tax. In 1993, nontaxable investment income totaled $6.4 million, which reduced the taxable 1993 earnings to approximately $11.7 million. This resulted in $4.0 million in tax expense, a 22.1% effective tax rate on the 1993 book earnings. The Company had a net operating loss for tax purposes in 1994. This loss was carried back to 1991 to recover federal and state income taxes paid. In addition, the Company realized capital losses to be carried back as an offset to capital gains in previous years. As a result, the Company carried back $3.6 million in capital losses realized in 1994 and recover $1.3 million of taxes paid in 1991, 1992 and 1993. The Company adopted SFAS 109 on a prospective basis during the first quarter of 1993. As a result, in 1993 the Company recognized income of $1.7 million, or $.22 per share, through a cumulative "catch-up" adjustment. There was no material impact on federal income taxes as a result of the implementation of SFAS 109. ACCOUNTING STANDARDS In March 1995, the Financial Accounting Standards Board (FASB) issued Statement 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The Statement provides guidance for the recognition of impairment losses related to long-lived assets and certain intangibles and related goodwill for (1) assets to be held and used and (2) assets to be disposed of. The Statement excludes financial instruments, deferred policy acquisition costs and deferred tax assets. For assets to be held and used, assets are to be reviewed when events or change in circumstances indicate the carrying amount of an asset may not be recoverable. If estimated future cash flows from the use and disposition of an asset are less than the carrying amount of the asset, recognition of an impairment loss is required. An impairment loss is determined by reducing the carrying amount of an asset to its fair value. This statement is effective for fiscal years beginning after December 15, 1995. The Company believes that the adoption of this statement in 1996 will not have a material impact on its financial statements. In October 1995, the FASB issued Statement 123, "Accounting for Stock-Based Compensation." The Statement applies to all transactions in which an entity acquired goods or services by issuing equity instruments or by incurring liabilities where the payment amounts are based on the entity's common stock price, except for employee stock ownership plans (ESOPs). The Statement covers transactions with employees and nonemployees. A new method of accounting for stock-based compensation arrangements with employees is established by the Statement based on fair value rather than intrinsic value that is contained in APB Opinion No. 25 (Opinion 25). The Statement does not, however, require an entity to adopt the new fair value method for preparing its basic financial statements. Entities are allowed (1) to continue to use the Opinion 25 method or (2) to adopt the Statement's fair value based method. Entities not adopting the fair valued method are required to determine and disclose pro forma net income as if the fair value based method had been adopted. The Statement's fair value based method measures the fair value of the stock compensation award, based on the stock price at the grant date, to which employees become entitled when they have rendered the requisite service or satisfied any other conditions necessary to earn the award (i.e. the award is vested). Total compensation is determined by multiplying the fair value of an award times the awards that ultimately vest. 29 The disclosure requirements of the Statement, including the pro forma information, are effective for financial statements for fiscal years beginning after December 15, 1995 (calendar 1996). The Company intends to continue to follow the intrinsic value based method according to Opinion 25 and disclose the fair value based method on a pro forma basis, beginning with the Company's December 31, 1996 financial statements. LEGISLATION NATURAL DISASTER ACT--Recent natural disasters such as Hurricane Andrew, the Midwestern floods and the Northridge Earthquake have sparked debate on the best way to provide affordable insurance coverage for such events. At this time, the Company supports the proposed Natural Disaster Act as the most desirable alternative. CALIFORNIA EARTHQUAKE AUTHORITY--The California Insurance Commissioner has been authorized to establish a state residential earthquake program. The most recent proposals for the program include industry participation, investment of private capital and reinsurance commitments. As the Company writes an insignificant amount of residential homeowner's insurance, it does not appear that the legislation will impact the Company in any significant manner. MCCARRAN-FERGUSON ACT--The repeal of the McCarran-Ferguson Act has long been a topic of considerable debate. Congress has conducted numerous hearings on the issue, but has taken no action. The current legislation is inclined to drop the proposal. SUPERFUND REFORM (ENVIRONMENTAL LIABILITY)--Environmental liability and the methods of funding the cleanup of polluted sites received considerable attention in Congress during 1995. The Superfund Reform '95 Coalition lobbied for reform of the original law including full repeal of the retroactive liability standard. In the past, insurance industry supporters have suggested a general tax on all insurers to pay for the cleanup rather than requiring retroactive liability. The Company would not be significantly affected by any retroactive tax assessments since the Company did not write a large volume of liability insurance prior to 1984. However, if a tax is levied against current liability writers for prior pollution losses, the Company could have some tax exposure. PROPOSITION 103 (RATE ROLLBACK INITIATIVE)--In November 1988, California voters approved Proposition 103, which requires insurance premium rates for certain lines of business to be rolled back twenty percent (20%) from the rates in effect in November 1987. As a result, in 1994 and 1993, the Company reduced pretax earnings by $71,280 and $416,400, respectively. No additional provision was made during 1995. The above amounts include interest for 1994 and 1993 in the amount of $71,280 and $259,200, respectively. The total amount of deferred premiums and interest accrued as of December 31, 1995, was $2.5 million. The state of California maintains that the Company is not in compliance with Proposition 103 and that the required amount of premiums to be returned is $6.5 million plus accrued interest. The Company maintains it had reduced rates by 20% or more on its most significant lines of business. This reduction is at issue with the California Department of Insurance. While it is impossible to predict the outcome, Management believes that the amount accrued is adequate to cover the ultimate rollback, if any. The matter has been set for hearing in March of 1996. 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 the sale of Company treasury stock to the Employee Stock Ownership Plan; issuance of common stock or convertible debentures; and small, short term borrowings. The Company maintains three sources of credit from two financial institutions: one $10.0 million secured and committed line of credit that cannot be canceled during its annual term; one $30.0 million secured line of credit that cannot be canceled during its annual term and one $3.0 million secured line of credit for obtaining letters of credit. At December 31, 1995, $2.8 million of the $10.0 million line of credit was outstanding which was used to fund the repayment of the 9.75% Industrial Development Bond that was called in December, 1995. Management believes that cash generated by operations, cash generated by investments and cash available from financing activities will provide sufficient liquidity to meet the Company's anticipated needs over the next 12-24 months. During 1995, the Company generated net operating cash flows of $24.3 million, down slightly from 1994's $27.3. Financing activities included net use of $3.5 million of funds to retire $6.3 million of long term debt. The majority of operating cash flows were added to the Company's investment portfolio. The Company's fixed-income portfolio continues to be biased in favor of U.S. government and agency securities due to their high liquidity and 30 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). The Company's fixed-income portfolio consists of securities rated A or better, with 99% rated AA or better. Currently, 80.5% of the Company's fixed-income portfolio is non-callable. 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. The Company's known debt and long-term accounts payable are added to the estimate of its unpaid losses and settlement expenses, 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 interest rate risk can best be minimized by such asset/liability matching. During 1995, the Company chose to reclassify $29.8 million of held-to-maturity debt securities to available-for-sale under the one-time exemption permitted by FASB without jeopardizing the status of the entire portfolio. Although it is likely the Company will hold these securities to maturity, they will provide an additional source of liquidity and can be used to react to future changes in the Company's asset/liability structure. The Company intends to hold 85% of the securities in the Company's fixed-income portfolio until their contractual maturity. These securities are classified as held-to-maturity and are carried at amortized cost. The remaining 15% are classified as available-for-sale and are carried at fair value; unrealized capital gains and losses on these securities are excluded from earnings and are recorded as a separate component of shareholders' equity, net of deferred income taxes. Equity portfolios increased $49.9 million during 1995. The Company had net purchases of $15.0 million of common stock, while generating $472,000 in capital gains through the disposal of fully appreciated stocks. Portfolio appreciation during the year amounted to $34.4 million. The securities within the equity portfolio remain almost equally divided between conservative, blue-chip stocks growing with market indices, and fundamentally solid equities generating substantial dividend income. The National Association of Insurance Commissioners (NAIC) has been working for several years on developing a model investment law. This law, which is expected to be passed in 1996, 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. 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 RBC standards became effective for 1994 annual statement filings. The Company continues to monitor 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. Management believes that the Company's capital levels are sufficient to support the level of risk inherent in its operations. 31
CONSOLIDATED BALANCE SHEETS December 31, 1994 1995 (restated) - ------------------------------------------------------------------------------------------------------------------------ Assets - ------------------------------------------------------------------------------------------------------------------------ Investments: Fixed maturities: Held-to-maturity, at amortized cost (fair value--$234,986,609 in 1994 and $260,957,796 in 1995) $246,796,658 $251,637,536 Available-for-sale, at fair value (amortized cost--$13,814,266 in 1994 and $43,990,338 in 1995) 13,338,669 45,119,811 Equity securities available-for-sale, at fair value (cost--$87,123,071 in 1994 and $102,580,834 in 1995) 104,067,362 153,957,535 Short-term investments, at cost which approximates fair value 52,329,819 23,874,732 - ------------------------------------------------------------------------------------------------------------------------ Total investments 416,532,508 474,589,614 Cash 8,185,806 1,196,926 Accrued investment income 5,166,083 5,854,731 Premiums and reinsurance balances receivable, net of allowances for insolvent reinsurers of $15,547,400 in 1994 and $16,336,146 in 1995 26,082,932 36,447,284 Ceded unearned premiums 40,978,088 50,189,740 Reinsurance balances recoverable on unpaid losses and settlement expenses 199,736,796 197,337,466 Deferred policy acquisition costs 19,208,212 15,806,911 Property and equipment, at cost, net of accumulated depreciation of $19,076,703 in 1994 and $21,565,315 in 1995 15,788,526 13,950,559 Income taxes--current 3,315,467 2,619,811 Income taxes--deferred 6,801,829 Other assets 16,006,822 16,654,099 - ------------------------------------------------------------------------------------------------------------------------ Total assets $757,803,069 $814,647,141 ======================================================================================================================== Liabilities and Shareholders' Equity - ------------------------------------------------------------------------------------------------------------------------ Liabilities: Unpaid losses and settlement expenses $394,966,040 $418,985,960 Unearned premiums 119,817,542 126,013,957 Reinsurance balances payable 39,859,746 37,744,456 Income taxes--deferred 4,904,394 Notes payable, short-term 2,800,000 Long-term debt: Convertible debentures 46,000,000 46,000,000 Industrial development bonds 6,255,000 Other liabilities 19,734,780 19,590,658 - ------------------------------------------------------------------------------------------------------------------------ Total liabilities 626,633,108 656,039,425 - ------------------------------------------------------------------------------------------------------------------------ Commitments and contingent liabilities - ------------------------------------------------------------------------------------------------------------------------ Shareholders' equity: Common stock ($1 par value, authorized 12,000,000 shares, issued 6,762,905 shares in 1994 and 8,453,449 shares in 1995) 6,762,905 8,453,449 Paid-in capital 25,503,282 23,831,969 Net unrealized appreciation of securities, net of tax 10,910,294 34,334,524 Retained earnings 91,394,229 95,378,097 Treasury stock at cost (604,015 shares in 1994 and 602,567 shares in 1995) (3,400,749) (3,390,323) - ------------------------------------------------------------------------------------------------------------------------ Total shareholders' equity 131,169,961 158,607,716 - ------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $757,803,069 $814,647,141 ========================================================================================================================
The accompanying notes are an integral part of the consolidated financial statements. 32 CONSOLIDATED STATEMENTS OF EARNINGS
Years ended December 31, 1993 1994 1995 (restated) (restated) - ------------------------------------------------------------------------------------------------------------------------------------ Net premiums earned $125,989,278 $140,184,488 $133,468,133 RLI Vision Corp. revenue 29,194,823 33,973,592 34,595,388 Net investment income 16,857,117 20,132,585 22,029,081 Net realized investment gains (losses) 253,945 (3,595,101) 456,510 - ------------------------------------------------------------------------------------------------------------------------------------ 172,295,163 190,695,564 190,549,112 - ------------------------------------------------------------------------------------------------------------------------------------ Losses and settlement expenses 79,737,403 101,641,666 85,889,995 Policy acquisition costs 27,640,459 47,106,098 43,042,045 Insurance operating expenses 15,062,838 15,142,384 14,470,053 RLI Vision Corp. operating expenses 27,989,084 32,115,483 33,438,154 Interest expense on debt 1,855,697 3,431,464 3,347,378 General corporate expenses 1,680,536 2,845,289 2,093,034 - ------------------------------------------------------------------------------------------------------------------------------------ 153,966,017 202,282,384 182,280,659 - ------------------------------------------------------------------------------------------------------------------------------------ Earnings (loss) before income taxes and cumulative effect of change in accounting principle 18,329,146 (11,586,820) 8,268,453 - ------------------------------------------------------------------------------------------------------------------------------------ Income tax expense (benefit): Current 10,435,263 (3,862,397) 1,225,889 Deferred (6,388,744) (2,948,552) (906,977) - ------------------------------------------------------------------------------------------------------------------------------------ 4,046,519 (6,810,949) 318,912 - ------------------------------------------------------------------------------------------------------------------------------------ Net earnings (loss) before cumulative effect of change in accounting principle 14,282,627 (4,775,871) 7,949,541 Cumulative effect to January 1, 1993 of initial application of SFAS 109 "Accounting for Income Taxes" 1,665,000 - ------------------------------------------------------------------------------------------------------------------------------------ Net earnings (loss) $ 15,947,627 $ (4,775,871) $ 7,949,541 - ------------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------------ Earnings per share: Primary Net earnings (loss) per share before cumulative effect of change in accounting principle $1.88 $(0.61) $1.01 Cumulative effect to January 1, 1993 of initial application of SFAS 109 "Accounting for Income Taxes" .22 - ------------------------------------------------------------------------------------------------------------------------------------ Primary net earnings (loss) per share $2.10 $(0.61) $1.01 - ------------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------------ Fully diluted Net earnings (loss) per share before cumulative effect of change in accounting principle $1.80 $(0.61) $1.01 Cumulative effect to January 1, 1993 of initial application of SFAS 109 "Accounting for Income Taxes" .20 - ------------------------------------------------------------------------------------------------------------------------------------ Fully diluted net earnings (loss) per share $2.00 $(0.61) $1.01 - ------------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------------ Weighted average number of common shares outstanding: Primary 7,599,563 7,786,004 7,849,799 Fully diluted 8,360,575 7,786,004 7,849,799 The accompanying notes are an integral part of the consolidated financial statements.
33 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Net Unrealized Treasury Common Paid-in Appreciation Retained Stock Years ended December 31, Stock Capital of Securities Earnings at Cost Total - ---------------------------------------------------------------------------------------------------------------------------------- Balance, January 1, 1993 (restated) $ 6,762,905 $21,409,616 $ 9,419,726 $86,971,422 $(5,864,428) $118,699,241 Net earnings 15,947,627 15,947,627 Treasury shares reissued (196,405 shares) 2,576,537 1,467,433 4,043,970 Net change in unrealized appreciation of securities 5,227,481 5,227,481 Dividends declared ($.42 per share) (3,211,947) (3,211,947) - ---------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1993 (restated) 6,762,905 23,986,153 14,647,207 99,707,102 (4,396,995) 140,706,372 Net loss (4,775,871) (4,775,871) Treasury shares reissued (138,368 shares) 1,517,129 996,246 2,513,375 Unrealized appreciation of securities from adoption of SFAS 115 327,707 327,707 Net change in unrealized appreciation of available- for-sale securities (4,064,620) (4,064,620) Dividends declared ($.45 per share) (3,537,002) (3,537,002) - ---------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1994 (restated) 6,762,905 25,503,282 10,910,294 91,394,229 (3,400,749) 131,169,961 Net earnings 7,949,541 7,949,541 Treasury shares reissued (1,448 shares) 23,241 10,426 33,667 5-for-4 stock split 1,690,544 (1,694,554) (4,010) Net change in unrealized appreciation of available- for-sale securities 23,424,230 23,424,230 Dividends declared ($.51 per share) (3,965,673) (3,965,673) - ---------------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1995 $ 8,453,449 $23,831,969 $34,334,524 $95,378,097 $(3,390,323) $158,607,716 - ---------------------------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements.
34 CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 1993 (restated) 1994 (restated) 1995 - ------------------------------------------------------------------------------------------------------------------------------------ Cash Flows from Operating Activities Net earnings (loss) $15,947,627 $ (4,775,871) $ 7,949,541 Adjustments to reconcile net earnings (loss) to net cash provided by operating activities: Provision for insolvencies 1,163,278 1,000,000 613,296 Net realized investment losses (gains) (253,945) 3,595,101 (456,510) Depreciation 3,182,808 3,397,241 3,499,295 Other items, net 889,238 (5,646,076) (119,261) Change in: Accrued investment income (1,208,707) (761,455) (688,648) Premiums and reinsurance balances receivable (net of direct write-offs and commutations) 3,398,291 145,383 (10,977,648) Reinsurance balances payable 4,821,929 9,090,049 (2,115,290) Ceded unearned premium 2,434,129 (7,308,036) (9,211,652) Reinsurance balances recoverable on unpaid losses (7,616,802) (54,528,764) 2,399,330 Deferred policy acquisition costs (7,639,187) (485,817) 3,401,301 Unpaid losses and settlement expenses 42,724,265 84,199,014 24,019,920 Unearned premiums 15,289,456 13,785,231 6,196,415 Income taxes: Current 7,267,637 (11,479,595) 695,656 Deferred (8,109,511) (2,948,552) (906,977) - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by operating activities 72,290,506 27,277,853 24,298,768 - ------------------------------------------------------------------------------------------------------------------------------------ Cash Flows from Investing Activities Purchase of: Fixed maturities, held-to-maturity (110,827,936) (64,032,621) (59,029,702) Fixed maturities, available-for-sale (4,793,980) (9,091,447) Equity securities, available-for-sale (35,344,941) (18,979,331) (32,221,842) Short-term investments, net (10,527,372) (7,267,683) Property and equipment (2,443,332) (4,045,374) (2,186,892) Proceeds from sale of: Fixed maturities, held-to-maturity 5,211,541 Fixed maturities, available-for-sale 1,260,031 3,383,745 Equity securities, available-for-sale 2,879,335 22,481,402 17,187,726 Short-term investments, net 28,455,087 Property and equipment 164,333 73,462 525,564 Proceeds from call or maturity of: Fixed maturities, held-to-maturity 36,339,029 46,181,373 25,234,977 Fixed maturities, available-for-sale 2,335,000 3,730,000 - ------------------------------------------------------------------------------------------------------------------------------------ Net cash used in investing activities (114,549,343) (26,787,721) (24,012,784) - ------------------------------------------------------------------------------------------------------------------------------------ Cash Flows from Financing Activities Proceeds from issuance of debt 46,000,000 2,800,000 Payments on debt (745,000) (6,255,000) Fractional shares paid 4,010 Treasury shares reissued 4,043,970 2,513,375 33,667 Cash dividends paid (3,132,338) (3,461,217) (3,849,521) - ------------------------------------------------------------------------------------------------------------------------------------ Net cash provided by (used in) financing activities 46,911,632 (1,692,842) (7,274,864) - ------------------------------------------------------------------------------------------------------------------------------------ Net increase (decrease) in cash 4,652,795 (1,202,710) (6,988,880) Cash at beginning of year 4,735,722 9,388,516 8,185,806 - ------------------------------------------------------------------------------------------------------------------------------------ Cash at end of year $ 9,388,516 $ 8,185,806 $ 1,196,926 - ------------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the consolidated financial statements. 35 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. DESCRIPTION OF BUSINESS: RLI Corp. is a holding company which, through its subsidiaries, underwrites specialty property and casualty insurance products and provides a wide range of products and services to the ophthalmic industry. The property and casualty insurance segment, RLI Insurance Group (the 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. The ophthalmic segment includes the operations of RLI Vision Corp. (RLI Vision) and its Canadian subsidiaries: RLI Planned Services Ltd. and RLI Insurance Agency Ltd. These companies offer a wide variety of products and services to the ophthalmic industry, including: wholesale distribution of soft contact lenses, spectacle frames and sunglasses; third party administration of extended service programs; manufacturing rigid gas permeable (RGP) contact lenses and spectacle lenses; and RLISYS practice management software. 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. On May 4, 1995, RLI Vision Corp. (formerly known as RLI Professional Technologies, Inc.), a wholly owned subsidiary of RLI Corp., acquired through merger, Target Industries, Inc., a wholesale optical goods distributor of contact lenses, Rx spectacles, frames and sunglasses, located in Cohasset, Massachusetts. As consideration, RLI Corp. issued 313,500 shares of its common stock. The combined enterprise is now doing business under the name of RLI Vision Corp. This business combination has been accounted for as a pooling-of-interests. The consolidated financial statements and related financial information for periods prior to the combination have been restated to include the accounts and results of operations of Target Industries, Inc. Prior to the combination, the Target Industries, Inc. fiscal year ended June 30. In recording the pooling-of-interests combination, Target Industries, Inc. June 30 financial statements for the fiscal years 1993, 1994, and 1995, were adjusted to reflect a fiscal period ending December 31 for combination with RLI Corp.'s 1993 and 1994 financial statements. The results of operations previously reported by the separate enterprises and the combined amounts presented in the accompanying consolidated financial statements are summarized as follows.
- ------------------------------------------------------ 1993 1994 Net Sales Revenue: RLI Corp. $155,124,621 $171,902,369 Target Industries, Inc. 17,170,542 18,793,195 - ------------------------------------------------------ Combined $172,295,163 $190,695,564 ====================================================== 1993 1994 Net income (loss): - ------------------------------------------------------ RLI Corp. $ 15,797,075 ($5,001,317) Target Industries, Inc. 150,552 225,446 - ------------------------------------------------------ Combined $ 15,947,627 ($4,775,871) =======================================================
Additionally, the accompanying consolidated balance sheet for the year ended December 31, 1994, has been restated to include the assets, liabilities, and equity of Target Industries, Inc. The net increase to RLI Corp.'s December 31, 1994 assets, liabilities, and equity was $5,501,935, $3,929,447, and $1,572,488, respectively, as a result of this merger. Prior years' share and per share data have additionally been restated to reflect the 5-for-4 stock split that occurred on June 21, 1995. C. SIGNIFICANT EVENT: On January 17, 1994, an earthquake occurred in the Northridge, California area. Losses incurred as a result of this earthquake represent the largest single loss event in the Company's history. The combined effects of the earthquake-- including losses, expenses and the reduction of revenue due to reinstatement of reinsurance coverages--reduced 1994 after-tax earnings by $25.0 million or $3.21 per share. In September 1995, the Company strengthened loss reserves related to the Northridge Earthquake. While relatively minor development had occurred throughout the first six months of 1995, the third quarter claim-by-claim review indicated that greater future development was likely. The overall impact in 1995 of the Northridge Earthquake was a reduction to after-tax earnings by $18.6 million or $2.37 per share. This additional development resulted in part from hidden damage and increased business interruption losses on the Company's excess policies which, in 1994, were estimated by adjusters to be well within the coverage limits of the primary and underlying excess layers. Also contributing to the increased development were unanticipated building code enactments, escalating construction costs, and the impact of reopened claims as a result of the involvement of public adjusters. 36 Following is a summary of the effects of the Northridge Earthquake. All amounts are shown in thousands, except per share data.
- ------------------------------------------------------------------- Earthquake Impact 1994 1995 - ------------------------------------------------------------------- Premiums earned decrease $(18,013) $ (1,227) - ------------------------------------------------------------------- Consolidated revenue decrease (18,013) (1,227) - ------------------------------------------------------------------- Losses and settlement expense increase (21,176) (27,338) Policy acquisition costs decrease 1,310 - ------------------------------------------------------------------- Total expense increase (19,866) (27,338) - ------------------------------------------------------------------- Loss before income taxes (37,879) (28,565) Net loss (25,021) (18,567) Primary net loss per share $(3.21) $(2.37) ===================================================================
D. INVESTMENTS: Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement requires that investments in all debt securities and those equity securities with readily determinable fair values be classified 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 85% 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. The Company holds no debt or equity securities in this category. 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 earnings and reported as a separate component of shareholders' equity net of deferred income taxes. All of the Company's equity securities and approximately 15% of debt securities are classified as available-for-sale. In December 1995, the Company reclassified $29.8 million of held-to-maturity debt securities to available-for-sale under the "one time exemption" permitted by the Financial Accounting Standards Board. This reclassification resulted in recording unrealized gains of $0.5 million, net of deferred income taxes. Short-term investments are carried at cost, which approximates fair value. The Company reviews 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 the Company is not relieved of its legal liability to its policyholders. The Company evaluates its reinsurance contracts for significant risk transfer. If a reinsurance contract is deemed to not transfer significant risk to the reinsurer, the contract is recorded using the deposit method of accounting. The Company has reviewed its reinsurance contracts for significant risk transfer and believes all contracts have been properly recorded in accordance with GAAP. The Company continuously reviews and monitors the financial condition of its reinsurers. The Company's policy is to charge to current earnings an estimate of unrecoverable amounts from troubled or insolvent reinsurers. During 1993, 1994, and 1995, the Company provided $1,163,278, $1,000,000, and $613,296, respectively, for uncollectible reinsurance balances. 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 settlement 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, 1995, 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. 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 com- 37 missions 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. Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes." This statement requires a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of SFAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in years in which those temporary differences are expected to be recovered or settled. Under SFAS 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company has reported the cumulative effect of the change in the method of accounting for income taxes in the 1993 consolidated statement of earnings. K. EARNINGS PER SHARE: Primary earnings per share are computed based on the weighted average number of shares of common stock and common stock equivalents outstanding during the period. Fully diluted earnings per share calculations are based on the weighted average number of shares of common stock and common stock equivalents outstanding for the period, assuming full conversion of all convertible debentures into common stock. Net earnings are adjusted for purposes of this calculation to eliminate interest and amortization of debt issuance costs on the convertible debentures, net of related income taxes. When the conversion of convertible debentures increases the earnings per share or reduces the loss per share, the effect on earnings is antidilutive. Under these circumstances the fully diluted net earnings or net loss per share is computed assuming no conversion of the convertible debentures. L. 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 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 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. Fair value disclosures for long-term debt are included in note 4. M. 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 of those risks and uncertainties, as well as the Company's methods for mitigating, quantifying, and minimizing such, are presented below and throughout the notes to 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 (75.1% of gross property premiums written during 1995). 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 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 38 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 reviews and 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 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. EXTERNAL FACTORS The Company's insurance subsidiaries are highly regulated by the states in which they are incorporated, as well as 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 policyholder losses covered by insolvent insurers. 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 RBC standards became effective for annual statement filings beginning December 31, 1994. The Company continues to monitor 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. Management believes that the Company's 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:
- ------------------------------------------------------------------------------- 1993 1994 1995 Interest on fixed maturities $13,029,859 $15,311,817 $17,333,118 - ------------------------------------------------------------------------------- Dividends on equity securities 3,976,593 5,290,715 5,444,146 Interest on short-term investments 2,189,198 1,846,881 1,893,693 Gross investment income 19,195,650 22,449,413 24,670,957 Less investment expenses 2,338,533 2,316,828 2,641,876 - ------------------------------------------------------------------------------- Net investment income $16,857,117 $20,132,585 $22,029,081 ================================================================================
Pretax net realized investment gains (losses) and net changes in unrealized appreciation/depreciation of investments for the years ended December 31 are summarized as follows:
- -------------------------------------------------------------------------------- 1993 1994 1995 - -------------------------------------------------------------------------------- Net realized investment gains (losses) Fixed maturities Held-to-maturity $ 46,677 $ 79,124 $(21,428) Available-for-sale 27,217 6,324 Equity securities 207,268 (3,701,442) 471,614 - -------------------------------------------------------------------------------- 253,945 (3,595,101) 456,510 - -------------------------------------------------------------------------------- Net changes in unrealized appreciation/depreciation on investments Fixed maturities Held-to-maturity 3,664,847 (22,112,459) 21,130,309 Available-for-sale (475,597) 1,605,070 Equity securities 7,945,381 (5,273,316) 34,432,410 - -------------------------------------------------------------------------------- 11,610,228 (27,861,372) 57,167,789 - -------------------------------------------------------------------------------- Net realized investment gains (losses) and changes in unrealized appreciation/depreciation on investments $11,864,173 $(31,456,473) $57,624,299 ================================================================================
Net unrealized appreciation on fixed maturity securities declined significantly during 1994, due primarily to climbing interest rates, not the result of issuer credit concerns. The higher interest rate environment and overall market pressures forced our interest-sensitive equity securities lower in 1994, thus reducing net unrealized appreciation. However, with the upturn in the market and general interest rate declines during 1995, the Company's fixed-income and equity securities posted substantial increases in unrealized appreciation, rebounding well beyond pre-1994 levels. 39 Below is a summary of the disposition of fixed maturities for the years ended December 31, with separate presentations for sales and calls/maturities.
Sales - ----------------------------------------------------------------------------------- Proceeds Gross Realized Net Realized from sales Gains Losses gain (loss) - ----------------------------------------------------------------------------------- 1993 $5,211,541 $9,222 $(479) $8,743 1994 Available-for-sale 1,260,031 (603) (603) 1995 Available-for-sale 3,383,745 15,447 (7,875) 7,572 ==================================================================================
Calls/Maturities - ---------------------------------------------------------------------------------- Proceeds from Gross Realized Net Realized calls/maturities Gains Losses gain (loss) - ---------------------------------------------------------------------------------- 1993 $36,339,029 $ 41,848 $(3,914) $ 37,934 1994 Held-to-maturity 46,181,373 107,106 (27,982) 79,124 Available-for-sale 2,335,000 28,773 (953) 27,820 1995 Held-to-maturity 25,234,977 11,567 (32,997) (21,428) Available-for-sale 3,730,000 (1,248) (1,248) ===================================================================================
The following is a schedule of amortized costs and estimated fair values of investments in fixed maturities and equity securities as of December 31, 1994 and 1995. Estimated fair values for fixed maturity and equity securities are based on quoted market prices where available, or on values obtained from independent pricing services.
- ----------------------------------------------------------------------------------------------------- Amortized Estimated Gross Unrealized Cost Fair Value Gains Losses - ----------------------------------------------------------------------------------------------------- 1994 Held-to-maturity U.S. governments $152,481,172 $143,898,057 $ 638,161 $ (9,221,276) Foreign governments 496,511 493,875 (2,636) States, political subdivisions & revenues 93,818,975 90,594,677 248,202 (3,472,500) - ---------------------------------------------------------------------------------------------------- Total held-to-maturity $246,796,658 $234,986,609 $ 886,363 $(12,696,412) - ---------------------------------------------------------------------------------------------------- Available-for-sale U.S. governments $ 11,161,851 $ 10,847,456 $ 242 $ (314,637) States, political subdivisions & revenues 2,652,415 2,491,213 (161,202) - ---------------------------------------------------------------------------------------------------- Fixed maturities 13,814,266 13,338,669 242 (475,839) Equity securities 87,123,071 104,067,362 19,603,431 (2,659,140) - ---------------------------------------------------------------------------------------------------- Total available-for-sale 100,937,337 117,406,031 19,603,673 (3,134,979) - ---------------------------------------------------------------------------------------------------- Total $347,733,995 $352,392,640 $20,490,036 $(15,831,391) ==================================================================================================== - ---------------------------------------------------------------------------------------------------- Amortized Estimated Gross Unrealized Cost Fair Value Gains Losses - ---------------------------------------------------------------------------------------------------- 1995 Held-to-maturity U.S. governments $148,846,846 $156,517,125 $ 7,767,238 $ (96,959) Foreign governments 498,208 509,260 11,052 States, political subdivisions & revenues 102,292,482 103,931,411 1,735,159 (96,230) - ---------------------------------------------------------------------------------------------------- Total held-to-maturity $251,637,536 $260,957,796 $ 9,513,449 $ (193,189) - ---------------------------------------------------------------------------------------------------- Available-for-sale U.S. governments $ 33,730,335 $ 34,767,197 $ 1,126,476 $ (89,614) States, political subdivisions & revenues 10,260,003 10,352,614 108,283 (15,672) - ---------------------------------------------------------------------------------------------------- Fixed maturities 43,990,338 45,119,811 1,234,759 (105,286) Equity securities 102,580,834 153,957,535 51,700,372 (323,671) - ---------------------------------------------------------------------------------------------------- Total available-for-sale 146,571,172 199,077,346 52,935,131 (428,957) - ---------------------------------------------------------------------------------------------------- Total $398,208,708 $460,035,142 $62,448,580 $ (622,146) ====================================================================================================
The amortized cost and estimated fair value of fixed maturity securities at December 31, 1995, by contractual maturity, are shown as follows. 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.
- ------------------------------------------------------------------------------ Amortized Cost Estimated Fair Value - ------------------------------------------------------------------------------ Held-to-maturity Due in one year or less $ 14,622,708 $ 14,772,295 Due after one year through five years 99,177,271 103,642,779 Due after five years through ten years 116,413,697 120,054,838 Due after ten years 21,423,860 22,487,884 - ------------------------------------------------------------------------------ $251,637,536 $260,957,796 - ------------------------------------------------------------------------------ Available-for-sale Due in one year or less $ 3,007,431 $ 3,015,964 Due after one year through five years 22,479,070 23,575,952 Due after five years through ten years 18,503,837 18,527,895 - ------------------------------------------------------------------------------ $ 43,990,338 $ 45,119,811 - ------------------------------------------------------------------------------
At December 31, 1994, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $10,910,294. This amount was net of deferred taxes of $5,558,400. At December 31, 1995, the net unrealized appreciation of available-for-sale fixed maturities and equity securities totaled $34,334,524. This amount is net of deferred taxes of $18,171,600. The Company is party to a securities lending program whereby fixed-income and equity securities are loaned to third parties, primarily major brokerage firms. As of December 31, 1994 and 1995, fixed maturities with a fair value of $69,995,135 and $59,511,640, respectively, were loaned. Addi- 40 tionally, at December 31, 1994, the Company had loaned $1,726,601 of equity securities. Agreements with custodian banks facilitating such lending require a minimum of 102% of the value of the loaned securities to be separately maintained as collateral for each loan. 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 $21,699,946 at December 31, 1995, were on deposit with either regulatory authorities or banks. Additionally, the Company has certain fixed maturities held in trust amounting to $10,927,015 at December 31, 1995. 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:
- ------------------------------------------------------------------------------------------------ 1993 1994 1995 - ------------------------------------------------------------------------------------------------ Deferred policy acquisition costs, beginning of year $11,083,208 $18,722,395 $19,208,212 - ------------------------------------------------------------------------------------------------ Deferred: Direct commissions 41,633,710 47,187,978 44,232,003 Premium taxes 4,323,682 4,135,567 4,185,861 Other direct underwriting expenses 14,729,245 12,088,813 12,122,153 Ceding commissions (14,262,107) (16,939,817) (24,666,527) - ------------------------------------------------------------------------------------------------ Net deferred 46,424,530 46,472,541 35,873,490 - ------------------------------------------------------------------------------------------------ Amortized 38,785,343 45,986,724 39,274,791 - ------------------------------------------------------------------------------------------------ Deferred policy acquisition costs, end of year $18,722,395 $19,208,212 $15,806,911 ================================================================================================ Policy acquisition costs: Amortized to expense 38,785,343 45,986,724 39,274,791 Period costs: Ceding commission--contingent(1) (12,967,381) 60,227 (456,527) Other 1,822,497 1,059,147 4,223,781 - ------------------------------------------------------------------------------------------------ Total policy acquisition costs $27,640,459 $47,106,098 $43,042,045 ================================================================================================
(1) During 1993 the Company participated in various reinsurance contracts that included contingent commissions. The Company did not renew these contracts in 1994, resulting in an increase in net policy acquisition costs and a decrease in ceded earned premiums. 4. LONG-TERM DEBT On July 28, 1993, the Company issued $46 million of 6.0% convertible debentures which mature July 15, 2003, and pay interest semi-annually. The Company received $45,080,000 in net proceeds from the issue ($46,000,000 principal less $920,000 of underwriting costs incurred) of which $30,500,000 has been 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, are convertible at the option of the holder at any time prior to maturity, into RLI Corp. common stock at an adjusted conversion price of $26.00 per share, subject to further adjustment in certain events. The Company has 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. The convertible debentures are general unsecured obligations of the Company and rank on a parity with all other unsecured and unsubordinated indebtedness of the Company. The convertible debentures include various covenants with which the Company has complied. These covenants are basic in nature and include maintenance of properties, payment of taxes, limitations on issuance or disposition of RLI Corp. stock or the stock of material subsidiaries, and limitations on liens. The fair value of the convertible debentures at December 31, 1995, was $47,840,000. On December 1, 1995, the Company retired its entire 9.75% Industrial Development Bond of $6,255,000. This tax-exempt issue was obtained by the Company on December 27, 1985, and proceeds were used by the Company to finance a portion of the acquisition, construction and equipping of an addition to the home office building and related facilities located in Peoria. The retirement of the debt included a scheduled principal payment of $815,000, along with the execution by the Company of its first available call provision, to call the remaining debt of $5,440,000 at a 102 call premium. The call was financed in part with available cash, along with short term borrowings totaling $2,800,000. Interest paid on outstanding debt for 1993, 1994, and 1995 amounted to $682,500, $3,345,714, and $3,372,479, respectively. The Company maintains three sources of credit from two financial institutions: one $10.0 million secured and committed line of credit that cannot be canceled during its annual term; a $30 million secured line of credit that cannot be canceled during its annual term; and a $3.0 million secured line of credit available for the issuance of letters of credit. As of December 31, 1995, $2.8 million of the $10.0 million line of credit was outstanding at a variable rate of 6.48%. It is anticipated that these short-term borrowings will be repaid during the first quarter 1996. 5. REINSURANCE In the ordinary course of business, the insurance subsidiaries assume and cede premiums with other insurance companies and various pools and associations of which they are members. A large portion of the reinsurance 41 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 which 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 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. Premiums written and earned along with losses and settlement expenses incurred for the years ended December 31 are summarized as follows:
- ----------------------------------------------------------------------------------------- Written 1993 1994 1995 - ----------------------------------------------------------------------------------------- Direct $248,944,184 $279,410,212 $270,887,545 Reinsurance assumed 425,168 17,905 548,601 Reinsurance ceded (105,838,301) (132,766,433) (140,983,251) - ----------------------------------------------------------------------------------------- Net $143,531,051 $146,661,684 $130,452,895 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Earned 1993 1994 1995 - ----------------------------------------------------------------------------------------- Direct $233,757,304 $265,453,514 $264,651,370 Reinsurance assumed 504,463 189,371 588,362 Reinsurance ceded (108,272,489) (125,458,397) (131,771,599) - ----------------------------------------------------------------------------------------- Net $125,989,278 $140,184,488 $133,468,133 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Losses and settlement expenses incurred 1993 1994 1995 - ----------------------------------------------------------------------------------------- Direct $131,276,131 $280,126,708 $160,294,644 Reinsurance assumed 348,478 (349,972) 809,657 Reinsurance ceded (51,887,206) (178,135,070) (75,214,306) - ----------------------------------------------------------------------------------------- Net $ 79,737,403 $101,641,666 $ 85,889,995 - ----------------------------------------------------------------------------------------- - -----------------------------------------------------------------------------------------
The Company was party to multiple-year, retrospectively-rated reinsurance contracts through 1993. These contracts included provisions for additional premiums to be paid to the reinsurer, or amounts to be returned to the Company in the form of contingent commissions based on cumulative loss experience. In 1993, the Financial Accounting Standards Board's Emerging Issues Task Force (EITF) issued Consensus No. 93-6, "Accounting and Reporting for Multiple-Year, Retrospectively-Rated Reinsurance Contracts by Ceding and Assuming Enterprises" (EITF 93-6). According to EITF 93-6 an asset should be recognized by the ceding enterprise for amounts due from the reinsurer relating to experience to date under those contracts. Accordingly, the Company recognized an asset for contingent commissions due from reinsurers based on experience under these contracts. During December 1993, the Company cancelled its multiple-year, retrospectively-rated reinsurance contracts. At December 31, 1995, 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) and Lloyds of London that amounted to $50,886,661 and $19,593,757, respectively. 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 is a reconciliation of the Company's liability for unpaid losses and settlement expenses (LAE) for the three years ended December 31, 1995. 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).
- --------------------------------------------------------------------------------------------- Year Ended December 31, (In thousands) 1993 1994 1995 - --------------------------------------------------------------------------------------------- Unpaid losses and LAE at beginning of year: Gross $268,043 $310,767 $394,966 Ceded (137,591) (145,208) (199,737) - --------------------------------------------------------------------------------------------- Net 130,452 165,559 195,229 - --------------------------------------------------------------------------------------------- Increase (decrease) in incurred losses and LAE: Current accident year 81,589 100,535 62,619 Prior accident years (1,852) 1,107 23,271 - --------------------------------------------------------------------------------------------- Total incurred 79,737 101,642 85,890 - --------------------------------------------------------------------------------------------- Loss and LAE payments for claims incurred: Current accident year (18,743) (36,501) (10,600) Prior accident years (24,726) (36,026) (48,023) - --------------------------------------------------------------------------------------------- Total paid (43,469) (72,527) (58,623) - --------------------------------------------------------------------------------------------- Insolvent reinsurer charge off (221) 643 514 Loss reserves commuted (940) (88) (1,376) - --------------------------------------------------------------------------------------------- Net unpaid losses and LAE at end of year 165,559 195,229 221,648 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Unpaid losses and LAE at end of year: Gross 310,767 394,966 418,986 Ceded (145,208) (199,737) (197,338) - --------------------------------------------------------------------------------------------- Net $165,559 $195,229 $221,648 - --------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------
During 1993 and 1994, overall development on prior accident-year loss and settlement expense reserves was insignificant to operating results and recorded loss and settlement expense reserves. For 1995, however, prior accident-year development has been significantly impacted by the effects of 42 the 1994 Northridge Earthquake. As previously discussed in note 1, the Company experienced $27.3 million of loss development from this event during calendar year 1995. The Company is subject to environmental claims and exposures through its commercial umbrella, general liability, and 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 data (including incurred but not reported losses) for the periods ended 1994 and 1995:
- ------------------------------------------------------------------------------- Inception-to-date December 31, (In thousands) 1994 1995 - ------------------------------------------------------------------------------- Loss and LAE payments for claims incurred Gross $ 3,549 $ 5,117 Ceded (2,933) (3,842) - ------------------------------------------------------------------------------- Net $ 616 $ 1,275 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Unpaid losses and LAE at end of year Gross $15,519 $20,154 Ceded (9,875) (13,398) - ------------------------------------------------------------------------------- Net $ 5,644 $ 6,756 - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
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 within 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 As discussed in note 1J, the Company adopted SFAS 109 as of January 1, 1993. The cumulative effect of this change in accounting for income taxes of $1,665,000 was determined as of January 1, 1993, and is reported separately in the consolidated statement of earnings for the year ended December 31, 1993. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below.
- ---------------------------------------------------------------------------------------------- 1993 1994 1995 - ---------------------------------------------------------------------------------------------- Deferred tax assets: Tax discounting of claim reserves $13,589,724 $15,402,122 $15,635,860 Unearned premium offset 5,065,358 5,419,657 5,307,695 Other, net 1,498,805 2,060,970 2,365,467 - ---------------------------------------------------------------------------------------------- 20,153,887 22,882,749 23,309,022 Less valuation allowance (300,000) (300,000) (300,000) - ---------------------------------------------------------------------------------------------- Total deferred tax assets $19,853,887 $22,582,749 $23,009,022 - ---------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------- Deferred tax liabilities: Net unrealized appreciation of securities $ 7,776,109 $ 5,764,109 $18,171,600 Deferred policy acquisition costs 6,552,838 6,722,874 5,532,419 Book/tax depreciation 1,717,133 1,720,598 1,535,324 Other, net 1,966,530 1,573,339 2,674,073 - ---------------------------------------------------------------------------------------------- Total deferred tax liabilities 18,012,610 15,780,920 27,913,416 - ---------------------------------------------------------------------------------------------- Net deferred tax asset (liability) $ 1,841,277 $ 6,801,829 $ (4,904,394) - ---------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------
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 which 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, 1993, 1994, and 1995, differed from the amounts computed by applying the U.S. federal tax rate of 35% to pretax income from continuing operations as a result of the following:
- ------------------------------------------------------------------------------- 1993 1994 1995 - ------------------------------------------------------------------------------- Provision for income taxes at the statutory federal tax rates $ 6,415,201 $(4,055,387) $2,893,959 Increase (reduction) in taxes resulting from: Dividends received deduction (844,496) (1,126,519) (1,170,146) Dividends paid deduction (248,163) (258,474) (265,754) Tax exempt interest income (1,385,440) (1,607,296) (1,428,846) State income tax provision 152,620 67,683 144,405 Other items, net (43,203) 169,044 145,294 - ------------------------------------------------------------------------------- $ 4,046,519 $(6,810,949) $318,912 - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
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%. Federal and state income taxes paid in 1993, 1994, and 1995, amounted to $2,962,003, $7,617,198, and $530,230, respectively. The IRS has examined the Company's income tax returns through the tax year ended December 31, 1990. In 1993 and 1994, the Company received tax refunds from certain of these tax years, the majority of which was 43 previously accrued. As a result, the Company recorded tax benefits of $129,411 in 1993 and $73,893 in 1994. Additionally, the Company received interest from the IRS in 1993 and 1994 of $941,731 and $56,590, respectively, which was recorded as investment income. The IRS is currently examining the Company's income tax returns for the years ended December 31, 1991 through 1994. Management believes any tax implications from examinations of these years should not materially impact the Company's consolidated financial position or results of operations. 8. EMPLOYEE BENEFITS The Company has a non-contributory defined benefit pension plan covering substantially all employees meeting age and service eligibilities, except those of RLI Vision Corp. The plan provides a benefit based on service and the highest five consecutive years' average compensation out of the last 10 years of service of a participant. 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. Therefore no contribution was made in 1993. During 1994 and 1995, the Company made the maximum tax deductible contribution allowed, totaling $312,740 and $397,158, 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 components of net periodic pension costs for each of the three years ended December 31, are as follows:
- ------------------------------------------------------------------------------- 1993 1994 1995 - ------------------------------------------------------------------------------- Service cost $356,478 $405,796 $277,870 Interest cost 185,686 234,127 239,607 Actual return on assets (346,070) 190,316 (796,106) Net amortization and deferral (25,101) (534,183) 486,482 - ------------------------------------------------------------------------------- Net pension expense $170,993 $296,056 $207,853 - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
The following table sets forth the plan's funded status at December 31, 1994 and 1995:
- ------------------------------------------------------------------------------- 1994 1995 - ------------------------------------------------------------------------------- Actuarial present value of benefit obligation: Accumulated benefit obligation: Vested $2,236,955 $3,055,535 Nonvested 69,754 90,201 - ------------------------------------------------------------------------------- $2,306,709 $3,145,736 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- Projected benefit obligation $2,751,264 $3,835,535 Plan assets at fair market value 2,684,511 3,253,386 - ------------------------------------------------------------------------------- Plan assets under projected benefit obligation $ (66,753) $ (582,149) Unrecognized net asset at January 1, being amortized over 17.2 years (299,611) (267,045) Unrecognized prior service cost 23,477 12,367 Unrecognized net loss (gain) (480,582) 307,666 - ------------------------------------------------------------------------------- Accrued pension costs $ (823,469) $ (529,161) - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------
At December 31, 1995, plan assets at fair value are comprised of approximately 5% fixed maturities, 94% equity securities and 1% invested cash. In 1994, the Company used a settlement rate of approximately 8.75%, an increase in salary levels of 6%, and an expected long-term return on plan assets of 10% in determining the projected benefit obligation. During 1995, the Company used the following rates to determine its projected benefit obligation: 7.25% settlement rate, 6% increase in salary, and 10% expected long-term return on plan assets. In December 1994, the Board passed a resolution to exclude all employees of RLI Vision from the defined benefit pension plan effective January 1, 1995, for benefit accrual purposes. This curtailment had an immaterial impact on the consolidated financial statements. The Company has a non-leveraged Employee Stock Ownership Plan (ESOP) which covers substantially all employees meeting eligibility requirements, except those of RLI Vision Corp. ESOP contributions are determined annually by the Company's Board of Directors and are expensed in the year earned and funded in the following year. During 1993, 1994, and 1995, the Company recognized expense of $2,645,973, $160,154, and $2,046,474, respectively, related to the ESOP. During 1993, the ESOP purchased 114,688 shares of the Company's treasury stock at an average price of $20.62 ($2,365,388). During 1994, the ESOP purchased 124,500 shares of the Company's treasury stock at an average price of $18.03 ($2,245,050) and 5,000 shares of the Company's common stock on the open market at an average price of $16.46 ($82,320). During 1995, no ESOP shares were purchased. All shares held by the ESOP are treated as outstanding in computing the Company's earnings per share. Dividends on ESOP shares are passed through to the participants. 44 At its December 1995 meeting, the Board voted in favor of making a contribution to the ESOP for 1995 based on the projected net income for the year. In 1994, the Board did not authorize a contribution based on that year's projected net loss. Additionally, in 1994, the Board resolved to exclude all employees of RLI Vision Corp. from the ESOP starting January 1, 1995, for benefit accrual purposes. During 1995, RLI Vision adopted a 401(k) retirement and savings plan to replace the ESOP and pension plans. This plan covers all employees who meet service and eligibility requirements. Employee 401(k) contributions are matched by RLI Vision at 50% of up to 6% of eligible compensation. A profit sharing contribution, determined annually by the Board, is expensed in the year earned and funded to the plan in the following year. During 1995, the Company recognized $92,197 for the matching contribution and $128,428 for the profit sharing contribution. All contributions are allocated among six mutual funds and RLI Corp. stock. The Company has a management and executive incentive plan for key employees of the Company. The plan is subject to limitations and is based on minimum profit levels and varying percentages of the managers' and executives' salaries determined annually by Management and the Board of Directors. The amounts earned under this plan for 1993, 1994, and 1995, were $988,900, $433,911, and $516,298, respectively. The Company has a directors deferred compensation plan and an excess ESOP for key employees through which Company shares are purchased for the directors and key employees. The Company funded the plans by establishing Rabbi Trusts and by purchasing Company treasury shares. Since the assets of the Rabbi Trusts are subject to claims of the Company's general creditors, such assets are recorded as other assets in the accompanying balance sheets. A corresponding liability for the same amount, which represents the Company's liability to its directors and key employees, is reflected as a component of other liabilities. During 1993, 1994, and 1995, the Company recognized expenses of $375,628, $81,850, and $145,550, respectively, under these plans. In 1995, the Rabbi Trusts purchased 1,448 shares of the Company's treasury stock, at an average price of $23.25 ($33,667). At December 31, 1995, the Trusts' assets were valued at $2,817,965. During 1995, the Company adopted and the shareholders approved a non-qualified Incentive Stock Option Plan (The Plan). Under The 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 in cash. Options may be granted only during the ten-year period ending in May, 2005. An optionee must exercise an option within the first to occur of ten years (five years if the optionee and affiliates own 10% or more of the shares) from the grant date, or three months after the optionee ceases to be an employee. During the year, the Company granted 65,625 options at a grant price of $20.60. Since no options were exercisable at year end, all 65,625 options remained outstanding at December 31, 1995. The Company does not provide post-retirement or post-employment benefits to employees and therefore does not have any liability under SFAS No. 106, "Employer's Accounting for Post-retirement Benefits Other Than Pensions" or SFAS 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 which 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:
- ------------------------------------------------------------------------------------ Year ended December 31, Net Income (Loss) 1993 1994 1995 - ------------------------------------------------------------------------------------ Consolidated net income (loss), statutory basis $18,609,617 $(4,057,703) $12,638,658 Proposition 103 liability (416,400) (71,280) Deferred policy acquisition costs 7,639,187 485,817 (3,401,296) Reinsurance contingent commissions (15,116,908) Deferred income tax benefit 6,388,744 2,948,552 906,977 Net income of non-insurance operations, interest expense on debt and general corporate expense (1,328,938) (3,181,152) (2,153,744) Implementation of SFAS 109 1,665,000 Other (1,492,675) (900,105) (41,054) - ------------------------------------------------------------------------------------ As reported in accompanying financial statements $15,947,627 $(4,775,871) $ 7,949,541 - ------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------ December 31, Shareholders' Equity 1994 1995 - ------------------------------------------------------------------------------------ Consolidated surplus, statutory basis $136,124,530 $172,312,961 Deferred policy acquisition costs 19,208,212 15,806,911 Non-admitted assets 2,328,527 2,237,739 Proposition 103 liability (2,499,680) (2,499,680) Deferred tax asset (liability) 6,801,829 (4,904,394) Statutory liability for reinsurance 450,800 2,045,800 Proceeds from RLI Corp. debt contributed to RLI Insurance Co. (37,500,000) (30,500,000) Equity of non-insurance companies 6,251,835 2,855,246 Other 3,908 1,253,133 - ------------------------------------------------------------------------------------ As reported in accompanying financial statements $131,169,961 $158,607,716 - ------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------
45 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 1996 without prior notice or approval is $17,231,297. The actual amount paid to the Company during 1995 was $7,373,877. 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. The Company has one standby letter of credit for $2,070,000, outstanding at December 31, 1995, to secure amounts sought in litigation involving an insurance claim. The letter of credit has not been drawn on. The Company maintains a liability which Management believes adequately covers estimated losses and related expenses that will be incurred as a result of this claim. Therefore, no loss is expected to result if draw downs on the letter of credit are required in the future. 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. As a result, in 1993 and 1994, the Company reduced pretax earnings by $416,400 and $71,280, respectively. No additional provision was made during 1995. The above amounts include interest for 1993 and 1994, in the amount of $259,000 and $71,280, respectively. The total amount of deferred premiums and interest accrued as of December 31, 1995, was $2,499,680. The state of California maintains that the Company is not in compliance with Proposition 103 and that the required amount of premiums to be returned is $6.5 million plus accrued interest. The Company maintains it had reduced rates by 20% or more on its most significant lines of business. This reduction is at issue with the California Department of Insurance. While it is impossible to predict the outcome, Management believes that the amount accrued is adequate to cover the ultimate rollback, if any. The matter has been set for hearing in March of 1996. The Company leases regional office facilities and automobiles under operating leases expiring in various years through 1999. Minimum future rental payments under noncancellable operating leases are as follows:
1996 $ 734,861 1997 607,577 1998 314,267 1999 57,699 ---------- Total minimum future rental payments $1,714,404 ---------- ----------
46 11. INDUSTRY SEGMENT INFORMATION Selected information by industry segment for 1993, 1994, and 1995 is summarized in the chart below. RLI Insurance Group: Specialty coverages of property and casualty insurance provided on a direct basis, primarily on commercial risks. RLI Vision Corp.: The wholesale distribution of soft contact lenses, spectacle frames and sunglasses; third party administration of extended service programs; manufacturing rigid gas permeable (RGP) contact lenses and spectacle lenses; RLISYS practice management software; and income from investments held by RLI Vision Corp. Investment Income: Net interest and dividend income from the fixed maturities, equity securities and short-term investments of RLI Corp. and RLI Insurance Group.
- ------------------------------------------------------------------------------------------------------------ Earnings (loss) before income taxes Segment Data Revenue and cumulative effect Assets - ------------------------------------------------------------------------------------------------------------ 1993 RLI Insurance Group $125,989,278 $ 3,548,578 $648,567,132 RLI Vision Corp. 29,194,823 1,205,739 12,337,586 Net investment income 16,857,117 16,857,117 Net realized investment gains 253,945 253,945 General corporate and interest expense (3,536,233) 12,961,586 - ------------------------------------------------------------------------------------------------------------ Consolidated $172,295,163 $ 18,329,146 $673,866,304 - ------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------ 1994 RLI Insurance Group $140,184,488 $(23,705,660) $730,112,294 RLI Vision Corp. 33,973,592 1,858,109 14,501,655 Net investment income 20,132,585 20,132,585 Net realized investment losses (3,595,101) (3,595,101) General corporate and interest expense (6,276,753) 13,189,120 - ------------------------------------------------------------------------------------------------------------ Consolidated $190,695,564 $(11,586,820) $757,803,069 - ------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------ 1995 RLI Insurance Group $133,468,133 $ (9,933,960) $786,243,404 RLI Vision Corp. 34,595,388 1,157,234 13,872,364 Net investment income 22,029,081 22,029,081 Net realized investment gains 456,510 456,510 General corporate and interest expense (5,440,412) 14,531,373 - ------------------------------------------------------------------------------------------------------------ Consolidated $190,549,112 $ 8,268,453 $814,647,141 - ------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------
47 12. UNAUDITED INTERIM FINANCIAL INFORMATION Selected quarterly information is as follows:
- ----------------------------------------------------------------------------------------------------------------------------- First Second Third Fourth Year End 1994 Total - ----------------------------------------------------------------------------------------------------------------------------- Net premiums earned $21,949,965 $36,470,083 $34,162,868 $47,601,572 $140,184,488 RLI Vision Corp. revenue 7,921,092 8,668,980 8,874,208 8,509,312 33,973,592 Net investment income 4,696,248 4,915,558 5,060,832 5,459,947 20,132,585 Net realized investment gains (losses) 11,634 (19,630) 105,105 (3,692,210) (3,595,101) Earnings (loss) before income taxes (23,839,629) 5,785,276 (26,068) 6,493,601 (11,586,820) Net earnings (loss) (14,955,965) 4,536,116 728,620 4,915,358 (4,775,871) Primary earnings (loss) per share* $(1.94) $0.58 $0.09 $0.63 $(0.61) Fully diluted earnings (loss) per share* $(1.94) $0.53 $0.09 $0.56 $(0.61) - ----------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------- 1995 - ----------------------------------------------------------------------------------------------------------------------------- Net premiums earned $35,562,960 $33,226,482 $32,170,742 $32,507,949 $133,468,133 RLI Vision Corp. revenue 8,732,501 9,011,315 8,964,995 7,886,577 34,595,388 Net investment income 5,400,021 5,265,829 5,575,171 5,788,060 22,029,081 Net realized investment gains (losses) (29,391) 136,542 11,297 338,062 456,510 Earnings (loss) before income taxes 7,248,585 7,623,243 (15,762,640) 9,159,265 8,268,453 Net earnings (loss) 5,336,931 5,479,819 (9,560,670) 6,693,461 7,949,541 Primary earnings (loss) per share* $0.68 $0.70 $(1.22) $0.85 $1.01 Fully diluted earnings (loss) per share* $0.60 $0.62 $(1.22) $0.75 $1.01 - ----------------------------------------------------------------------------------------------------------------------------- - -----------------------------------------------------------------------------------------------------------------------------
*Since the weighted average shares for the quarters are calculated independent 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. 48 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, 1995 and 1994, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the years in the three year period ended December 31, 1995. 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, 1995 and 1994, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1995, in conformity with generally accepted accounting principles. As discussed in note 1 to the consolidated financial statements, in 1994 the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and in 1993, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." January 25, 1996 KPMG Peat Marwick LLP Certified Public Accountants Peat Marwick Plaza 303 East Wacker Drive Chicago, Illinois 60601 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 Peat Marwick 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 by it 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, 1995, the Company's system of internal controls was adequate to accomplish the objectives described herein. The Audit Committee is comprised solely of five 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. 49 CORPORATE DATA ANNUAL MEETING The annual meeting of shareholders will be held at 2:00 p.m., local time, on May 2, 1996, at the Company's offices at 9025 North Lindbergh Drive, Peoria, IL. COMMON STOCK/CONVERTIBLE DEBENTURE SYMBOLS RLI common stock (NYSE): RLI RLI convertible debenture (NYSE): RLIS TRADING AND DIVIDEND INFORMATION 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.
Stock Price Dividends High Low Close Declared - -------------------------------------------------------------------------------- 1995 1st Quarter 19 1/10 16 3/10 18 7/10 $.12 2nd Quarter 23 1/4 18 6/10 22 3/4 .13 3rd Quarter 23 5/8 21 7/8 22 3/8 .13 4th Quarter 25 21 3/4 25 .13 - -------------------------------------------------------------------------------- 1994 1st Quarter 22 2/10 18 6/10 19 1/10 $.11 2nd Quarter 19 1/10 17 7/10 17 3/10 .11 3rd Quarter 18 8/10 16 1/2 17 3/10 .12 4th Quarter 17 3/10 15 9/10 16 4/10 .12 - --------------------------------------------------------------------------------
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 19 consecutive years. Since 1989, RLI dividends qualify for the Enterprise Zone dividend subtraction modification for Illinois state income tax returns. CORPORATE HEADQUARTERS 9025 North Lindbergh Drive, Peoria, IL 61615-1431, (309) 692-1000, (800) 331-4929, Fax: (309) 692-1068 FINANCIAL INFORMATION For Management's perspective on specific issues, call RLI Treasurer, Tim Krueger, direct at (309) 693-5884. SHAREHOLDER INQUIRIES Shareholders of record requesting information concerning individual account balances, stock certificates, dividends, stock transfers or address corrections should contact the Transfer Agent and Registrar at: Norwest Bank Minnesota, N.A., 161 North Concord Exchange, P.O. Box 64854 South St. Paul, MN 55164-0854, Phone: (800) 468-9716, Internet: shareowner@aol.com RLI ON THE INTERNET For up-to-date financial information, earnings releases, press releases, and a wide variety of other RLI information, contact us on the Internet at: http://www.rlicorp.com. RLI Vision maintains a separate Internet site at: http://www.rlivision.com. BONDHOLDER INQUIRIES Inquiries concerning lost bonds, interest payments, changes of address, and other matters relating to ownership should be directed to RLI's convertible debt trustee: Norwest Corporate Trust Services, Sixth & Marquette, Minneapolis, MN 55479-0069, Phone: (612) 667-9764 ANNUAL REPORT AND FORM 10-K Additional copies of this report and the Annual Report to the Securities and Exchange Commission, Form 10-K, will be furnished without charge to any shareholder. Simply contact the Treasurer at our Corporate Headquarters. "Street Name" shareholders wishing to have their names placed on a mailing list to receive copies of annual reports, quarterly reports, and other shareholder materials, should also indicate their desire to the Treasurer at the Corporate Headquarters. DIVIDEND DIRECT DEPOSIT PLAN Shareholders may have their dividends deposited directly into their checking, savings or money market accounts. If you wish to sign up for this Plan, send your request to Shareholder Information at the Transfer Agent and Registrar address listed at left. DIVIDEND REINVESTMENT PLAN An Automatic Dividend Reinvestment and Stock Purchase Plan is offered to shareholders of RLI on a voluntary basis. As a shareholder, you may add to your holdings in the following ways: Shares purchased with dividends are purchased as an open market transaction. Optional cash payments may also be made, in any amount, from $25 to $2,000 per month to purchase shares also as an open market transaction. The Company pays the additional costs associated with the open market purchases, which will have a slight tax impact on participating shareholders. A summary outlining the provisions of the Plan and an enrollment form may be obtained by contacting Shareholder Information at the Transfer Agent and Registrar address listed at left. STOCK OWNERSHIP At December 31, 1995, stock ownership was as follows:
Shares % ------------------------------- Insiders 706,833 9.00 ESOP 1,410,290 17.96 Institutions 3,286,585 41.86 Other Public 2,447,174 31.18 ------------------------------- 7,850,882 100.00%
53 EX-21.1 4 EXHIBIT 21.1 Exhibit 21.1 Subsidiaries of the Registrant The following companies are subsidiaries of the Registrant as of December 31, 1995.
Jurisdiction of Percentage Name Incorporation Ownership - ---- ------------- --------- RLI Insurance Company Illinois 100% RLI Aviation, Inc. Illinois 100% Replacement Lens Inc. Illinois 100% RLI Vision Corp. Illinois 100% Mt. Hawley Insurance Company Kansas 99.5% License Express Services, Inc. Illinois 100% RLI Insurance Ltd. Bermuda 100% RLI Insurance Agency Ltd. Canada 100% RLI Planned Services Ltd. Canada 100%
42 EX-23.1 5 EXHIBIT 23.1 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 (No. 333- 01637) on Form S-8 of RLI Corp. of our reports dated January 25, 1996, relating to the consolidated balance sheets of RLI Corp. and subsidiaries as of December 31, 1995 and 1994, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1995, and all related schedules, which reports are incorporated by reference in, or appear in (with respect to the schedules), the 1995 annual report on Form 10-K of RLI Corp. As discussed in Note 1 to the consolidated financial statements, in 1994 the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and in 1993 the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." KPMG Peat Marwick LLP Chicago, Illinois March 22, 1996 43 EX-28.1 6 EXHIBIT 29.1 Exhibit 29.1 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:
At December 31, 1995 (In thousands) -------------- Net liability reported on a statutory basis $221,997 Adjustments: Interest imputed on commutation settlements (349) ---- Net liability reported on a GAAP basis $221,648 -------- -------- Reconciliation of the GAAP net liability: Gross unpaid losses and settlement expenses $418,986 Reinsurance balances recoverable on unpaid losses and settlement expenses (197,338) ------- Net liability reported on a GAAP basis $221,648 -------- --------
44 EX-27 7 EXHIBIT 27
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED FINANCIAL STATEMENTS IN THE RLI CORP. ANNUAL REPORT TO SHAREHOLDERS FOR THE PERIOD ENDED DECEMBER 31, 1995, ATTACHED AS EXHIBIT 13 TO RLI CORP.'S FORM 10K AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS DEC-31-1995 DEC-31-1995 1,197 474,590 36,447 0 0 800,696 35,516 (21,565) 814,647 605,135 46,000 0 0 8,453 150,155 814,647 0 190,549 0 176,841 2,093 0 3,347 8,268 318 7,950 0 0 0 7,950 1.01 1.01
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