4. STOCK BASED COMPENSATION

Our RLI Corp. Omnibus Stock Plan (omnibus plan) was in place from 2005 to 2010. The omnibus plan provided for equity-based compensation, including stock options, up to a maximum of 3,000,000 shares of common stock (subject to adjustment for changes in our capitalization and other events). Between 2005 and 2010, we granted 2,457,644 stock options under this plan, including incentive stock options (ISOs), which were adjusted as part of the special dividends paid in 2013 and prior years.

During the second quarter of 2010, our shareholders approved the RLI Corp. Long-Term Incentive Plan (LTIP), which provides for equity-based compensation and replaced the omnibus plan. In conjunction with the adoption of the LTIP, effective May 6, 2010, options were no longer granted under the omnibus plan. Awards under the LTIP may be in the form of restricted stock, stock options (non-qualified only), stock appreciation rights, performance units, as well as other stock-based awards. Eligibility under the LTIP is limited to employees or directors of the company or any affiliate. The granting of awards under the LTIP is solely at the discretion of the board of directors. The maximum number of shares of common stock available for distribution under the LTIP is 4,000,000 shares (subject to adjustment for changes in our capitalization and other events). Since 2010, we have granted 2,777,000 stock options under the LTIP, including 464,500 thus far in 2014.

Under the LTIP, as under the omnibus plan, we grant stock options for shares with an exercise price equal to the fair market value of the shares at the date of grant. Options generally vest and become exercisable ratably over a five-year period and expire eight years after grant.

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

The following tables summarize option activity for the periods ended September 30, 2014 and 2013:



				Weighted
		Weighted		Average	Aggregate
	Number of	Average		Remaining	Intrinsic
	Options	Exercise		Contractual	Value
	Outstanding	Price		Life	(in 000’s)

Outstanding options at January 1, 2014	2,595,084	$	26.04
Options granted	464,500	$	42.90
Options exercised	(47,412)	$	17.95		$	1,250
Options canceled/forfeited	(740)	$	16.51
Outstanding options at September 30, 2014	3,011,432	$	28.77	5.25	$	43,850
Exercisable options at September 30, 2014	1,351,312	$	22.29	3.99	$	28,382

				Weighted
		Weighted		Average	Aggregate
	Number of	Average		Remaining	Intrinsic
	Options	Exercise		Contractual	Value
	Outstanding	Price		Life	(in 000’s)

Outstanding options at January 1, 2013	2,945,204	$	22.23
Options granted	582,200	$	36.31
Options exercised	(761,362)	$	17.18		$	17,211
Options canceled/forfeited	(44,880)	$	25.93
Outstanding options at September 30, 2013	2,721,162	$	26.59	5.65	$	46,590
Exercisable options at September 30, 2013	1,060,662	$	21.09	4.35	$	23,995

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

Thus far in 2014, 464,500 stock options were granted with a weighted average exercise price of $42.90 and a weighted average fair value of $7.76. We recognized $0.9 million of expense in the third quarter of 2014, and $2.9 million in the first nine months of 2014, related to options vesting. Since options granted under our LTIP are non-qualified, we recorded a tax benefit of $0.3 million in the third quarter of 2014, and $1.0 million in the first nine months of 2014, related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $5.2 million, which will be recognized over the remainder of the vesting period. Comparatively, we recognized $1.0 million of expense in the third quarter of 2013, and $2.8 million of expense in the first nine months of 2013. We recorded a tax benefit of $0.3 million in the third quarter of 2013, and $1.0 million in the first nine months of 2013, related to this compensation expense.

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



	2014			2013

Weighted-average fair value of grants	$	7.76		$	6.58
Risk-free interest rates		1.70	%		0.80	%
Dividend yield		1.94	%		2.00	%
Expected volatility		23.19	%		25.41	%
Expected option life		5.17	years		5.23	years

The risk-free rate was determined based on U.S. treasury yields that most closely approximated the option’s expected life. The dividend yield was calculated based on the average annualized dividends paid during the most recent five-year period. It excluded the special dividends paid in the fourth quarters of 2013 and prior years. The expected volatility was calculated based on the median of the rolling volatilities for the expected life of the options. In previous years, expected volatility was calculated based on the mean reversion of RLI’s stock. The expected option life was determined based on historical exercise behavior and the assumption that all outstanding options will be exercised at the midpoint of the current date and remaining contractual term, adjusted for the demographics of the current year’s grant.

In 2013 and 2014, each outside director received $10,000 worth of restricted common shares as part of annual director compensation. The shares were issued annually from the LTIP during the first quarter of each year. The shares were directly owned by each director on the date of issuance and included a one-year restriction on the sale or transfer of such shares. In the first quarter of 2014, we issued a total of 2,097 restricted shares and recognized $0.1 million of compensation expense. This restricted share program has been terminated and no further restricted shares will be issued going forward.