8. EMPLOYEE BENEFITS

EMPLOYEE STOCK OWNERSHIP, 401(K) AND BONUS AND INCENTIVE PLANS

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

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

Our ESOP and 401(k) cover all employees meeting eligibility requirements. ESOP and 401(k) profit-sharing contributions are determined annually by our board of directors and are expensed in the year earned. ESOP and 401(k)-related expenses (basic and profit-sharing) were $14.1 million, $12.4 million and $7.8 million, for 2014, 2013 and 2012, respectively.

During 2014, the ESOP purchased 178,987 shares of RLI stock on the open market at an average price of $44.43 ($7.9 million) relating to the contribution for plan year 2013. Shares held by the ESOP as of December 31, 2014, totaled 3,482,617 and are treated as outstanding in computing our earnings per share. During 2013, the ESOP purchased 140,484 shares of RLI stock on the open market at an average price of $35.03 ($4.9 million) relating to the contribution for plan year 2012. During 2012, the ESOP purchased 189,282 shares of RLI stock on the open market at an average price of $35.01 ($6.6 million) relating to the contribution for plan year 2011. The above mentioned ESOP purchases relate only to our annual contributions to the plan and do not include amounts or shares resulting from the reinvestment of dividends.

Annual bonuses are awarded to executives, managers and associates through our incentive plans, provided certain financial and operational goals are met. Annual expenses for these incentive plans totaled $23.1 million, $23.2 million and $16.7 million for 2014, 2013 and 2012, respectively.

DEFERRED COMPENSATION

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

In 2014, the trusts purchased 9,920 shares of our common stock on the open market at an average price of $44.40 ($0.4 million). In 2013, the trusts purchased 13,922 shares of our common stock on the open market at an average price of $38.33 ($0.5 million). In 2012, the trusts purchased 14,968 shares of our common stock on the open market at an average price of $34.24 ($0.5 million). At December 31, 2014, the trusts’ assets were valued at $35.3 million.

STOCK OPTIONS AND STOCK PLANS

Our RLI Corp. Omnibus Stock Plan (omnibus plan) was in place from 2005 to 2010. The omnibus plan provided for equity-based compensation, including stock options, up to a maximum of 3,000,000 shares (subject to adjustment for changes in our capitalization and other events). Between 2005 and 2010, we granted 2,458,059 stock options under this plan, including incentive stock options (ISOs), which were adjusted as part of the special dividends paid in 2014 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 (nonqualified 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 executive resources committee 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 2,824,500 stock options under the LTIP, including 512,000 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.

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.

Shares issued may be less than the number of shares actually exercised, as our plan allows net settlement to cover the option exercise price and taxes due upon option exercise. Shares netted are valued at the closing stock price at the time of option exercise. In these instances, the actual number of shares issued will be less than the options exercised and can result in a decrease to shareholders’ equity. Specifically, when options are exercised with significant intrinsic value (i.e. market value in excess of exercise price) and the exercise is facilitated via net settlement, amounts withheld for taxes result in a decrease in shareholders’ equity. During 2013, the aggregate intrinsic value of options exercised was $22.4 million. A majority of these options were exercised via net settlement with taxes withheld at the statutory minimum rate. As shown in the consolidated statements of shareholders’ equity, the exercise of options in 2013 resulted in a decrease to paid-in-capital, as the taxes withheld pursuant to net settlement exceeded amounts paid in for options that were exercised using cash. This was not the case in 2014 or 2012 as the intrinsic value of the options exercised was not as significant ($6.2 million and $4.7 million, respectively). Therefore, the exercise of options in 2014 and 2012 resulted in increases to paid-in-capital.

On November 13, 2014, the board of directors declared a $3.00 per share special cash dividend to be paid on December 22, 2014, to shareholders of record at the close of business on November 28, 2014. To preserve the intrinsic value for option holders, the board also approved, pursuant to the terms of our various stock option plans, a proportional adjustment to both the exercise price and the number of shares covered by each award for all outstanding ISOs and an adjustment to the exercise price (equivalent to the special dividend) for all outstanding non-qualified options. Most (99 percent) of the outstanding options at the time of the adjustment were non-qualified. These adjustments did not result in any incremental compensation expense as the aggregate fair value, aggregate intrinsic value and the ratio of the exercise price to the market price are approximately equal immediately before and after the adjustment. Similarly, on November 14, 2013, the board of directors declared a $1.50 per share special cash dividend to be paid on December 20, 2013, to shareholders of record at the close of business on November 29, 2013. On November 14, 2012, the board of directors declared a $2.50 per share special cash dividend to be paid on December 20, 2012, to shareholders of record at the close of business on November 30, 2012. The share and exercise price adjustments made for the 2014 special dividend were also made for the 2013 and 2012 special dividends and did not result in any incremental compensation expense.

The following tables summarize option activity in 2014, 2013 and 2012:


				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	512,000	$	40.46
Special dividend*	415	$	16.72
Options exercised	(214,042)	$	18.93		$	6,164
Options canceled/forfeited	(740)	$	13.51
Outstanding options at December 31, 2014	2,892,717	$	26.65	5.18	$	65,809
Exercisable options at December 31, 2014	1,238,257	$	20.02	3.94	$	36,385


				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	$	22.22
Options granted	632,700	$	35.67
Special dividend*	272	$	16.38
Options exercised	(935,692)	$	17.40		$	22,422
Options canceled/forfeited	(47,400)	$	24.86
Outstanding options at December 31, 2013	2,595,084	$	26.04	5.56	$	58,790
Exercisable options at December 31, 2013	934,544	$	20.36	4.28	$	26,474


				Weighted
		Weighted		Average	Aggregate
	Number of	Average		Remaining	Intrinsic
	Options	Exercise		Contractual	Value
	Outstanding	Price		Life	(in 000’s)
Outstanding options at January 1, 2012	2,561,732	$	21.62
Options granted	669,800	$	31.71
Special dividend*	2,172	$	15.39
Options exercised	(282,260)	$	19.03		$	4,712
Options canceled/forfeited	(6,240)	$	20.42
Outstanding options at December 31, 2012	2,945,204	$	22.22	5.43	$	29,865
Exercisable options at December 31, 2012	1,362,184	$	18.29	4.27	$	19,135

*An adjustment was made to the exercise price and number of ISO options outstanding for the special cash dividends paid during December 2014, 2013 and 2012. “Special dividend” represents the incremental options issued as a result of this adjustment.

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.

In 2014, 512,000 options were granted with an average exercise price of $40.46 and an average fair value of $7.89. Of these grants, 369,500 were granted at the board meeting in May with a calculated fair value of $7.71. We recognized $3.9 million of expense during 2014 related to options vesting. Since options granted under our plan are non-qualified, we recorded a tax benefit of $1.4 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $4.8 million, which will be recognized over the remainder of the vesting period.

In 2013, 632,700 options were granted with an average exercise price of $35.67 and an average fair value of $6.88. Of these grants, 472,700 were granted at the board meeting in May with a calculated fair value of $6.47. We recognized $3.8 million of expense during 2013 related to options vesting. Since options granted under our plan are non-qualified, we recorded a tax benefit of $1.3 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $4.5 million, which will be recognized over the remainder of the vesting period.

In 2012, 669,800 options were granted with an average exercise price of $31.71 and an average fair value of $6.55. Of these grants, 437,800 were granted at the board meeting in May with a calculated fair value of $6.54. We recognized $3.6 million of expense during 2012 related to options vesting. Since options granted under our plan are non-qualified, we recorded a tax benefit of $1.3 million related to this compensation expense. Total unrecognized compensation expense relating to outstanding and unvested options was $4.3 million, which will be recognized over the remainder of the vesting period.

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


	2014			2013			2012
Weighted-average fair value of grants	$	7.89		$	6.88		$	6.55
Risk-free interest rates		1.70	%		0.87	%		0.90	%
Dividend yield		1.94	%		2.00	%		1.93	%
Expected volatility		23.17	%		25.40	%		25.62	%
Expected option life		5.19	years		5.26	years		5.43	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, exclusive of special dividends. In 2014, the expected volatility was calculated based on the median of the rolling volatilities for the expected life of the options. In 2013 and 2012, 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 director received $10,000 worth of restricted common shares as part of annual director compensation. The shares were issued 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. In the first quarter of 2013, we issued a total of 2,320 restricted shares and recognized $0.1 million of compensation expense. This restricted share program was terminated in 2014.