RLI 10-Q 2005
Washington, D.C. 20549
(Exact name of registrant as specified in its charter)
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.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of July 19, 2005 the number of shares outstanding of the registrants Common Stock was 25,467,693.
PART I FINANCIAL INFORMATION
Item 1. Financial Statements
RLI Corp. and Subsidiaries
Condensed Consolidated Statement of Earnings and Comprehensive Earnings
The accompanying notes are an integral part of the financial statements.
RLI Corp. and Subsidiaries
Condensed Consolidated Statement of Earnings and Comprehensive Earnings
The accompanying notes are an integral part of the financial statements.
RLI Corp. and Subsidiaries Condensed Consolidated Balance Sheet
The accompanying notes are an integral part of the financial statements.
RLI Corp. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
The accompanying notes are an integral part of the financial statements.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - The financial information is prepared in conformity with accounting principles generally accepted in the United States of America (GAAP), and such principles are applied on a basis consistent with those reflected in the 2004 annual report filed with the Securities and Exchange Commission. Management has prepared the financial information included herein without audit by independent certified public accountants. The condensed consolidated balance sheet as of December 31, 2004 has been derived from, and does not include all the disclosures contained in, the audited consolidated financial statements for the year ended December 31, 2004.
The information furnished includes all adjustments and normal recurring accrual adjustments that are, in the opinion of management, necessary for a fair statement of results for the interim periods. Results of operations for the three and six month periods ended June 30, 2005 and 2004 are not necessarily indicative of the results of a full year.
The accompanying financial data should be read in conjunction with the notes to the financial statements contained in the 2004 Annual Report on Form 10-K.
Earnings Per Share: Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the dilution that could occur if securities or other contracts to issue common stock (common stock equivalents) were exercised or converted into common stock. When inclusion of common stock equivalents increases the earnings per share or reduces the loss per share, the effect on earnings is antidilutive. Under these circumstances, the diluted net earnings or net loss per share is computed excluding the common stock equivalents.
Pursuant to disclosure requirements contained in Statement 128, Earnings Per Share, the following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the financial statements.
Other Accounting Standards: In December 2002, the Financial Accounting Standards Board (FASB) published Statement of Financial Accounting Standards (SFAS) 148, Accounting for Stock-Based Compensation Transition and Disclosure. SFAS 148 amended SFAS 123, Accounting for Stock-Based Compensation and provided alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. Because we have not elected to adopt the fair-value-based method of accounting for stock compensation, the transitional provisions of this statement did not impact us. In addition, SFAS 148 amended the disclosure requirements of SFAS 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation, including disclosures in interim financial statements. The transition guidance and annual disclosure provisions of SFAS 148 were effective for fiscal years ending after December 15, 2002. The disclosure provisions became effective for annual reporting in 2002 and interim reporting in 2003.
In December 2004, the FASB revised Statement No. 123 (SFAS
123R), Share-Based Payment, which requires companies to expense the estimated
fair value of employee stock options and similar awards, for all options
vesting, granted, or modified after the effective date of this revised
statement. The accounting provisions of
SFAS 123R were to become effective for interim periods beginning after June 15,
2005. In April 2005, the Securities and Exchange Commission (SEC) adopted
a final rule amending
Stock based compensation: We grant to officers and directors stock options for shares with an exercise price equal to the fair market value of the shares at the date of grant. We account for stock option grants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and accordingly recognize no compensation expense for the stock option grants.
Had compensation cost for the plan been determined consistent with SFAS 123, our net income and earnings per share would have been reduced to the following pro forma amounts:
These pro forma amounts may not be representative of the effects of SFAS 123 on pro forma net income for future periods, as options normally vest over several years and additional awards may be granted in the future. During the first quarter of 2005, a resolution was adopted by our board of directors permitting the Company to accelerate the vesting of all unvested stock options, including directors stock options, effective May 5, 2005; subject to certain share transfer restrictions. Acceleration was applicable to all stock grants issued prior to May 5, 2005. This modification, which occurred prior to the effective date of SFAS 123R, effectively removes these options from expense consideration under SFAS 123R. These options will continue to be accounted for under the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees. Under APB 25, compensation expense recorded for accelerated vesting is measured by applying two criteria: (1) the difference between the market price and the option exercise price on the date of acceleration, and (2) the number of options that would have been forfeited as un-exercisable (unvested) had acceleration not occurred. Using the guidance set forth in APB 25, our historical forfeiture rate of less than 10%, and certain other assumptions for anticipated retirements, we recorded $750,000 of compensation expense in the second quarter of 2005. This expense represents our best estimate of the total expense associated with acceleration. In future periods, we will compare the actual number of options that would have been forfeited as unvested to our assumptions and adjust expense up or down based on that review.
Pension Plan: On December 31, 2003, our pension plan was amended to freeze benefit accruals as of March 1, 2004. Additionally, the plan was also closed to new participants after December 31, 2003. Participants benefits may increase in the future based on changes in their final average earnings. Future pay increases are indexed to a maximum of 5% annually. Increases in excess of 5% will not be reflected in the determination of participants final average earnings. The table below represents the various components of pension expense for the six month periods ended June 30, 2005 and 2004.
The ERISA required minimum contribution during the fiscal year ending December 31, 2005, is $0. We have not decided whether to contribute any amount in excess of the required minimum contribution.
Intangible assets: In accordance with SFAS 142, Goodwill and Other Intangible Assets, the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is reason to suspect that their values may have been diminished or impaired. Goodwill and indefinite-lived intangible assets, which relate to our surety segment, are listed separately on the balance sheet and totaled $26.2 million at June 30, 2005 and December 31, 2004. Impairment testing was performed during the second quarter of 2005, pursuant to the requirements of SFAS 142. Based upon this review, these assets do not appear to be impaired.
Intangible assets with definite lives continue to be amortized over their estimated useful lives. Definite-lived intangible assets that continue to be amortized under SFAS 142 relate to our purchase of customer-related and marketing-related intangibles. These intangibles have useful lives ranging from five to 10 years. Amortization of intangible assets was $226,000 for the first six months of 2005, compared to $661,000 for the same period last year. At June 30, 2005, net intangible assets totaled $757,000, net of $4.9 million of accumulated amortization, and are included in other assets.
2. INDUSTRY SEGMENT INFORMATION - Selected information by industry segment for the six-month periods ended June 30, 2005 and 2004 is presented below.
The following table further summarizes revenues by major product type within each segment:
A detailed discussion of earnings and results by segment is contained in managements discussion and analysis of financial condition and results of operations.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: This discussion and analysis may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Various risk factors that could affect future results are listed in the Companys filings with the Securities & Exchange Commission, including the Form 10-K for the year ended December 31, 2004.
We are a holding company that underwrites selected property and casualty insurance through major subsidiaries collectively known as RLI Insurance Group, or the Group. The Group provides property and casualty coverages primarily for commercial risks and has accounted for 87% of our consolidated revenue for the first six months of 2005 compared to 89% for the same period last year.
As a niche company, we offer specialty insurance products designed to meet specific insurance needs of targeted insured groups. A niche company underwrites a particular type of coverage for certain markets that are underserved by the insurance industry, such as our commercial earthquake coverage or oil and gas surety bonds. A niche company also provides a type of product not generally offered by other companies, such as our stand-alone personal umbrella policy, which we offer without the underlying auto or homeowners coverage. The excess and surplus lines market provides an alternative for customers with hard-to-place risks and risks that admitted insurers specifically refuse to write. When we underwrite within the excess and surplus lines market, we are selective in the lines of business and types of risks we choose to write. Often the development of these specialty insurance products is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients. Once a proposal is submitted, underwriters determine whether a proposal would be a viable product in keeping with our business objectives.
Management measures the results of our insurance operations by monitoring certain measures of growth and profitability across three distinct business segments: casualty, property and surety. Growth is measured in terms of gross premiums written and profitability is analyzed through GAAP (accounting principles generally accepted in the United States of America) combined ratios, which are further subdivided into their respective loss and expense components. The GAAP combined ratios represent the profit generated from our insurance operations.
The foundation of our overall business strategy is to underwrite for profit. This drives our ability to provide shareholder returns in three different ways: the underwriting profit itself, investment income from fixed-income portfolios, and long-term growth in our equity portfolio. Our investment strategy is based on preservation of capital as the first priority, with a secondary focus on generating total return.
The property and casualty insurance business is cyclical and influenced by many factors, including price competition, economic conditions, natural or man-made disasters (for example, earthquakes, hurricanes, and terrorism), 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 have fully developed, because premiums are charged before claims are incurred. This requires that liabilities be estimated and recorded in recognition of future loss and settlement obligations. Due to the inherent uncertainty in estimating these liabilities, there can be no assurance that actual liabilities will not exceed recorded amounts; if actual liabilities do exceed recorded amounts, there will be an adverse effect on net earnings. In evaluating the objective performance measures previously mentioned, it is important to consider the following individual characteristics of each major insurance segment.
Our property segment primarily underwrites commercial fire, earthquake, builders risk, difference in conditions, other inland marine coverages, ocean marine and, in the state of Hawaii, select personal lines policies. Property insurance results are subject to the variability introduced by perils such as earthquakes, fires and hurricanes. Our major catastrophe exposure is to losses caused by earthquakes, as approximately 39% of 2005s total property premiums were written in California. We limit our 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.
The casualty portion of our business consists largely of general liability, transportation, multi-peril program business, commercial umbrella, personal umbrella, executive products and other specialty coverages. In addition, we provide employers indemnity and at-home business owners coverage. The casualty book of business is subject to the risk of accurately estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty line may also be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses.
The surety segment specializes in writing small to large commercial and small contract surety products, as well as those for the energy (plugging and abandonment), petrochemical and refining industries. The commercial surety products usually involve a statutory requirement for bonds. This industry has historically maintained a relatively low loss ratio. Losses may fluctuate, however, due to adverse economic conditions that may affect the financial viability of an insured. The contract surety market guarantees the construction work of a commercial contractor for a specific project. As such, this line has historically produced marginally higher loss ratios than other surety lines. Generally, losses occur due to adverse economic conditions, inclement weather conditions or the deterioration of a contractors financial condition.
Critical Accounting Policies
GAAP and non-GAAP Financial Performance Metrics
Throughout this quarterly report, we present our operations in the way we believe will be most meaningful, useful and transparent to anyone using this financial information to evaluate our performance. In addition to the GAAP presentation of net income and certain statutory reporting information, we show certain non-GAAP financial measures that are valuable in managing our business and drawing comparisons to our peers. These measures include gross revenues, gross written premiums, net written premiums and combined ratios.
Following is a list of non-GAAP measures found throughout this report with their definitions, relationships to GAAP measures, and explanations of their importance to our operations.
This is an RLI-defined metric equaling the sum of gross premiums written, net investment income and realized gains (losses). It is used by our management as an overall barometer of gross business volume across all operating segments.
Gross premiums written
While net premiums earned is the related GAAP measure used in the statement of earnings, gross premiums written is the component of net premiums earned that measures insurance business produced before the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an overall gauge of gross business volume in our insurance underwriting operations with some indication of profit potential subject to the levels of our retentions, expenses and loss costs.
Net premiums written
While net premiums earned is the related GAAP measure used in the statement of earnings, net premiums written is the component of net premiums earned that measures the difference between gross premiums written and the impact of ceding reinsurance premiums, but without respect to when those premiums will be recognized as actual revenue. We use this measure as an indication of retained or net business volume in our insurance underwriting operations. It is an indicator of future earnings potential subject to our expenses and loss costs.
This ratio is a common industry measure of profitability for any underwriting operation, and is calculated in two segments. First, the expense ratio reflects the sum of policy acquisition costs and insurance operating expenses, divided by net premiums earned. The second component, the loss ratio, is losses and settlement expenses divided by net premiums earned. The sum of the loss and expense ratios is the combined ratio. The difference between the combined ratio and 100 reflects the per-dollar rate of underwriting profit or loss. For example, a combined ratio of 95 implies that for every $100 of premium we earn, we record $5 of underwriting profit.
Net Unpaid Loss and Settlement Expenses
Unpaid losses and settlement expenses, as shown in the liabilities section of our balance sheet, represents the total obligations to claimants for both estimates of known claims and estimates for incurred but not reported (IBNR) claims. The related asset item, Reinsurance balances recoverable on unpaid losses and settlement expense, is the estimate of known claims and estimates of IBNR that we expect to recover from reinsurers. The net of these two items is generally referred to as net unpaid loss and settlement expenses and is commonly referred to in our disclosures regarding the process of establishing these various estimated amounts.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.
The most critical accounting policies involve significant estimates and include those used in determining the liability for unpaid losses and settlement expenses, investment valuation, recoverability of reinsurance balances and deferred policy acquisition costs.
Unpaid Losses and Settlement Expenses
We accrue liabilities intended to represent the ultimate settlement cost of losses and loss expenses incurred but not yet settled as of the accounting date. This includes both claims whose loss circumstances have been reported to us and for which our claims personnel have established estimates of ultimate cost (case reserves), and claims which have occurred, but which have not yet been reported to us (incurred but not reported or IBNR reserves). The ultimate cost of both of these categories, and therefore the liability booked to represent their ultimate cost, involve estimates.
The estimates underlying the accrued liabilities are derived from generally accepted actuarial techniques, applied to our actual experience, and take into account insurance industry data to the extent judged relevant to our operations.
Our experience in a given accounting period is affected by all those factors which affect the quality of the business written in competitive coverage marketplaces: the premiums for which the coverage can be sold, the frequency and severity of claims ultimately produced on that business, the terms at which we purchase reinsurance coverage, and our expense structure. In the estimation of ultimate loss and loss expense liabilities, the factors which most significantly affect the ultimate results are:
changes in claim frequency and severity, or, more generally, the underwriting quality of the business written;
changes in the coverage sold (limits of coverage, deductibles, exclusions and extensions of coverage, reinsurance terms); and
changes in the overall profitability of the competitive coverage marketplace.
One of the unique and challenging features of the property and casualty insurance business is that products must be priced before costs have fully developed, because premiums are charged before claims are incurred. This requires that liabilities be estimated and recorded in recognition of incurred losses and settlement obligations that have not been reported. Due to the inherent uncertainty in estimating these liabilities, there can be no assurance that actual liabilities will not exceed recorded amounts; if actual liabilities do exceed recorded amounts, there will be an adverse effect. Furthermore, we may determine that recorded reserves are more than adequate to cover expected losses as happened in the first and second quarters of 2005, when favorable experience on casualty business led us to reduce our reserves. Further information on these reserve releases is contained in the discussion of results below.
Underwriting Quality of the Business Written
In general, competitive insurance marketplaces change over time. This is particularly true of the excess and surplus lines marketplace. The principal feature of those changes is the average profitability of business in a given segment, which is principally determined by the premium charged as well as the frequency and severity of claims produced. Because the quality of business changes continuously, the ultimate profitability of the business being written in the current accounting period must be estimated. As the quality of the business changes, the reliability of recent experience as a guide to the results of current business weakens.
We therefore monitor changes in the quality of business written by the number of claims per unit of exposure, the cost per claim, and the shifts in the distribution of business by geographic region and product segment. We incorporate our understanding of those changes into our estimates of the ultimate cost of current claims for which reserves have been established.
Changes in the Coverage Sold
The excess and surplus lines marketplace is characterized by somewhat greater regulatory latitude in coverage terms and pricing. As competitive marketplace conditions change, our underwriters respond by modifying our coverage terms. While this is an appropriate response to a changing competitive environment, it also weakens the reliability of past experience as a predictor of the ultimate cost of claims arising from current business. The admitted marketplaces in which we operate provide for more stable terms and pricing because of their regulated nature. However, this regulation limits our ability to quickly adapt terms and pricing in light of changing marketplace dynamics.
Reinsurance is also important to our operations. Reinsurance is purchased in a related, but distinct competitive marketplace which also changes over time. The changes in the relative cost of reinsurance affect the ultimate cost of net loss liabilities for which we accrue reserves. In general, as we grow and increase our financial capacity to absorb fluctuations in results, our need for, and purchase of, reinsurance may decrease incrementally.
Changes in Overall Profitability
During and immediately after the period in which coverage is provided and the corresponding premiums are earned, there may be little actual claim experience from which to estimate the ultimate cost of those claims. In particular, for longer-tailed liability lines such as excess coverage, the reporting, case reserving, and settlement of those claims may take considerable time.
We therefore use generally accepted actuarial techniques which use the premiums charged for coverage as a basis for estimating the ultimate cost of losses and loss expenses for relatively immature accident periods. While this is technically appropriate, it does introduce another variable into the reserve estimate: the changing profitability of premiums for a given product over time. Since the ultimate profitability of the business written in a given period depends upon all the factors mentioned above, highly accurate profitability estimates of the longer-tailed lines are difficult to achieve.
We have insignificant exposure to asbestos and environmental policy liabilities. We entered affected liability lines after the industry had already recognized them as a problem, and we adopted appropriate coverage exclusions. What exposure does exist is through our commercial umbrella, general liability, and discontinued assumed reinsurance lines of business. The majority of that exposure is in the excess layers of our commercial umbrella and assumed reinsurance books of business. Although our asbestos and environmental exposure is limited, management cannot determine our ultimate liability with any reasonable degree of certainty. This ultimate liability is difficult to assess due to evolving legislation on such issues as joint and several liability, retroactive liability, and standards of cleanup and because our participation exists in the excess layers of coverage on these risks.
Throughout each year, our internal and external investment managers buy and sell securities to maximize overall investment returns in accordance with investment policies established and monitored by our board of directors and officers. This includes selling individual securities that have unrealized losses when the investment manager believes future performance can be improved by buying other securities deemed to offer superior long-term return potential.
We classify our investments in debt and equity securities with readily
determinable fair values into one of three categories.
Management regularly evaluates our fixed maturity and equity securities
portfolio to determine impairment losses for
securitys fair value being below cost, credit ratings, current economic conditions, the anticipated speed of cost recovery, and our decisions to hold or divest a security. Impairment losses result in a reduction of the underlying investments cost basis. Significant changes in these factors could result in a considerable charge for impairment losses as reported in the consolidated financial statements.
Part of our evaluation of whether particular securities are other-than-temporarily impaired involves assessing whether we have both the intent and ability to continue to hold securities in an unrealized loss position. We have not sold any securities for the purpose of generating cash over the last several years to pay claims, dividends or any other expense or obligation. Accordingly, we believe that our sale activity supports our ability to continue to hold securities in an unrealized loss position until our cost may be recovered.
Recoverability of Reinsurance Balances
Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, rather than being netted with the related liabilities, since reinsurance does not relieve us of our liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and settlement expenses impact the estimates for the ceded portion of such liabilities. We continually monitor the financial condition of our reinsurers. Our policy is to periodically charge to earnings an estimate of unrecoverable amounts from troubled or insolvent reinsurers. Further discussion of the security of our recoverable reinsurance balances can be found in note 5 to the financial statements included in our 2004 Annual Report on Form 10-K.
Deferred Policy Acquisition Costs
We defer commissions, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premiums to be earned, related investment income, anticipated losses and settlement expenses as well as certain other costs expected to be incurred as the premiums are earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the premiums written.
SIX MONTHS ENDED JUNE 30, 2005, COMPARED TO SIX MONTHS ENDED JUNE 30, 2004
Consolidated gross revenues, as displayed in the table that follows, totaled $402.2 million for the first six months of 2005 compared to $412.6 million for the same period in 2004.
Gross premiums written for the Group declined 4% from 2004 levels due to a decline in property writings, coupled with a slowdown in growth of casualty writings. Net investment income improved 14% to $29.3 million. This growth is attributable to continued positive operating cash flow, coupled with an increased invested asset base. Additionally, the sale of certain securities during the first six months of 2005 resulted in the recognition of $7.4 million in realized gains.
Consolidated net revenue for the first six months of 2005 increased $1.6 million, or 1%, from the same period in 2004. Net premiums earned was off 2%, due to the continued decline in premium production of our property segment, while net investment income advanced 14%.
Net after-tax earnings for the first six months of 2005 totaled $63.7 million, $2.43 per diluted share, compared to $35.3 million, $1.35 per diluted share, for the same period in 2004. Results for 2005 include certain favorable developments from prior years loss reserves. We did not experience similar reserve releases during the first six months of 2004. During the second quarter of 2005, positive development on prior accident years casualty loss reserves resulted in additional pretax earnings of $16.1 million ($0.40 per diluted share). Mid-year results also include positive first quarter development on prior accident years casualty loss reserves of $9.1 million ($0.23 per diluted share). Additionally, losses related to last years Florida hurricanes did not develop as expected, improving first quarter 2005s results by $3.8 million (affecting casualty by $2.8 million and property by $1.0 million), or $.10 per diluted share. These amounts are net of performance-related bonus accruals, which affected other insurance and general corporate expenses. Bonuses earned by executives, managers and associates are predominately influenced by corporate performance (operating earnings and return on capital), which advanced significantly during 2005 due to these positive developments.
Results for the first six months of 2005 include realized gains of $7.4 million, $0.18 per diluted share, compared to $4.3 million, $0.10 per diluted share for the same period last year.
Comprehensive earnings, which include net earnings plus unrealized gains/losses net of tax, totaled $59.8 million, $2.28 per diluted share, for the first six months of 2005, compared to comprehensive earnings of $20.9 million, $0.80 per diluted share, for the same period in 2004. Unrealized losses, net of tax, for the first six months of 2005 were $3.9 million, $0.15 per diluted share, compared to unrealized losses of $14.4 million, $0.55 per diluted share, for the same period in 2004. Both periods were negatively impacted, to varying degrees, by rising interest rates and volatility experienced in the bond and equity markets.
RLI INSURANCE GROUP
As indicated earlier, gross premiums written for the Group declined to $365.5 million for the first six months of 2005, compared to $382.6 million reported for the same period in 2004, as property writings declined markedly and casualty growth slowed. Gross writings for the property segment declined $21.5 million (21%), due to a continued trend of rate softening, increased competition, and a reduced presence in the construction marketplace. Underwriting income improved to a pre-tax profit of $56.0 million for the first six months of 2005, compared to $22.6 million for the same period in 2004, as the surety and casualty segments posted improvements. Results for 2005 were favorably impacted by prior accident years casualty reserve releases, as well as favorable development on last years hurricane reserves. The GAAP combined ratio totaled 77.4 for the first six months of 2005, compared to 91.1 for the same period in 2004. The Groups loss ratio decreased to 42.7 for 2005, compared to 58.9 for 2004, reflective of the prior accident years reserve releases.
Gross premiums written for the Groups property segment decreased $21.5 million, or 21% from the same period last year. For the first six months of 2005, gross property premiums totaled $80.6 million. Rate softening, which began in 2003, continued to impact the segment. Increased competition and market capacity continue to drive down pricing, particularly on our California earthquake business. Additionally, construction premium declined $17.8 million (74%) due to market softening and the re-underwriting of the book. During the first six months, we exited several large accounts, as we shifted our underwriting focus toward smaller to mid-sized accounts. On a positive note, our new marine division, launched during the second quarter of 2005, added to the segments premium, and our domestic fire posted a 7% increase in writings, as account retention increased and new business opportunities materialized. For the segment, net premiums written and net premiums earned declined, driven primarily by the continued decline in overall writings. Underwriting profit for the segment was $13.5 million for the first six months of 2005, compared to $16.1 million for the same period in 2004.
Underwriting income for the property segment was favorably impacted by a first quarter 2005 reduction in reserves for last years hurricanes. Net of related bonuses, this release improved 2005s results by $1.0 million. Additionally, results for the first half of 2005 were favorably impacted by $1.5 million in increased reinsurance profit commission recognition, due to changes in estimated losses on the related contracts. These changes served to partially offset the impact of the continued decline in premium writings and the corresponding reduction in revenue. Results for 2005 translate into a GAAP combined ratio of 68.0, compared to 67.4 for the same period last year. The loss ratio, at 31.0, was 1.3 points higher than last years posting. Both periods reflect excellent underwriting performance. The expense ratio, at 37.0, declined 0.7 points from last years posting, helped by increased reinsurance profit commission recognition. Given the continued decline in premium writings, the fixed nature of certain expenses and normalization of reinsurance costs, the expense ratio is likely to increase during the second half of 2005.
The casualty segment posted gross premiums written of $254.3 million for the first six months of 2005, up 1% from 2004. As expected, rates are beginning to soften at a modest pace in the casualty segment. Despite this softening, we continue to find opportunities for profitable growth, particularly in transportation, umbrella, and executive products. Transportation writings advanced $4.1 million, or 15%, during the first six months of 2005, while umbrella was up $2.6 million, or 6%. In executive products (directors and officers liability), we posted improved writings following multiple quarters of declining premiums. We have shifted our underwriting focus away from large-cap public companies, which we believe to be significantly under-priced, to mid-cap, not-for-profit and private sectors, where pricing is more favorable. Our largest growth contributor over the past several years, general liability, recorded a $1.9 million, or 2%, decline in writing for the first six months of 2005, reflective of increased competition in that marketplace. Additionally, our specialty program business declined $6.9 million, or 22%, due to increased competition and exiting certain unprofitable accounts. As the casualty market softens, we will continue to remain focused on growing areas that provide the best return, while maintaining strict adherence to underwriting discipline.
In total, the casualty segment posted an underwriting profit of $41.1 million, compared to a profit of $6.6 million for the same period last year. Results for 2005 include favorable experience on prior accident years (2002 through 2004) for general liability, transportation and specialty programs. Due to this positive emergence, during the first and second quarters, we released reserves. These reserve releases improved the segments underwriting results by $26.1 million, net of related bonuses. Moreover, a re-evaluation of last years hurricanes resulted in the release of reserves, adding $2.8 million of underwriting income, net of related bonuses. Hurricane reserves on specialty program business (package policies on service stations and hotels) developed favorably and expected demand surge did not materialize, resulting in this first quarter 2005 reserve release. Overall, the combined ratio for the casualty segment was 77.3 for 2005 compared to 96.3 in 2004. The reserve releases reduced 2005s combined ratio by 16 points.
The surety segment posted gross premiums written of $30.6 million for the first six months of 2005, up 9% from the same period last year. Premium growth was experienced in miscellaneous, commercial and energy business, areas that have traditionally posted profits, and in contract surety, where results have begun to improve. For the fourth consecutive quarter, the segment posted underwriting profits. For the first six months of 2005, underwriting profit totaled $1.5 million, compared to an underwriting loss of $127,000 for the same period in 2004. The combined ratio for the surety segment totaled 94.0 in 2005, versus 100.5 for the same period in 2004. The segments loss ratio was 32.1 for 2005, compared to 38.6 for 2004. 2004s loss ratio was adversely impacted by reserve additions on contract bonds written in 2002 and earlier. The expense ratio remained flat at 61.9. We are encouraged by the improvement in the segments underwriting results and have added additional underwriters with the expectation of modest growth for the segment going forward.
We are in litigation regarding certain commercial surety bond claims arising out of a specific bond program. We are currently investigating and evaluating our obligations due to a variety of complex issues. The bankruptcy aspects of this litigation have been largely resolved by way of a settlement reached in May 2005, pursuant to which the Commercial Money Center (CMC) bankruptcy trustee released its claim to the income stream under the leases and its rights under the bonds. The bankruptcy settlement in effect leaves the banks as the sole entities making claims to the income stream and under the bonds and thus removed a major obstacle to meaningful settlement discussions. Moreover, the parties continue to await a ruling by the Federal District Court on motions filed in the litigation.
On July 22, 2005, we announced that in the third quarter of 2005, we reached a confidential settlement agreement with Lakeland Bank, one of the banks involved in this litigation. This settlement ends our litigation with Lakeland, but does not resolve our pending litigation with the four other investor banks. The settlement with Lakeland relates to surety bonds representing 17% of the amount to which the five investor banks had claimed entitlement. The settlement does not have a material adverse impact on our financial statements taken as a whole. While it is impossible to ascertain the ultimate outcome of the pending litigation between us and the remaining four investor banks at this time, we continue to believe we have meritorious defenses with respect to each of the remaining banks making claims and we will continue to vigorously assert those defenses in the pending litigation. We believe that we are adequately reserved for the ultimate outcome of remaining litigation and that resolution will not have a material adverse effect on our financial statements taken as a whole. However, litigation is subject to inherent uncertainties, and if there were an outcome unfavorable to us, there exists the possibility of a material adverse impact on our financial condition, results of operations or cash flows in the period in which the outcome occurs.
Additional commentary on this litigation can be found in Item 3 Legal Proceedings of our 2004 Annual Report on Form 10K.
INVESTMENT INCOME AND REALIZED CAPITAL GAINS
During the first six months of 2005, net investment income increased by 14.0% over that reported for the same period in 2004. This improvement was due to an increased asset base and continued positive operating cash flow available for allocation to the investment portfolio. On an after-tax basis, investment income increased by 14.5%. Operating cash flows were $78.3 million in the first six months of 2005, down from $97.0 million reported for the same period in 2004. Cash flows in excess of current needs were primarily used to purchase fixed-income securities, which continue to be comprised primarily of high-grade, tax-exempt, corporate and U.S. government/agency issues. The average annual yields on our investments for the first six months of 2005 and 2004 were as follows.
During the first six months of 2005, the average after-tax yield of the fixed-income portfolio was relatively stable. The yield increased slightly on taxable bonds but decreased slightly on tax-exempt bonds.
The fixed-income portfolio increased by $29.9 million during the first six months of 2005. This portfolio had a tax-adjusted total return on a mark-to-market basis of 2.62%. Our equity portfolio increased by $0.2 million during the first six months of 2005, to $316.1 million. The equity portfolio had a total return of 1.33% during the first six months of 2005.
We realized a total of $7.4 million in capital gains in the first six months of 2005, compared to capital gains of $4.3 million in the first six months of 2004. The increase in net realized gains is due in part to the timing of the sale of individual securities.
We regularly evaluate the quality of our investment portfolio. When we believe that a specific security has suffered an other-than-temporary decline in value, the investments value is adjusted by reclassifying the decline from unrealized to realized losses. This has no impact on shareholders equity. There have been no losses associated with the other-than-temporary impairment of securities since 2002.
The following table is used as part of our impairment analysis and illustrates certain industry-level measurements relative to our equity portfolio as of June 30, 2005, including market value, cost basis, and unrealized gains and losses.
(1) Calculated as the percentage of net unrealized gain (loss) to cost basis.
The following table is also used as part of our impairment analysis and illustrates the total value of securities that were in an unrealized loss position as of June 30, 2005. It segregates the securities based on type, noting the fair value, cost (or amortized cost), and unrealized loss on each category of investment as well as in total. The table further classifies the securities based on the length of time they have been in an unrealized loss position.
Investment Positions with Unrealized Losses
Segmented by Type and Period of Continuous
Unrealized Loss at June 30, 2005
The following table shows the composition of the fixed income securities in loss positions at June 30, 2005 by the National Association of Insurance Commissioners (NAIC) rating and the generally equivalent S&P and Moodys ratings. Not all of the securities are rated by S&P and/or Moodys.
As of June 30, 2005, we held ten common stock positions that were in unrealized loss positions. Unrealized losses on these securities totaled $1.5 million. All of these securities have been in an unrealized loss position for less than nine months.
The fixed income portfolio contained 122 positions at a loss as of June 30, 2005. Of these 122 securities, 38 have been in an unrealized loss position for more than 12 consecutive months. The fixed income unrealized losses can primarily be attributed to an increase in medium and long-term interest rates since the purchase of many of these fixed income securities. We continually monitor the credit quality of our fixed income investments to gauge our ability to be repaid principal and interest. We consider price declines of securities in our other-than-temporary-impairment analysis where such price declines provide evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration, as opposed to rising interest rates.
Our effective tax rate for the first six months of 2005 was 30.1% compared to 29.1% for the same period in 2004. Effective rates are dependent upon components of pretax earnings and the related tax effects. The effective rate for 2005 is higher due to the increase in underwriting income, which is taxed at 35%. Income tax expense attributable to income from operations differed from the amounts computed by applying the U.S. federal tax rate of 35% to pretax income for the first six months of 2005 and 2004 as a result of the following:
LIQUIDITY AND CAPITAL RESOURCES
We have three primary types of cash flows: (1) cash flows from operating activities, which consist mainly of cash generated by our underwriting operations and income earned on our investment portfolio, (2) cash flows from investing activities related to the purchase, sale and maturity of investments, and (3) cash flows from financing activities that impact our capital structure, such as changes in debt and shares outstanding.
Cash flows from operating activities decreased during the first six months of 2005 compared to last year, due to an increase in claim payments coupled with a decline in premium volume. The following table summarizes these cash flows for the six month periods ended June 30, 2005 and 2004.
We have $100.0 million in long-term debt outstanding. On December 12, 2003, we completed a public debt offering, issuing $100.0 million in senior notes maturing January 15, 2014 (a 10-year maturity), and paying interest semi-annually at the rate of 5.95% per annum. The notes were issued at a discount resulting in proceeds, net of discount and commission, of $98.9 million.
We have begun to reduce our usage of short-term credit facilities through reverse-repurchase transactions at the insurance subsidiaries. As of December 31, 2004, we were party to nine reverse repurchase agreements (short-term debt) totaling $46.8 million. As of June 30, 2005, we were party to seven reverse repurchase agreements (short-term debt) totaling $36.8 million. Going forward, it is anticipated that we will continue to pay off the reverse repurchase agreements via operating cash flow.
We are not party to any off-balance sheet arrangements.
At June 30, 2005, we had short-term investments, cash and other investments maturing within one year, of approximately $105.5 million and investments of $336.6 million maturing within five years. We maintain revolving lines of credit with two financial institutions, each of which permits us to borrow up to an aggregate principal amount of $10.0 million. Under certain conditions, each of the lines may be increased up to an aggregate principal amount of $20.0 million. The facilities have three-year terms that expire on May 31, 2008. As of June 30, 2005, no amounts were outstanding on these facilities.
We believe that cash generated by operations, cash generated by investments and cash available from financing activities will provide sufficient sources of liquidity to meet our anticipated needs over the next 12 to 24 months.
We maintain a well-diversified investment portfolio representing policyholder funds that have not yet been paid out as claims, as well as the capital we hold for our shareholders. As of June 30, 2005, our investment portfolio had a book value of $1.6 billion. Invested assets at June 30, 2005, increased by $44.7 million, from December 31, 2004.
As of June 30, 2005, our fixed-income portfolio had the following rating distribution:
As of June 30, 2005, the duration of the fixed income portfolio was 4.85 years. Our fixed-income portfolio remained well diversified, with 679 individual issues as of June 30, 2005. During the first six months of 2005, the total return on our bond portfolio on a tax-equivalent, mark-to-market basis was 2.62%.
In addition, at June 30, 2005, our equity portfolio had a value of $316.1 million and is also a source of liquidity. The securities within the equity portfolio remain primarily invested in large-cap issues with strong dividend performance. Included within our equity portfolio are certain real estate investment trust (REIT) securities. The strategy remains one of value investing, with security selection taking precedence over market timing. We use a buy-and-hold strategy, minimizing both transactional costs and taxes.
As of June 30, 2005, our portfolio had a dividend yield of 3.0% compared to 1.8% for the S&P 500 index. Because of the corporate-dividend-received deduction applicable to our dividend income, we pay an effective tax rate of only 14.2% on dividends, compared to 35.0% on taxable interest and REIT income and 5.0% on municipal bond interest income. As with our bond portfolio, we maintain a well-diversified group of 113 equity securities. During the first six months of 2005, the total return on our equity portfolio on a mark-to-market basis was 1.33%.
Our capital structure is comprised of equity and debt outstanding. As of June 30, 2005, our capital structure consisted of $100.0 million in 10-year maturity senior notes maturing in 2014 (long-term debt), $36.8 million in reverse repurchase debt agreements with maturities from zero to seven months (short-term debt), and $676 million of shareholders equity. Debt outstanding comprised 17% of total capital as of June 30, 2005.
Our 116th consecutive quarterly dividend payment was declared in the second quarter of 2005 and paid on July 15, 2005, in the amount of $0.16 per share. With this payment, we surpassed the $100 million mark in dividends paid to our shareholders. Since the inception of cash dividends in 1976, we have increased our annual dividend every year. In its annual Handbook of Dividend Achievers, Mergent FIS (formerly a division of Moodys) ranked us 171st of more than 11,000 U.S. public companies in dividend growth over the last decade.
Dividend payments to us from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the regulatory authority of Illinois. The maximum dividend distribution is limited by Illinois law to the greater of 10% of RLI Insurance Companys policyholder surplus as of December 31 of the preceding year, or its net income 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 2005 without prior approval is $60.6 million. The actual amount paid in 2004 was $19.6 million.
Interest and fees on debt obligations increased to $3.7 million for the first six months of 2005, up $258,000 from the same period in 2004. This slight increase in expense is the result of rising interest rates in the reverse repurchase markets. As of June 30, 2005, outstanding debt balances totaled $136.8 million, compared to $147.1 million at June 30, 2004. The June 30, 2005 debt balance is comprised of the $100.0 million in senior notes and $36.8 million in reverse repurchase agreements. The June 30, 2004 balance of $147.1 million consisted of $100.0 million in senior notes and $47.1 in reverse repurchase agreements. The Company has incurred interest expense on debt at the following average interest rates for the six month periods ended June 30, 2005 and 2004:
THREE MONTHS ENDED JUNE 30, 2005, COMPARED TO THREE MONTHS ENDED JUNE 30, 2004
Consolidated gross revenues, as displayed in the table that follows, totaled $218.5 million for the second quarter of 2005 compared to $214.9 million for the same period in 2004.
Gross revenue improved 2% from 2004 levels due to increased investment income and realized investment gains. Net investment income improved 10% to $14.7 million. This growth is attributable to continued positive operating cash flow, coupled with an increased invested asset base. Additionally, the sale of certain securities during the second quarter of 2005 resulted in the recognition of $4.4 million in realized gains.
Consolidated net revenue for the second quarter of 2005 was flat at $142.7 million. Net premiums earned were down 3%, due to the continued decline in premium production of our property segment and a shift in mix of business on our casualty segment. Offsetting this decline, net investment income advanced 10% and realized investment gains more than doubled.
Net after-tax earnings for the second quarter of 2005 totaled $34.4 million, $1.31 per diluted share, compared to $18.4 million, $0.71 per diluted share, for the same period in 2004. Results for 2005 include certain favorable developments from prior years loss reserves. We did not experience similar reserve releases during the second quarter of 2004. During the second quarter of 2005, positive development on prior accident years casualty loss reserves resulted in additional pretax earnings of $16.1 million ($0.40 per diluted share). This amount is net of performance-related bonus accruals, which affected other insurance and general corporate expenses. Bonuses earned by executives, managers and associates are predominately influenced by corporate performance (operating earnings and return on capital), which advanced significantly during the quarter.
During the second quarter of 2005, we recorded $4.5 million in equity in earnings of unconsolidated investees, which included $3.9 million relating to Maui Jim. This result was up significantly from the $1.8 million recorded for the same period in 2004, as Maui Jim experienced exceptional seasonal sales results. Net sales for Maui Jim advanced 33% and gross margins have improved. Additionally, as a percentage of sales, operating expenses have declined in 2005. Operating expenses were higher in 2004 due to resources committed to marketing and expansion efforts.
Results for the second quarter of 2005 also include realized gains of $4.4 million, $0.11 per diluted share, compared to $1.9 million, $0.05 per diluted share for the same period last year.
Comprehensive earnings, which include net earnings plus unrealized gains/losses net of tax, totaled $48.1 million, $1.83 per diluted share, for the second quarter of 2005, compared to a comprehensive loss of $3.6 million, $0.14 per diluted share, for the same period in 2004. Unrealized gains, net of tax, for the second quarter of 2005 were $13.7 million, $0.52 per diluted share, compared to unrealized losses of $22.0 million, $0.85 per diluted share, for the same period in 2004. Results for 2005 were favorably impacted by improvements in the bond market, while second quarter 2004 results were negatively impacted by volatility in the bond market.
RLI INSURANCE GROUP
Gross premiums written for the Group were flat at $199.4 for the second quarter of 2005. Underwriting income improved to a pre-tax profit of $29.6 million for the second quarter of 2005, compared to $11.8 million for the same period in 2004, as the surety and casualty segments posted improvements. Results for the second quarter of 2005 were favorably impacted by prior accident years casualty reserve releases. The GAAP combined ratio totaled 76.1 for the second quarter of 2005, compared to 90.7 for the same period in 2004. The Groups loss ratio decreased to 39.9 for the second quarter of 2005, compared to 58.0 for 2004, reflective of the prior years reserve releases.