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 appear throughout this report. These statements relate to our current expectations, beliefs, intentions, goals or strategies regarding the future and are based on certain underlying assumptions by the Company. These forward looking statements generally include words such as "expect," "predict," "estimate," "will," "should," "anticipate," "believe" and similar expressions. Such assumptions are, in turn, based on information available and internal estimates and analyses of general economic conditions, competitive factors, conditions specific to the property and casualty insurance and reinsurance industries, claims development and the impact thereof on our loss reserves, the adequacy and financial security of our reinsurance programs, developments in the securities market and the impact on our investment portfolio, regulatory changes and conditions and other factors and are subject to various risks, uncertainties and other factors, including, without limitation those set forth in "Item 1A. Risk Factors" within the Annual Report on Form 10-K for the year endedDecember 31, 2019 and Part II within this report. Actual results could differ materially from those expressed in, or implied by, these forward looking statements. We assume no obligation to update any such statements. You should review the various risks, uncertainties and other factors listed from time to time in ourSecurities and Exchange Commission filings. 22 Table of Contents OVERVIEWRLI Corp. is aU.S. -based, specialty insurance company that underwrites select property and casualty insurance through major subsidiaries collectively known asRLI Insurance Group (Group). Our focus is on niche markets and developing unique products that are tailored to customers' needs. We hire underwriters and claim examiners with deep expertise and provide exceptional customer service and support. We maintain a highly diverse product portfolio and underwrite for profit in all market conditions. In 2019, we achieved our 24th consecutive year of underwriting profitability. Over the 24 year period, we averaged an 88.3 combined ratio. This drives our ability to provide shareholder returns in three different ways: the underwriting income itself, net investment income from our investment portfolio and long-term appreciation in our equity portfolio. We measure the results of our insurance operations by monitoring 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 combined ratios, which are further subdivided into their respective loss and expense components. 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, pandemics 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 coverages 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 be more or less than recorded amounts; if actual liabilities differ from recorded amounts, there will be an adverse or favorable effect on net earnings. The casualty portion of our business consists largely of commercial excess, personal umbrella, general liability, transportation and executive products coverages, as well as package business and other specialty coverages, such as professional liability and workers' compensation for office-based professionals. We also assume a limited amount of hard-to-place risks through a quota share reinsurance agreement. The casualty business is subject to the risk of estimating losses and related loss reserves because the ultimate settlement of a casualty claim may take several years to fully develop. The casualty segment is also subject to inflation risk and may be affected by evolving legislation and court decisions that define the extent of coverage and the amount of compensation due for injuries or losses. Our property segment is comprised primarily of commercial fire, earthquake, difference in conditions and marine coverages. We also offer select personal lines policies, including homeowners' coverages. Property insurance results are subject to the variability introduced by perils such as earthquakes, fires, hurricanes and other storms. Our major catastrophe exposure is to losses caused by earthquakes, primarily on theWest Coast . Our second largest catastrophe exposure is to losses caused by wind storms to commercial properties throughout the Gulf andEast Coast , as well as to homes we insure inHawaii . We seek to limit our net aggregate exposure to a catastrophic event by minimizing the total policy limits written in a particular region, purchasing reinsurance and maintaining consistent policy terms and conditions throughout insurance cycles. We also use computer-assisted modeling techniques to provide estimates that help the Company carefully manage the concentration of risks exposed to catastrophic events. The surety segment specializes in writing small to large-sized commercial and contract surety coverages, including payment and performance bonds. We also offer miscellaneous bonds including license and permit, notary and court bonds. Often, our surety coverages involve a statutory requirement for bonds. While these bonds typically maintain a relatively low loss ratio, losses may fluctuate due to adverse economic conditions affecting the financial viability of our principals. The contract surety product guarantees the construction work of a commercial contractor for a specific project. Generally, losses occur due to the deterioration of a contractor's financial condition. This line has historically produced marginally higher loss ratios than other surety lines during economic downturns. The insurance marketplace is intensely competitive across all of our segments. However, we believe that our business model is built to create underwriting income by focusing on sound risk selection and discipline. Our primary focus will continue to be on underwriting profitability, with a secondary focus on premium growth where we believe underwriting profit exists, as opposed to general premium growth or market share measurements. 23 Table of Contents
GAAP, non-GAAP and Performance Measures
Throughout this quarterly report, we include certain non-generally accepted accounting principles (non-GAAP) financial measures. Management believes that these non-GAAP measures further explain the Company's results of operations and allow for a more complete understanding of the underlying trends in the Company's business. These measures should not be viewed as a substitute for those determined in accordance with generally accepted accounting principles inthe United States of America (GAAP). In addition, our definitions of these items may not be comparable to the definitions used by other companies.
The 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.
Underwriting Income Underwriting income or profit represents one measure of the pretax profitability of our insurance operations and is derived by subtracting losses and settlement expenses, policy acquisition costs and insurance operating expenses from net premiums earned, which are all GAAP financial measures. Each of these captions is presented in the statements of earnings but is not subtotaled. However, this information is available in total and by segment in note 6 to the unaudited condensed consolidated interim financial statements in this quarterly report on Form 10-Q and in note 12 to the consolidated financial statements in our 2019 Annual Report on Form 10-K, regarding operating segment information. The nearest comparable GAAP measure is earnings before income taxes which, in addition to underwriting income, includes net investment income, net realized gains or losses, net unrealized gain or losses on equity securities, general corporate expenses, debt costs and our portion of earnings from unconsolidated investees. A reconciliation of net earnings to underwriting income follows: For the Three-Month Periods For the Six-Month Periods Ended June 30, Ended June 30, (in thousands) 2020 2019 2020 2019 Net earnings$ 92,166 $ 40,467 $ 30,899 $ 105,940 Income tax expense 22,713 8,361 4,616 24,629 Earnings before income taxes$ 114,879 $ 48,828 $ 35,515 $ 130,569 Equity in earnings of unconsolidated investees (5,100) (8,468) (9,614) (13,782) General corporate expenses 1,994 3,283 3,749 6,559 Interest expense on debt 1,903 1,861 3,800 3,722 Net unrealized (gains) losses on equity securities (74,705) (8,810) 55,690 (42,308) Net realized (gains) losses 2,109 (4,764) (13,043) (13,832) Net investment income (16,917) (16,998) (34,695) (33,563) Net underwriting income$ 24,163 $ 14,932 $ 41,402 $ 37,365 Combined Ratio The combined ratio, which is derived from components of underwriting income, is a common industry performance measure of profitability for underwriting operations and is calculated in two components. First, the loss ratio is losses and settlement expenses divided by net premiums earned. The second component, the expense ratio, reflects the sum of policy acquisition costs and insurance operating expenses divided by net premiums earned. All items included in these components of the combined ratio are presented in our GAAP consolidated financial statements. 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 income or loss. Critical Accounting Policies In preparing the unaudited condensed consolidated interim financial statements, we are 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 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, deferred policy acquisition costs and deferred taxes. For a detailed discussion of each of these policies, refer to our 2019 Annual Report on Form 10-K. 24 Table of Contents We adopted ASU 2016-13, Financial Instruments - Credit Losses, onJanuary 1, 2020 , which eliminated the concept of other-than-temporary impairment and required the recognition of a reversible allowance for credit losses on available-for-sale fixed income securities. See note 1. B. for more information on the adoption of the ASU. Available-for-sale securities in the fixed income portfolio are subjected to several criteria to determine if those securities should be included in the allowance for expected credit loss evaluation, including:
? Changes in technology that may impair the earnings potential of the investment,
? The discontinuance of a segment of business that may affect future earnings
potential,
? Reduction of or non-payment of interest and/or principal,
? Specific concerns related to the issuer's industry or geographic area of
operation,
? Significant or recurring operating losses, poor cash flows and/or deteriorating
liquidity ratios and
? Downgrades in credit quality by a major rating agency.
If changes in interest rates and credit spreads do not reasonably explain the unrealized loss for an available-for-sale security or if any of the criteria above indicate a potential credit loss, the security is subjected to a discounted cash flow analysis. Inputs into the discounted cash flow analysis include prepayment assumptions for structured securities, default rates and recoverability rates based on credit rating. The allowance for any security is limited to the amount that the securities fair value is below amortized cost. If we intend to sell a security or if we determine it is more likely than not that we will be required to sell a security before recovery of its amortized cost basis, any allowance for credit loss or unrealized loss would be written off and the amortized cost basis of the security would be written down to the security's fair value.
There have been no other significant changes to critical accounting policies during the year.
IMPACT OF COVID-19 The coronavirus (COVID-19) pandemic continues to impact individuals, businesses and the economy. As an employee-owned company, the health and well-being of our customers, partners and associates is our highest priority. While a large percentage of our associates are still working from home, our processes and controls continue to operate effectively and we have been able to maintain the highest service and support levels possible for our customers. It is difficult to predict how and to what extent the economic slowdown will have on our revenues in the coming months. To date, our most impacted product line has been public transportation. A large number of our passenger transportation customers have been unable to effectively operate under social-distancing protocols and stay-at-home orders. For the six-month period endedJune 30, 2020 , transportation gross written premium was down$33.3 million when compared to 2019. We would expect transportation premium to continue to be down from prior periods until the use of public transportation increases, which may not be until after there is a vaccine, effective treatment or significant reduction in cases. Additionally, slowdowns in the construction industry contributed to premium declines for our general liability and surety products in the second quarter. A number of our products support the construction industry and revenues may continue to be impacted to the extent this sector experiences disruption. However, we have many product lines that may see little to no impact on the amount of premium we write, including our personal lines products, management liability products and property businesses. We have been fair and flexible with our customers in regards to modifying exposures and payment terms and we are in compliance with any applicable state regulatory directives on such changes. Insureds continue to make payments in accordance with the agreed upon schedules and we have not experienced a material increase in the amount of expense associated with uncollectible receivables. The loss exposure arising out of the spread of COVID-19 and resulting shutdown will take time to resolve. We do not offer event cancellation, travel, trade credit or pandemic-related coverages which would be more directly impacted by the COVID-19 pandemic. The Company has received a number of claims, the majority of which relate to business interruption. We are reviewing the individual circumstances of each claim submitted and will fulfill our obligation to pay if coverage applies. The derivative implications that COVID-19 has on the economy may have negative implications on products that are correlated with the credit cycle, including, but not limited to, some of our executive products and surety offerings. In the second quarter of 2020,$5.8 million of net reserves were established to address the increased risk of loss and expense that emanated from the economic downturn brought on by the pandemic. Combined with the reserves established in the first quarter 25
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that addressed the expected increase in costs to investigate and defend business
interruption claims,
Actuarial models base future emergence on historic experience, with adjustments for current trends, and the appropriateness of these assumptions involved greater uncertainty as ofJune 30, 2020 . We expect there will be impacts to the timing of loss emergence and ultimate loss ratios for certain coverages. The industry is experiencing new issues, including the postponement of civil court cases, the extension of various statutes of limitations, changes in settlement trends and a significant reduction in economic activity and insured exposure in some classes. Our booked reserves include consideration of these factors, but the duration and degree to which these issues persist, along with potential legislative, regulatory or judicial actions, could result in loss reserve deficiencies and reduce earnings in future periods. We continue to evaluate opportunities for expense savings and efficiencies and have taken targeted actions to reduce or defer expenses, including certain hiring freezes, position consolidations and executive merit increase suspensions. Travel was limited and any decision on granting share-based compensation, which normally takes place at our May board meeting, was deferred until a later date, resulting in a reduced level of compensation expense in the second quarter. Bonus and profit sharing expense is correlated with company performance and is responsible for the largest portion of the total expense decline for the six-month period endedJune 30 , when compared to 2019. The performance-related expenses recognized for the 2020 fiscal year will be dependent on the full year's results and may increase or decrease in the second half of the year. Although we have recovered a large portion of the market value declines recorded in the first quarter, equity securities have not fully returned to levels recorded at year end. Net after-tax realized and unrealized losses on equity securities were$33.9 million in the first half of 2020. Conversely, lower interest rates increased the fair value of the fixed income portfolio, which resulted in$40.5 million of after-tax other comprehensive earnings for the six-month period endedJune 30, 2020 . With the decline in yields, reinvestment rates are now lower than in previous years, which will cap the portfolio's ability to generate higher levels of investment income, absent a larger invested asset base.Maui Jim, Inc. (Maui Jim ) andPrime Holdings Insurance Services, Inc. (Prime) continued to contribute towards positive net earnings. While earnings for Prime were modestly higher,Maui Jim results were negatively impacted by the shutdown much of the traditional retail sector experienced during the second quarter. The economic downturn may continue to impact the results of these investees, particularly if there is any lasting impact on the retail sector as it relates toMaui Jim . We produced solid operating results in the first half of the year and believe our financial position has remained strong despite the impact of the COVID-19 pandemic. We generated$83.8 million of net operating cash inflows and believe we have adequate liquidity. Our revolving credit facility provides for a borrowing capacity of$60.0 million , which can be increased to$120.0 million under certain circumstances. Additionally, our membership in theFederal Home Loan Bank system provides a secured lending facility with an aggregate borrowing capacity of approximately$30.0 million . There were no amounts outstanding under any of these facilities as ofJune 30, 2020 . In addition to the$160.7 million of cash and other investments maturing within one year as ofJune 30, 2020 , we believe that cash generated from operations, the liquidity of our fixed income portfolio and our unused lines of credit provide sufficient sources of cash to meet our anticipated needs over the next 12 to 24 months. Ultimately, the extent to which COVID-19 will impact our business will be influenced by how long it takes for the economy to recover. We continue to evaluate all aspects of our operations and are making necessary adjustments to manage our business. Our diversified portfolio of products and financial strength have allowed us to remain on solid footing. We believe we have a strong and sustainable underwriting approach that will allow us to weather the economic downturn and uncertainty we are currently experiencing. RESULTS OF OPERATIONS
Six Months Ended
Consolidated revenue for the first half of 2020 decreased$85.6 million from the first half of 2019 as performance in the equity portfolio varied significantly between the periods. Overall market declines resulted in$55.7 million of unrealized losses on equity securities in 2020, while positive returns generated$42.3 million of unrealized gains in our equity portfolio in the first half of 2019. Net premiums earned for the Group increased 3 percent, driven by growth from our casualty and property segments. Investment income increased 3 percent due to a larger asset base relative to the prior year. Realized gains during the first half were$13.0 million and were comprised of$12.8 million of realized gains on equity securities from rebalancing our portfolio,$2.6 million of realized gains on the fixed income portfolio and$2.4 million of other realized losses. This compares 26 Table of Contents
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