Toggle SGML Header (+)


Section 1: 10-Q (10-Q)

rli-Current Folio_10Q

Table of Contents

13

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended September 30, 2018

 

or

 

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from                 to                

 

Commission File Number:    001-09463

 

RLI Corp.

(Exact name of registrant as specified in its charter)

 

 

 

 

Delaware

 

37-0889946

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

 

 

 

9025 North Lindbergh Drive, Peoria, IL

 

61615

(Address of principal executive offices)

 

(Zip Code)

 

(309) 692-1000

(Registrant’s telephone number, including area code)

 

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.   Yes  ☒    No ☐

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).   Yes  ☒    No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

 

 

Large accelerated filer ☒

 

Accelerated filer ☐

 

 

 

Non-accelerated filer ☐

 

Smaller reporting company ☐

 

 

 

 

 

Emerging growth company ☐

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ☐   No ☒

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

As of October 12, 2018, the number of shares outstanding of the registrant’s Common Stock was 44,484,654.

 

 

 

 

 

 


 

Table of Contents

 

 

Table of Contents

 

 

 

 

 

 

 

 

 

 

Page

 

 

 

 

Part I - Financial Information 

3

 

 

 

 

 

Item 1. 

Financial Statements

3

 

 

 

 

 

 

Condensed Consolidated Statements of Earnings and Comprehensive Earnings For the Three and Nine-Month Periods Ended September 30, 2018 and 2017 (unaudited)

3

 

 

 

 

 

Condensed Consolidated Balance Sheets as of September 30, 2018 (unaudited) and December 31, 2017

4

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows For the Nine-Month Periods Ended September 30, 2018 and 2017 (unaudited)

5

 

 

 

 

 

 

Notes to unaudited condensed consolidated interim financial statements

6

 

 

 

 

 

Item 2.

Management’s discussion and analysis of financial condition and results of operations

23

 

 

 

 

 

Item 3. 

Quantitative and qualitative disclosures about market risk

37

 

 

 

 

 

Item 4. 

Controls and procedures

37

 

 

 

 

Part II - Other Information 

37

 

 

 

 

 

Item 1.

Legal proceedings

37

 

 

 

 

 

Item 1a.

Risk factors

37

 

 

 

 

 

Item 2.

Unregistered sales of equity securities and use of proceeds

37

 

 

 

 

 

Item 3.

Defaults upon senior securities

37

 

 

 

 

 

Item 4.

Mine safety disclosures

37

 

 

 

 

 

Item 5.

Other information

37

 

 

 

 

 

Item 6.

Exhibits

38

 

 

 

 

Signatures 

 

39

 

 

 

 

2


 

Table of Contents

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Earnings and Comprehensive Earnings

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Three-Month Periods

 

For the Nine-Month Periods

 

 

Ended September 30,

 

Ended September 30,

(in thousands, except per share data)

 

2018

 

2017

 

2018

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Net premiums earned

   

$

200,815

    

$

182,025

 

$

587,364

 

$

549,641

Net investment income

 

 

16,314

 

 

14,187

 

 

45,123

 

 

40,430

Net realized gains

 

 

18,808

 

 

35

 

 

48,117

 

 

1,390

Other-than-temporary impairment (OTTI) losses on investments

 

 

(161)

 

 

 -

 

 

(217)

 

 

(2,090)

Net unrealized gains (losses) on equity securities

 

 

4,848

 

 

 -

 

 

(34,535)

 

 

 -

Consolidated revenue

 

$

240,624

 

$

196,247

 

$

645,852

 

$

589,371

Losses and settlement expenses

 

 

110,231

 

 

123,190

 

 

304,305

 

 

306,927

Policy acquisition costs

 

 

68,414

 

 

62,066

 

 

201,473

 

 

186,264

Insurance operating expenses

 

 

14,408

 

 

11,701

 

 

42,191

 

 

38,582

Interest expense on debt

 

 

1,862

 

 

1,856

 

 

5,576

 

 

5,569

General corporate expenses

 

 

2,947

 

 

1,956

 

 

7,871

 

 

7,816

Total expenses

 

$

197,862

 

$

200,769

 

$

561,416

 

$

545,158

Equity in earnings of unconsolidated investees

 

 

3,587

 

 

3,660

 

 

15,853

 

 

15,404

Earnings (loss) before income taxes

 

$

46,349

 

$

(862)

 

$

100,289

 

$

59,617

Income tax expense (benefit)

 

 

6,977

 

 

(2,596)

 

 

15,450

 

 

11,847

Net earnings

 

$

39,372

 

$

1,734

 

$

84,839

 

$

47,770

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive earnings (loss), net of tax

 

 

(7,696)

 

 

8,444

 

 

(41,769)

 

 

30,812

Comprehensive earnings

 

$

31,676

 

$

10,178

 

$

43,070

 

$

78,582

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

Basic:

 

 

 

 

 

 

 

 

 

 

 

 

Basic net earnings per share

 

$

0.89

 

$

0.04

 

$

1.91

 

$

1.09

Basic comprehensive earnings per share

 

$

0.71

 

$

0.23

 

$

0.97

 

$

1.79

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted:

 

 

 

 

 

 

 

 

 

 

 

 

Diluted net earnings per share

 

$

0.88

 

$

0.04

 

$

1.90

 

$

1.07

Diluted comprehensive earnings per share

 

$

0.70

 

$

0.23

 

$

0.96

 

$

1.77

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average number of common shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

44,400

 

 

44,058

 

 

44,311

 

 

44,008

Diluted

 

 

44,940

 

 

44,515

 

 

44,760

 

 

44,517

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash dividends paid per common share

 

$

0.22

 

$

0.21

 

$

0.65

 

$

0.62

 

See accompanying notes to the unaudited condensed consolidated interim financial statements.

 

3


 

Table of Contents

RLI Corp. and Subsidiaries

Condensed Consolidated Balance Sheets

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30,

 

December 31,

(in thousands, except share data)

    

2018

    

2017

 

 

 

 

 

 

 

ASSETS

   

 

 

   

 

 

Investments and cash:

 

 

 

 

 

 

Fixed income:

 

 

 

 

 

 

Available-for-sale, at fair value (amortized cost - $1,745,648 at 9/30/18 and $1,646,411 at 12/31/17)

 

$

1,719,617

 

$

1,672,239

Equity securities, at fair value (cost - $210,119 at 9/30/18 and $182,002 at 12/31/17)

 

 

394,375

 

 

400,492

Short-term investments, at cost which approximates fair value

 

 

18,526

 

 

9,980

Other invested assets

 

 

38,777

 

 

33,808

Cash

 

 

59,469

 

 

24,271

Total investments and cash

 

$

2,230,764

 

$

2,140,790

Accrued investment income

 

 

14,417

 

 

15,166

Premiums and reinsurance balances receivable, net of allowances for uncollectible amounts of $17,076 at 9/30/18 and $16,935 at 12/31/17

 

 

138,480

 

 

134,351

Ceded unearned premium

 

 

66,400

 

 

57,928

Reinsurance balances recoverable on unpaid losses and settlement expenses, net of allowances for uncollectible amounts of $9,827 at 9/30/18 and $10,014 at 12/31/17

 

 

320,027

 

 

301,991

Deferred policy acquisition costs

 

 

84,232

 

 

77,716

Property and equipment, at cost, net of accumulated depreciation of $52,418 at 9/30/18 and $47,676 at 12/31/17

 

 

55,469

 

 

55,849

Investment in unconsolidated investees

 

 

95,007

 

 

90,067

Goodwill and intangibles

 

 

54,626

 

 

59,302

Other assets

 

 

14,100

 

 

14,084

TOTAL ASSETS

 

$

3,073,522

 

$

2,947,244

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

Unpaid losses and settlement expenses

 

$

1,377,111

 

$

1,271,503

Unearned premiums

 

 

483,305

 

 

451,449

Reinsurance balances payable

 

 

18,396

 

 

21,624

Funds held

 

 

73,304

 

 

74,560

Income taxes-deferred

 

 

38,260

 

 

53,768

Bonds payable, long-term debt

 

 

149,068

 

 

148,928

Accrued expenses

 

 

45,420

 

 

52,848

Other liabilities

 

 

16,802

 

 

18,966

TOTAL LIABILITIES

 

$

2,201,666

 

$

2,093,646

 

 

 

 

 

 

 

Shareholders’ Equity

 

 

 

 

 

 

Common stock ($0.01 par value at 9/30/18 and $1.00 par value at 12/31/17)

 

 

 

 

 

 

(100,000,000 shares authorized at 9/30/18 and 12/31/17)

 

 

 

 

 

 

(67,414,868 shares issued, 44,484,654 shares outstanding at 9/30/18)

 

 

 

 

 

 

(67,078,569 shares issued, 44,148,355 shares outstanding at 12/31/17)

 

$

674

 

$

67,079

Paid-in capital

 

 

303,399

 

 

233,077

Accumulated other comprehensive earnings

 

 

(22,344)

 

 

157,919

Retained earnings

 

 

983,126

 

 

788,522

Deferred compensation

 

 

7,765

 

 

8,640

Less: Treasury shares at cost

 

 

 

 

 

 

(22,930,214 shares at 9/30/18 and 12/31/17)

 

 

(400,764)

 

 

(401,639)

TOTAL SHAREHOLDERS’ EQUITY

 

$

871,856

 

$

853,598

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

 

$

3,073,522

 

$

2,947,244

 

See accompanying notes to the unaudited condensed consolidated interim financial statements.

4


 

Table of Contents

RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Nine-Month Periods

 

 

Ended September 30,

(in thousands)

 

2018

 

2017

 

 

 

 

 

 

 

Net cash provided by operating activities

    

$

163,369

    

$

145,933

Cash Flows from Investing Activities

 

 

 

 

 

 

Investments purchased

 

$

(636,859)

 

$

(335,361)

Investments sold

 

 

444,637

 

 

131,605

Investments called or matured

 

 

102,244

 

 

103,193

Net change in short-term investments

 

 

(8,546)

 

 

(6,910)

Net property and equipment purchased

 

 

(4,838)

 

 

(7,262)

Other

 

 

89

 

 

408

Net cash used in investing activities

 

$

(103,273)

 

$

(114,327)

 

 

 

 

 

 

 

Cash Flows from Financing Activities

 

 

 

 

 

 

Cash dividends paid

 

$

(28,815)

 

$

(27,288)

Stock plan share issuance

 

 

3,917

 

 

4,290

Net cash used in financing activities

 

$

(24,898)

 

$

(22,998)

 

 

 

 

 

 

 

Net increase in cash

 

$

35,198

 

$

8,608

 

 

 

 

 

 

 

Cash at the beginning of the period

 

$

24,271

 

$

18,269

Cash at September 30

 

$

59,469

 

$

26,877

 

See accompanying notes to the unaudited condensed consolidated interim financial statements.

 

 

5


 

Table of Contents

NOTES TO UNAUDITED CONDENSED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

 

1.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

A.  DESCRIPTION OF BUSINESS

 

RLI Corp. (the “Company”) is an insurance holding company that was organized in 1965. On May 4, 2018, RLI Corp. changed its state of incorporation from the State of Illinois to the State of Delaware (the “Reincorporation”). The Reincorporation was effected by merging RLI Corp., an Illinois corporation (“RLI Illinois”) into RLI Corp., a Delaware corporation (“RLI Delaware”). The separate corporate existence of RLI Illinois ceased and RLI Delaware continues in existence as the surviving corporation and possesses all rights, privileges, powers and franchises of RLI Illinois. The Reincorporation did not result in any change in the name, business, management, fiscal year, location of the principal executive offices, assets or liabilities of the Company. Each outstanding share of RLI Illinois common stock, which had a par value of $1.00 per share, was automatically converted into one outstanding share of RLI Delaware common stock, with a par value of $0.01 per share. In order to reflect the new par value of common stock on the balance sheet, a $66.6 million reclassification from common stock to paid-in-capital was made during the second quarter. For more information on the Reincorporation, see RLI Corp.’s Form 8-K filed on May 7, 2018.

 

B.  BASIS OF PRESENTATION

 

The unaudited condensed consolidated interim financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (GAAP) for interim financial reporting and with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the disclosures required by GAAP for complete financial statements. As such, these unaudited condensed consolidated interim financial statements should be read in conjunction with our 2017 Annual Report on Form 10-K. Management believes that the disclosures are adequate to make the information presented not misleading, and all normal and recurring adjustments necessary to present fairly the financial position at September 30, 2018 and the results of operations of RLI Corp. and subsidiaries for all periods presented have been made. The results of operations for any interim period are not necessarily indicative of the operating results for a full year. Certain reclassifications were made to 2017 to conform to the classifications used in the current year.

 

The preparation of the unaudited condensed consolidated interim financial statements requires management to make estimates and assumptions relating to the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the unaudited condensed consolidated interim financial statements and the reported amounts of revenue and expenses during the period. These estimates are inherently subject to change and actual results could differ significantly from these estimates.

 

C.  ADOPTED ACCOUNTING STANDARDS

 

ASU 2014-09, Revenue from Contracts with Customers (Topic 606)

 

ASU 2014-09 was issued to clarify and remove inconsistencies within revenue recognition requirements. The core principle of the update is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, the transaction price for a contract is allocated among separately identifiable performance obligations and a portion of the transaction price is recognized as revenue when the associated performance obligation has been completed or transferred to the customer. All contracts and fulfillment activities within the scope of Topic 944, Financial Services – Insurance, investment income, investment related gains and losses and equity in earnings of unconsolidated investees are outside the scope of this ASU.

 

We adopted ASU 2014-09 on January 1, 2018. However, nearly all (over 99 percent) of our consolidated revenue is scoped out and therefore exempt from the guidance contained within this ASU. For the remaining portion, the revenue recognition policy we utilize aligns with the new guidance and there were no changes to the way we recognize revenue. Although the recognition of earnings from equity method investees is out of scope from the update, the recognition of revenue by our equity method investees would be subject to the new guidance if the revenue streams are within this update’s scope. Any impact on revenues would affect the net income of each of the equity method investees, upon which we calculate our portion of earnings to recognize. Our equity method investees are private companies and this guidance becomes effective for private companies in periods beginning after December 15, 2018. As a result, their earnings and our portion of those earnings

6


 

Table of Contents

are not impacted in 2018. We expect that revenue generated by both of our equity method investees will either be outside the scope of this update or largely unaffected by the changes.

 

 ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities

 

This ASU was issued to improve the recognition and measurement of financial instruments. The new guidance makes targeted improvements to GAAP as follows:

a.

Requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net earnings;

b.

Simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment;

c.

Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet;

d.

Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes;

e.

Requires an entity to present separately in other comprehensive earnings the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments;

f.

Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; and

g.

Clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets.

 

We adopted ASU 2016-01 on January 1, 2018. A cumulative-effect adjustment to the balance sheet was made as of the beginning of the year, which moved $142.2 million of net unrealized gains and losses on equity securities from accumulated other comprehensive earnings to retained earnings. During the first nine months of 2018, we recognized $34.5 million of unrealized losses on equity securities within net earnings and $7.3 million of income tax benefit. This compares to $14.6 million of unrealized gains on equity securities, net of tax, that was recognized through other comprehensive earnings for the comparable period in 2017. The future impact to our net earnings will vary depending upon the level of volatility in the performance of the securities held in our equity portfolio and the overall market.

 

ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments

 

ASU 2016-15 was issued to reduce the diversity in practice of how certain cash receipts and payments, for which current guidance is silent, are classified in the statement of cash flows. The update addresses eight specific issues, including contingent consideration payments made after a business combination, distributions received from equity method investees and the classification of cash receipts and payments that have aspects of more than one class of cash flows. We adopted ASU 2016-15 on January 1, 2018. The adoption did not have a material impact on our statement of cash flows.

 

ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income

 

ASU 2018-02 was issued as a result of the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA) on December 22, 2017. Accounting guidance required deferred tax items to be revalued based on the new tax laws (the most significant of which reduced the corporate tax rate to 21 percent from 35 percent) with the change included in income from continuing operations. Since other comprehensive income was not affected by the revaluation of the deferred tax items, the net accumulated other comprehensive income (AOCI) balance was reflective of the historic 35 percent tax rate instead of the newly enacted rate, a difference that is referred to as a stranded tax effect. This ASU allows for the option to reclassify the stranded tax effects resulting from the implementation of the TCJA out of AOCI and into retained earnings. ASU 2018-02 does not replace the guidance requiring changes from the enactment of other tax laws or rates to be included within income from continuing operations and is applicable only to changes from the TCJA.

 

We adopted ASU 2018-02 during the first quarter of 2018. A current period adjustment was made to the balance sheet, which moved $3.7 million of stranded tax effects on the unrealized balances of our fixed income securities and equity method investees from accumulated other comprehensive earnings to retained earnings. The entire unrealized balance on equity securities was reclassified from AOCI into retained earnings from the adoption of ASU 2016-01 on January 1, 2018 and was

7


 

Table of Contents

therefore unaffected by this ASU. As there was no impact to net earnings and the balance sheet effect is limited to a reclassification within the equity section, there was not a material impact on our financial statements.

 

D.  PROSPECTIVE ACCOUNTING STANDARDS

 

 ASU 2016-02, Leases (Topic 842)

 

ASU 2016-02 was issued to improve the financial reporting of leasing transactions. Under current guidance for lessees, leases are only included on the balance sheet if certain criteria, classifying the agreement as a capital lease, are met. This update will require the recognition of a right-of-use asset and a corresponding lease liability, discounted to the present value, for all leases that extend beyond 12 months. For operating leases, the asset and liability will be expensed over the lease term on a straight-line basis, with all cash flows included in the operating section of the statement of cash flows. For finance leases, interest on the lease liability will be recognized separately from the amortization of the right-of-use asset in the statement of comprehensive income and the repayment of the principal portion of the lease liability will be classified as a financing activity while the interest component will be included in the operating section of the statement of cash flows.

 

This ASU is effective for annual and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. ASU 2018-10, Codification Improvements to Topic 842, Leases was issued to clarify certain aspects of ASU 2016-02 and the two updates will be adopted concurrently. ASU 2016-02 requires leases to be recognized and measured at the beginning of the earliest period presented using a modified retrospective approach upon adoption. However, ASU 2018-11, Leases (Topic 842): Targeted Improvements provides an alternative transition method by which leases are recognized at the date of adoption and a cumulative-effective adjustment to the opening balance of retained earnings is recognized in the period of adoption. We plan to adopt using this alternative. Approximately $33 million of undiscounted future lease liabilities would have to be discounted to present value and added to our balance sheet with a corresponding right-of-use asset if the guidance were applicable on September 30, 2018. We do not have any financing leases, but we do have approximately $7 million of annual operating lease expenses. We do not expect that there will be a materially different annual rental expense upon adoption.

 

ASU 2016-13, Financial Instruments – Credit Losses (Topic 326)

 

ASU 2016-13 was issued to provide more decision-useful information about the expected credit losses on financial instruments. Current GAAP delays the recognition of credit losses until it is probable a loss has been incurred. The update will require a financial asset measured at amortized cost, including reinsurance balances recoverable, to be presented at the net amount expected to be collected by means of an allowance for credit losses that runs through net earnings. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses. However, the amendments would limit the amount of the allowance to the amount by which fair value is below amortized cost. The measurement of credit losses on available-for-sale securities is similar under current GAAP, but the update requires the use of the allowance account through which amounts can be reversed, rather than through an irreversible write-down.

 

This ASU is effective for annual and interim reporting periods beginning after December 15, 2019. Early adoption is permitted beginning after December 15, 2018. Upon adoption, the update will be applied using the modified-retrospective approach, by which a cumulative-effect adjustment will be made to retained earnings as of the beginning of the first reporting period presented. This update will have the most impact on our available-for-sale fixed income portfolio and reinsurance balances recoverable. However, as our fixed income portfolio is weighted towards higher rated bonds (82.8 percent rated A or better at September 30, 2018), we purchase reinsurance from financially strong reinsurers and we already have an allowance for uncollectible reinsurance amounts, we do not expect that the effect of adoption will be material.

 

ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities

 

Under current practices, the amortization period for callable debt securities held at a premium is generally the contractual life of the instrument. However, if an entity has a large number of similar loans, it may consider estimates of future principal prepayments. For those who choose to not incorporate an estimate of future prepayments, ASU 2017-08 shortens the amortization period for premium on debt securities to the earliest call date, rather than the maturity date, to align the amortization method with how the securities are quoted, priced and traded. After the earliest call date, if the call option is not exercised, the entity shall reset the effective yield using the payment terms of the debt security. Any excess of the amortized cost basis over the amount payable will be amortized to the next call date or to maturity if there are no other call dates. The method of accounting for a discount does not change and will continue to be amortized over the life of the bond.

8


 

Table of Contents

 

This ASU is effective for annual and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. The update will be applied using a modified retrospective basis through a cumulative-effect adjustment to retained earnings as of the beginning of the period of adoption. As we currently incorporate estimates of future principal prepayments when calculating the effective yield for bonds carrying a premium, we do not expect the adoption of this update to have a material impact on our financial statements.

 

ASU 2018-07, Compensation-Stock Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment Accounting

 

ASU 2018-07 was issued to simplify the accounting for share-based transactions by expanding the scope of Topic 718 from only being applicable to share-based payments to employees to also include share-based payment transactions for acquiring goods and services from nonemployees. As a result, nonemployee share-based transactions will be measured by estimating the fair value of the equity instruments at the grant date, taking into consideration the probability of satisfying performance conditions. This ASU is effective for annual and interim reporting periods beginning after December 15, 2018. Early adoption is permitted. Our long term incentive plan limits the awards of share-based payments to employees and directors of the Company or any affiliate. The share-based compensation expense to nonemployee directors was $0.2 million in the first nine months of 2018. Costs associated with such payments are not expected to materially increase and we do not expect this update to have a material impact on our financial statements.

 

ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement

 

ASU 2018-13 modifies the disclosure requirements for assets and liabilities measured at fair value. The requirements to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, the policy for timing of transfers between levels and the valuation processes for Level 3 fair value measurements have all been removed. However, the changes in unrealized gains and losses included in other comprehensive income for recurring Level 3 fair value measurements held at the end of the reporting period must be disclosed along with the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements (or other quantitative information if it is more reasonable). Finally, for investments measured at net asset value, the requirements have been modified so that the timing of liquidation and the date when restrictions from redemption might lapse are only disclosed if the investee has communicated the timing to the entity or announced the timing publicly.

 

This ASU is effective for annual and interim reporting periods beginning after December 15, 2019. As the amendments are only disclosure related and we do not currently have any assets or liabilities that are measured based on Level 3 inputs, our financial statements will not be materially impacted by this update.

 

ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement that is a Service Contract

 

ASU 2018-15 requires a customer in a cloud computing arrangement (i.e. hosting arrangement) that is a service contract to follow the internal-use software guidance to determine which implementation costs to capitalize as assets or expense as incurred. Relevant implementation costs in the development stage are capitalized, while costs incurred during the preliminary project and post-implementation stages are expensed as the activities are performed. Capitalized costs are expensed over the term of the hosting arrangement. This ASU is effective for annual and interim reporting periods beginning after December 15, 2019. Early adoption is permitted. This update can either be applied retrospectively or prospectively to all implementation costs incurred after the date of adoption. We have not yet completed the analysis of how adopting this ASU will affect our financial statements.

 

E.  INTANGIBLE ASSETS

 

Goodwill and intangible assets totaled $54.6 million and $59.3 million at September 30, 2018 and December 31, 2017, respectively, as detailed in the following table.

 

9


 

Table of Contents

 

 

 

 

 

 

 

Goodwill and Intangible Assets

 

 

September 30,

 

 

December 31,

(in thousands)

 

 

2018

 

 

2017

Goodwill

 

 

 

 

 

 

Energy surety

 

$

25,706

 

$

25,706

Miscellaneous and contract surety

 

 

15,110

 

 

15,110

Small commercial

 

 

5,246

 

 

5,246

Medical professional liability *

 

 

 -

 

 

3,595

Total goodwill

 

$

46,062

 

$

49,657

 

 

 

 

 

 

 

Intangibles

 

 

 

 

 

 

State insurance licenses

 

$

7,500

 

$

7,500

Definite-lived intangibles, net of accumulated amortization of $2,929 at 9/30/18 and $5,678 at 12/31/17

 

 

1,064

 

 

2,145

Total intangibles

 

$

8,564

 

$

9,645

 

 

 

 

 

 

 

Total goodwill and intangibles

 

$

54,626

 

$

59,302


*   The medical professional liability goodwill balance reflects a cumulative non-cash impairment charge of $12.4 million and $8.8 million as of September 30, 2018 and December 31, 2017, respectively.

 

All definite-lived intangible assets are amortized against future operating results based on their estimated useful lives. Amortization of intangible assets was $0.1 million for the third quarter of 2018 and $0.3 million for the nine-month period ended September 30, 2018, compared to $0.2 million for the third quarter of 2017 and $0.6 million for the nine-month period ended September 30, 2017.

 

Annual impairment testing was performed on our energy surety goodwill, miscellaneous and contract surety goodwill, small commercial goodwill and state insurance license indefinite-lived intangible asset during the second quarter of 2018. Based upon these reviews, none of the assets were impaired. In addition, as of September 30, 2018, there were no triggering events that would suggest an updated review was necessary on the above mentioned goodwill and intangible assets.

 

As previously disclosed, adverse loss experience triggered the need to test the medical professional liability reporting unit during the first quarter of 2018 and the second quarter of 2017. The testing resulted in a $4.4 million non-cash impairment charge in 2018 and a $3.4 million non-cash impairment charge in 2017. In each instance, a fair value for the medical professional liability reporting unit’s agency relationships, carried as a definite-lived intangible, was determined by using a discounted cash flow valuation. In 2018, the carrying value exceeded the fair value, resulting in a $0.8 million non-cash impairment charge. In 2017, the resulting non-cash impairment charge on definite-lived intangibles was $1.8 million. A fair value for the medical professional liability reporting unit’s goodwill was determined by using a weighted average of a market approach and discounted cash flow valuation. The carrying value exceeded the fair value in each year, resulting in a $3.6 million non-cash impairment charge in the first quarter of 2018 and a $1.6 million non-cash impairment charge during the second quarter of 2017. Subsequent to the first quarter 2018 impairment, the medical professional liability reporting unit had no remaining goodwill or intangible assets. All impairment charges were recorded as net realized losses in the respective period’s consolidated statement of earnings.

 

F.  EARNINGS PER SHARE

 

Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common shareholders 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 or 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 anti-dilutive. Under these circumstances, the diluted net earnings or net loss per share is computed excluding the common stock equivalents. The following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the unaudited condensed consolidated interim financial statements.

10


 

Table of Contents

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Three-Month Period

 

For the Three-Month Period

 

 

Ended September 30, 2018

 

Ended September 30, 2017

 

 

Income

 

Shares

 

Per Share

 

Income

 

Shares

 

Per Share

(in thousands, except per share data)

    

(Numerator)

    

(Denominator)

    

Amount

    

(Numerator)

    

(Denominator)

    

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic EPS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income available to common shareholders

   

$

39,372

    

44,400

    

$

0.89

    

$

1,734

    

44,058

    

$

0.04

Effect of Dilutive Securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock options

 

 

 -

 

540

 

 

 

 

 

 -

 

457

 

 

 

Diluted EPS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income available to common shareholders

 

$

39,372

 

44,940

 

$

0.88

 

$

1,734

 

44,515

 

$

0.04

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Nine-Month Period

 

For the Nine-Month Period

 

 

Ended September 30, 2018

 

Ended September 30, 2017

 

 

Income

 

Shares

 

Per Share

 

Income

 

Shares

 

Per Share

(in thousands, except per share data)

    

(Numerator)

    

(Denominator)

    

Amount

    

(Numerator)

    

(Denominator)

    

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic EPS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income available to common shareholders

   

$

84,839

    

44,311

    

$

1.91

    

$

47,770

    

44,008

    

$

1.09

Effect of Dilutive Securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock options

 

 

 -

 

449

 

 

 

 

 

 -

 

509

 

 

 

Diluted EPS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income available to common shareholders

 

$

84,839

 

44,760

 

$

1.90

 

$

47,770

 

44,517

 

$

1.07

 

G.  COMPREHENSIVE EARNINGS

 

Our comprehensive earnings include net earnings plus after-tax unrealized gains and losses on our fixed income portfolio in 2018. In 2017, after-tax unrealized gains and losses on our equity portfolio were also included. With the adoption of ASU 2016-01 on January 1, 2018, we began recognizing unrealized gains and losses on the equity portfolio through net income. See note 1.C to the unaudited condensed consolidated interim financial statements for more information. In reporting comprehensive earnings on a net basis in the statement of earnings, we used the federal statutory tax rate of 21 percent in 2018 and 35 percent in 2017.

 

Unrealized losses, net of tax, on the fixed income portfolio for the first nine months of 2018 were $41.8 million, compared to $30.8 million of unrealized gains, net of tax, on the fixed income and equity portfolios during the same period last year. Unrealized losses in the first nine months of 2018 were attributable to rising interest rates, which decreased the fair value of securities held in the fixed income portfolio. In 2017, unrealized gains were primarily the result of tightening credit spreads which increased the fair value of fixed income securities, though positive pricing movements in equity securities also contributed.

 

The following table illustrates the changes in the balance of each component of accumulated other comprehensive earnings for each period presented in the unaudited condensed consolidated interim financial statements. The 2017 activity and balances include the net unrealized gain and loss activity on both fixed income and equity securities, while the 2018 activity and ending balance reflect only the net unrealized gain and loss activity on fixed income securities due to the aforementioned adoption of ASU 2016-01.

 

11


 

Table of Contents

 

 

 

 

 

 

 

 

 

 

 

 

 

(in thousands)

 

For the Three-Month Periods

 

For the Nine-Month Periods

 

 

Ended September 30,

 

Ended September 30,

Unrealized Gains/Losses on Available-for-Sale Securities

    

2018

    

2017

    

2018

    

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Beginning balance

 

$

(14,648)

 

$

144,978

 

$

157,919

 

$

122,610

Cumulative effect adjustment of ASU 2016-01

 

 

 -

 

 

 -

 

 

(142,219)

 

 

 -

Adjusted beginning balance

 

$

(14,648)

 

$

144,978

 

$

15,700

 

$

122,610

Other comprehensive earnings before reclassifications

 

 

(7,034)

 

 

9,141

 

 

(41,829)

 

 

33,066

Amounts reclassified from accumulated other comprehensive earnings

 

 

(662)

 

 

(697)

 

 

60

 

 

(2,254)

Net current-period other comprehensive earnings (loss)

 

$

(7,696)

 

$

8,444

 

$

(41,769)

 

$

30,812

Reclassification of stranded tax effect per ASU 2018-02

 

 

 -

 

 

 -

 

 

3,725

 

 

 -

Ending balance

 

$

(22,344)

 

$

153,422

 

$

(22,344)

 

$

153,422

 

The sale or other-than-temporary impairment of an available-for-sale security results in amounts being reclassified from accumulated other comprehensive earnings to current period net earnings. The effects of reclassifications out of accumulated other comprehensive earnings by the respective line items of net earnings are presented in the following table. As previously mentioned, 2018 activity is reflective of activity on fixed income securities classified as available-for-sale, while 2017 also includes activity from the equity portfolio.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amount Reclassified from Accumulated Other

 

 

(in thousands)

 

Comprehensive Earnings

 

 

 

 

For the Three-Month

 

For the Nine-Month

 

 

Component of Accumulated 

 

Periods Ended September 30, 

 

Periods Ended September 30, 

 

Affected line item in the

Other Comprehensive Earnings

    

2018

    

2017

    

2018

    

2017

    

Statement of Earnings

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized gains and losses on available-for-sale securities

 

$

999

 

$

1,073

 

$

141

 

$

5,558

 

Net realized gains (losses)

 

 

 

(161)

 

 

 -

 

 

(217)

 

 

(2,090)

 

Other-than-temporary impairment (OTTI) losses on investments

 

 

$

838

 

$

1,073

 

$

(76)

 

$

3,468

 

Earnings (loss) before income taxes

 

 

 

(176)

 

 

(376)

 

 

16

 

 

(1,214)

 

Income tax expense (benefit)

 

 

$

662

 

$

697

 

$

(60)

 

$

2,254

 

Net earnings (loss)

 

 

2.    INVESTMENTS

 

Our investments are primarily composed of fixed income debt securities and common stock equity securities. We carry our equity securities at fair value and categorize all of our debt securities as available-for-sale, which are carried at fair value. When available, we obtain quoted market prices to determine fair value for our investments. If a quoted market price is not available, fair value is estimated using a secondary pricing source or using quoted market prices of similar securities. We have no investment securities for which fair value is determined using Level 3 inputs as defined in note 3 to the unaudited condensed consolidated interim financial statements, “Fair Value Measurements.”

 

12


 

Table of Contents

Fixed Income Securities - Available-for-Sale

 

The amortized cost and fair value of available-for-sale securities at September 30, 2018 and December 31, 2017 were as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2018

 

    

Cost or

    

Gross

    

Gross

    

    

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

Asset Class

    

Cost

    

Gains

    

Losses

    

Value

U.S. government

 

$

177,339

 

$

 8

 

$

(3,560)

 

$

173,787

U.S. agency

 

 

30,647

 

 

111

 

 

(855)

 

 

29,903

Non-U.S. govt. & agency

 

 

8,178

 

 

 -

 

 

(271)

 

 

7,907

Agency MBS

 

 

415,476

 

 

1,299

 

 

(14,749)

 

 

402,026

ABS/CMBS*

 

 

120,737

 

 

113

 

 

(1,283)

 

 

119,567

Corporate

 

 

675,731

 

 

2,862

 

 

(11,901)

 

 

666,692

Municipal

 

 

317,540

 

 

4,727

 

 

(2,532)

 

 

319,735

Total Fixed Income

 

$

1,745,648

 

$

9,120

 

$

(35,151)

 

$

1,719,617

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Available-for-sale

 

 

 

 

 

 

 

 

 

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

    

Cost or

    

Gross

    

Gross

    

    

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

Asset Class

    

Cost

    

Gains

    

Losses

    

Value

U.S. government

 

$

92,561

 

$

23

 

$

(895)

 

$

91,689

U.S. agency

 

 

18,541

 

 

347

 

 

(110)

 

 

18,778

Non-U.S. govt. & agency

 

 

7,501

 

 

143

 

 

(56)

 

 

7,588

Agency MBS

 

 

329,129

 

 

3,420

 

 

(4,078)

 

 

328,471

ABS/CMBS*

 

 

70,405

 

 

436

 

 

(315)

 

 

70,526

Corporate

 

 

508,128

 

 

12,575

 

 

(1,681)

 

 

519,022

Municipal

 

 

620,146

 

 

17,272

 

 

(1,253)

 

 

636,165

Total Fixed Income

 

$

1,646,411

 

$

34,216

 

$

(8,388)

 

$

1,672,239


*Non-agency asset-backed and commercial mortgage-backed

 

The following table presents the amortized cost and fair value of available-for-sale debt securities by contractual maturity dates as of September 30, 2018:

 

 

 

 

 

 

 

 

 

 

September 30, 2018

Available-for-sale

 

Amortized

 

Fair

(in thousands)

    

Cost

    

Value

Due in one year or less

 

$

41,952

 

$

42,115

Due after one year through five years

 

 

379,636

 

 

378,403

Due after five years through 10 years

 

 

611,198

 

 

602,738

Due after 10 years

 

 

176,649

 

 

174,768

Mtge/ABS/CMBS*

 

 

536,213

 

 

521,593

Total available-for-sale

 

$

1,745,648

 

$

1,719,617


*Mortgage-backed, asset-backed and commercial mortgage-backed

 

Unrealized Losses on Fixed Income Securities

 

We conduct and document periodic reviews of all fixed income securities with unrealized losses to evaluate whether the impairment is other-than-temporary. The following tables are used as part of our impairment analysis and illustrate the total value of fixed income securities that were in an unrealized loss position as of September 30, 2018 and December 31, 2017. The tables segregate the securities based on type, noting the fair value, cost (or amortized cost) and unrealized loss on each category of

13


 

Table of Contents

investment as well as in total. The tables further classify the securities based on the length of time they have been in an unrealized loss position. As of September 30, 2018, unrealized losses on fixed income securities, as shown in the following tables, were 1.6 percent of total invested assets. Unrealized losses increased through the first nine months of 2018, as interest rates increased from the end of 2017, which decreased the fair value of securities held in the fixed income portfolio.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2018

 

December 31, 2017

(in thousands)

&