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Section 1: 10-Q (10-Q)

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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 March 31, 2020

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 incorporation or organization)

(I.R.S. Employer Identification Number)

9025 North Lindbergh Drive, PeoriaIL

61615

(Address of principal executive offices)

(Zip Code)

(309) 692-1000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Trading Symbol

Name of each exchange on which registered

Common Stock $0.01 par value

RLI

New York Stock Exchange

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, a 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 April 20, 2020, the number of shares outstanding of the registrant’s Common Stock was 44,922,656.

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-Month Periods Ended March 31, 2020 and 2019 (unaudited)

3

Condensed Consolidated Balance Sheets as of March 31, 2020 and December 31, 2019 (unaudited)

4

Condensed Consolidated Statements of Shareholders’ Equity For the Three-Month Periods Ended March 31, 2020 and 2019 (unaudited)

5

Condensed Consolidated Statements of Cash Flows For the Three-Month Periods Ended March 31, 2020 and 2019 (unaudited)

6

Notes to Unaudited Condensed Consolidated Interim Financial Statements

7

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

22

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

33

Item 4.

Controls and Procedures

33

Part II - Other Information

33

Item 1.

Legal Proceedings

33

Item 1a.

Risk Factors

33

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

34

Item 3.

Defaults upon Senior Securities

34

Item 4.

Mine Safety Disclosures

34

Item 5.

Other Information

34

Item 6.

Exhibits

34

Signatures

35

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

Ended March 31,

(in thousands, except per share data)

2020

2019

Net premiums earned

   

$

215,582

    

$

204,689

Net investment income

 

17,778

 

16,565

Net realized gains

 

15,152

 

9,068

Net unrealized gains (losses) on equity securities

(130,395)

33,498

Consolidated revenue

$

118,117

$

263,820

Losses and settlement expenses

 

111,021

 

94,297

Policy acquisition costs

 

72,941

 

71,292

Insurance operating expenses

 

14,381

 

16,667

Interest expense on debt

 

1,897

 

1,861

General corporate expenses

 

1,755

 

3,276

Total expenses

$

201,995

$

187,393

Equity in earnings of unconsolidated investees

 

4,514

 

5,314

Earnings (loss) before income taxes

$

(79,364)

$

81,741

Income tax expense (benefit)

 

(18,097)

 

16,268

Net earnings (loss)

 

$

(61,267)

 

$

65,473

Other comprehensive earnings (loss), net of tax

 

(13,031)

 

29,301

Comprehensive earnings (loss)

 

$

(74,298)

 

$

94,774

Earnings per share:

Basic:

Basic net earnings (loss) per share

 

$

(1.36)

 

$

1.47

Basic comprehensive earnings (loss) per share

 

$

(1.65)

 

$

2.13

Diluted:

Diluted net earnings (loss) per share

 

$

(1.36)

 

$

1.46

Diluted comprehensive earnings (loss) per share

 

$

(1.65)

 

$

2.11

Weighted average number of common shares outstanding:

Basic

 

44,920

 

44,536

Diluted

 

44,920

 

44,887

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

3

Table of Contents

RLI Corp. and Subsidiaries

Condensed Consolidated Balance Sheets

(Unaudited)

March 31,

December 31,

(in thousands, except share and per share data)

    

2020

    

2019

ASSETS

   

   

Investments and cash:

Fixed income:

Available-for-sale, at fair value

 

$

1,963,585

 

$

1,983,086

(amortized cost of $1,912,851 and allowance for credit losses of $878 at 3/31/20)

(amortized cost of $1,915,278 and allowance for credit losses of $0 at 12/31/19)

 

 

Equity securities, at fair value (cost - $272,152 at 3/31/20 and $262,131 at 12/31/19)

 

356,403

 

460,630

Other invested assets

53,562

70,441

Cash

 

42,701

 

46,203

Total investments and cash

$

2,416,251

$

2,560,360

Accrued investment income

 

14,944

 

14,587

Premiums and reinsurance balances receivable, net of allowances for uncollectible amounts of $16,948 at 3/31/20 and $16,682 at 12/31/19

 

154,084

 

160,369

Ceded unearned premium

 

88,789

 

93,656

Reinsurance balances recoverable on unpaid losses and settlement expenses, net of allowances for uncollectible amounts of $8,539 at 3/31/20 and $9,402 at 12/31/19

 

366,441

 

384,517

Deferred policy acquisition costs

 

84,208

 

85,044

Property and equipment, at cost, net of accumulated depreciation of $64,322 at 3/31/20 and $62,703 at 12/31/19

 

52,741

 

53,121

Investment in unconsolidated investees

 

108,081

 

103,836

Goodwill and intangibles

 

54,025

 

54,127

Other assets

 

39,047

 

36,104

TOTAL ASSETS

 

$

3,378,611

 

$

3,545,721

LIABILITIES AND SHAREHOLDERS’ EQUITY

Liabilities

Unpaid losses and settlement expenses

 

$

1,574,760

 

$

1,574,352

Unearned premiums

 

516,867

 

540,213

Reinsurance balances payable

 

30,865

 

25,691

Funds held

 

80,333

 

83,358

Income taxes-deferred

 

26,546

 

56,727

Bonds payable, long-term debt

 

149,349

 

149,302

Accrued expenses

 

27,536

 

66,626

Other liabilities

 

56,650

 

54,064

TOTAL LIABILITIES

 

$

2,462,906

 

$

2,550,333

Shareholders’ Equity

Common stock ($0.01 par value, 100,000,000 shares authorized)

(67,852,870 shares issued, 44,922,656 shares outstanding at 3/31/20)

(67,799,229 shares issued, 44,869,015 shares outstanding at 12/31/19)

$

679

$

678

Paid-in capital

 

325,052

 

321,190

Accumulated other comprehensive earnings

 

39,464

 

52,473

Retained earnings

 

943,509

 

1,014,046

Deferred compensation

 

6,970

 

7,980

Less: Treasury shares at cost

(22,930,214 shares at 3/31/20 and 12/31/19)

 

(399,969)

 

(400,979)

TOTAL SHAREHOLDERS’ EQUITY

$

915,705

$

995,388

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

 

$

3,378,611

 

$

3,545,721

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

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RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Shareholders’ Equity

(Unaudited)

   

   

   

   

   

Accumulated

   

   

   

 

Total

Other

Common

Shareholders’

Common

Paid-in

Comprehensive

Retained

Deferred

Treasury

(in thousands, except share and per share data)

Shares

Equity

Stock

Capital

Earnings (Loss)

Earnings

Compensation

Shares at Cost

Balance, January 1, 2019

 

44,504,043

$

806,842

$

674

$

305,660

$

(14,572)

$

908,079

$

8,354

$

(401,353)

Net earnings (loss)

 

65,473

65,473

Other comprehensive earnings (loss), net of tax

 

 

29,301

 

 

 

29,301

 

 

 

Deferred compensation

 

 

 

 

 

 

 

(1,039)

 

1,039

Share-based compensation

 

50,213

 

2,892

 

1

 

2,891

 

 

 

 

Dividends and dividend equivalents ($0.22 per share)

 

 

(9,803)

 

 

 

 

(9,803)

 

 

Balance, March 31, 2019

 

44,554,256

$

894,705

$

675

$

308,551

$

14,729

$

963,749

$

7,315

$

(400,314)

   

   

   

   

   

Accumulated

   

   

   

Total

Other

 

Common

Shareholders’

Common

Paid-in

Comprehensive

Retained

Deferred

Treasury

 

(in thousands, except share and per share data)

Shares

Equity

Stock

Capital

Earnings (Loss)

Earnings

Compensation

Shares at Cost

 

Balance, January 1, 2020

 

44,869,015

$

995,388

$

678

$

321,190

$

52,473

$

1,014,046

$

7,980

$

(400,979)

Cumulative-effect adjustment from ASU 2016-13

1,095

22

1,073

Net earnings (loss)

 

(61,267)

(61,267)

Other comprehensive earnings (loss), net of tax

 

 

(13,031)

 

 

 

(13,031)

 

 

 

Deferred compensation

 

 

 

 

 

 

 

(1,010)

 

1,010

Share-based compensation

 

53,641

 

3,863

 

1

 

3,862

 

 

 

 

Dividends and dividend equivalents ($0.23 per share)

 

 

(10,343)

 

 

 

 

(10,343)

 

 

Balance, March 31, 2020

 

44,922,656

$

915,705

$

679

$

325,052

$

39,464

$

943,509

$

6,970

$

(399,969)

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

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RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

For the Three-Month Periods

Ended March 31,

(in thousands)

2020

2019

Net cash provided by (used in) operating activities

    

$

(5,767)

    

$

30,787

Cash Flows from Investing Activities

Purchase of:

Fixed income securities, available-for-sale

$

(69,233)

$

(95,984)

Equity securities

(31,811)

(31,962)

Property and equipment

(1,910)

(1,510)

Other

(2,611)

(4,134)

Proceeds from sale of:

Fixed income securities, available-for-sale

20,414

86,046

Equity securities

38,042

26,347

Other

2,267

154

Proceeds from call or maturity of:

Fixed income securities, available-for-sale

54,890

24,745

Net proceeds from sale (purchase) of short-term investments

 

-

 

(32,537)

Net cash provided by (used in) investing activities

 

$

10,048

 

$

(28,835)

Cash Flows from Financing Activities

Cash dividends paid

 

$

(10,332)

 

$

(9,797)

Proceeds from stock option exercises

 

2,549

 

2,886

Net cash used in financing activities

 

$

(7,783)

 

$

(6,911)

Net decrease in cash

$

(3,502)

$

(4,959)

Cash at the beginning of the period

46,203

30,140

Cash at March 31

 

$

42,701

 

$

25,181

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

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NOTES TO UNAUDITED CONDENSED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

A. 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 2019 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 March 31, 2020 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 2019 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.

B. ADOPTED ACCOUNTING STANDARDS

ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments

ASU 2016-13 was issued to provide more decision-useful information about the expected credit losses on financial instruments. Previous guidance delayed the recognition of credit losses until it was probable a loss had been incurred. This update requires a financial asset measured at amortized cost to be presented at the net amount expected to be collected by means of an allowance for credit losses that is included in net earnings. Credit losses relating to available-for-sale debt securities are also required to be recorded through a reversible allowance for credit losses, but is limited to the amount by which fair value is less than amortized cost.

We adopted ASU 2016-13 on January 1, 2020 using the modified-retrospective approach. The standard applied to three of the Company’s balance sheet accounts: available-for-sale fixed income securities, premiums receivable and reinsurance balances recoverable. The impact of this standard was and is expected to continue to be immaterial, as our fixed income portfolio is weighted towards higher rated bonds (85 percent rated A or better at March 31, 2020 and December 31, 2019), we purchase reinsurance from financially strong reinsurers, we have a long history of collecting premium receivables through various economic cycles and we had previously maintained an allowance for uncollectible premium and reinsurance balances. In total, the cumulative-effect adjustment made to the balance sheet as of the beginning of the year resulted in a $1.1 million increase to retained earnings and an increase to accumulated other comprehensive earnings of less than $0.1 million.

C. REINSURANCE

Ceded unearned premiums and reinsurance balances recoverable on paid and unpaid losses and settlement expenses are reported separately as assets, instead of being netted with the related liabilities, since reinsurance does not relieve the Company of our legal liability to our policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. We continuously monitor the financial condition of our reinsurers and actively follow up on any past due or disputed amounts. As part of our monitoring efforts, we review their annual financial statements, quarterly disclosures and Securities and Exchange Commission (SEC) filings for those reinsurers that are publicly traded. We also review insurance industry developments that may impact the financial condition of our reinsurers. We analyze the credit risk associated with our reinsurance balances recoverable by monitoring the AM Best and Standard & Poor’s (S&P) ratings of our reinsurers. Additionally, we perform an in depth reinsurer financial condition analysis prior to the renewal of our reinsurance placements.

We subject our reinsurance recoverables to detailed recoverable tests, including a segment-based analysis using the average default rating percentage by S&P rating. Our policy is to charge to earnings, in the form of a credit allowance, an estimate of unrecoverable amounts from reinsurers. This credit allowance is reviewed on an ongoing basis to ensure that the amount makes a reasonable provision for reinsurance balances that we may be unable to recover. Once regulatory action (such

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as receivership, finding of insolvency, order of conservation or order of liquidation) is taken against a reinsurer, the paid and unpaid recoverable for the reinsurer are specifically identified and written off through the use of our allowance for estimated unrecoverable amounts from reinsurers. When we write-off such a balance, it is done in full.

The allowances for uncollectible amounts on paid and unpaid reinsurance recoverables were $15.7 million and $8.5 million, respectively, at March 31, 2020. At December 31, 2019, the amounts were $15.7 million and $9.4 million, respectively. Adoption of ASU 2016-03 resulted in a $1.3 million decrease to the allowance for uncollectible amounts on reinsurance recoverables in 2020, while other changes in the allowances were due to changes in the amount of reinsurance balances outstanding, the composition of reinsurers from whom the balances were recoverable and their associated S&P default ratings. No write-offs or recoveries were applied to the allowances in the first quarter of 2020.

D. INTANGIBLE ASSETS

Goodwill and intangible assets totaled $54.0 million and $54.1 million at March 31, 2020 and December 31, 2019, respectively, as detailed in the following table:

Goodwill and Intangible Assets

March 31,

December 31,

(in thousands)

2020

2019

Goodwill

Energy surety

$

25,706

$

25,706

Miscellaneous and contract surety

15,110

15,110

Small commercial

5,246

5,246

Total goodwill

$

46,062

$

46,062

Intangibles

Indefinite-lived intangibles - state insurance licenses

7,500

7,500

Definite-lived intangibles, net of accumulated amortization of $3,572 at 3/31/20 and $3,470 at 12/31/19

463

565

Total intangibles

$

7,963

$

8,065

Total goodwill and intangibles

$

54,025

$

54,127

All definite-lived intangible assets are amortized based on their estimated useful lives. Amortization of intangible assets was $0.1 million for the first quarter of 2020 and 2019.

Annual impairment assessment was performed on our energy surety goodwill, miscellaneous and contract surety goodwill, small commercial goodwill and state insurance license indefinite-lived intangible asset during 2019. Based upon these reviews, none of the assets were impaired. In addition, there were no triggering events as of March 31, 2020 that would suggest our goodwill and intangible assets should be tested for impairment.

E. 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:

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For the Three-Month Period

For the Three-Month Period

Ended March 31, 2020

Ended March 31, 2019

Income

Shares

Per Share

Income

Shares

Per Share

(in thousands, except per share data)

    

(Numerator)

    

(Denominator)

    

Amount

    

(Numerator)

    

(Denominator)

    

Amount

Basic EPS

Earnings (loss) available to common shareholders

   

$

(61,267)

    

44,920

    

$

(1.36)

    

$

65,473

    

44,536

    

$

1.47

Effect of Dilutive Securities

Stock options

 

-

 

-

 

-

 

351

Diluted EPS

Earnings (loss) available to common shareholders

 

$

(61,267)

 

44,920

 

$

(1.36)

 

$

65,473

 

44,887

 

$

1.46

F. COMPREHENSIVE EARNINGS

Our comprehensive earnings include net earnings plus after-tax unrealized gains and losses on our fixed income portfolio. In reporting other comprehensive earnings on a net basis in the statement of earnings, we used the federal statutory tax rate of 21 percent. Other comprehensive earnings (loss), as shown in the consolidated statements of earnings and comprehensive earnings, is net of tax expense (benefit) of $(3.5) million and $7.8 million for the first quarter of 2020 and 2019, respectively.

Unrealized gains (losses), net of tax, on the fixed income portfolio were $(13.0) million for the first three months of 2020, compared to $29.3 million during the same period last year. Unrealized losses in the first three months of 2020 were attributable to widening credit spreads, which more than offset declines in interest rates and decreased the fair value of securities held in the fixed income portfolio. In contrast, declining interest rates increased the fair value of securities held in the fixed income portfolio in the first three months of 2019.

The following table illustrates the changes in the balance of each component of accumulated other comprehensive earnings (loss) for each period presented in the unaudited condensed consolidated interim financial statements:

(in thousands)

For the Three-Month Periods

Ended March 31,

Unrealized Gains/Losses on Available-for-Sale Securities

    

2020

    

2019

    

Beginning balance

 

$

52,473

 

$

(14,572)

 

Cumulative-effect adjustment of ASU 2016-13 (see note 1.B.)

22

-

Adjusted beginning balance

$

52,495

$

(14,572)

Other comprehensive earnings before reclassifications

 

(11,880)

 

 

29,795

Amounts reclassified from accumulated other comprehensive earnings

 

(1,151)

 

 

(494)

Net current-period other comprehensive earnings (loss)

 

$

(13,031)

 

$

29,301

 

Ending balance

 

$

39,464

 

$

14,729

 

Balance of securities for which an allowance for credit losses has been recognized in net earnings

$

5,727

 

$

-

Credit losses on or the sale of an available-for-sale security results in amounts being reclassified from accumulated other comprehensive earnings to current period net earnings. During the first quarter of 2020, $0.8 million of credit loss expense was recognized on available-for sale securities, increasing the allowance for credit losses on fixed income securities to $0.9 million. No write-offs or recoveries were applied to the allowances in the first quarter of 2020. The effects of reclassifications out of accumulated other comprehensive earnings by the respective line items of net earnings are presented in the following table:

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Amount Reclassified from Accumulated Other

(in thousands)

Comprehensive Earnings

For the Three-Month

Component of Accumulated 

Periods Ended March 31, 

Affected line item in the

Other Comprehensive Earnings

    

2020

    

2019

    

Statement of Earnings

Unrealized gains and losses on available-for-sale securities

$

2,306

$

625

Net realized gains

(849)

-

Credit losses presented within net realized gains

$

1,457

$

625

Earnings (loss) before income taxes

(306)

(131)

Income tax benefit (expense)

$

1,151

$

494

Net earnings (loss)

G. FAIR VALUE MEASUREMENTS

Fair value is defined as the price in the principal market that would be received for an asset to facilitate an orderly transaction between market participants on the measurement date. We determined the fair value of certain financial instruments based on their underlying characteristics and relevant transactions in the marketplace. We maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The following are the levels of the fair value hierarchy and a brief description of the type of valuation inputs that are used to establish each level. Financial assets are classified based upon the lowest level of significant input that is used to determine fair value.

Pricing Level 1 is applied to valuations based on readily available, unadjusted quoted prices in active markets for identical assets.

Pricing Level 2 is applied to valuations based upon quoted prices for similar assets in active markets, quoted prices for identical or similar assets in inactive markets; or valuations based on models where the significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities) or can be corroborated by observable market data.

Pricing Level 3 is applied to valuations that are derived from techniques in which one or more of the significant inputs are unobservable.

As a part of management’s process to determine fair value, we utilize widely recognized, third-party pricing sources to determine our fair values. We have obtained an understanding of the third-party pricing sources’ valuation methodologies and inputs. The following is a description of the valuation techniques used for financial assets that are measured at fair value, including the general classification of such assets pursuant to the fair value hierarchy.

Corporate, Agencies, Government and Municipal Bonds: The pricing vendor employs a multi-dimensional model which uses standard inputs including (listed in approximate order of priority for use) benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, market bids/offers and other reference data. The pricing vendor also monitors market indicators, as well as industry and economic events. All bonds valued using these techniques are classified as Level 2. All corporate, agency, government and municipal securities were deemed Level 2.

Mortgage-backed Securities (MBS)/Commercial Mortgage-backed Securities (CMBS) and Asset-backed Securities (ABS): The pricing vendor evaluation methodology includes principally interest rate movements and new issue data. Evaluations of the tranches (non-volatile, volatile or credit sensitivity) are based on the pricing vendors’ interpretation of accepted modeling and pricing conventions. This information is used to determine the cash flows for each tranche, benchmark yields, prepayment assumptions and to incorporate collateral performance. To evaluate MBS and CMBS volatility, an option adjusted spread model is used in combination with models that simulate interest rate paths to determine market price information. This process allows the pricing vendor to obtain evaluations of a broad universe of securities in a way that reflects changes in yield curve, index rates, implied volatility, mortgage rates and recent trade activity. MBS/CMBS and ABS with corroborated, observable inputs are classified as Level 2. All of our MBS/CMBS and ABS are deemed Level 2.

Regulation D Private Placement Securities: All Regulation D privately placed bonds are classified as corporate securities and deemed Level 3. The pricing vendor evaluation methodology for these securities includes a combination of observable and unobservable inputs. Observable inputs include public corporate spread matrices classified by sector, rating and

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average life, as well as investment and non-investment grade matrices created from fixed income indices. Unobservable inputs include a liquidity spread premium calculated based on public corporate spread and private corporate spread matrices. The quantitative detail of the liquidity spread premium is neither provided nor reasonably available to the Company. An increase to the credit spread assumptions would result in a lower fair value measurement.

For all of our fixed income securities classified as Level 2, as described above, we periodically conduct a review to assess the reasonableness of the fair values provided by our pricing services. Our review consists of a two-pronged approach. First, we compare prices provided by our pricing services to those provided by an additional source. In some cases, we obtain prices from securities brokers and compare them to the prices provided by our pricing services. In both comparisons, if discrepancies are found, we compare our prices to actual reported trade data for like securities. No changes to the fair values supplied by our pricing services have occurred as a result of our reviews. Based on these assessments, we have determined that the fair values of our Level 2 securities provided by our pricing services are reasonable.

Common Stock: As of March 31, 2020, all of our common stock holdings are traded on an exchange. Exchange traded equities have readily observable price levels and are classified as Level 1 (fair value based on quoted market prices).

Due to the relatively short-term nature of cash, short-term investments, accounts receivable and accounts payable, their carrying amounts are reasonable estimates of fair value. Our investments in private funds, classified as other invested assets, are measured using the investments’ net asset value per share and are not categorized within the fair value hierarchy.

H. RISKS AND UNCERTAINTIES

Certain risks and uncertainties are inherent to our day-to-day operations. Adverse changes in the economy could lower demand for our insurance products or negatively impact our investment results, both of which could have an adverse effect on the revenue and profitability of our operations. The global COVID-19 pandemic has resulted in and is expected to continue to result in significant disruptions in economic activity and financial markets. The cumulative effects of COVID-19 on the Company, and the effect of any other public health outbreak, cannot be predicted at this time, but could reduce demand for our insurance policies, result in increased level of losses, settlement expenses or other operating costs, reduce the market value of invested assets held by the Company or negatively impact the fair value of our goodwill.

Catastrophe Exposures

Our catastrophe reinsurance treaty renewed on January 1, 2020. We purchased limits of $400 million in excess of $25 million first-dollar retention for earthquakes in California, $425 million in excess of $25 million first-dollar retention for earthquakes outside of California and $275 million in excess of $25 million first-dollar retention for all other perils. These amounts are subject to certain co-participations by the Company on losses in excess of the $25 million retentions. On March 1, 2020, we purchased $100 million of additional catastrophe reinsurance protection on top of the previously described coverage. This increases the limits to $500 million for earthquakes in California, $525 million for earthquakes outside of California and $375 for all other perils, all of which are still subject to $25 million first-dollar retentions and certain co-participations in excess of the retentions.

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.

Realized gains and losses on disposition of investments are based on specific identification of the investments sold on the settlement date. The following is a summary of the disposition of fixed income and equity securities for the three-month periods ended March 31, 2020 and 2019:

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SALES

Proceeds

Gross Realized

Net Realized

(in thousands)

 

From Sales

 

Gains

 

Losses

 

Gain (Loss)

2020

Available-for-sale

$

19,858

$

2,270

$

(102)

$

2,168

Equities

 

38,042

 

17,792

 

(2,633)

 

15,159

2019

Available-for-sale

$

92,277

$

1,356

$

(723)

$

633

Equities

 

26,347

 

9,034

 

(592)

 

8,442

CALLS/MATURITIES

Gross Realized

Net Realized

(in thousands)

    

Proceeds

    

Gains

    

Losses

    

Gain (Loss)

2020

Available-for-sale

$

54,890

$

145

$

(7)

$

138

2019

Available-for-sale

$

24,745

$

1

$

(9)

$

(8)

FAIR VALUE MEASUREMENTS

Assets measured at fair value on a recurring basis as of March 31, 2020 and December 31, 2019 are summarized below:

As of March 31, 2020

Fair Value Measurements Using

    

Quoted Prices in

    

Significant Other

    

Significant

    

    

Active Markets for

Observable

Unobservable

Identical Assets

Inputs

Inputs

(in thousands)

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

Total

Fixed income securities - available-for-sale

U.S. government

$

$

186,974

$

$

186,974

U.S. agency

37,042

37,042

Non-U.S. govt. & agency

7,316

7,316

Agency MBS

414,262

414,262

ABS/CMBS*

223,601

223,601

Corporate

683,615

4,803

688,418

Municipal

405,972

405,972

Total fixed income securities - available-for-sale

$

$

1,958,782

$

4,803

$

1,963,585

Equity securities

356,403

356,403

Other invested assets

12,056

12,056

Total

$

368,459

$

1,958,782

$

4,803

$

2,332,044

As of December 31, 2019

Fair Value Measurements Using

Quoted Prices in

    

Significant Other

    

Significant

    

    

Active Markets for

Observable

Unobservable

Identical Assets

Inputs

Inputs

(in thousands)

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

Total

Fixed income securities - available-for-sale

U.S. government

$

$

193,661

$

$

193,661

U.S. agency

38,855

38,855

Non-U.S. govt. & agency

7,628

7,628

Agency MBS

420,165

420,165

ABS/CMBS*

224,870

224,870

Corporate

690,297

1,770

692,067

Municipal

405,840

405,840

Total fixed income securities - available-for-sale

$

$

1,981,316

$

1,770

$

1,983,086

Equity securities

460,630

460,630

Total

$

460,630

$

1,981,316

$

1,770

$

2,443,716

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

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