Washington, D.C. 20549

 

FORM 10-K

 

 

Commission File Number            0-6612

 

RLI CORP.

(Exact name of registrant as specified in its charter)

 

 

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

 

 

Securities registered pursuant to Section 12(g) of the Act:     NONE

 

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.

ý Yes  o No

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

ý Yes  o No

 

The aggregate market value of the voting stock held by non-affiliates of the Registrant as of June 28, 2002, based upon the closing sale price of the Common Stock on June 28, 2002 as reported on the New York Stock Exchange, was $506,528,277.  Shares of Common Stock held directly or indirectly by each officer and director along with shares held by the Company ESOP have been excluded in that such persons may be deemed to be affiliates.  This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

The number of shares outstanding of the Registrant’s Common Stock, $1.00 par value, on February 27, 2003 was 25,115,520.

 

DOCUMENTS INCORPORATED BY REFERENCE.

 

Portions of the Annual Report to Shareholders for the past year ended December 31, 2002, are incorporated by reference into Parts I and II of this document.

 

Portions of the Registrant’s definitive Proxy Statement for the 2003 annual meeting of security holders to be held May 1, 2003, are incorporated herein by reference into Part III of this document.

 

Exhibit index is located on pages 37-38 of this document.

 

 

PART I

 

Item 1.  Business

 

We conduct operations principally through four insurance companies. RLI Insurance Company, our principal subsidiary, writes multiple lines insurance on an admitted basis in all 50 states, the District of Columbia and Puerto Rico. Mt. Hawley Insurance Company, a subsidiary of RLI Insurance Company, writes surplus lines insurance in all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. Underwriters Indemnity Company, or UIC, a subsidiary of RLI Insurance Company, has authority to write multiple lines of insurance on an admitted basis in 33 states and the District of Columbia and surplus lines insurance in Ohio. Planet Indemnity Company, or PIC, a subsidiary of Mt. Hawley, has authority to write multiple lines insurance on an admitted basis in 48 states and the District of Columbia. PIC has authority to write surplus lines insurance in an additional three states. Other companies in our group include: Replacement Lens Inc., RLI Insurance Agency, Ltd., RLI Insurance Ltd., Underwriters Indemnity General Agency, Inc., Safe Fleet Insurance Services, Inc. and Surety America, LLC.

 

We maintain an Internet website at http://www.rlicorp.com. We make available free of charge on our website our annual report on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

 

On December 26, 2002, we completed the sale of 4.8 million shares of common stock in an underwritten public offering at a price of $25.25 per share. After considering the 5.0% underwriting discount, we received $115.1 million in net proceeds, before expenses.  On January 9, 2003, we sold an additional 420,000 shares pursuant to an over-allotment option granted to the underwriters, receiving an additional $10.1 million in net proceeds. The proceeds from the offering were used to pay indebtedness under our line of credit and to increase surplus at our insurance companies.  As a result of the offering, we believe that we have adequate capital to support our operations through 2003.

 

As a ‘‘niche’’ company, we offer specialty insurance products designed to meet specific insurance needs of targeted insured groups. A niche company underwrites a particular type of coverage for certain markets that are underserved by the insurance industry, such as our difference in conditions coverage and oil and gas surety bonds. A niche company also provides a type of product not generally offered by other companies, such as our personal umbrella business policy. The excess and surplus market provides an alternative market for customers with hard-to-place risks and risks that admitted insurers specifically refuse to write. When we underwrite within the surplus lines market, we are highly selective in the line of business and type of risks we choose to write. Typically the development of these specialty insurance products is generated through proposals brought to us by an agent or broker seeking coverage for a specific group of clients. We have not taken any specific measures to develop any future targeted areas, because new product ideas are typically offered to us for consideration. Once a proposal is submitted, underwriters determine whether it would be a viable product in keeping with our business objectives.

 

Since 1977, when we first began underwriting specialty property and casualty coverages for commercial risks, highly cyclical market conditions and a number of other factors have influenced our growth and underwriting profits. From 1987 to 2001, the industry experienced generally soft market conditions featuring intensified competition for admitted and surplus lines insurers, resulting in rate decreases. We continually monitored our rates and controlled our costs in an effort to maximize profits during this entrenched soft market condition. As a result of catastrophic losses, such as Hurricane Andrew and the Northridge Earthquake, in the mid-1990’s, property rates hardened in California, Florida and the wind belt, but remained soft in other areas of the country. During this period, rates hardened and premium growth was achieved in the commercial property book of business. Otherwise, rates for property and casualty lines continued to decline over time. To maintain profitability, underwriters tightened selection criteria, broadened their focus to other market segments and gave up business where rates fell below our tolerance.

 

Since the end of 1999, a trend of modest price firming emerged in many of the markets in which we participate. Since early in 2001, a return to conservative underwriting has become common in the industry for the segments in which we write business. We believe that insurance companies, as a whole, have continued to be more conservative in their underwriting philosophy and will continue to be conservative in the near future. The insurance industry has been impacted by a number of factors that obligate companies to adopt conservative underwriting practices. The primary factor is the declining interest rate environment, which has virtually eliminated the ability of a company to offset underwriting losses with investment income. Other factors include increasing reinsurance costs, industry reserving practices, increasing industry insolvencies, new corporate governance requirements, and the unfavorable equity market performance. All of these combine to force companies to focus more on conservative underwriting. We believe that conservative underwriting will manifest itself in higher premium rates, more selectivity in risks insured and reduction in coverages. The events of September 11, 2001 and the reduction in available reinsurance capacity have

 

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opened up more demand for our specialty products.  While we anticipate a steady growth in market share, we do not anticipate any increase that would warrant disclosure of a material impact. We expect the demand for specialty products to increase in the areas of primary casualty business, and directors and officers insurance, particularly as increased reinsurance costs limit new companies from entering these lines of business. We also expect that our personal umbrella policy will grow as we are one of the few insurers that write this coverage without also writing the underlying auto and homeowners insurance.

 

We initially wrote specialty property and casualty insurance through independent underwriting agents. We opened our first branch office in 1984, and began to shift from independent underwriting agents to wholly-owned branch offices that market to wholesale producers. We also market certain products to retail producers from several of our Casualty, Surety and Property Divisions. We produce a limited amount of business under agreements with underwriting general agents under the auspices of our product vice presidents. The majority of business is marketed through our branch offices located in Los Angeles, California; Oakland, California; Glastonbury, Connecticut; Sarasota, Florida; Atlanta, Georgia; Alpharetta, Georgia; Honolulu, Hawaii; Chicago, Illinois; Peoria, Illinois; Boston, Massachusetts; St. Paul, Minnesota; Summit, New Jersey; Cleveland, Ohio; Philadelphia, Pennsylvania; Dallas, Texas; Houston, Texas; and Seattle, Washington.

 

For the year ended December 31, 2002, the following table provides the geographic distribution of the Company’s risks insured as represented by direct premiums earned for all product lines.  For the year ended December 31, 2002, no other state accounted for more than 1.5% of total direct premiums earned for all product lines.

 

State		Direct Premiums Earned			Percent of Total
		(in thousands)
California		$	151,903		25.1	%
Texas		66,839			11.1	%
Florida		51,918			8.6	%
New York		41,717			6.9	%
Illinois		21,818			3.6	%
Georgia		20,412			3.4	%
Pennsylvania		17,460			2.9	%
Ohio		16,394			2.7	%
New Jersey		14,341			2.4	%
Tennessee		13,433			2.2	%
Missouri		11,328			1.9	%
Hawaii		11,034			1.8	%
Michigan		10,345			1.7	%
All Other		155,818			25.7	%
Total direct premiums		$	604,760		100.0	%

 

In the ordinary course of business, we rely on other insurance companies as business partners to share risks through reinsurance. A large portion of the reinsurance is put into effect under contracts known as treaties and, in some instances, by negotiation on each individual risk, known as facultative placements. In addition, there are quota share, excess of loss and catastrophe reinsurance contracts that protect against losses over stipulated amounts arising from any one occurrence or event. The arrangements provide greater diversification of business and serve to limit the maximum net loss on catastrophes and large and unusually hazardous risks. Reinsurance is subject to certain risks, specifically market risk, which affects the cost of, and the ability to secure, these contracts, and collection risk, which is the risk that our reinsurers may not pay on losses in a timely fashion or at all. The following table illustrates, through premium written volume, the degree to which we utilize reinsurance.  For an expanded discussion of the impact of reinsurance on our operations, see Note 5 to our consolidated financial statements included in our Annual Report to Shareholders for the year ended December 31, 2002 attached as Exhibit 13.

 

		Year Ended December 31,
(in thousands)		2002			2001			2000
Direct		$	707,453		$	511,985		$	437,866
Reinsurance ceded		(293,815		)	(196,772		)	(177,013		)
Net		$	413,638		$	315,213		$	260,853

 

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Specialty Insurance Market Overview

The specialty insurance market differs significantly from the standard market. In the standard market, insurance rates and forms are highly regulated, products and coverages are largely uniform with relatively predictable exposures, and companies tend to compete for customers on the basis of price. In contrast, the specialty market provides coverage for risks that do not fit the underwriting criteria of the standard carriers. Competition tends to focus less on price and more on availability, service and other value-based considerations. While specialty market exposures may have higher insurance risks than their standard market counterparts, we manage these risks to achieve higher financial returns. To reach our financial and operational goals we must have extensive knowledge and expertise in our markets. Most of our risks are considered on an individual basis and restricted limits, deductibles, exclusions and surcharges are employed in order to respond to distinctive risk characteristics.

 

We operate in the excess and surplus market and the specialty admitted market.

 

Excess and Surplus Market

The excess and surplus market focuses on hard-to-place risks and risks that admitted insurers specifically refuse to write. Excess and surplus eligibility allows our insurance subsidiaries to underwrite nonstandard market risks with more flexible policy forms and unregulated premium rates. This typically results in coverages that are more restrictive and more expensive than in the standard admitted market.  In 2001, the excess and surplus market represented approximately $15.7 billion, or 4.4%, of the entire $357.0 billion, domestic property and casualty industry, as measured by direct premiums written. For the year ended December 31, 2002, our excess and surplus units had direct premiums written of $292.0 million representing approximately 41.3% of our total gross written premium for the period.

 

Specialty Admitted Market

We also write business in the specialty admitted market. Most of these risks are unique and hard to place in the standard market, but for marketing and regulatory reasons, they must remain with an admitted insurance company. The specialty admitted market is subject to greater state regulation than the excess and surplus market, particularly with regard to rate and form filing requirements, restrictions on the ability to exit lines of business, premium tax payments and membership in various state associations, such as state guaranty funds and assigned risk plans. For the year ended December 31, 2002, our specialty admitted units had direct premiums written of $415.5 million representing approximately 58.7% of our total direct written premium for the period.

 

Business Overview

We presently underwrite selected property and casualty insurance across three distinct business segments: casualty, property and surety.  See Note 11 to our consolidated financial statements included in our Annual Report to Shareholders for the year ended December 31, 2002 attached as Exhibit 13.

 

Casualty Segment

General Liability

Our general liability business consists primarily of coverage for third party liability of commercial insureds including manufacturers, contractors, apartments and mercantile risks. Net earned premiums totaled $75.9 million, $47.7 million and $34.9 million, or 20%, 15% and 13% of consolidated net revenues for the years 2002, 2001 and 2000, respectively.

 

Commercial and Personal Umbrella Liability

Our commercial umbrella coverage is principally written in excess of primary liability insurance provided by other carriers and, to a small degree, in excess of primary liability written by us. The personal umbrella coverage, which is produced through the Specialty Markets Division, is written in excess of the homeowners and automobile liability coverage provided by other carriers. Net earned premiums totaled $33.8 million, $56.3 million and $62.9 million, or 9%, 18% and 24% of consolidated net revenues for the years 2002, 2001 and 2000, respectively.

 

Executive Products

We produce financial products such as directors’ and officers’, or D&O, liability and other miscellaneous professional liability for a variety of low to moderate classes of risks. Recent events affecting the economy have resulted in several insurers ceasing to write D&O coverage, and this has created an opportunity to raise rates significantly and reduce exposures. The package of coverages offered has been expanded to include a variety of coverages of interest to corporations and executives, such as employment practices liability and fiduciary liability. This is designed to give the product broader appeal. Net earned premiums totaled $8.4 million, $4.5 million and $3.0 million, or 2%, 1% and 1% of consolidated net revenues for the years 2002, 2001 and 2000, respectively.

 

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Specialty Program Business

We began writing program business in 1998 through a broker in New Jersey. During 2001, we improved our infrastructure to streamline processing through automation and utilization of new technologies that shorten the time required to launch new products and programs. We continue to develop new programs for a variety of affinity groups. Coverages offered include: commercial property, general liability, commercial automobile, inland marine, and crime. Often, these coverages are combined into a package or portfolio policy. We have recently moved to a strategy of bringing most risk underwriting ‘‘in house’’ while continuing to rely upon program administrators for policy servicing and sales. Net earned premiums totaled $28.5 million, $8.5 million and $4.6 million for 2002, 2001 and 2000, respectively. These amounts represent 7%, 3% and 2% of consolidated net revenues for 2002, 2001 and 2000, respectively.

 

Commercial Transportation

In 1997, we opened a transportation insurance facility in Atlanta to offer automobile liability and physical damage insurance to local, intermediate and long haul truckers, public transportation risks and equipment dealers. We also offer incidental, related insurance coverages, including general liability, commercial umbrella and excess liability, and motor truck cargo. The facility is staffed by highly experienced transportation underwriters who produce business through independent agents and brokers nationwide. Net earned premiums totaled $44.2 million, $23.5 million and $14.2 million, or 12%, 8% and 5% of consolidated net revenues for 2002, 2001 and 2000, respectively

 

Other

We offer a variety of other smaller programs, including deductible buy-back, in-home business, and employer’s excess indemnity. Net earned premiums from these lines totaled $17.3 million, $16.4 million and $17.3 million or 5%, 5% and 7% of consolidated net revenues for the years 2002, 2001 and 2000, respectively.

 

Property Segment

Commercial Property

Our commercial property coverage consists primarily of excess and surplus lines and specialty insurance such as fire and ‘‘difference in conditions,’’ which includes earthquake, wind, flood and collapse coverages written in the United States. We write coverage for a wide range of commercial and industrial risks such as office buildings, apartments, condominiums, certain industrial and mercantile structures, buildings under construction and movable equipment. We also write boiler and machinery coverage under the same management as commercial property. In 2002, 2001, and 2000, net earned premiums totaled $82.2 million, $62.9 million and $51.8 million, or 22%, 20% and 20%, respectively, of our consolidated net revenues.

 

Homeowners/Residential Property

In 1997, we acquired a book of homeowners and dwelling fire business for Hawaii homeowners from the Hawaii Property Insurance Association. In the aftermath of Hurricane Iniki in 1992, this business was available at reasonable rates and terms. Net earned premiums totaled $7.0 million, $7.9 million and $8.7 million, or 2%, 3% and 3% of consolidated net revenues for 2002, 2001, and 2000, respectively.

 

Other

We acquired property business as a part of our acquisition of Underwriters Indemnity Holdings on January 29, 1999. All property coverages associated with this business were non-renewed in accordance with allowed policy provisions. In 2000, net earned premiums were negative ($485,000), as reinsurance adjustments resulted in a reclass between premium earned and ceded commissions. This change resulted in no net impact to our bottom line. No premiums were earned on this business in 2002 or 2001.

 

Surety Segment

Our surety business focuses on writing contract bonds for small size contractors, energy-related business for oil and gas operators and a wide range of commercial surety bonds through independent agencies, regional and national brokers.  Net earned premium totaled $50.7 million, $45.3 million, and $34.7 million, or 13%, 15% and 13% of consolidated net revenues for 2002, 2001 and 2000, respectively.

 

Competition

Our specialty property and casualty insurance subsidiaries are part of an extremely competitive industry that is cyclical and historically characterized by periods of high premium rates and shortages of underwriting capacity followed by periods of severe competition and excess underwriting capacity.  Within the United States alone, approximately 2,500 companies, both stock and mutual, actively market property and casualty products. Our primary competitors in our casualty segment include ACE, AIG, Great West Casualty, Berkshire Hathaway Insurance Group and others. Our primary competitors in our property segment include AIG, Markel Group, St. Paul Companies and

 

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others. Our primary competitors in our surety segment include Travelers, USF&G and Zurich Companies. The combination of products, service, pricing and other methods of competition vary from line to line. Our principal methods of meeting this competition are innovative products, marketing structure and quality service to the agents and policyholders at a fair price. We compete favorably in part because of our sound financial base and reputation, as well as our broad geographic penetration into all 50 states, the District of Columbia, Puerto Rico, the Virgin Islands and Guam. In the property and casualty area, we have acquired experienced underwriting specialists in our branch and home offices. We have continued to maintain our underwriting and marketing standards by not seeking market share at the expense of earnings. New products and new programs are offered where the opportunity exists to provide needed insurance coverage with exceptional service on a profitable basis.

 

Ratings

A.M. Best ratings for the industry range from ‘‘A++’’ (Superior) to ‘‘F’’ (In Liquidation) with some companies not being rated. Standard & Poor’s ratings for the industry range from ‘‘AAA’’ (Superior) to ‘‘CC’’ (Default Expected). Publications of both A.M. Best and Standard & Poor’s indicate that ‘‘A’’ and ‘‘A+’’ ratings are assigned to those companies that, in their opinion, have achieved excellent overall performance when compared to the standards established by these firms and have a strong ability to meet their obligations to policyholders over a long period of time. In evaluating a company’s financial and operating performance, both firms review the company’s profitability, leverage and liquidity, as well as the company’s spread of risk, the quality and appropriateness of its reinsurance, the quality and diversification of its assets, the adequacy of its policy and loss reserves, the adequacy of its surplus, its capital structure and the experience and objectives of its management. These ratings are based on factors relevant to policyholders, agents, insurance brokers and intermediaries and are not directed to the protection of investors.

 

During 2001, A.M. Best gave a group rating to the combined entity of both RLI Insurance Company and Mt. Hawley Insurance Company based on the similarities of management structure and strategy for the two firms. In 2002, the rating for the two companies was reaffirmed as ‘‘A’’, and both companies were assigned a financial size category of ‘‘IX’’. UIC’s A.M. Best rating for 2002 remained ‘‘A-’’ (Excellent). PIC’s A.M. Best rating for 2002 remained ‘‘A-’’ (Excellent). In 2002, Standard & Poor’s reaffirmed our ‘‘A+’’ rating, citing our strong operating performance, capitalization and risk management. As of December 31, 2002, we had no public debt outstanding; therefore, no debt rating existed.

 

Reinsurance

We reinsure a significant portion of our property and casualty insurance exposure, paying to the reinsurer a portion of the premiums received on such policies.  Earned premiums ceded to non-affiliated reinsurers totaled $265.1 million, $194.3 million, and $161.5 million in 2002, 2001 and 2000, respectively.  Insurance is ceded principally to reduce net liability on individual risks and to protect against catastrophic losses. Although reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, it does make the assuming reinsurer liable to the insurer to the extent of the insurance ceded.

 

We attempt to purchase reinsurance from a number of financially strong reinsurers. Retention levels are adjusted each year to maintain a balance between the growth in surplus and the cost of reinsurance. Of our top 10 largest reinsurers (listed below), two are rated by A.M. Best Company as ‘‘A++, Superior’’ (General Cologne Re and Transatlantic Re), five are listed as ‘‘A+, Superior’’ (American Re, Employers Re, Liberty Mutual, Everest Re and Toa-Re), and three are rated as ‘‘A, Excellent,’’ (Continental Casualty, Odyssey America Re and St. Paul Fire & Marine). All other reinsurance balances recoverable, when considered by individual reinsurer, are less than 5% of shareholders’ equity.

 

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The following table sets forth the largest reinsurers in terms of amounts recoverable, net of reinsurance payables from such reinsurers as of December 31, 2002.  Also shown are the amounts of written premium ceded by the Company to such reinsurers during 2002.

 

(in thousands)­­­		Gross Reinsurer Exposure as of December 31, 2002			Percent of Total		Ceded Premiums Written			Percent of Total
American Re-Insurance Co.		$	96,023		22.8	%	$	47,794		16.3	%
Employers Reinsurance Corp.		55,976			13.3		37,517			12.8
General Cologne Re		47,143			11.2		31,426			10.7
Transatlantic Reinsurance Co.		18,011			4.3		2,460			0.8
Liberty Mutual Insurance Co.		16,344			3.9		13,389			4.6
Everest Reinsurance Co.		14,188			3.4		12,512			4.2
Continental Casualty Co.		10,757			2.6		4,027			1.4
St. Paul Fire & Marine Ins.		10,610			2.5		3,860			1.3
Toa-Re Insurance Co.		10,080			2.4		8,267			2.8
Odyssey America Re		10,019			2.4		3,962			1.3
All other reinsurers		132,337			31.2		128,601			43.8