UNITED FIRE GROUP INC – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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FORWARD-LOOKING STATEMENTS This report may contain forward-looking statements about our operations, anticipated performance and other similar matters.The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and/or projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about our company, the industry in which we operate, and beliefs and assumptions made by management. Words such as "expect(s)," "anticipate(s)," "intend(s)," "plan(s)," "believe(s)," "continue(s)," "seek(s)," "estimate(s)," "goal(s)," "target(s)," "forecast(s)," "project(s)," "predict(s)," "should," "could," "may," "will continue," "might," "hope," "can" and other words and terms of similar meaning or expression in connection with a discussion of future operations, financial performance or financial condition, are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in Part II Item 1A, "Risk Factors" of this document. Among the factors that could cause our actual outcomes and results to differ are:
• The frequency and severity of claims, including those related to catastrophe
losses, and the impact those claims have on our loss reserve adequacy.
• Developments in the domestic and global financial markets that could affect
our investment portfolio and financing plans.
• The calculation and recovery of deferred policy acquisition costs ("DAC").
• The valuation of pension and other postretirement benefit obligations.
• Our relationship with our agencies and agents.
• Our relationship with our reinsurers.
• The financial strength rating of our reinsurers.
• Changes in industry trends and significant industry developments.
• Our exposure to international catastrophes through our assumed reinsurance
program.
• Governmental actions, policies and regulations, including, but not limited
to, domestic health care reform, financial services regulatory reform,
corporate governance, new laws or regulations or court decisions interpreting
existing laws and regulations or policy provisions.
• NASDAQ policies or regulations relating to corporate governance and the cost
to comply. These are representative of the risks, uncertainties, and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report or as of the date they are made. Except as required under the federal securities laws and the rules and regulations of theSecurities and Exchange Commission , we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. 31
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CRITICAL ACCOUNTING ESTIMATES Critical accounting estimates are defined as those that are representative of significant judgments and uncertainties and that potentially may result in materially different results under different assumptions and conditions. We base our discussion and analysis of our results of operations and financial condition on the amounts reported in our Consolidated Financial Statements, which we have prepared in accordance with GAAP. As we prepare these Consolidated Financial Statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses for the reporting period. We evaluate our estimates on an ongoing basis. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. Our critical accounting estimates are: the valuation of investments; the valuation of reserves for losses, claims, and loss settlement expenses and the related valuation of reinsurance recoverable on paid and unpaid losses; the valuation of reserves for future policy benefits; the calculation of the deferred policy acquisition costs asset; the recoverability of goodwill and other intangible assets; and the valuation of pension and postretirement benefit obligations. These critical accounting estimates are more fully described in our Management's Discussion and Analysis of Results of Operations and Financial Condition presented in our Annual Report on Form 10-K for the year endedDecember 31, 2011 .
INTRODUCTION
The purpose of the Management's Discussion and Analysis is to provide an understanding of our results of operations and consolidated financial position. Our Management's Discussion and Analysis should be read in conjunction with our consolidated financial statements and related notes, including those in our Annual Report on Form 10-K for the year endedDecember 31, 2011 . When we provide information on a statutory basis, we label it as such, otherwise, all other data is presented in accordance with GAAP.
OUR BUSINESS
Founded in 1946 asUnited Fire & Casualty Company , we provide insurance protection for individuals and businesses through several regional companies. We are licensed as a property and casualty insurer in 43 states plus theDistrict of Columbia and are represented by approximately 1,200 independent agencies. Our life insurance subsidiary is licensed in 36 states and is represented by more than 900 independent agencies.
Segments
We operate two business segments, each with a wide range of products:
• property and casualty insurance, which includes commercial insurance,
personal insurance, surety bonds and assumed insurance; and
• life insurance, which includes deferred and immediate annuities, universal
life products and traditional life (primarily single premium whole life
insurance) products.
We manage these business segments separately, as they generally do not share the same customer base, and each has different products, pricing, and expense structures.
For the nine-month period endedSeptember 30, 2012 , property and casualty business accounted for 90.9 percent of our net premiums earned, of which 89.8 percent was generated from commercial lines. Life insurance business made up 9.1 percent of our net premiums earned, of which 70.7 percent was generated from traditional life insurance products.
Pooling Arrangement
All of our property and casualty insurance subsidiaries, with the exception of
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are members of an intercompany reinsurance pooling arrangement. The insurance entities ofMercer Insurance Group participated in their own pooling arrangement in 2011, which was in place when we acquiredMercer Insurance Group onMarch 28, 2011 . EffectiveJanuary 1, 2012 , one pooling arrangement covers all participating insurance subsidiaries ofUnited Fire Group, Inc. Pooling arrangements permit the participating companies to rely on the capacity of the entire pool's capital and surplus, rather than being limited to policy exposures of a size commensurate with each participant's own surplus level.
Geographic Concentration
For the nine-month period endedSeptember 30, 2012 , premium revenues for our property and casualty insurance segment were generated from approximately 90 percent commercial lines business and 10 percent personal lines business. Our top five states for direct premiums written wereTexas ,Iowa ,California ,New Jersey andMissouri . In our life insurance company, according to statutory financial measures that include annuities as premium income, our top five states for business wereIowa ,Minnesota ,Illinois ,Wisconsin andNebraska , for the nine months endedSeptember 30, 2012 .
Segment Revenue and Expense
We evaluate segment profit or loss based upon operating and investment results. Segment profit or loss described in the following sections of the Management's Discussion and Analysis is reported on a pre-tax basis. Additional segment information is presented in Part I, Item 1, Note 6 "Segment Information" to the unaudited Consolidated Financial Statements. Our primary sources of revenue are premiums and investment income. Major categories of expenses include losses and loss settlement expenses, future policy benefits, underwriting and other operating expenses and interest on policyholders' accounts. Profit Factors The profitability of our company is influenced by many factors, including price, competition, economic conditions, interest rates, catastrophic events and other natural disasters, man-made disasters, state regulations, court decisions, and changes in the law. Unless a connection between future increased extreme weather events and climate change is ultimately proven true, management believes that climate change considerations will not have a material impact on our profitability. To manage these risks and uncertainties, we seek to achieve consistent profitability through strong agency relationships, exceptional customer service, fair and prompt claims handling, disciplined underwriting, superior loss control services, and effective and efficient use of technology. 33
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CONSOLIDATED FINANCIAL HIGHLIGHTS
Three Months Ended September 30, Nine Months Ended September 30, (In Thousands) 2012 2011 % 2012 2011(1) % Revenues Net premiums earned $ 176,531 $ 158,704 11.2 % $ 508,124 $ 425,118 19.5 % Investment income, net of investment expenses 28,665 26,926 6.5 86,560 81,730 5.9 Net realized investment gains Other-than-temporary impairment charges - - - (4 ) - - All other net realized gains 1,300 1,219 6.6 4,662 4,996 (6.7 ) 1,300 1,219 6.6 4,658 4,996 (6.8 ) Other income 85 725 (88.3 ) 584 1,610 (63.7 ) $ 206,581 $ 187,574 10.1 % $ 599,926 $ 513,454 16.8 % Benefits, Losses and Expenses Losses and loss settlement expenses $ 119,756 $ 120,861 (0.9 )% $ 318,006 $ 332,854 (4.5 )% Future policy benefits 9,815 9,167 7.1 28,309 25,229 12.2 Amortization of deferred policy acquisition costs 36,167 43,022 (15.9 ) 104,897 112,800 (7.0 ) Other underwriting expenses 20,496 14,101 45.4 63,031 44,878 40.4 Interest on policyholders' accounts 10,327 10,897 (5.2 ) 31,610 32,224 (1.9 ) $ 196,561 $ 198,048 (0.8 )% $ 545,853 $ 547,985 (0.4 )% Income (loss) before income taxes $ 10,020 $ (10,474 ) NM(2) $ 54,073 $ (34,531 ) NM(2) Federal income tax expense (benefit) 1,290 (5,698 ) 122.6 11,443 (17,651 ) 164.8 % Net income (Loss) $ 8,730 $ (4,776 ) NM(2) $ 42,630 $ (16,880 ) NM(2) (1) The information presented for 2011 includesMercer Insurance Group's results after theMarch 28, 2011 acquisition date. (2) Not meaningful.
The following is a summary of our financial performance for the three- and nine-month periods ended
Consolidated Results of Operations
For the three-month period endedSeptember 30, 2012 , net income was$8.7 million , compared to a net loss of$4.8 million for the same period of 2011, driven primarily by growth in property and casualty premium revenue, combined with a reduction in the combined ratio. Consolidated net premiums earned increased to$176.5 million , compared to$158.7 million for the same period of 2011. This increase represents organic growth and is the result of a combination of rate increases across most commercial and personal lines, growth in premium audit collections, and new business writings. For the nine-month period endedSeptember 30, 2012 , net income was$42.6 million , compared to a net loss of$16.9 million for the same period of 2011. Like the quarterly results, the improvement was driven by growth in property and casualty premium revenue and a reduction in the combined ratio. Year to date consolidated net premiums earned increased to$508.1 million , compared to$425.1 million for the same period of 2011 due in part to the acquisition ofMercer Insurance Group inMarch 2011 , which accounted for$34.9 million of additional earned premium. Our organic growth was$48.1 million over the same period of 2011. Losses and loss settlement expenses remained flat between the third quarter of 2012 compared to the third quarter of 2011, in spite of the growth in premium noted above. This was due to reduced catastrophe loss experience, offset by an increase in severity in the other liability and workers' compensation lines of business. Pre-tax catastrophe losses totaled$8.5 million compared to$23.9 million in the third quarter of 2011. In the third quarter of 2011, we recorded 34
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losses from two storms; a straight-line windstorm known as a derecho hitIowa , and a wind and hail event affectedUnited Fire policyholders inWestern Iowa ,South Dakota ,Nebraska andNorthwest Missouri . Losses and loss settlement expenses decreased to$318.0 million for the nine-month period endedSeptember 30, 2012 , compared to$332.9 million for the same period of 2011. The decrease is due to primarily to reduced catastrophe loss experience. Pre-tax catastrophe losses totaled$34.5 million for the nine-month period endedSeptember 30, 2012 , compared to$77.0 million in the same period of 2011. ThroughSeptember 30, 2011 , in addition to the third quarter catastrophe losses, we also experienced severe storm losses that occurred during the second quarter and assumed reinsurance losses related to theNew Zealand earthquake and the earthquake and tsunami inJapan that occurred during the first quarter. EffectiveJanuary 1, 2012 , we adopted the updated accounting guidance that limits the amount of underwriting expenses eligible for deferral on a prospective basis. The adoption of the updated accounting guidance resulted in the recognition of approximately$9.9 million ($8.6 million for our property and casualty insurance segment;$1.3 million for our life insurance segment) of expense in the nine-month period endedSeptember 30, 2012 that we would not have recognized had the accounting guidance remained unchanged. This represents a reduction to net income of$0.25 per share. Refer to the "Deferred Policy Acquisition Costs" under "Note 1 of the Notes to Unaudited Financial Statements" for further discussion of the impact of the updated accounting guidance related to deferred policy acquisition costs on our reported results.
Consolidated Financial Condition
As ofSeptember 30, 2012 , the book value per share of our common stock was$29.66 . We repurchased 35,891 and 137,792 shares in the three- and nine-month periods endedSeptember 30, 2012 . Under our share repurchase program, which expires inAugust 2014 , we are authorized to purchase an additional 1,332,087 shares of common stock. Net unrealized investment gains totaled$149.3 million as ofSeptember 30, 2012 , an increase of$25.0 million , net of tax, or 20.1 percent sinceDecember 31, 2011 . The increase in net unrealized gains resulted from an increase in the fair value of both our fixed maturity and equity portfolios. Our stockholders' equity increased to$753.8 million atSeptember 30, 2012 , from$696.1 million atDecember 31, 2011 . The increase was primarily attributable to net income of$42.6 million and net unrealized investment gains of$25.0 million , net of tax, less stockholder dividends of$11.5 million . 35
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RESULTS OF OPERATIONS
Property and Casualty Insurance Segment Results
Three Months Ended September 30, Nine Months Ended September 30, (In Thousands) 2012 2011 2012 2011(1) Net premiums written (2) $ 155,433 $ 143,412 $ 500,303 $ 413,165 Net premiums earned $ 161,232 $ 144,065 $ 461,902 $ 384,838 Losses and loss settlement expenses (114,846 ) (115,127 ) (302,376 ) (316,916 ) Amortization of deferred policy acquisition costs (34,060 ) (40,547 ) (98,355 ) (105,663 ) Other underwriting expenses (16,332 ) (11,050 ) (50,353 ) (35,576 ) Underwriting gain (loss) (2) $ (4,006 ) $ (22,659 ) $ 10,818 $ (73,317 ) Investment income, net of investment expenses 11,051 8,085 33,409 26,273 Net realized investment gains (losses) Other-than-temporary impairment charges - - (4 ) - All other net realized gains 1,214 692 1,769 2,293 1,214 692 1,765 2,293 Other income (19 ) 504 177 1,042
Income (loss) before income taxes $ 8,240 $ (13,378 )
$ 46,169 $ (43,709 ) GAAP Ratios: Net loss ratio 65.9 % 63.3 % 58.0 % 62.4 % Catastrophes - effect on net loss ratio 5.3 16.6 7.5 20.0 Net loss ratio 71.2 % 79.9 % 65.5 % 82.4 % Expense ratio (3) 31.3 35.8 32.2 36.7 Combined ratio 102.5 % 115.7 % 97.7 % 119.1 % (1) The information presented for 2011 includesMercer Insurance Group's results after theMarch 28, 2011 acquisition date. (2) The Measurement of Results section of this report defines data prepared in accordance with statutory accounting practices, which is a comprehensive basis of accounting other than U.S. GAAP. (3) Includes policyholder dividends. Net premiums earned increased 12 percent in the third quarter of 2012, compared to the third quarter of 2011, due to organic growth, rate increases and an increase in audit premiums. Audit premiums result from business policies that are audited after the policy period to determine accurate premiums based on sales or payrolls or endorsements. An increase in audit premiums indicates that our commercial customers are increasing their business.
Commercial lines renewal pricing experienced mid-single digit percentage increases for the fourth consecutive quarter. Competitive market conditions continued to ease on renewals, but persisted on new business during the quarter. In addition to the increase in audit premiums, we are also seeing growth in premium from policy changes and a decline in the number of out-of-business policy cancellations. Personal lines pricing has also improved, with upper-single digit percentage increases for homeowners and low-to-mid single-digit percentage increases for personal auto. Policy retention rates dropped slightly due to our rate increases.
The GAAP combined ratio decreased 13.2 percentage points for the three-month period endedSeptember 30, 2012 , compared with the same period of 2011. For the nine-month period endedSeptember 30, 2012 , our combined ratio decreased by 21.4 percentage points as compared to the same period of 2011. These decreases are attributable to reductions in net loss ratio and expense ratio from 2011. The net loss ratio, a component of the combined ratio, decreased by 8.7 percentage points and 16.9 percentage points in the three- and nine-month periods endedSeptember 30, 2012 , as compared to the same periods in 2011. The decrease is due primarily to reduced catastrophe loss experience. Pre-tax catastrophe losses totaled$8.5 million and$34.5 million for the three- and nine-month periods endedSeptember 30, 2012 , as compared to$23.9 million and$77.0 million for the same periods of 2011. ThroughSeptember 30, 2011 , in addition to the third quarter catastrophe 36
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losses, we also experienced severe storm losses that occurred during the second quarter and assumed reinsurance losses related to theNew Zealand earthquake and the earthquake and tsunami inJapan that occurred during the first quarter. Non-catastrophe loss severity declined in the second quarter compared to the first quarter of 2012. In the third quarter, however, we experienced an increase in the number and severity of losses in our other liability and workers' compensation lines of business losses that were within our retained limits. The expense ratio, a component of the combined ratio, decreased 4.5 percentage points for both the three- and nine-month periods endedSeptember 30, 2012 , as compared to the same periods in 2011. The expenses associated with the acquisition of theMercer Insurance Group increased the expense ratio reported for 2011. As explained in "Deferred Policy Acquisition Costs" under "Note 1 of the Notes to Unaudited Financial Statements", we adopted new accounting guidance that limits the amount of underwriting expenses eligible for deferral, effectiveJanuary 1, 2012 . The adoption of the updated accounting guidance resulted in the recognition of approximately$1.4 million and$8.6 million of additional expense for the three- and nine- month periods endedSeptember 30, 2012 in our property and casualty insurance segment. The impact of the new accounting guidance on our results for the full year will be influenced by a number of factors including: the volume of premiums written; our assessment of successful acquisition efforts; the profitability of our lines of property and casualty business, which impacts the level of premium deficiency charge recorded; and the normal amortization pattern of these deferred policy acquisition costs, which is generally over one year. The greatest impact will be experienced in the most current quarter as the recorded deferred policy acquisitions costs would amortize to expense in succeeding quarters to offset a portion of the initial impact when assessed on an annual basis. Accordingly, the impact of the new accounting guidance on our results reported for the three- and nine-month periods endedSeptember 30, 2012 should not be considered to be representative of the impact for the full year.
For a detailed discussion of our consolidated investment results, refer to the "Investment Portfolio" section of this item.
The following tables display our premiums earned, losses and loss settlement expenses and loss ratio by line of business:
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Table of Contents Three Months Ended September 30, 2012 2011(4) Losses Losses and Loss and Loss Net Settlement Net Settlement (In Thousands) Premiums Expenses Loss Premiums Expenses Loss Unaudited Earned Incurred Ratio Earned Incurred Ratio Commercial lines Other liability (1) $ 50,887 $ 28,579 56.2 % $ 43,692 $ 18,114 41.5 % Fire and allied lines (2) 33,574 24,637 73.4 31,556 37,710 119.5 Automobile 34,087 24,703 72.5 30,999 26,364 85.0 Workers' compensation 17,606 16,933 96.2 14,257 11,572 81.2 Fidelity and surety 4,365 1,962 44.9 4,375 925 21.1 Miscellaneous 258 214 82.9 216 (134 ) (62.0 ) Total commercial lines $ 140,777 $ 97,028 68.9 % $ 125,095 $ 94,551 75.6 % Personal lines Fire and allied lines (3) $ 10,247 $ 11,758 114.7 % $ 10,009 $ 10,962 109.5 % Automobile 5,711 3,562 62.4 5,012 5,025 100.3 Miscellaneous 235 42 17.9 226 90 39.8 Total personal lines $ 16,193 $ 15,362 94.9 % $ 15,247 $ 16,077 105.4 % Reinsurance assumed $ 4,262 $ 2,456 57.6 % $ 3,723 $ 4,499 120.8 % Total $ 161,232 $ 114,846 71.2 % $ 144,065 $ 115,127 79.9 % (1) "Other liability" is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured's premises, and products manufactured or sold. (2) "Fire and allied lines" includes fire, allied lines, commercial multiple peril, and inland marine. (3) "Fire and allied lines" includes fire, allied lines, homeowners, and inland marine. (4) The Form 10-Q we filed onNovember 7, 2011 , contained a misclassification between two lines of business for net premiums earned and losses and loss settlement expenses incurred. The two lines of business affected were other liability and fire and allied lines. That report showed net premiums earned, losses and loss settlement expenses incurred, and loss ratio of$29,846 ,$9,213 and 30.9%, respectively, for other liability, and net premiums earned, losses and loss settlement expenses incurred, and loss ratio of$45,402 ,$46,611 and 102.7%, respectively, for fire and allied lines. The reclassification for these lines shown in this table reflect a reclassification to other liability from fire and allied lines of$13,846 in net premiums earned and$8,901 in losses and loss settlement expenses incurred. The reclassification had no impact on net income. 38
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Nine Months Ended September 30,
2012 2011(1)(3) Losses Losses and Loss and Loss Net Settlement Net Settlement (In Thousands) Premiums Expenses Loss Premiums Expenses Loss Unaudited Earned Incurred Ratio Earned Incurred Ratio Commercial lines Other liability $ 145,604 $ 70,793 48.6 % $ 114,518 $ 51,239 44.7 % Fire and allied lines 97,365 81,968 84.2 85,848 113,072 131.7 Automobile 98,785 75,891 76.8 83,584 57,719 69.1 Workers' compensation 50,068 30,260 60.4 39,352 33,131 84.2 Fidelity and surety 12,780 1,607 12.6 12,280 944 7.7 Miscellaneous 735 278 37.8 627
251 40.0 Total commercial lines
Personal lines Fire and allied lines $ 30,479 $ 22,633 74.3 % $ 26,045 $ 30,471 117.0 % Automobile 15,896 10,999 69.2 13,674 10,995 80.4 Miscellaneous 691 158 22.9 571 193 33.8 Total personal lines $ 47,066 $ 33,790 71.8 % $ 40,290 $ 41,659 103.4 % Reinsurance assumed $ 9,499 $ 7,789 82.0 % $ 8,339 $ 18,901 NM(2) Total $ 461,902 $ 302,376 65.5 % $ 384,838 $ 316,916 82.4 % (1) The information presented for 2011 includesMercer Insurance Group's results after theMarch 28, 2011 acquisition date. (2) Not meaningful. (3) The Form 10-Q we filed onNovember 7, 2011 contained a misclassification between two lines of business for net premiums earned and losses and loss settlement expenses incurred. The two lines of business affected were other liability and fire and allied lines. That report showed net premiums earned, losses and loss settlement expenses incurred, and loss ratio of$86,796 ,$31,023 and 35.7%, respectively, for other liability, and net premiums earned, losses and loss settlement expenses incurred, and loss ratio of$113,570 ,$133,288 and 117.4%, respectively, for fire and allied lines. The reclassification for these lines shown in this table reflect a reclassification to other liability from fire and allied lines of$27,722 in net premiums earned and$20,216 in losses and loss settlement expenses incurred. The reclassification had no impact on net income.
• Other liability - The loss ratio deteriorated in the three- and nine-month
periods ended
The deterioration in this line was due to an influx of severe losses in the three-month period endedSeptember 30, 2012 .
• Commercial fire and allied lines - The loss ratio improved in the three-
and nine-month periods ended
periods of 2011. The improvement in this line was due to the reduction in
our catastrophe loss experience.
• Commercial automobile - The loss ratio improved in the three-month period
ended
deterioration in this line was due to an influx of severe losses in the
Most of these severe losses were recorded in the first two quarters of 2012.
• Workers' compensation - The loss ratio deteriorated in the three-month
period ended
an increase in severity related to several large claims incurred during
this time period in 2012. However, the loss ratio improved in the
nine-month period ended
2011. The improvement in this line reflects the high severity and
frequency that occurred in 2011, as well as adverse development incurred
in 2011 on claims that occurred in 2010. • Personal fire and allied lines - The loss ratio deteriorated in the three-month period endedSeptember 30 , 39
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2012, compared to the same period of 2011 due to an increase in catastrophe losses in this time period in 2012. However, the loss ratio improved in the nine-month period endedSeptember 30, 2012 , compared to the same period of 2011. The improvement in this line was due to the reduction in our catastrophe loss experience.
Life Insurance Segment Results
Nine Months Ended September Three Months Ended September 30, 30, (In Thousands) 2012 2011 2012 2011 Revenues Net premiums earned $ 15,299 $ 14,639 $ 46,222 $ 40,280 Investment income, net 17,614 18,841 53,151 55,457 Net realized investment gains 86 527 2,893 2,703 Other income 104 221 407 568 Total revenues $ 33,103 $ 34,228 $ 102,673 $ 99,008 Benefits, Losses and Expenses Losses and loss settlement expenses $ 4,910 $ 5,734 $ 15,630 $ 15,938 Future policy benefits 9,815 9,167 28,309 25,229 Amortization of deferred policy acquisition costs 2,107 2,475 6,542 7,137 Other underwriting expenses 4,164 3,051 12,678 9,302 Interest on policyholders' accounts 10,327 10,897 31,610 32,224 Total benefits, losses and expenses $ 31,323 $ 31,324 $ 94,769 $ 89,830 Income before income taxes $ 1,780 $ 2,904 $ 7,904 $ 9,178 Income before income taxes decreased by$1.1 million and$1.3 million in the three- and nine-month periods endedSeptember 30, 2012 , respectively, as compared to the same periods of 2011. Net premiums earned increased 4.5 percent and 14.8 percent in the three- and nine-month periods endedSeptember 30, 2012 , respectively, as compared to the same periods of 2011, due to increased sales of our single premium whole life product. Investment income decreased 6.5 percent and 4.2 percent in the three- and nine-month periods endedSeptember 30, 2012 , respectively, as compared to the same periods of 2011. The historically low interest rates continue to reduce both our investment income and margin on earnings. Loss and loss settlement expenses decreased 14.4 percent and 1.9 percent in the three- and nine-month periods endedSeptember 30, 2012 , respectively, as compared to the same periods of 2011, due to a decrease in both annuity benefits and traditional life insurance death benefits. Future policy benefits increased 7.1 percent and 12.2 percent in the three- and nine-month periods endedSeptember 30, 2012 , respectively, as compared to the same periods of 2011, due to both the increase in sales of our single premium whole life product and the demographics of our insureds.
Amortization of deferred policy acquisition costs decreased as result of a change in accounting rules related to the recognition of deferred policy acquisition costs. As previously described in our Property and Casualty Insurance Segment, we prospectively adopted this rules change on
Other underwriting expenses have increased. This was primarily driven by the increase in sales of our single premium whole life product, resulting in an increase in incentives and commissions paid to our agencies, along with the impact of the change in accounting guidance, as mentioned above.
Deferred annuity deposits decreased 58.6 percent and 21.7 percent for the three- and nine-month periods endedSeptember 30, 2012 , as compared with the same periods in 2011. It has been prudent to lower the credited rate we have offered during the low investment return environment, thus affecting current deposits. Sales of single premium deferred annuities have also decreased in regard to overall portfolio production, due to strong sales of traditional life 40
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products. While deferred annuity deposits are not recorded as a component of net premiums written or net premiums earned, they do generate investment income. Net cash outflow related to our annuity business was$13.2 million and$18.8 million in the three- and nine-month periods endedSeptember 30, 2012 , compared to a net cash inflow of$19.5 million and a net cash outflow of$16.9 million in the same periods of 2011. We attribute this to the activity described in the prior paragraph. Investment Portfolio Our invested assets totaled$3,069.1 million atSeptember 30, 2012 , compared to$2,908.0 million atDecember 31, 2011 , an increase of$161.1 million , which is due primarily to an overall strategy to keep less cash on hand in the low interest rate environment. If extra cash is needed we have an ability to borrow funds available under our revolving credit facility. AtSeptember 30, 2012 , fixed maturity securities and equity securities comprised 92.3 percent and 5.8 percent of the value of our investment portfolio, respectively. Because the primary purpose of our investment portfolio is to fund future claims payments, we follow a conservative investment philosophy, investing most of our funds in a diversified portfolio of high quality, intermediate-term taxable corporate bonds, taxable U.S. government bonds and tax-exempt U.S. municipal bonds.
Composition
We develop our investment strategies based on a number of factors, including estimated duration of reserve liabilities, short- and long-term liquidity needs, projected tax status, general economic conditions, expected rates of inflation and regulatory requirements. We administer our investment portfolio based on investment guidelines approved by management and the investment committee of our Board of Directors that comply with applicable statutory regulations.
The composition of our investment portfolio at
Property & Casualty Insurance Segment Life Insurance Segment Total Percent Percent Percent (Dollars in Thousands) of Total of Total of Total Fixed maturities (1) $ 1,134,375 85.0 % $ 1,698,179
97.9 % $ 2,832,554 92.3 % Equity securities 161,374 12.1 18,350 1.0 179,724 5.8 Trading securities 14,498 1.1 - - 14,498 0.5 Mortgage loans - - 4,683 0.3 4,683 0.2 Policy loans - - 7,308 0.4 7,308 0.2 Other long-term investments 23,231 1.7 6,268 0.4 29,499 1.0 Short-term investments 800 0.1 - - 800 - Total $ 1,334,278 100.0 % $ 1,734,788 100.0 % $ 3,069,066 100.0 %
(1) Available-for-sale fixed maturities are carried at fair value. Held-to-maturity fixed maturities are carried at amortized cost.
AtSeptember 30, 2012 , we classified$2,830.7 million , or 99.4 percent, of our fixed maturities portfolio as available-for-sale, compared to$2,697.2 million , or 99.4 percent, atDecember 31, 2011 . We classify our remaining fixed maturities as held-to-maturity or trading. We record held-to-maturity securities at amortized cost. We record trading securities, primarily convertible redeemable preferred debt securities, at fair value, with any changes in fair value recognized in earnings.
As of
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Table of Contents Credit Quality The following table shows the composition of fixed maturity securities held in our available-for-sale, held-to-maturity and trading security portfolios, by credit rating atSeptember 30, 2012 andDecember 31, 2011 . Information contained in the table is generally based upon the issue credit ratings provided by Moody's, unless the rating is unavailable, in which case we obtain it from Standard & Poor's. (In Thousands) September 30, 2012 December 31, 2011 Rating Carrying Value % of Total Carrying Value % of Total AAA $ 458,483 16.1 % $ 409,124 15.0 % AA 635,677 22.3 631,250 23.3 A 662,484 23.3 626,927 23.1 Baa/BBB 1,007,310 35.4 929,188 34.2 Other/Not Rated 83,098 2.9 118,356 4.4 $ 2,847,052 100.0 % $ 2,714,845 100.0 % Duration Our investment portfolio is invested primarily in fixed maturity securities whose fair value is susceptible to market risk, specifically interest rate changes. Duration is a measurement used to quantify our inherent interest rate risk and analyze our ability to match our invested assets to our claims liabilities. If our invested assets and claims liabilities have similar durations, then any change in interest rates will have an equal effect on these accounts. The primary purpose for matching invested assets and claims liabilities is liquidity. With appropriate matching, our investments will mature when cash is needed, preventing the need to liquidate other assets prematurely. Mismatches in the duration of assets and liabilities can cause significant fluctuations in our results of operations.
Group
The weighted average effective duration of our portfolio of fixed maturity securities, at
Property and Casualty Insurance Segment
The weighted average effective duration of our portfolio of fixed maturity securities, at
Life Insurance Segment
The weighted average effective duration of our portfolio of fixed maturity securities, at
Investment Results We invest the premiums received from our policyholders and annuitants in order to generate investment income, which is an important component of our revenues and profitability. The amount of investment income that we are able to generate is affected by many factors, some of which are beyond our control. Some of these factors are: volatility in the financial markets, economic growth, inflation, changes in interest rates, world political conditions, terrorist attacks or threats of terrorism, adverse events affecting other companies in our industry or the industries in which we invest and other unpredictable national or world events. In our life insurance segment, net investment income decreased 6.5 percent and 4.2 percent in the three- and nine-month periods endedSeptember 30, 2012 , compared with the same periods of 2011, due to historically low yields that reduce both our investment income and margin on earnings. We are maintaining our investment philosophy of purchasing quality investments rated investment grade or better, and we are more closely matching the duration of our investment portfolio to our 42
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liabilities.
In our property and casualty insurance segment, our acquisition ofMercer Insurance Group and an increase in the value of our investments in limited liability partnerships contributed to the increase of 36.7 percent and 27.2 percent in net investment income in the three- and nine-month periods endedSeptember 30, 2012 , respectively, compared to with the same periods of 2011. The increases were somewhat offset by the impact of low interest rates. Our property and casualty insurance segment holds certain investments in limited liability partnerships that are accounted for under the equity method of accounting, with changes in the value of these investments recorded in investment income. We regularly monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires other-than-temporary impairment charges to be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in fair value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which fair value has been less than cost; the financial condition and near-term prospects of the issuer; our intention to hold the investment; and the likelihood that we will be required to sell the investment. Changes in unrealized gains and losses on available-for-sale securities do not affect net income and earnings per share but do impact comprehensive income, stockholders' equity and book value per share. We believe that any unrealized losses on our available-for-sale securities atSeptember 30, 2012 , are temporary based upon our current analysis of the issuers of the securities that we hold and current market events. It is possible that we could recognize impairment charges in future periods on securities that we own atSeptember 30, 2012 , if future events and information cause us to determine that a decline in value is other-than-temporary. However, we endeavor to invest in high quality assets to provide protection from future credit quality issues and corresponding other-than-temporary impairment write-downs. LIQUIDITY AND CAPITAL RESOURCES Liquidity measures our ability to generate sufficient cash flows to meet our short- and long-term cash obligations. Our cash inflows are primarily a result of premiums, annuity deposits, reinsurance recoveries, sales or maturities of investments, and investment income. Cash provided from these sources is used primarily to fund the payment of losses and loss settlement expenses, policyholder benefits under life insurance contracts, annuity withdrawals, purchase of investments, operating expenses, dividends, pension plan contributions, and in recent years, common stock repurchases. Cash outflows may be variable because of the uncertainty regarding settlement dates for losses. In addition, the timing and amount of individual catastrophe losses are inherently unpredictable and could increase our liquidity requirements. The timing and amount of reinsurance recoveries may be affected by reinsurer solvency and reinsurance coverage disputes. Historically, we have generated substantial cash inflows from operations. It is our policy to invest the cash generated from operations in securities with maturities that correlate to the anticipated timing of payments for losses and loss settlement expenses of the underlying insurance policies. The majority of our assets are invested in available-for-sale fixed maturity securities. The following table displays a summary of cash sources and uses in 2012 and 2011. 43
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Table of Contents Cash Flow Summary Nine Months Ended September 30, (In Thousands) 2012 2011 Cash provided by (used in) Operating activities $ 125,346 $ 54,586 Investing activities (115,919 ) (147,983 ) Financing activities (71,388 ) 67,817
Net decrease in cash and cash equivalents $ (61,961 ) $ (25,580 )
Operating Activities Net cash flows provided by operating activities totaled$125.3 million and$54.6 million for the nine-month periods endedSeptember 30, 2012 and 2011, respectively. The increase reflects the higher level of property and casualty premiums collected, and a lower level of property and casualty loss payments. Our cash flows from operations were sufficient to meet our liquidity needs for the nine-month periods endedSeptember 30, 2012 and 2011. Investing Activities Cash in excess of operating requirements is generally invested in fixed maturity securities and equity securities. Fixed maturities provide regular interest payments and allow us to match the duration of our liabilities. Equity securities provide dividend income, potential dividend income growth and potential appreciation. For further discussion of our investments, including our philosophy and portfolio, see the "Investment Portfolio" section contained in this item. In addition to investment income, possible sales of investments and proceeds from calls or maturities of fixed maturity securities also can provide liquidity. During the next five years,$1.3 billion , or 44.3 percent of our fixed maturity portfolio will mature. We invest funds required for short-term cash needs primarily in money market accounts, which are classified as cash equivalents. AtSeptember 30, 2012 , our cash and cash equivalents included$31.0 million related to these money market accounts, compared to$62.9 million atDecember 31, 2011 . Net cash flows used in investing activities totaled$115.9 million and$148.0 million for the nine-month periods endedSeptember 30, 2012 and 2011, respectively. While we purchased$130.5 million more in investments in the nine-month period endedSeptember 30, 2012 , we had cash outflows for investing activities of$171.4 in the nine-month period endedSeptember 30, 2011 due to the acquisition ofMercer Insurance Group . Financing Activities Net cash flows used in financing activities totaled$71.4 million for the nine-month period endedSeptember 30, 2012 compared to net cash flows provided of$67.8 million for the nine-month period endedSeptember 30, 2011 . In the first quarter of 2011, we borrowed$79.9 million to partially finance the purchase ofMercer Insurance Group . In 2012, we paid the remaining balance of$45.0 million outstanding on our credit facility. In 2012, we also fully repaid the$15.6 million of trust preferred securities outstanding atDecember 31, 2011 . 44
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Credit Facilities In December of 2011,United Fire entered into a credit agreement with a syndicate of financial institutions as lenders,KeyBank National Association as administrative agent, lead arranger, sole book runner, swingline lender and letter of credit issuer, andBankers Trust Company as syndication agent. The four-year credit agreement provides for a$100.0 million unsecured revolving credit facility that includes a$20.0 million letter of credit subfacility and a swing line subfacility in the amount of up to$5.0 million . As ofSeptember 30, 2012 , there were no balances outstanding under this credit agreement. If no event of default has occurred or is continuing to occur, and certain other conditions are satisfied during the term of this credit facility, we have the right to increase the total facility from$100.0 million up to$125.0 million . The credit facility is available for general corporate purposes, including working capital, acquisitions and liquidity purposes. Principal of the credit facility is due in full at maturity, onDecember 22, 2015 . The interest rate is based on our monthly choice of either a base rate or the London Interbank Offered Rate ("LIBOR") plus, in each case, a calculated margin amount. A commitment fee on each lender's unused commitment under the credit facility is also payable quarterly. The credit agreement contains customary representations, covenants and events of default, including certain covenants that limit or restrict our ability to engage in certain activities. Subject to certain exceptions, these activities include restricting our ability to sell or transfer assets or enter into a merger or consolidate with another company, grant certain types of security interests, incur certain types of liens, impose restrictions on subsidiary dividends, enter into leaseback transactions, or incur certain indebtedness. The credit agreement contains certain financial covenants including covenants that require us to maintain a minimum consolidated net worth, a debt to capitalization ratio and minimum stockholders' equity. As ofSeptember 30, 2012 , we have not been in default and were in compliance with all covenants of the credit agreement. Stockholders' Equity Stockholders' equity increased 8.3 percent to$753.8 million atSeptember 30, 2012 , from$696.1 million atDecember 31, 2011 . The increase was primarily attributable to net income of$42.6 million and an increase in net unrealized investment gains of$25.0 million , net of tax, less stockholder dividends of$11.5 million . As ofSeptember 30, 2012 , the book value per share of our common stock was$29.66 , compared to$27.29 atDecember 31, 2011 . Off-Balance Sheet Arrangements Pursuant to an agreement with one of our limited liability partnership investments, we are contractually committed to make capital contributions up to$15.0 million , upon request by the partnership, throughDecember 31, 2017 . Our remaining potential contractual obligation was$6.5 million atSeptember 30, 2012 . MEASUREMENT OF RESULTS Our consolidated financial statements are prepared on the basis of GAAP. We also prepare financial statements for each of our insurance subsidiaries based on statutory accounting principles and file them with insurance regulatory authorities in the states where they do business. Management evaluates our operations by monitoring key measures of growth and profitability. We believe that disclosure of certain Non-GAAP financial measures enhances investor understanding of our financial performance. The following provides further explanation of the key measures management uses to evaluate our results: Premiums written is a statutory measure of our overall business volume. Premiums written is an important measure of business production for the period under review. Net premiums written comprise direct and assumed premiums written, less ceded premiums written. Direct premiums written is the amount of premiums charged for policies issued during the period. For the property and casualty insurance segment there are no differences between direct statutory premiums written and direct premiums written under GAAP. However, for the life insurance segment, 45
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deferred annuity deposits (i.e., sales) are included in direct statutory premiums written, whereas they are excluded for GAAP. Assumed premiums written is consideration or payment we receive in exchange for insurance we provide to other insurance companies. We report these premiums as revenue as they are earned over the underlying policy period. Ceded premiums written is the portion of direct premiums written that we cede to our reinsurers under our reinsurance contracts. Three Months Ended September 30, Nine Months Ended September 30, (In Thousands) 2012 2011 2012 2011(1) Net premiums written $ 170,725 $ 158,036 $ 546,500 $ 453,391 Net change in unearned premium 5,959 1,843 (35,347 ) (27,700 ) Net change in prepaid reinsurance premium (153 ) (1,175 ) (3,029 ) (573 ) Net premiums earned $ 176,531 $ 158,704 $ 508,124 $ 425,118 (1) The information presented for 2011 includesMercer Insurance Group's results after theMarch 28, 2011 acquisition date. Combined ratio is a commonly used statutory financial measure of property and casualty underwriting performance. A combined ratio below 100.0 percent generally indicates a profitable book of business. The combined ratio is the sum of two separately calculated ratios, the loss and loss settlement expense ratio (the "net loss ratio") and the underwriting expense ratio (the "expense ratio"). When prepared in accordance with GAAP, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premiums earned. The expense ratio is calculated by dividing nondeferred underwriting expenses and amortization of deferred policy acquisition costs by net premiums earned. When prepared in accordance with statutory accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss settlement expenses by net premium earned, and the expense ratio is calculated by dividing underwriting expenses by net premiums written. Catastrophe losses is a commonly used non-GAAP financial measure, which utilize the designations of the Insurance Services Office (ISO) and are reported with loss and loss settlement expense amounts net of reinsurance recoverables, unless specified otherwise. According to the ISO, a catastrophe loss is defined as a single unpredictable incident or series of closely related incidents that result in$25.0 million or more in U.S. industry-wide direct insured losses to property and that affect a significant number of insureds and insurers ("ISO catastrophe"). In addition to ISO catastrophes, we also include as catastrophes those events ("non-ISO catastrophes"), which may include U.S. or international losses, that we believe are, or will be, material to our operations, either in amount or in number of claims made. Management, at times, may determine for comparison purposes that it is more meaningful to exclude extraordinary catastrophe losses and resulting litigation. The frequency and severity of catastrophic losses we experience in any year affect our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. Portions of our catastrophe losses may be recoverable under our catastrophe reinsurance agreements. We include a discussion of the impact of catastrophes because we believe it is meaningful for investors to understand the variability in periodic earnings. Three Months Ended September 30, Nine Months Ended September 30, (In Thousands) 2012 2011 2012 2011 ISO catastrophes $ 7,204 $ 20,365 $ 33,148 $ 59,011 Non-ISO catastrophes (1) 1,289 3,528 1,398 17,964 Total catastrophes $ 8,493 $ 23,893 $ 34,546 $ 76,975
(1) This number includes international assumed losses.
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