RLI CORP — Interim / Quarterly Report 2003

Oct 30, 2003

10-Q 1 a03-4560_110q.htm 10-Q

*UNITED STATES SECURITIES AND EXCHANGE COMMISSION* Washington, D.C. 20549

*FORM 10-Q*

*(Mark One)*

| ý | Quarterly Report Pursuant to
Section 13 or 15(d) of the Securities Exchange Act of 1934 |
| --- | --- |
| | For
the quarterly period ended September 30, 2003 |
| or | |
| o | 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: 0-6612 |

*RLI Corp.*

(Exact name of registrant as specified in its charter)

ILLINOIS	37-0889946
(State or other
jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)
9025
North Lindbergh Drive, Peoria, IL	61615
(Address of
principal executive offices)	(Zip Code)
(309)
692-1000
(Registrant’s
telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes ý No o

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

Yes ý No o

APPLICABLE ONLY TO CORPORATE ISSUERS:

As of October 22, 2003 the number of shares outstanding of the registrant’s Common Stock was 25,150,430.

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*PART I – FINANCIAL INFORMATION*

*Item 1. Financial Statements*

RLI Corp. & Subsidiaries

Condensed Consolidated Statement of Earnings and Comprehensive Earnings

| (Unaudited) | For the
Three-Month Period Ended September 30, — 2003 | | 2002 | |
| --- | --- | --- | --- | --- |
| Net
premiums earned | $ 118,953,696 | | $ 91,639,002 | |
| Net
investment income | 11,205,067 | | 9,401,086 | |
| Net
realized investment gains (loss) | 8,970,646 | | (6,636,108 | ) |
| | 139,129,409 | | 94,403,980 | |
| Losses
and settlement expenses | 73,271,740 | | 53,992,262 | |
| Policy
acquisition costs | 30,314,044 | | 27,804,288 | |
| Insurance
operating expenses | 6,754,906 | | 5,426,266 | |
| Interest
expense on debt | 146,441 | | 456,651 | |
| General
corporate expenses | 821,571 | | 693,998 | |
| | 111,308,702 | | 88,373,465 | |
| Equity
in earnings of uncons. investee | 1,623,632 | | 1,127,566 | |
| Earnings
before income taxes | 29,444,339 | | 7,158,081 | |
| Income
tax expense | 4,075,019 | | 1,517,907 | |
| Net
earnings | $ 25,369,320 | | $ 5,640,174 | |
| Other
comprehensive (loss), net of tax | (7,583,532 | ) | (19,089,011 | ) |
| Comprehensive
earnings (loss) | $ 17,785,788 | | $ (13,448,837 | ) |
| Earnings
per share: | | | | |
| Basic: | | | | |
| Basic
net earnings per share | $ 1.01 | | $ 0.28 | |
| Basic
compre. earnings (loss) per share | $ 0.71 | | $ (0.68 | ) |
| Diluted: | | | | |
| Diluted
net earnings per share | $ 0.98 | | $ 0.28 | |
| Diluted
compre. earnings (loss) per share | $ 0.69 | | * | |
| Weighted
average number of common shares outstanding | | | | |
| Basic | 25,126,924 | | 19,868,315 | |
| Diluted | 25,921,958 | | 20,466,885 | |
| Cash
dividends declared per common share | $ 0.10 | | $ 0.09 | |

• The impact of common stock equivalents was antidilutive

The accompanying notes are an integral part of the financial statements.

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| (Unaudited) | For the
Nine-Month Period Ended September 30, — 2003 | 2002 | |
| --- | --- | --- | --- |
| Net
premiums earned | $ 341,725,342 | $ 247,427,375 | |
| Net
investment income | 32,755,092 | 28,057,979 | |
| Net
realized investment gains (loss) | 11,322,861 | (3,772,542 | ) |
| | 385,803,295 | 271,712,812 | |
| Losses
and settlement expenses | 206,798,410 | 144,463,119 | |
| Policy
acquisition costs | 88,624,737 | 75,757,707 | |
| Insurance
operating expenses | 20,587,186 | 17,624,660 | |
| Interest
expense on debt | 593,169 | 1,361,660 | |
| General
corporate expenses | 2,870,921 | 2,612,882 | |
| | 319,474,423 | 241,820,028 | |
| Equity
in earnings of uncons. investee | 5,166,277 | 3,566,907 | |
| Earnings
before income taxes | 71,495,149 | 33,459,691 | |
| Income
tax expense | 16,298,025 | 8,760,993 | |
| Net
earnings | $ 55,197,124 | $ 24,698,698 | |
| Other
compre. earnings (loss), net of tax | 12,316,686 | (32,032,857 | ) |
| Comprehensive
earnings (loss) | $ 67,513,810 | $ (7,334,159 | ) |
| Earnings
per share: | | | |
| Basic: | | | |
| Basic
net earnings per share | $ 2.20 | $ 1.24 | |
| Basic
compre. Earnings (loss) per share | $ 2.69 | $ (0.37 | ) |
| Diluted: | | | |
| Diluted
net earnings per share | $ 2.14 | $ 1.21 | |
| Diluted
compre. earnings (loss) per share | $ 2.62 | * | |
| Weighted
average number of common shares outstanding | | | |
| Basic | 25,107,405 | 19,852,123 | |
| Diluted | 25,793,093 | 20,425,765 | |
| Cash
dividends declared per common share | $ 0.29 | $ 0.26 | |

• The impact of common stock equivalents was antidilutive

The accompanying notes are an integral part of the financial statements.

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RLI Corp. and Subsidiaries Condensed Consolidated Balance Sheet

| | September
30, 2003 | | December
31, 2002 | |
| --- | --- | --- | --- | --- |
| | (Unaudited) | | | |
| ASSETS | | | | |
| Investments | | | | |
| Fixed
maturities | | | | |
| Held-to-maturity,
at amortized cost | $ 191,305,570 | | $ 231,780,601 | |
| Trading,
at fair value | 8,425,209 | | 8,195,821 | |
| Available-for-sale,
at fair value | 676,053,528 | | 484,818,576 | |
| Equity
securities, at fair value | 250,357,695 | | 227,342,269 | |
| Short-term
investments, at cost | 50,681,151 | | 47,890,010 | |
| Total
investments | 1,176,823,153 | | 1,000,027,277 | |
| Accrued
investment income | 11,104,522 | | 9,454,106 | |
| Premiums
and reinsurance balances receivable | 137,508,223 | | 122,257,711 | |
| Ceded
unearned premium | 101,995,864 | | 95,406,453 | |
| Reinsurance balances
recoverable on unpaid losses | 349,274,825 | | 340,886,393 | |
| Deferred
policy acquisition costs | 63,078,249 | | 60,102,086 | |
| Property
and equipment | 18,524,438 | | 17,756,773 | |
| Investment
in unconsolidated investee | 30,446,867 | | 25,260,857 | |
| Goodwill
and indefinite-lived intangibles | 26,214,491 | | 27,882,491 | |
| Other
assets | 16,294,272 | | 20,293,790 | |
| TOTAL
ASSETS | $ 1,931,264,904 | | $ 1,719,327,937 | |
| LIABILITIES
AND SHAREHOLDERS’ EQUITY | | | | |
| Liabilities: | | | | |
| Unpaid
losses and settlement expenses | $ 842,858,570 | | $ 732,838,191 | |
| Unearned
premiums | 365,670,014 | | 350,803,158 | |
| Reinsurance
balances payable | 91,095,339 | | 78,231,343 | |
| Short-term
debt, LOC and notes payable | 48,282,750 | | 54,356,250 | |
| Income
taxes-current | 3,763,871 | | 1,786,897 | |
| Income
taxes-deferred | 33,626,307 | | 26,022,212 | |
| Other
liabilities | 19,234,762 | | 18,734,426 | |
| TOTAL
LIABILITIES | 1,404,531,613 | | 1,262,772,477 | |
| Shareholders’
Equity: | | | | |
| Common
stock ($1 par value) (30,942,917 shares issued at 9/30/03) (30,472,864 shares issued at 12/31/02) | 30,942,917 | | 30,472,864 | |
| Paid-In
Capital | 179,708,477 | | 170,204,681 | |
| Accumulated
other comprehensive earnings | 83,613,833 | | 71,297,147 | |
| Retained
Earnings | 313,482,575 | | 265,573,238 | |
| Deferred
compensation | 5,939,296 | | 5,531,085 | |
| Less: Treasury shares at cost (5,792,487 shares at 9/30/03) (5,791,689 shares at 12/31/02) | (86,953,807 | ) | (86,523,555 | ) |
| TOTAL
SHAREHOLDERS’ EQUITY | 526,733,291 | | 456,555,460 | |
| TOTAL
LIABILITIES AND SHAREHOLDERS’ EQUITY | $ 1,931,264,904 | | $ 1,719,327,937 | |

The accompanying notes are an integral part of the financial statements.

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RLI Corp. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

| | For the
Nine-Month Period Ended September 30, — 2003 | | 2002 | |
| --- | --- | --- | --- | --- |
| Net cash provided by operating activities | $ 149,828,290 | | $ 120,843,001 | |
| Cash
Flows from Investing Activities | | | | |
| Investments
purchased | (366,777,772 | ) | (179,999,399 | ) |
| Investments
sold | 175,104,977 | | 57,642,603 | |
| Investments
called or matured | 44,541,962 | | 39,588,627 | |
| Net
proceeds from the sale of insurance shell | 5,100,000 | | 0 | |
| Net
decrease in short-term investments | (3,694,641 | ) | (42,354,048 | ) |
| Change
in notes receivable | 1,500,000 | | 500,000 | |
| Net
property and equipment purchased | (3,199,574 | ) | (2,433,909 | ) |
| Net
cash used in investing activities | (147,425,048 | ) | (127,056,126 | ) |
| Cash
Flows from Financing Activities | | | | |
| Cash
dividends paid | (6,994,044 | ) | (4,861,747 | ) |
| Payments
on debt | (6,500,000 | ) | (762,875 | ) |
| Proceeds
from issuance of debt | 426,500 | | 10,940,000 | |
| Proceeds
from issuance of common stock | 10,047,504 | | 0 | |
| ISO
Share issuance | 638,839 | | 416,969 | |
| Treasury
shares (purchased) reissued | (22,041 | ) | 480,778 | |
| Net
cash (used in)provided by financing activities | (2,403,242 | ) | 6,213,125 | |
| Net
increase in cash | 0 | | 0 | |
| Cash
at the beginning of the year | 0 | | 0 | |
| Cash
at September 30 | $ 0 | | $ 0 | |

The accompanying notes are an integral part of the financial statements.

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*NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS*

*1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES* - The financial information is prepared in conformity with accounting principles generally accepted in the United States of America (GAAP), and such principles are applied on a basis consistent with those reflected in the 2002 annual report filed with the Securities and Exchange Commission. Management has prepared the financial information included herein without audit by independent certified public accountants. The condensed consolidated balance sheet as of December 31, 2002 has been derived from, and does not include all the disclosures contained in, the audited consolidated financial statements for the year ended December 31, 2002.

The information furnished includes all adjustments and normal recurring accrual adjustments, which are, in the opinion of management, necessary for a fair statement of results for the interim periods. Results of operations for the nine-month periods ended September 30, 2003 and 2002 are not necessarily indicative of the results of a full year.

The accompanying financial data should be read in conjunction with the notes to the financial statements contained in the 2002 Annual Report on Form 10-K.

*Earnings Per Share* : Basic earnings per share (EPS) excludes dilution and is computed by dividing income available to common stockholders 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 (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 antidilutive. Under these circumstances, the diluted net earnings or net loss per share is computed excluding the common stock equivalents.

Pursuant to disclosure requirements contained in Statement 128, “Earnings Per Share,” the following represents a reconciliation of the numerator and denominator of the basic and diluted EPS computations contained in the financial statements.

| | For the
Nine-Month Period Ended September 30, 2003 — Income (Numerator) | Shares (Denominator) | Per Share Amount |
| --- | --- | --- | --- |
| Basic EPS | | | |
| Income
available to common stockholders | $ 55,197,124 | 25,107,405 | $ 2.20 |
| Effect of Dilutive Securities | | | |
| Incentive
Stock Options | — | 685,688 | |
| Diluted EPS | | | |
| Income
available to common stockholders | $ 55,197,124 | 25,793,093 | $ 2.14 |

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| | For the
Nine-Month Period Ended September 30, 2002 — Income (Numerator) | Shares (Denominator) | Per Share Amount |
| --- | --- | --- | --- |
| Basic EPS | | | |
| Income
available to common stockholders | $ 24,698,698 | 19,852,123 | $ 1.24 |
| Effect of Dilutive Securities | | | |
| Incentive
Stock Options | — | 573,642 | |
| Diluted EPS | | | |
| Income
available to common stockholders | $ 24,698,698 | 20,425,765 | $ 1.21 |

*Other Accounting Standards:* In December 2002, the Financial Accounting Standards Board (FASB) published Statement of Financial Accounting Standards (SFAS) 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation” and provides alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require more prominent and more frequent disclosures in financial statements about the effects of stock-based compensation, including disclosures in interim financial statements. The transition guidance and annual disclosure provisions of SFAS 148 are effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The provisions for interim-period disclosures were effective for interim periods beginning after December 31, 2002 and are summarized in the stock based compensation section on the following page.

*Stock based compensation:* We grant to officers and directors stock options for shares with an exercise price equal to the fair market value of the shares at the date of grant. We account for stock option grants in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and accordingly recognize no compensation expense for the stock option grants.

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Had compensation cost for the plan been determined consistent with SFAS 123, our net income and earnings per share would have been reduced to the following pro forma amounts:

| | For the
Nine-Month Period Ended September 30, — 2003 | | 2002 | |
| --- | --- | --- | --- | --- |
| Net
income, as reported | $ 55,197,124 | | $ 24,698,698 | |
| Add:
Stock-based employee compensation expense included in reported income, net of
related tax effects | — | | — | |
| Deduct:
Total stock-based employee compensation expense determined under
fair-value-based methods for all awards, net of related tax effects | (1,256,847 | ) | (1,135,237 | ) |
| Pro
forma net income | $ 53,940,277 | | $ 23,563,461 | |
| Earnings
per share: | | | | |
| Basic
–as reported | $ 2.20 | | $ 1.24 | |
| Basic
–pro forma | $ 2.15 | | $ 1.19 | |
| Diluted
–as reported | $ 2.14 | | $ 1.21 | |
| Diluted
–pro forma | $ 2.09 | | $ 1.15 | |

	For the Three-Month Period Ended September 30, — 2003		2002
Net
income, as reported	$ 25,369,320		$ 5,640,174
Add:
Stock-based employee compensation expense included in reported income, net of
related tax effects	—		—
Deduct:
Total stock-based employee compensation expense determined under fair-value-based
methods for all awards, net of related tax effects	(424,468	)	(378,412	)
Pro
forma net income	$ 24,944,852		$ 5,261,762
Earnings
per share:
Basic
–as reported	$ 1.01		$ 0.28
Basic
–pro forma	$ 0.99		$ 0.26
Diluted
–as reported	$ 0.98		$ 0.28
Diluted
–pro forma	$ 0.96		$ 0.26

These pro forma amounts may not be representative of the effects of SFAS 123 on pro forma net income for future periods because options vest over several years and additional awards may be granted in the future.

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*Intangible assets:* In accordance with SFAS 142, “Goodwill and Other Intangible Assets,” the amortization of goodwill and indefinite-lived intangible assets is not permitted. Goodwill and indefinite-lived intangible assets remain on the balance sheet and are tested for impairment on an annual basis, or when there is reason to suspect that their values may have been diminished or impaired. Goodwill and indefinite-lived intangible assets, which relate to our surety segment, are listed separately on the balance sheet and totaled $26.2 million at September 30, 2003. In conjunction with the sale of the insurance company shell in July 2003, we recorded a $1.7 million reduction to indefinite-lived intangible assets, which represented the unamortized value of insurance licenses sold during this transaction. Impairment testing was performed during 2003, pursuant to the requirements of SFAS 142. Based upon this valuation analysis, these assets do not appear to be impaired.

Intangible assets with definite lives continue to be amortized over their estimated useful lives. Definite-lived intangible assets that continue to be amortized under SFAS 142 relate to our purchase of customer-related and marketing-related intangibles. At September 30, 2003, net definite-lived intangible assets totaled $2.4 million, net of $3.3 million of accumulated amortization, and are included in other assets. Definite-lived intangibles are subject to review for impairment pursuant to the requirements of SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS 144 requires, among other things, that we review our long-lived assets and certain related intangibles for impairment whenever changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. Of our $2.4 million net definite-lived intangible asset, $874,000 relates to the contract surety book. Given the difficulties experienced in the contract surety book, we believed a review of this intangible asset was warranted during the second quarter of 2003. In accordance with SFAS 144, this asset was tested for impairment by comparing the asset’s projected undiscounted cash flows to its carrying value. Results of this test indicated projected undiscounted cash flows in excess of the current carrying value. As a result, no impairment was indicated. We will continue to monitor the recoverability of this definite-lived intangible asset.

*Other accounting standards:* In April 2003, the FASB issued SFAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 149 was designed to improve financial reporting by requiring contracts with comparable characteristics be accounted for similarly. With some exception, this Statement is effective on a prospective basis for contracts entered into or modified after June 30, 2003.

In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 establishes standards for the classification in the statement of financial position of certain financial instruments that have characteristics of both liabilities and equity but may have previously been presented either entirely as equity or between the liabilities section and the equity section of the statement of financial position. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period after June 15, 2003.

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It is to be implemented by reporting a cumulative effect of a change in accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption.

The provisions of SFAS 149 and 150 are not anticipated to have a material impact on our consolidated financial statements. For a discussion of other recently issued accounting pronouncements, see pages 36-39 of our 2002 Annual Report.

*2. INDUSTRY SEGMENT INFORMATION* - Selected information by industry segment for the nine months ended September 30, 2003 and 2002 is presented below.

SEGMENT DATA— (in thousands)	EARNINGS — 2003		2002		REVENUES — 2003	2002
Property	$ 26,866		$ 13,986		$ 82,088	$ 64,555
Casualty	3,410		(889	)	224,271	145,418
Surety	(4,561	)	(3,515	)	35,366	37,454
Net
investment income	32,755		28,058		32,755	28,058
Realized
gains (loss)	11,323		(3,773	)	11,323	(3,773	)
General
corporate expense and interest on debt	(3,464	)	(3,974	)
Equity
in earnings of unconsolidated investee	5,166		3,567
Total
segment earnings before income taxes	$ 71,495		$ 33,460
Income
taxes	16,298		8,761
Total	$ 55,197		$ 24,699		$ 385,803	$ 271,712

The following table further summarizes revenues by major product type within each segment:

| (in thousands) | For the
Nine-Month Period Ended September 30, — 2003 | 2002 |
| --- | --- | --- |
| Property | | |
| Commercial
property | $ 76,724 | $ 59,255 |
| Homeowners/residential
property | 5,364 | 5,300 |
| Total | $ 82,088 | $ 64,555 |
| Casualty | | |
| General
liability | $ 92,800 | $ 52,113 |
| Specialty
program business | 38,846 | 17,530 |
| Commercial
transportation | 37,277 | 32,120 |
| Commercial
and personal umbrella | 30,748 | 24,896 |
| Executive
products | 9,810 | 5,888 |
| Other | 14,790 | 12,871 |
| Total | $ 224,271 | $ 145,418 |
| Surety | $ 35,366 | $ 37,454 |

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*3. OTHER MATTERS* - On July 1, 2003, we sold an insurance company shell, Underwriters Indemnity Holdings, Inc.(UIH) and its insurance subsidiary, Lexon Insurance Company(formerly known as Underwriters Indemnity Company) to a group of private investors. As part of the sale, we retained the right to use the Underwriters Indemnity name. This transaction, which was recognized in the third quarter, resulted in an after-tax gain of $6.9 million, $0.27 per diluted share. This gain relates to the value of licenses sold and certain tax benefits associated with a tax loss on the sale of this shell.

Additionally, we recorded a $1.7 million reduction to indefinite-lived intangible assets, which represented the unamortized value of insurance licenses sold during this transaction.

In conjunction with the sale of the shell, in-force business was assumed by one of our other insurance subsidiaries, RLI Insurance Company. The sale of this shell will have no material impact on our ongoing insurance operations.

*ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.*

“SAFE HARBOR” STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: This discussion and analysis may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Various risk factors that could affect future results are listed in the Company’s filings with the Securities Exchange Commission, including the Form 10-K for the year ended December 31, 2002.

*OVERVIEW*

We are a holding company that underwrites selected property, casualty, and surety insurance through major subsidiaries collectively known as RLI Insurance Group (the Group). The Group provides specialty property and casualty coverages for primarily commercial risks and accounted for 89% of our consolidated revenue for the first nine months of 2003 compared to 91% for the same period last year.

*Critical Accounting Policies*

In preparing the unaudited consolidated financial statements, our management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of revenues and expenses for the reporting period. Actual results could differ significantly from those estimates.

The most critical accounting policies involve significant estimates and include those used in determining the liability for unpaid losses and

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settlement expenses, investment valuation, recoverability of reinsurance balances and deferred acquisition costs.

Unpaid Losses and Settlement Expenses

The liability for unpaid losses and settlement expenses represents estimates of amounts needed to pay reported and unreported claims and related expenses. The estimates are based on certain actuarial and other assumptions related to the ultimate cost to settle such claims. Such assumptions are subject to occasional changes due to evolving economic, social and political conditions. All estimates are periodically reviewed and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments are reflected in the results of operations in the period in which they are determined.

Historically, we have not experienced significant development, favorable or unfavorable, either with the liability in total or within industry segments. Additional information with respect to reserve development patterns for individual calendar year ended liabilities can be found on pages 10-12 of our 2002 Annual Report on Form 10K. Adding to the complexities inherent in the reserving process are issues related to coverage, expansion of coverage, and reinsurance program applicability.

We have insignificant exposure to asbestos and environmental policy liabilities, as a result of entering liability lines after the industry had already recognized it as a problem. What exposure does exist is through our commercial umbrella, general liability, and discontinued assumed reinsurance lines of business. The majority of the exposure that does exist is in the excess layers of our commercial umbrella and assumed reinsurance books of business. Although our environmental exposure is limited, management cannot determine our ultimate liability with any reasonable degree of certainty. This ultimate liability is difficult to assess due to evolving legislation on such issues as joint and several liability, retroactive liability, and standards of cleanup. Additionally, we participate primarily in the excess layers, making it even more difficult to assess the ultimate impact.

Investment Valuation

Throughout each year, external investment managers buy and sell securities to maximize overall investment returns in accordance with investment policies established by the finance and investment committee of our board of directors. This includes selling individual securities that have unrealized losses when the investment manager believes future performance can be surpassed by buying other securities deemed to offer superior long-term return potential.

We classify our investments in debt and equity securities with readily determinable fair values into one of three categories: held-to-maturity securities, available-for-sale securities and trading securities. Held-to-maturity instruments are carried at amortized cost, while both available-for-sale securities and trading securities are carried at fair value.

Management regularly evaluates our fixed maturity and equity securities portfolio to determine impairment losses for other-than-temporary declines in the fair value of the investments. Criteria considered during this process include, but are not limited to: the current fair value as compared to the cost (amortized, in certain cases) of the security, degree and duration of the

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security’s fair value being below cost, credit ratings, current economic conditions, the anticipated speed of cost recovery. This evaluation ultimately impacts our decisions to hold or divest of a security.

In addition, we may consider the profitability, leverage, growth and cash flow of a company that has issued a security. Impairment losses result in a reduction of the underlying investment’s cost basis. Significant changes in these factors could result in a considerable charge for impairment losses as reported in the consolidated financial statements.

We have not sold any securities for the purpose of generating cash over the last several years, whether to pay claims, dividends or any other expense or obligation. Accordingly, we believe that our sale activity supports our intent and ability to continue to hold securities in an unrealized loss position until such time as our cost may be recovered.

Recoverability of Reinsurance Balances

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 appropriate liabilities, since reinsurance does not relieve us of our legal liability to policyholders. Such balances are subject to the credit risk associated with the individual reinsurer. Additionally, the same uncertainties associated with estimating unpaid losses and settlement expenses impact the estimates for the ceded portion of such liabilities. We continually monitor the financial condition of our reinsurers. Our policy is to periodically charge to earnings an estimate of unrecoverable amounts from troubled or insolvent reinsurers.

Deferred Policy Acquisition Costs

We defer commissions, premium taxes and certain other costs related to the acquisition of insurance contracts. These costs are capitalized and charged to expense in proportion to premium revenue recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. This would also give effect to the premium to be earned, related investment income, anticipated losses and settlement expenses as well as certain other costs expected to be incurred as the premium is earned. Judgments as to ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with the premiums written.

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*NINE MONTHS ENDED SEPTEMBER 30, 2003, COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2002*

Consolidated gross revenues, as displayed in the table that follows, totaled $602.1 million for the first nine months of 2003 compared to $559.1 million for the same period in 2002.

| Gross revenues (in thousands) | For the
Nine-Month Period Ended September 30, — 2003 | 2002 | |
| --- | --- | --- | --- |
| Gross
premiums written | $ 558,037 | $ 534,815 | |
| Net
investment income | 32,755 | 28,058 | |
| Net
realized investment gains | 11,323 | (3,773 | ) |
| Total
gross revenues | $ 602,115 | $ 559,100 | |

Gross premium writings of the Group improved 4% over 2002 levels due to growth in the casualty segment, where market conditions remain firm. Net investment income improved 17% to $32.8 million. This growth is attributable to increased cash flows from operations and the infusion of new capital from 2002’s equity offering. Additionally, the sale of certain securities and an insurance company shell during the first nine months of 2003 resulted in $11.3 million of realized gains, compared to $3.8 million in realized losses for the same period last year. 2002’s realized losses include $6.5 million of impairment losses recorded on securities whose market value was deemed to be other-than-temporarily impaired. This adjustment was a reclassification from unrealized losses to realized losses.

Consolidated net revenue for the first nine months of 2003 increased $114.1 million or 42% from the same period in 2002. Net premiums earned, the main driver of this measurement, jumped 38%, benefiting from increased retentions and the significant momentum gained from last year’s written premium growth.

Net after-tax earnings for the first nine months of 2003 totaled $55.2 million, $2.14 per diluted share, compared to $24.7 million, $1.21 per diluted share, for the same period in 2002. Significantly improved underwriting income, particularly on the property book, coupled with growth in investment income, decreased debt costs, and increased realized investment gains, favorably impacted 2003 earnings.

Results for the first nine months of 2003 include a realized gain of $3.4 million, $0.13 per diluted share, related to the sale of an insurance company shell, which was completed on July 1, 2003. Additionally, we recognized a $3.5 million, $0.14 per diluted share, tax benefit from the sale of the insurance company shell. Excluding the sale of the shell, all other realized investment gains totaled $5.1 million, $0.20 per diluted share, in after-tax realized investment gains, compared with $2.5 million, $0.12 per diluted share, in after-tax realized investment losses for the same period in 2002.

Comprehensive earnings, which include net earnings plus unrealized gains/losses net of tax, totaled $67.5 million, $2.62 per diluted share, for the first nine months of 2003, compared to a comprehensive loss of $7.3

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million, $0.37 per diluted share, for the same period in 2002. Unrealized gains, net of tax, for the first nine months of 2003 were $12.3 million, $0.48 per diluted share, compared to unrealized losses of $32.0 million, $1.58 per diluted share, for the same period in 2002. 2002 results were negatively impacted by the volatility experienced in the equity and bond markets.

*RLI INSURANCE GROUP*

As indicated earlier, gross premiums written for the Group increased to $558.0 million for the first nine months of 2003, compared to $534.8 million reported for the same period in 2002. Improved pricing and various growth initiatives in the casualty segment positively impacted gross premiums written, while the property and surety segments posted reduced writings. Underwriting income improved to a pre-tax profit of $25.7 million for the first nine months of 2003 compared to $9.6 million for the same period in 2002. The GAAP combined ratio declined to 92.5 for the first nine months of 2003, compared to 96.1 for the same period in 2002. The property segment was responsible for the majority of the improved results, posting a 67.3 GAAP combined ratio. Additionally, the casualty segment recorded improved earnings from last year. The surety segment’s results, however, were negatively impacted by contract surety losses.

| Gross premiums written (in
thousands) | For the Nine-Month Period Ended September 30, — 2003 | | 2002 | |
| --- | --- | --- | --- | --- |
| Property | $ 148,938 | | $ 160,370 | |
| Casualty | 368,787 | | 324,699 | |
| Surety | 40,312 | | 49,746 | |
| Total | $ 558,037 | | $ 534,815 | |
| Underwriting profits (losses) (in
thousands) | 2003 | | 2002 | |
| Property | $ 26,866 | | $ 13,986 | |
| Casualty | 3,410 | | (889 | ) |
| Surety | (4,561 | ) | (3,515 | ) |
| Total | $ 25,715 | | $ 9,582 | |
| Combined ratio | 2003 | | 2002 | |
| Property | 67.3 | | 78.3 | |
| Casualty | 98.4 | | 100.6 | |
| Surety | 112.8 | | 109.3 | |
| Total | 92.5 | | 96.1 | |

Gross premiums written for the Group’s property segment declined $11.4 million, or 7% from the same period last year. For the first nine months of 2003, gross property premiums totaled $148.9 million. Growth in property rates slowed during the first nine months of 2003. Fewer accounts are experiencing rate increases and average rate increases are lower than in 2002. Additionally, competitive pressure in our domestic fire line and California earthquake business has contributed to the decline in gross writings. Net premiums written totaled $80.6 million, up 3%, due to slightly increased retentions. Net earned premiums grew by 27%, benefiting from increased retentions and the significant momentum gained from last year’s premium volume. Underwriting profit for the

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property segment was $26.9 million for the first nine months of 2003, compared to $14.0 million for the same period in 2002. The GAAP combined ratio decreased to 67.3, compared to 78.3 for the same period last year. Exceptional seasonal results on our domestic fire and continued profitability on our California earthquake business contributed to these extraordinary results. Partially offsetting these improvements, our construction book was negatively impacted by spring hail storms and tornados. During the first nine months of 2002, loss experience on the construction book and discontinued property classes negatively impacted results.

The casualty segment posted gross premiums written of $368.8 million for the first nine months of 2003, up $44.1 million, or 14%, from 2002. Growth initiatives and a continued favorable rate environment contributed to growth in the following products: general liability up $51.8 million, executive products up $15.4 million, and personal umbrella up $5.7 million. Partially offsetting these increases, program business declined $28.7 million, due to exiting one unprofitable program in late 2002 and tighter risk selection on remaining programs. The casualty segment posted an underwriting profit of $3.4 million, compared to an underwriting loss of $889,000 for the same period last year. These results translate into a combined ratio of 98.4 in 2003 versus 100.6 for the same period in 2002. The segment’s expense ratio at 26.3 has continued to show improvement, as premium volume has continued to increase, while the loss ratio at 72.1 remains in check.

Gross premiums written for the surety segment totaled $40.3 million for the first nine months of 2003, down $9.4 million, or 19%, from the same period in 2002. This decrease is primarily related to underwriting changes made in contract surety, as part of corrective actions designed to return this segment to profitability. Certain relationships with contract producers were terminated during the fourth quarter of 2002, resulting in targeted reductions to contract writings. The surety book reported an underwriting loss of $4.6 million for the first nine months of 2003, compared to an underwriting loss of $3.5 million for the same period last year. Though slightly improved from the 116.0 combined ratio reported for the year-ended December 31, 2002, the combined ratio for the first nine months of 2003 was 112.8, above the 109.3 ratio reported for the first nine months of 2002. Loss experience on the contract book continued to impact this segment’s results. Corrective action was taken during 2002 and underwriting guidelines and authority have been further refined in 2003. New claim reports for contract surety have declined during 2003. We remain cautiously optimistic that changes made to date will begin to result in improved underwriting results. We will continue to carefully monitor the effectiveness of underwriting changes made to this segment.

We are in litigation regarding certain commercial surety bond claims arising out of a specific bond program. We are currently investigating and evaluating our obligations due to a variety of complex coverage issues. A detailed discussion on this litigation can be found on page 20 of our 2002 Annual Report on Form 10K. No additional information is available as of the third quarter of 2003.

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*INVESTMENT INCOME*

Our investment portfolio generated net dividend and interest income of $32.8 million during the first nine months of 2003, an increase of 17% over that reported for the same period in 2002. Continued growth in operating cash flows and investment of the proceeds from the recent equity offering completed on January 9, 2003 have resulted in the rise in investment income. Cash flows in excess of current needs were used to purchase fixed-income securities, which continue to be comprised primarily of high-grade corporate bonds and tax-exempt municipals.

As of September 30, 2003, 96% of our fixed income portfolio consisted of securities rated A or better, with 82% rated AA or better. 100% of fixed income securities held as of September 30, 2003 were investment grade. The year-to-date yields on our fixed income investments for the nine-month periods ended September 30, 2003 and 2002 are as follows:

	2003	2002
Taxable	5.16 %	6.22 %
Non-taxable	4.34 %	4.87 %

The year-to-date yields in 2003 are lower than the yields during this same time period in 2002. The decline in yields is primarily due to fluctuations in interest rates and the subsequent reinvestment of called and matured bonds at lower yields. Despite the lower yields, the overall impact on investment income has been limited due to continued growth in operational cash flow, investment of proceeds from the equity offering, and sector diversification.

We maintain an equity investment in a private mortgage banking company. As of September 30, 2003, our equity investment, which consisted of common shares and warrants to acquire common shares, had a carrying value and estimated market value of $7.1 million. We recorded $2.0 million in net investment income during the first nine months of 2003 related to Statement of Financial Accounting Standards (SFAS) 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 133 requires that we recognize the change in the fair value of stock warrants received with the purchase of a note receivable. This compares to $1.6 million recognized for the same period of 2002. We employ a consistent valuation formula to recognize investment income or loss each quarter and to adjust the carrying value of our investment. This formula is based on the investee’s book value, the volume of mortgages originated and profitability.

We experienced a net realized gain from investments of $11.3 million in the first nine months of 2003. Included in this number is a $3.4 million gain related to the sale of Underwriters Indemnity Holdings (UIH), an insurance company shell that was sold on July 1, 2003. The remaining $7.9 million realized gain was due to the sale of certain equity and fixed income securities during the first nine months of 2003. The realized gain is sizable when compared to a net realized loss of $3.8 million for the same period in 2002. The increase in net realized gains is due in part to the timing of the sale of individual securities. Additionally, during the first nine months of 2002, we recorded $6.5 million of impairment losses on securities whose market value was deemed to be other-than-temporarily impaired. This adjustment was a reclassification from unrealized losses to realized losses.

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We regularly evaluate the quality of our investment portfolio. When we believe that a specific security has suffered an other-than-temporary decline in value, the investment’s value is adjusted by charging off the loss against income. During the first nine months of 2003, there were no losses associated with the other-than-temporary-impairment of securities. During the first nine months of 2002, our analysis identified $6.5 million in other-than-temporary declines in value that we recognized as a realized loss. Partially offsetting the impairment loss, $2.7 million in net realized gains were recorded from the sale of certain equity and fixed income investments during the first nine months of 2002 bringing the net realized loss to $3.8 million during the first nine months of 2002.

The following table illustrates certain industry-level categories relative to our equity portfolio at September 30, 2003, including market value, cost basis and unrealized gains and losses.

| (dollars in thousands) | Cost Basis | 9/30/03 Mkt Value | Gains | Gross
Unrealized Losses | | Net | Unrealized Gain/Loss% (1) |
| --- | --- | --- | --- | --- | --- | --- | --- |
| Consumer Discretionary | $ 9,470 | $ 12,444 | $ 2,974 | $ — | | $ 2,974 | 31.4 % |
| Consumer Staples | 17,816 | 35,174 | 17,392 | (34 | ) | 17,358 | 97.4 % |
| Energy | 7,434 | 13,709 | 6,275 | — | | 6,275 | 84.4 % |
| Financials | 12,455 | 37,789 | 25,334 | — | | 25,334 | 203.4 % |
| Healthcare | 7,504 | 24,338 | 16,834 | — | | 16,834 | 224.3 % |
| Industrials | 17,416 | 30,993 | 13,577 | — | | 13,577 | 78.0 % |
| Materials | 9,180 | 11,774 | 2,685 | (91 | ) | 2,594 | 28.3 % |
| Information Technology | 8,576 | 12,639 | 4,103 | (40 | ) | 4,063 | 47.4 % |
| Telecommunications | 8,381 | 11,849 | 3,468 | — | | 3,468 | 41.4 % |
| Utilities | 38,641 | 52,496 | 14,026 | (171 | ) | 13,855 | 35.9 % |
| Private Investments | 7,153 | 7,153 | — | — | | — | 0.0 % |
| | $ 144,026 | $ 250,358 | $ 106,668 | $ (336 | ) | $ 106,332 | 73.8 % |

(1) Calculated as the percentage of net unrealized gain (loss) to cost basis.

The following table illustrates the number of individual securities that were in an unrealized loss position as of September 30, 2003, their fair value and cost, and length of time they have been in an unrealized loss position.

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*Investment Positions with Unrealized Losses*

*Segmented by Type and Period of Continuous*

*Unrealized Loss at September 30, 2003*

| (dollars in
thousands) | 0-6 Mos. | | 7-9 Mos. | 10-12 Mos. | > 12 Mos. | Total | |
| --- | --- | --- | --- | --- | --- | --- | --- |
| Common
Stock | | | | | | | |
| # of positions | 4 | | — | — | — | 4 | |
| Fair value | $ 5,659 | | $ — | $ — | $ — | $ 5,659 | |
| Cost or Amortized Cost | 5,995 | | — | — | — | 5,995 | |
| Unrealized Loss | (336 | ) | — | — | — | (336 | ) |
| Fixed
Income Securities | | | | | | | |
| # of positions | 184 | | — | — | — | 184 | |
| Fair value | $ 346,823 | | $ — | $ — | $ — | $ 346,823 | |
| Cost or Amortized Cost | 355,961 | | — | — | — | 355,961 | |
| Unrealized Loss | (9,138 | ) | — | — | — | (9,138 | ) |
| Total
Invested Assets | | | | | | | |
| # of positions | 188 | | — | — | — | 188 | |
| Fair value | $ 352,482 | | $ — | $ — | $ — | $ 352,482 | |
| Cost or Amortized Cost | 361,956 | | — | — | — | 361,956 | |
| Unrealized Loss | (9,474 | ) | — | — | — | (9,474 | ) |

As of September 30, 2003, we held four common stocks that were in an unrealized loss position. All four equity positions were at a loss for less than six months.

The fixed income portfolio contained 184 positions at a loss as of September 30, 2003. All of the fixed income positions were at a loss for less than six months. The fixed income unrealized losses can be attributed to an increase in medium and long term interest rates since the purchase of many of these fixed income securities. After a lengthy period of downward pressure on medium and long term interest rates, this trend started to reverse in June 2003. This upward trend in interest rates created unrealized losses for many fixed income investors. As interest rates rise, the prices of many of the fixed income securities in our portfolio will decline, generating increasing levels of unrealized losses. We continually monitor the credit quality of our fixed income investments; our ability to be repaid principal and interest. We consider price declines of securities in our other-than-temporary-impairment analysis where such price declines provide evidence of declining credit quality, and we distinguish between price changes caused by credit deterioration as opposed to rising interest rates.

As of September 30, 2003, we held no equity or fixed income securities that individually had an unrealized loss greater than 12%. Based on our evaluation of equity securities held within specific industry sectors, as well as the duration and magnitude of unrealized losses, we do not believe any securities suffered an other-than-temporary decline in value as of September 30, 2003.

Our available-for-sale portfolio of debt and equity securities had a net change in unrealized gains before tax of $18.9 million for the first nine months of 2003, compared with a $49.1 million unrealized loss for the same

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period in 2002. The 2003 year-to-date gains reflects $15.2 million unrealized gain for stocks and $3.7 million for bonds. Our net cumulative unrealized gain before tax was $128.3 million as of September 30, 2003, up from $109.4 million at December 31, 2002. Unrealized appreciation on securities, net of tax, is reflected in accumulated other comprehensive earnings, a component of shareholders’ equity.

Interest and fees on debt obligations decreased to $593,000 for the first nine months of 2003, a decrease of $768,000 from the same period in 2002. Reduced debt balances, resulting from the early January payoff of all remaining balances on the line of credit, and lower interest rates on outstanding balances led to the decrease in overall debt expense. Proceeds from the December 2002 equity offering and the January 2003 over-allotment were used, in part, to pay off all outstanding balances on the line of credit. As of September 30, 2003, outstanding short-term balances totaled $48.3 million, compared to $87.4 million at September 30, 2002. The September 30, 2003 short-term debt balances consisted only of reverse repurchase agreements. At September 30, 2002, short-term debt balances were comprised of $40.0 million under a line of credit and $47.4 million under reverse repurchase agreements. The Company has incurred interest expense on debt at the following average interest rates for the nine month periods ended September 30, 2003 and 2002:

	2003	2002
Line
of credit	2.55 %	2.59 %
Reverse
repurchase agreements	1.43 %	2.01 %
Total
debt	1.44 %	2.24 %

*INCOME TAXES*

Our effective tax rate for the first nine months of 2003 was 23%, compared to 26% for the same period in 2002. Effective rates are dependent upon components of pretax earnings and the related tax effects. Increased underwriting profits and investment gains during 2003 resulted in additional income taxable at 35%. As detailed below, however, the tax benefit associated with the sale of an insurance shell, coupled with increased tax exempt income, resulted in an overall decline in the effective tax rate. Income tax expense attributable to income from operations differed from the amounts computed by applying the U.S. federal tax rate of 35% to pretax income for the first nine months of 2003 and 2002 as a result of the following:

	2003 — Amount		%		2002 — Amount		%
Provision
for income taxes at the statutory rate of 35%	$ 25,023,302		35	%	$ 11,710,892		35	%
Increase
(reduction) in taxes resulting from:
Sale
of insurance shell	(4,719,543	)	(6	)%	—		—
Tax
exempt interest income	(3,015,105	)	(4	)%	(2,170,366	)	(6	)%
Dividends
received deduction	(1,139,998	)	(2	)%	(1,145,243	)	(4	)%
Dividends
paid deduction	(226,519	)	—		(229,324	)	(1	)%
Other
items, net	375,888		—		595,034		2	%
Total
tax expense	$ 16,298,025		23	%	$ 8,760,993		26	%

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*LIQUIDITY AND CAPITAL RESOURCES*

Historically, our primary sources of liquidity have been funds generated from insurance premiums and investment income (operating activities) and maturing investments (investing activities). In addition, we have occasionally received proceeds from financing activities such as the sale of common stock to the public or to the employee stock ownership plan, the sale of convertible debentures, and short-term borrowings. We continually monitor capital adequacy and surplus leverage, including the Group’s statutory premiums to surplus ratio.

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, before expenses. The proceeds from the offering were used to pay indebtedness under our line of credit and to increase surplus at our insurance companies.

Our 109th consecutive dividend payment was declared in the third quarter, and was paid on October 15, 2003, in the amount of $.10 per share.

Invested assets at September 30, 2003 increased by $176.8 million, or 18%, from December 31, 2002. Contributing to this increase was the investment of cash flows from operations and $10.1 million in proceeds from the over-allotment option exercised in connection with our equity offering.

At September 30, 2003 we had short-term investments, cash and other investments maturing within one year, of approximately $64.6 million and additional investments of $186.6 million maturing within five years. We maintain a $40.0 million line of credit with two financial institutions. This facility has a three-year term that expires on May 31, 2005. It is non-cancelable during its term. As of September 30, 2003, no amounts were outstanding on this facility. Additionally, we were party to four reverse repurchase transactions totaling $48.3 million.

We believe that cash generated by operations, cash generated by investments and cash available from financing activities will provide sufficient sources of liquidity to meet our anticipated needs over the next twelve to twenty-four months. Cash generated from operations during the first nine months of 2003 was $149.8 million, compared to $120.8 million for the same period last year.

Dividend payments from our principal insurance subsidiary are restricted by state insurance laws as to the amount that may be paid without prior approval of the regulatory authority of Illinois. The maximum dividend distribution is limited by Illinois law to the greater of: 10% of RLI Insurance Company’s policyholder surplus as of December 31 of the preceding year or its net income for the 12-month period ending December 31 of the preceding year. Therefore, the maximum dividend distribution that can be paid by RLI Insurance Company during 2003 without prior approval is $40.1 million - 10% of RLI Insurance Company’s 2002 policyholder surplus. The actual amount paid to us thus far in 2003 is $5.5 million.

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On October 8, 2003, we filed a shelf registration statement with the Securities and Exchange Commission to offer and sell up to $150.0 million in debt, convertible debt or trust preferred securities. If issued, the debt offering will fund general corporate purposes, which may include the payment of outstanding debt and contributions to operating subsidiaries. On October 17, 2003, the Securities and Exchange Commission declared our registration effective.

*THREE MONTHS ENDED SEPTEMBER 30, 2003, COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2002*

Consolidated gross revenues, as displayed in the table that follows, totaled $214.2 million for the third quarter of 2003 compared to $198.1 million for the same period in 2002.

| Gross revenues (in thousands) | For the
Three-Month Period Ended September 30, — 2003 | 2002 | |
| --- | --- | --- | --- |
| Gross premiums written | $ 194,029 | $ 195,314 | |
| Net
investment income | 11,205 | 9,401 | |
| Net
realized investment gains (loss) | 8,971 | (6,637 | ) |
| Total
gross revenues | $ 214,205 | $ 198,078 | |

Gross premium writings of the Group declined 1% from 2002 levels. Increased writings in the casualty segment, where market conditions remain firm, were offset by declines in property and surety writings. Net investment income improved 19% to $11.2 million for the third quarter of 2003. This growth is attributable to increased cash flows from operations and the infusion of new capital from 2002’s equity offering. Additionally, the sale of certain securities and an insurance company shell during the third quarter of 2003 resulted in $9.0 million of realized gains, compared to realized losses of $6.6 million for the same period last year. During the third quarter of 2002, we recorded $6.5 million of impairment losses on securities whose market value was deemed to be other-than-temporarily impaired. This adjustment was a reclassification from unrealized losses to realized losses.

Consolidated net revenue for the third quarter of 2003 increased $44.7 million or 47% from the same period in 2002. Net premiums earned, the main driver of this measurement, increased 30%, benefiting from increased retentions and the significant momentum gained from last year’s written premium growth.

Net after-tax earnings for the third quarter of 2003 totaled $25.4 million, $0.98 per diluted share, compared to $5.6 million, $0.28 per diluted share, for the same period in 2002. Significantly improved underwriting income, particularly on the property book, coupled with growth in investment income, decreased debt costs, and increased realized investment gains, favorably impacted 2003 earnings.

Results for the third quarter of 2003 include a realized gain of $3.4 million, $0.13 per diluted share, related to the sale of an insurance company shell, which was completed on July 1, 2003. Additionally, we recognized a $3.5 million, $0.14 per diluted share, tax benefit from the sale of the insurance

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company shell. Excluding the sale of the shell, all other realized investment gains totaled $3.6 million, $0.14 per diluted share, in after-tax realized investment gains, compared with $4.3 million, $0.21 per diluted share, in after-tax realized investment losses for the same period in 2002.

Comprehensive earnings, which include net earnings plus unrealized gains/losses net of tax, totaled $17.8 million, $0.69 per diluted share, for the third quarter of 2003, compared to a comprehensive loss of $13.5 million, $0.68 per diluted share, for the same period in 2002. Unrealized losses, net of tax, for the third quarter of 2003 totaled $7.6 million, $0.29 per diluted share, compared to $19.1 million, $0.96 per diluted share, for the same period in 2002. Both periods were negatively impacted by the volatility experienced in the equity and bond markets.

*RLI INSURANCE GROUP*

Gross premiums written for the Group declined 1% to $194.0 million for the third quarter of 2003. Declines in property and surety writings served to offset growth experienced in the casualty segment, where the market remains firm. Underwriting income improved to a pre-tax profit of $8.6 million for the third quarter of 2003, compared to $4.4 million for the same period in 2002. The GAAP combined ratio declined to 92.8 for the third quarter of 2003, as both the surety and casualty segments posted improvements.

| Gross premiums written (in thousands) | For the
Three-Month Period Ended September 30, — 2003 | | 2002 | |
| --- | --- | --- | --- | --- |
| Property | $ 48,354 | | $ 54,260 | |
| Casualty | 131,831 | | 123,880 | |
| Surety | 13,844 | | 17,174 | |
| Total | $ 194,029 | | $ 195,314 | |
| Underwriting profits (losses) (in thousands) | 2003 | | 2002 | |
| Property | $ 7,923 | | $ 6,914 | |
| Casualty | 2,047 | | (261 | ) |
| Surety | (1,357 | ) | (2,237 | ) |
| Total | $ 8,613 | | $ 4,416 | |
| Combined ratio | 2003 | | 2002 | |
| Property | 71.7 | | 70.4 | |
| Casualty | 97.4 | | 100.5 | |
| Surety | 112.1 | | 117.3 | |
| Total | 92.8 | | 95.2 | |

Gross premiums written for the Group’s property segment declined $5.9 million, or 11% from the same period last year. Competitive pressures in our domestic fire line and a stabilization of property rates during the third quarter have contributed to the decline in gross writings. Net premiums written totaled $25.8 million, down 2%, due to the slowdown in production. Net earned premiums grew by 20%, benefiting from the significant momentum gained from

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last year’s premium volume. Underwriting profit for the property segment was $7.9 million for the third quarter of 2003, compared to $6.9 million for the same period in 2002. The GAAP combined ratio for the third quarter of 2003 was 71.7, up slightly from the 70.4 posting for the same period last year. While our domestic fire and California earthquake business continue to trend favorably, losses on the construction book during the third quarter of 2003 drove the combined ratio higher.

The casualty segment posted gross premiums written of $131.8 million for the third quarter of 2003, up $8.0 million, or 6%, from 2002. Growth initiatives and a continued favorable rate environment contributed to growth in the following products: general liability up $14.7 million, executive products up $4.1 million, transportation up $3.3 million, and personal umbrella up $1.6 million. Partially offsetting these increases, program business declined $14.2 million in the quarter, due to exiting one unprofitable program in late 2002 and tighter risk selection on remaining programs. The casualty segment posted an underwriting profit of $2.0 million compared to an underwriting loss of $261,000 for the same period last year. These results translate into a combined ratio of 97.4 for the third quarter of 2003, versus 100.5 for the same period in 2002. The segment’s expense ratio at 26.1 has continued to show improvement, as premium volume has continued to increase, while the loss ratio at 71.3 remains in check.

Gross premiums written for the surety segment totaled $13.8 million for the third quarter of 2003, down $3.3 million, or 19%, from the same period in 2002. This decrease is primarily related to underwriting changes made in contract surety, which resulted in targeted reductions to contract writings. The surety book reported an underwriting loss of $1.4 million for the third quarter of 2003, compared to a loss of $2.2 million for the same period in 2002. Loss experience on the contract book negatively impacted both periods. As mentioned previously, corrective action was taken during 2002 and underwriting guidelines and authority have been further refined in 2003. New claim reports for contract surety declined during the quarter. We remain cautiously optimistic that changes made to date will begin to result in improved underwriting results. We will continue to carefully monitor the effectiveness of underwriting changes made to this segment.

*INVESTMENT INCOME*

Our investment portfolio generated net dividend and interest income of $11.2 million during the third quarter of 2003, an increase of 19% over that reported for the same period in 2002. A substantial driver of this upward trend is an increase in interest income in our fixed-income portfolio.

Yields on our fixed income investments for the third quarter of 2003 and third quarter 2002 are as follows:

	2003	2002
Taxable	4.92 %	6.13 %
Non-taxable	3.98 %	4.77 %

The quarter-to-date yields in 2003 are lower than the yields during this same time period in 2002. The decline in yields is primarily due to fluctuations in interest rates and the subsequent reinvestment of called and matured bonds at lower yields. Despite the lower yields, the overall impact on investment income has been limited due to continued growth in operational cash flow,

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investment of proceeds from the equity offering, and sector diversification.

We recorded $855,000 in net investment income during the third quarter of 2003 related to Statement of Financial Accounting Standards (SFAS) 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS 133 requires that we recognize the change in the fair value of stock warrants received with the purchase of a note receivable. This compares to $472,000 recognized for the same period of 2002.

We experienced a net realized gain from investments of $9.0 million in the third quarter of 2003. Included in this number is a $3.4 million gain related to the sale of Underwriters Indemnity Holdings (UIH), an insurance company shell that was sold on July 1, 2003. The remaining $5.6 million realized gain was due to the sale of certain equity and fixed income securities during the third quarter of 2003. This gain compared to a net realized loss of $6.6 million for the same period in 2002. This change is due in part to the gain on the sale of UIH and the timing of sales of individual securities. In addition, during the third quarter of 2002, we recorded $6.5 million of impairment losses on securities whose market value was deemed to be other-than-temporarily impaired. This adjustment was a reclassification from unrealized losses to realized losses.

We regularly evaluate the quality of our investment portfolio. When we believe that a specific security has suffered an other-than-temporary decline in value, the investment’s value is adjusted by charging off the loss against income. During the third quarter of 2003, there were no losses associated with the other-than-temporary-impairment of securities. As mentioned above, in September 2002, we recorded $6.5 million of impairment losses on securities whose market value was deemed to be other-than-temporarily impaired.

*INCOME TAXES*

The Company’s effective tax rate for the third quarter of 2003 was 14% compared to 21% for the third quarter of 2002. Increased underwriting profits and investment gains, during the third quarter of 2003, resulted in additional income taxable at 35%. As detailed below, however, the tax benefit associated with the sale of an insurance shell, coupled with increased tax exempt income, resulted in an overall decline in the effective tax rate. Income tax expense attributable to income from operations differed from the amounts computed by applying the U.S. federal tax rate of 35% to pretax income for the third quarter of 2003 and 2002 as a result of the following:

	2003 — Amount		%		2002 — Amount		%
Provision
for income taxes at the statutory rate of 35%	$ 10,305,519		35	%	$ 2,505,328		35	%
Increase
(reduction) in taxes resulting from:
Sale
of insurance shell	(4,719,543	)	(16	)%	—		—
Tax
exempt interest income	(1,020,747	)	(4	)%	(748,860	)	(10	)%
Dividends
received deduction	(388,001	)	(1	)%	(366,692	)	(5	)%
Dividends
paid deduction	(76,110	)	—		(77,514	)	(1	)%
Other
items, net	(26,099	)	—		205,645		2	%
Total
tax expense	$ 4,075,019		14	%	$ 1,517,907		21	%

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*ITEM 3. Quantitative and Qualitative Disclosures About Market Risk*

Market risk is the risk of economic losses due to adverse changes in the estimated fair value of a financial instrument as the result of changes in equity prices, interest rates, foreign exchange rates and commodity prices. Our consolidated balance sheets include assets and liabilities whose estimated fair values are subject to market risk. The primary market risks are equity price risk associated with investments in equity securities and interest rate risk associated with investments in fixed maturities. From time to time, equity prices and interest rates fluctuate causing an effect on our investment portfolio. We have no exposure to foreign exchange risk and no direct commodity risk.

Our market risk exposures at September 30, 2003, have not materially changed from those identified in the 10-K at December 31, 2002.

ITEM 4. Controls and Procedures

We maintain a system of controls and procedures designed to provide reasonable assurance as to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. An evaluation of the effectiveness of the design and operation of our disclosure controls and procedures was performed, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective, as of the end of the period covered by this report.

In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurances of achieving the desired control objective, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. We believe that our disclosure controls and procedures provide such reasonable assurance.

No changes were made to our internal control over financial reporting during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

*PART II - OTHER INFORMATION*

| Item
1. | Legal
Proceedings – There
were no changes during the quarter. |
| --- | --- |
| Item 2. | Change in Securities and Use of Proceeds – Not Applicable |
| Item 3. | Defaults Upon Senior Securities – Not Applicable |

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Item 4.	Submission of Matters to a Vote of Security Holders – Not Applicable
Item 5.	Other Information – Not Applicable
Item 6.	Exhibits and Reports on Form 8-K
(a)	Exhibit 31.1
Certification Pursuant to Rule 13a-14(a) under Securities Exchange Act of
1934
	Exhibit 31.2
Certification Pursuant to Rule 13a-14(a) under Securities Exchange Act of
1934
	Exhibit 32.1
Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
	Exhibit 32.2
Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
(b)	On July 16, 2003, the
Company filed a report on Form 8-K which furnished a copy of its press
release announcing the financial results for the second quarter of 2003.

*SIGNATURES*

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

/s/ Joseph E.
Dondanville
Joseph E. Dondanville
Sr. Vice President,
Chief Financial Officer (Duly authorized and Principal Financial and Accounting Officer)
Date: October 30, 2003

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