PROTECTIVE INSURANCE CORPORATION Protective Insurance Corporation is a property-casualty insurer specializing in marketing and underwriting property, liability and workers' compensation coverage for trucking and public transportation fleets, as well as coverage for trucking industry independent contractors. We operate as one reportable property and casualty insurance segment, offering a range of products and services, the most significant being commercial automobile and workers' compensation insurance products. The term "Protective," as used throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A"), refers toProtective Insurance Corporation , the parent company. The terms the "Company," "we," "us" and "our," as used throughout this MD&A, refer to Protective and all of its subsidiaries, unless the context clearly indicates otherwise. The term "Insurance Subsidiaries," as used throughout this MD&A, refers toProtective Insurance Company ,Protective Specialty Insurance Company ,Sagamore Insurance Company andB&L Insurance, Ltd.
Effective
EffectiveJanuary 1, 2018 , we adopted Accounting Standards Update ("ASU") 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, or ASU 2016-01, resulting in a cumulative-effect adjustment of$71.0 million ($46.2 million , net of tax). This adjustment moved our historical unrealized gains and losses, net of tax, on our equity portfolio from accumulated other comprehensive income (loss) to retained earnings, but had no impact on overall shareholders' equity. In addition, for 2018 and forward, the change in fair value for equity securities is required to be recognized in net earnings rather than in other comprehensive income (loss). The impact to our consolidated statements of operations will vary depending upon the level of volatility in the performance of the securities held in our equity portfolio and the overall market. OnDecember 22, 2017 , theU.S. Tax Cuts and Jobs Act (the "U.S. Tax Act") was signed into law, which lowered theU.S. corporate income tax rate from 35% to 21% effectiveJanuary 1, 2018 . We finalized our accounting for the tax effects of theU.S. Tax Act during 2018. No material adjustments to income tax expense (benefit) were recorded during 2018. OnSeptember 4, 2020 ,A.M. Best Company, Inc. ("A.M. Best") affirmed our financial strength rating of "A" (Excellent).A.M. Best continues to categorize our balance sheet as "very strong" and our operating performance as "adequate," but its outlook remains negative. OnFebruary 16, 2021 , in connection with the announced Merger Agreement discussed below,A.M. Best placed our financial strength rating under review with positive implications.
Special Committee and Contingent Sale Agreement
OnMay 5, 2020 , the Board of Directors (the "Board") of Protective formed a special committee of independent directors (the "Special Committee") to evaluate a Stockholder Support and Contingent Sale Agreement (the "Contingent Sale Agreement") entered into by and among certain prospective third party purchasers (the "Offering Parties"), certain of Protective's shareholders and the other parties thereto (The Contingent Sale Agreement was amended and restated onAugust 17, 2020 ). InJune 2020 , Protective announced that the Board determined the transactions contemplated by the Contingent Sale Agreement were not in the best interests of Protective and our stakeholders. As part of this evaluation, the Board determined that it would also recommend against the potential tender offer contemplated by the Contingent Sale Agreement if it were commenced, and that if the transactions contemplated by the Contingent Sale Agreement were consummated, it expects to take the necessary actions to redeem all or certain of the Class A shares of Protective purchased by the Offering Parties pursuant to Protective's Code of By-laws. Protective also announced that the Special Committee of the Board was exploring, with the assistance of its independent financial and legal advisors, strategic alternatives that may be available to Protective.
During 2020, we incurred an aggregate of
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--------------------------------------------------------------------------------Proposed Merger with The Progressive Corporation
Merger Agreement
OnFebruary 14, 2021 , Protective entered into an Agreement and Plan of Merger (the "Merger Agreement") with The Progressive Corporation, anOhio corporation ("Progressive"), andCarnation Merger Sub Inc. , anIndiana corporation and wholly-owned indirect subsidiary of Progressive ("Merger Sub"). The Merger Agreement provides for, subject to the satisfaction or waiver of specified conditions, the merger of Merger Sub with and into Protective (the "Merger"), whereupon the separate existence of Merger Sub will cease and Protective will continue as the surviving corporation and as a wholly-owned indirect subsidiary of Progressive. The Board, at the unanimous recommendation of the Special Committee, unanimously determined that the Merger Agreement and the transactions contemplated thereby, including the Merger, are advisable and fair to, and in the best interests of, Protective and its shareholders, and approved, adopted and declared advisable the Merger Agreement and the transactions contemplated thereby. The Merger is expected to close prior to the end of the third quarter of 2021. At the effective time of the Merger, each issued and outstanding share of common stock, without par value, of Protective (other than each share of Protective's common stock that is owned by Protective as treasury stock or by any subsidiary of Protective and each share of Protective's common stock owned by Progressive, Merger Sub or any other subsidiary of Progressive immediately prior to the effective time of the Merger) will be automatically canceled and converted into the right to receive$23.30 in cash, without interest, for a total transaction value of approximately$338 million . The Merger Agreement contains various customary representations and warranties from each of Protective, Progressive and Merger Sub. Protective has also agreed to various customary covenants, including but not limited to conducting its business in the ordinary course and not engaging in certain types of transactions during the period between the execution of the Merger Agreement and the closing of the Merger. However, the Merger Agreement permits Protective to continue to pay regular quarterly dividends not to exceed$0.10 per share of its common stock. The consummation of the Merger is subject to certain conditions, including approval of the Merger by Protective's Class A shareholders, legal and regulatory approvals including from theIndiana Department of Insurance and the expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, as well as other customary closing conditions.
For additional information regarding the risks associated with the Merger, please see Part I, Item 1A, "Risk Factors," of this Annual Report on Form 10-K.
Voting and Support Agreement
OnFebruary 14, 2021 , Protective also entered into a Voting and Support Agreement (the "Voting Agreement") with Progressive and certain of Protective's shareholders. The Voting Agreement requires that the Protective shareholders party to the Voting Agreement: (i) appear at the meeting of the holders of Protective's Class A common stock to consider resolutions to approve the Merger Agreement and the Merger or otherwise cause their shares of Protective's common stock to be counted as present for purposes of calculating a quorum, and (ii) vote their shares (a) in favor of the adoption of the Merger Agreement, the Merger and the other transactions contemplated thereby and any action reasonably requested by Progressive or the Board in furtherance of the foregoing, (b) against any action or agreement that would result in a material breach of any covenant, representation or warranty or other obligation or agreement of Protective contained in the Merger Agreement and (c) against any takeover proposal or superior proposal (provided, that if the Board changes its recommendation with respect to the Merger, any shares of Class A common stock owned by such shareholders in excess of approximately 35% of the outstanding shares of Class A common stock will be voted in the same proportion as those shares of Class A common stock voted by the holders of Protective's Class A common stock that are not party to the Voting Agreement). 29 --------------------------------------------------------------------------------
Expected Credit Losses Standard (CECL) Adoption
OnJanuary 1, 2020 , we adopted the provisions of ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, or ASU 2016-13. ASU 2016-13 introduced a current expected credit loss ("CECL") model for measuring expected credit losses for certain types of financial instruments held at the reporting date requiring significant judgment in application based on historical experience, current conditions and reasonable supportable forecasts, but is not prescriptive about certain aspects of estimating expected losses. We adopted the guidance using a modified retrospective approach as ofJanuary 1, 2020 and recognized a cumulative effect adjustment of$15.5 million ($12.3 million net of tax), to the opening balance of retained earnings. The adjustment was primarily related to estimating credit losses on our accounts receivable balances, reinsurance recoverable balances and commercial mortgage loans at the date of adoption with$15.0 million ($11.9 million , net of tax) attributed to our ongoing litigation withPersonnel Staffing Group ("PSG") discussed in Note T, "Litigation, Commitments and Contingencies," to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K. During the third quarter of 2020, we performed an update to our CECL allowance calculation related to the PSG matter and recorded an additional allowance of$1.5 million ($1.2 million , net of tax). No additional allowance was recorded in the fourth quarter of 2020. This allowance is included within other operating expenses in the consolidated statement of operations for the year endedDecember 31, 2020 . The updated guidance in ASU 2016-13 also amended the previous other-than-temporary impairment ("OTTI") model for available-for-sale fixed income securities by requiring the recognition of impairments relating to credit losses through an allowance account and limiting the amount of credit loss to the difference between a security's amortized cost basis and its fair value. In addition, the length of time a security has been in an unrealized loss position will no longer impact the determination of whether a credit loss exists. We adopted the guidance related to available-for-sale fixed income securities onJanuary 1, 2020 using a prospective transition approach for available-for-sale fixed income securities that were purchased with credit deterioration or had recognized an OTTI write-down prior to the effective date. The effect of the prospective transition approach was to maintain the same amortized cost basis before and after the effective date. For those securities in an unrealized loss position where we intended to sell as ofDecember 31, 2020 , we recorded a write down to earnings of$1.8 million during the year endedDecember 31, 2020 . We also analyzed securities in an unrealized loss position for credit losses and recorded an allowance for credit losses of$1.0 million as ofDecember 31, 2020 . We reviewed our remaining fixed income securities in an unrealized loss position as ofDecember 31, 2020 and determined the losses were primarily the result of non-credit factors, such as the increase in market volatility due to the disruption in global financial markets as a result of the novel coronavirus ("COVID-19") pandemic and responses to it. We currently do not intend to sell nor do we expect to be required to sell these securities before recovery of their amortized cost.
COVID-19 Impacts
Beginning inMarch 2020 and continuing through the date of this Annual Report on Form 10-K, the global pandemic associated with COVID-19 and related economic conditions have impacted the global economy and our results of operations. For the year endedDecember 31, 2020 , net premiums earned within our commercial automobile products, specifically public transportation, were negatively impacted due to a reduction in miles driven, which is the basis for premiums we receive, as well as an overall reduction in public transportation units insured. The declines in public transportation persisted throughout the year and have continued into 2021, but we saw a recovery in the third and fourth quarters within other commercial automobile products that has continued through the date of this Annual Report on Form 10-K. However, losses and loss expenses incurred during the same period reflected favorable impacts within all commercial automobile products as a result of declines in accident frequency due to lower traffic density. In addition to these impacts on our underwriting loss, as defined below, we incurred net realized and unrealized losses on investments of$9.2 million for the year endedDecember 31, 2020 , primarily due to investment losses realized as a result of the significant declines in the global financial markets experienced during the first and second quarters due to the COVID-19 pandemic. As ofDecember 31, 2020 , both our fixed income and equity security investments have recovered to a net gain position. Additionally, insurance departments throughout the country have issued bulletins and regulations urging or requiring insurers to extend grace periods for the payment of policy premiums and to refrain from canceling or non-renewing policies for the non-payment of policy premiums for policyholders adversely affected by COVID-19; however, we have not seen a material decrease or slowdown in premium collection to date. Our liquidity and capital resources were not materially impacted by COVID-19 and related economic conditions during 2020. For further discussion regarding the potential impacts of COVID-19 and related economic conditions on our results, see Part I, Item 1A, "Risk Factors," of this Annual Report on Form 10-K. 30
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Liquidity and Capital Resources
The primary sources of our liquidity are (1) funds generated from insurance operations, including net investment income, (2) proceeds from the sale of investments, and (3) proceeds from maturing investments.
We generally experience positive cash flows from operations. Premiums are collected on insurance policies in advance of the disbursement of funds for payment of claims. Operating costs of our property/casualty Insurance Subsidiaries, other than loss and loss expense payments and commissions paid to related agency companies, average less than one-third of net premiums earned on a consolidated basis and the remaining amount is available for investment for varying periods of time depending on the type of insurance coverage provided and the timing of the claim payments. Because losses are often settled in periods subsequent to when they are incurred, operating cash flows may, at times, become negative as loss settlements on claim reserves established in prior years exceed current revenues. Our cash flow relating to premiums is significantly affected by reinsurance programs in effect, whereby we cede both premium and risk to other insurance and reinsurance companies. These programs vary significantly among products and certain contracts call for reinsurance payment patterns, which do not coincide with the collection of premiums by us from our insureds. OnAugust 31, 2017 , our Board of Directors authorized the reinstatement of our share repurchase program for up to 2,464,209 shares of our Class A or Class B Common Stock. The repurchases may be made in the open market or through privately negotiated transactions, from time-to-time, and in accordance with applicable laws, rules and regulations. The share repurchase program may be amended, suspended or discontinued at any time and does not commit us to repurchase any shares of our common stock. We have funded, and intend to continue to fund, the share repurchase program from cash on hand. The actual number and value of the shares to be purchased will depend on the performance of our stock price, market volume and other market conditions. During the year endedDecember 31, 2020 , we paid$1.8 million to repurchase 126,764 shares of Class B Common Stock under the share repurchase program. No share repurchases have been made sinceMarch 20, 2020 . Additionally, in connection with the Merger Agreement with Progressive discussed above, we are prohibited from repurchasing any of our Class A or Class B Common Stock under the share repurchase program. For several years, our investment philosophy has emphasized the purchase of short-term bonds with high quality and liquidity. Our fixed income investment portfolio continues to emphasize shorter-duration instruments. If there was a hypothetical increase in interest rates of 100 basis points, the price of our fixed income portfolio, including cash, atDecember 31, 2020 would be expected to fall by approximately 2.8%. The credit quality of our fixed income securities remains high with a weighted average rating of AA-, including cash. The average contractual life of our fixed income and short-term investment portfolio was 7.1 years atDecember 31, 2020 compared to 6.9 years atDecember 31, 2019 . The average duration of our fixed income portfolio remains shorter than the average duration of our liabilities. We also remain an active participant in the equity securities market. The long-term horizon for our equity investments allows us to invest in positions where ultimate value, and not short-term market fluctuation, is the primary focus. Investments made by our domestic property/casualty Insurance Subsidiaries are regulated by guidelines promulgated by theNational Association of Insurance Commissioners (the "NAIC"), which are designed to provide protection for both policyholders and shareholders. Net cash provided by operating activities was$74.9 million during 2020 compared to$86.7 million for 2019. The$11.8 million decrease in operating cash flows during 2020 reflected lower premium volume and lower investment income from our fixed income securities when compared to the same period of 2019. Additionally, net cash from operations in 2019 benefited from the impact of growth in premiums and the timing of related claims payments. Net cash provided by operating activities was$86.7 million for 2019 compared to$100.7 million in 2018. The$14.0 million decrease was primarily related to an increase in payments for losses and loss adjustment expenses and operating expenses, partially offset by higher premium volume as well as higher investment income during 2019. Net cash used in investing activities was$86.0 million for 2020 compared to$151.9 million in 2019. The$65.9 million change was primarily due to a$31.3 million decrease in the investment of cash and cash equivalents into fixed income securities,$52.0 million higher proceeds from maturities of fixed income securities and a$30.1 million increase in net proceeds from sales of equity securities, partially offset by$18.8 million less in limited partnership distributions during 2020 compared to 2019. Net cash used in investing activities was$151.9 million for 2019 compared to net cash provided by investing activities of$23.7 million in 2018. The$175.6 million change was primarily the result of a decrease in proceeds from sales of our fixed income and equity securities of$229.7 million compared to 2018. We also had higher purchases of fixed income and equity securities of$8.2 million during 2019 compared to 2018. These cash outflows were partially offset by$33.4 million in distributions received from our limited partnership investments in 2019 compared to$6.9 million in 2018 and$20.4 million higher proceeds from maturities of fixed income securities during 2019 compared to 2018. Additionally, during 2018, we purchased$10.0 million of company-owned life insurance, which did not recur in 2019. 31 -------------------------------------------------------------------------------- Net cash used in financing activities for 2020 consisted of regular cash dividend payments to shareholders of$5.7 million ($0.40 per share) and$1.8 million to repurchase 126,764 shares of our Class B common stock. Financing activities for 2019 consisted of regular cash dividend payments to shareholders of$5.9 million ($0.40 per share) and$11.5 million to repurchase 677,088 shares of our Class A and Class B common stock. Financing activities for 2018 consisted of regular cash dividend payments to shareholders of$16.8 million ($1.12 per share) and$4.6 million to repurchase 199,668 shares of our Class A and Class B common stock. Our assets atDecember 31, 2020 included$47.0 million of investments included within cash and cash equivalents on the consolidated balance sheet that are readily convertible to cash without market penalty and an additional$117.0 million of fixed income investments maturing in less than one year. We believe these liquid investments, plus the expected cash flow from premium collections, are sufficient to provide for projected claim payments and operating cost demands. In the event competitive conditions produce inadequate premium rates and we choose to further restrict volume or our premiums are further restricted due to market conditions, including related to the impact of COVID-19, we believe the liquidity of our investment portfolio would permit us to continue to pay claims as settlements are reached without requiring the disposal of investments at a loss, regardless of interest rates in effect at the time. We maintain a revolving credit facility with a$40.0 million limit, with the option for up to an additional$35.0 million in incremental loans at the discretion of the lenders, which has an expiration date ofAugust 9, 2022 . Interest on this revolving credit facility is referenced to the London Interbank Offered Rate ("LIBOR") and can be fixed for periods of up to one year at our option. Outstanding drawings on this revolving credit facility were$20.0 million as ofDecember 31, 2020 . AtDecember 31, 2020 , the effective interest rate was 1.25% and we had$20.0 million remaining under the revolving credit facility. The current outstanding borrowings were used to repay our previous line of credit. Our revolving credit facility has two financial covenants, each of which were met as ofDecember 31, 2020 . These covenants require us to have a minimumU.S. generally accepted accounting principles ("GAAP") net worth and a maximum consolidated debt to equity ratio of 0.35. Annualized net premiums written by our Insurance Subsidiaries for 2020 equaled approximately 126.9% of the combined statutory surplus of these subsidiaries. According to the NAIC, acceptable ranges for the ratio of net premiums written to statutory surplus include results of up to 300%. This ratio is designed to measure our ability to absorb above-average losses and our financial strength. Additionally, the statutory capital of each of our Insurance Subsidiaries substantially exceeded minimum risk-based capital requirements set by the NAIC as ofDecember 31, 2020 . As a result, we have the ability to increase our business without seeking additional capital to meet regulatory guidelines. Consolidated shareholders' equity is composed largely of GAAP shareholders' equity of our Insurance Subsidiaries. As such, there are statutory restrictions on the transfer of substantial portions of this equity to Protective. AtDecember 31, 2020 ,$50.6 million may be transferred by dividend or loan to Protective without approval by, or prior notification to, regulatory authorities. An additional$151.1 million of shareholders' equity of our Insurance Subsidiaries could be advanced or loaned to Protective with prior notification to, and approval from, regulatory authorities, although transfers of this size would not be practical. We believe these restrictions pose no material liquidity concerns for us. We also believe the financial strength and stability of our Insurance Subsidiaries would permit access by Protective to short-term and long-term sources of credit when needed. Protective had cash and marketable securities valued at$12.9 million atDecember 31, 2020 . 32
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Non-GAAP Measures
We believe investors' understanding of our performance is enhanced by our disclosure of underwriting income (loss), which is a measure that is not calculated in accordance with GAAP. Underwriting income (loss) represents the pre-tax profitability or loss of our insurance operations and is derived by subtracting net realized and unrealized gains (losses) on investments and net investment income from income (loss) before federal income tax expense (benefit). For the year endedDecember 31, 2020 , we also excluded corporate charges incurred in conjunction with the Board's review of the Contingent Sale Agreement, activities of the Special Committee as well as the CECL allowance adjustment related to the PSG matter discussed above from the calculation of underwriting income (loss). For the year endedDecember 31, 2018 we had a goodwill impairment charge, which was excluded from the calculation of 2018 underwriting income (loss). We believe the exclusion of these charges and the CECL allowance adjustment increases the period-to-period comparability of our operational results. We use underwriting income (loss) as an internal performance measure in the management of our operations because we believe it gives us and users of our financial information useful insight into our results of operations, our underlying business performance and our ongoing operating trends. Underwriting income (loss) should not be viewed as a substitute for income (loss) before federal income tax expense (benefit) calculated in accordance with GAAP, and other companies may define underwriting income (loss) differently. The ratio of consolidated other operating expenses, less commissions and other income, to net premiums earned, or our expense ratio, and the ratio of losses and loss expenses incurred, plus other operating expenses, less commissions and other income, to net premiums earned, or our combined ratio, are measures of our profitability that we believe increase the period-to-period comparability of our operational results. For the year endedDecember 31, 2020 , we also excluded the corporate charges and CECL allowance adjustment, and for the year endedDecember 31, 2018 , we also excluded the goodwill impairment charge, discussed above from other operating expenses when calculating our expense ratio and our combined ratio, as these ratios are intended to depict our underlying business performance and ongoing operating trends. We believe the exclusion of these charges and the CECL allowance adjustment improves the comparability of our expense and combined ratios with our ratios in prior years. Our management uses these ratios to evaluate performance, allocate resources and forecast future operating periods. While expense ratios and combined ratios are widely used within our industry, our use of such ratios may not be directly comparable to similarly titled measures reported by other companies. (dollars in thousands) 2020 2019
2018
Income (loss) before federal income tax expense (benefit)$ 6,363 $ 8,673 $ (43,872 ) Less: Net realized and unrealized gains (losses) on investments (9,236 ) 12,889 (25,691 ) Less: Net investment income 25,422 26,249 22,048 Less: Corporate charges and CECL allowance adjustment included in other operating expenses 1 (4,422 ) - - Less:Goodwill impairment charge included in other operating expenses - - (3,152 ) Underwriting loss$ (5,401 ) $ (30,465 ) $ (37,077 ) Other operating expenses$ 143,428 $ 138,456 $ 137,177 Less: Corporate charges and CECL allowance adjustment 1 4,422 - - Less: Goodwill impairment charge - - 3,152 Other operating expenses, excluding corporate charges, CECL allowance adjustment and goodwill impairment charge$ 139,006 $ 138,456 $ 134,025 Ratios Losses and loss expenses incurred$ 318,958 $ 348,468 $ 345,864 Net premiums earned 445,515 447,288 432,880 Loss ratio 71.6 % 77.9 % 79.9 % Other operating expenses$ 143,428 $ 138,456 $ 137,177 Less: Commissions and other income 7,048 9,171 9,932 Other operating expenses, less commissions and other income 136,380 129,285 127,245 Net premiums earned 445,515 447,288 432,880 Expense ratio 30.6 % 28.9 % 29.4 % Impact of corporate charges and CECL allowance adjustment 1 (1.0 )% - - Impact of goodwill impairment charge - 0.0 % (0.7 )% Expense ratio, excluding corporate charges, CECL allowance adjustment and goodwill impairment charge 29.6 % 28.9 % 28.7 % Combined ratio 102.2 % 106.8 % 109.3 % Combined ratio, excluding corporate charges, CECL allowance adjustment and goodwill impairment charge 101.2 % 106.8 % 108.6 %
1 Represents the corporate charges incurred in conjunction with the Board's
review of the Contingent Sale Agreement, activities of the Special Committee
and an adjustment to our CECL allowance related to the PSG litigation matter
discussed above.
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Results of Operations
2020 Compared to 2019
2020 2019 Change % Change
Gross premiums written $ 547,561 $ 574,918 $ (27,357 ) (4.8 )%
Ceded premiums written (106,561 ) (122,676 ) 16,115 (13.1 )%
Net premiums written $ 441,000 $ 452,242 $ (11,242 ) (2.5 )%
Net premiums earned $ 445,515 $ 447,288 $ (1,773 ) (0.4 )%
Net investment income 25,422 26,249 (827 ) (3.2 )%
Commissions and other income 7,048 9,171 (2,123 ) (23.1 )%
Net realized and unrealized gains
(losses) on investments (9,236 ) 12,889 (22,125 ) (171.7 )%
Total revenue 468,749 495,597
Losses and loss expenses incurred 318,958 348,468 (29,510 ) (8.5 )%
Other operating expenses 143,428 138,456 4,972 3.6 %
Total expenses 462,386 486,924
Income (loss) before federal income tax
expense (benefit) 6,363 8,673 (2,310 )
Federal income tax expense (benefit) 1,900 1,326 574
Net income (loss) $ 4,463 $ 7,347 $ (2,884 )
Gross premiums written for 2020 decreased $27.4 million (4.8%), while net
premiums earned decreased $1.8 million (0.4%), as compared to 2019. The lower
net premiums earned in 2020 were primarily the result of declines in premiums
within our commercial automobile products, specifically public transportation,
as a result of a reduction in miles driven, which is the basis for premiums we
receive, as well as an overall reduction in public transportation units insured,
both due to the impact of COVID-19. During the second half of the year, we saw
a recovery in premiums within certain commercial automobile products due to a
return to a more normal level of miles driven, but the declines in public
transportation continued. Additionally, we experienced reduced premiums
associated with lower retention rates as we continue to take actions to improve
profitability, including rate increases and non-renewal of certain risks. These
decreases were partially offset by rate increases, growth in existing business
lines and new business policies sold mainly in our commercial automobile
products. The difference in the percentage change for premiums written compared
to earned was reflective of the normal differences in the financial statement
recognition of earned premiums compared to written, as well as differences in
reinsurance ceding rates on the mix of business in-force.
Premiums ceded to reinsurers on our insurance business averaged 19.5% of gross
premiums written for 2020 compared to 21.3% for 2019. The decrease in premiums
ceded was the result of growth in our commercial automobile products, which
carry a lower ceded reinsurance percentage when compared to ceding rates on our
workers' compensation products, in addition to the non-renewal of the
reinsurance treaty, which impacted the second half of 2020, discussed below.
Losses and loss expenses incurred during 2020 decreased $29.5 million (8.5%) to
$319.0 million compared to $348.5 million in 2019, while the loss ratio
decreased to 71.6% for 2020 compared to 77.9% for 2019. The loss ratio is
calculated as the percentage of losses and loss expenses incurred to net
premiums earned. The lower losses and loss expenses and lower loss ratio for
2020 reflected the results of our underwriting actions, including non-renewal of
unprofitable business as well as significant rate increases in commercial
automobile. Additionally, losses and loss expenses incurred reflected favorable
impacts from COVID-19 within all commercial automobile products as a result of
declines in accident frequency due to lower traffic density.
Commercial automobile products covered by our reinsurance treaties from July 3,
2013 through July 2, 2019 are subject to an unlimited aggregate stop-loss
provision. Currently each of these treaty years is reserved at or above the
attachment level of these treaties. For every $100 of additional loss, we are
only responsible for our $25 retention under these reinsurance treaties.
Commercial automobile products covered by our reinsurance treaty from July 3,
2019 through July 2, 2020 are also subject to an unlimited aggregate stop-loss
provision. Once the aggregate stop-loss level is reached, for every $100 of
additional loss, we are responsible for our $65 retention under this reinsurance
treaty. This increase in our retention compared to recent years reflects the
combination of 1) a decreased need for stop-loss reinsurance protection
resulting from a significant decrease in our commercial automobile average
policy loss limits, 2) a higher cost for this coverage and 3) our confidence in
profitability improvements given the limits reductions and rate increases on our
commercial automobile products. In 2020, due to continued rate achievement in
commercial automobile, improvements in our mix of business and reductions to our
average policy loss limits, we decided to non-renew the annual aggregate
deductible treaty for policies written on or after July 3, 2020 .
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Net investment income for 2020 decreased 3.2% to $25.4 million compared to $26.2
million for 2019. The decrease reflected lower interest rates earned on cash and
cash equivalent balances in 2020, partially offset by an increase in average
funds invested resulting from positive cash flow from operations, as well as the
continued reallocation from equity investments in limited partnerships and cash
and cash equivalent investments into short-duration, high-quality bonds.
Net realized and unrealized losses on investments of $9.2 million during 2020
were primarily driven by $6.8 million in net realized losses on sales of
securities, excluding impairment losses, $2.9 million in impairments and a $1.4
million decrease in the value of our limited partnership investments, partially
offset by $1.9 million in unrealized gains on equity securities during the
period. Comparative 2019 net realized and unrealized gains on investments of
$12.9 million were primarily driven by $9.3 million in unrealized gains on
equity securities during the period, net realized gains on sales of securities,
excluding impairment losses, of $2.5 million and a $1.6 million increase in the
value of our limited partnership investments, partially offset by impairments on
our fixed income securities of $0.5 million recognized during the period.
Realized investment gains and losses result from decisions regarding overall
portfolio realignment as well as the sale of individual securities, including
the change in the aggregate value of limited partnerships and, as such, should
not be expected to be consistent from period to period.
Other operating expenses for 2020 increased $5.0 million (3.6%) to $143.4
million compared to $138.5 million in 2019. This increase was primarily due to
the $2.9 million of corporate charges incurred during 2020 for third party
advisors to the Special Committee in connection with their review of the
Contingent Sale Agreement as well as other strategic alternatives, as discussed
above, and the $1.5 million increase to the CECL allowance related to our
ongoing litigation with PSG recorded in the third quarter of 2020, as discussed
above. The ratio of consolidated other operating expenses less commissions and
other income to net premiums earned (the "expense ratio") was 30.6% during 2020,
or 29.6% excluding the corporate charges and CECL allowance adjustment discussed
above, compared to 28.9% during 2019.
Federal income tax expense was $1.9 million for the year ended December 31, 2020
compared to $1.3 million for the year ended December 31, 2019 . The effective
tax rate on consolidated income for 2020 was 29.9% compared to 15.3% during
2019. The difference in the effective federal income tax rate from the normal
statutory rate was primarily related to the impact of a valuation allowance on
our deferred tax assets recorded in the current period, in addition to the
effects of tax-exempt investment income and the dividends received deduction.
In assessing the valuation of deferred tax assets, we consider whether it is
more likely than not that some portion or all of the deferred tax assets will
not be realized. The ultimate realization of deferred tax assets is dependent
upon the generation of future taxable income or availability to carryback the
losses to taxable income during the periods in which those temporary differences
become deductible. We considered several factors when analyzing the need for a
valuation allowance, including our current three year cumulative GAAP loss
through December 31, 2020 , the increase in deferred tax assets due to the
adoption of CECL at January 1, 2020 discussed above, the change in unrealized
gains and losses and the loss of a high taxable income year from the carryback
period. The three year cumulative loss limits our ability to use projected
income beyond 2020 in the analysis. As of December 31, 2020 and 2019, we had no
valuation allowance. However, the application of intra-period tax allocation
rules to benefits associated with deferred tax assets resulted in a charge to
continuing operations as of December 31, 2020 of $1.3 million in the
consolidated statement of operations, offset by a corresponding benefit in
shareholders' equity within accumulated other comprehensive income (loss).
As a result of the factors discussed above, net income for 2020 was
2019 Compared to 2018
2019 2018 Change % Change
Gross premiums written $ 574,918 $ 582,500 $ (7,582 ) (1.3 )%
Ceded premiums written (122,676 ) (138,102 ) 15,426 (11.2 )%
Net premiums written $ 452,242 $ 444,398 $ 7,844 1.8 %
Net premiums earned $ 447,288 $ 432,880 $ 14,408 3.3 %
Net investment income 26,249 22,048 4,201 19.1 %
Commissions and other income 9,171 9,932 (761 ) (7.7 )%
Net realized and unrealized gains
(losses) on investments 12,889 (25,691 ) 38,580 (150.2 )%
Total revenue 495,597 439,169
Losses and loss expenses incurred 348,468 345,864 2,604 0.8 %
Other operating expenses 138,456 137,177 1,279 0.9 %
Total expenses 486,924 483,041
Income (loss) before federal income tax
expense (benefit) 8,673 (43,872 ) 52,545
Federal income tax expense (benefit) 1,326 (9,797 ) 11,123 Net income (loss)$ 7,347 $ (34,075 ) $ 41,422 35
-------------------------------------------------------------------------------- Gross premiums written for 2019 decreased$7.6 million (1.3%) due to the non-renewal of unprofitable business during the year, while net premiums earned increased$14.4 million (3.3%), as compared to 2018. The higher net premiums earned in 2019 were primarily the result of lower premiums ceded when compared to 2018, as discussed below. The difference in the percentage change for premiums written compared to earned was reflective of the normal differences in the financial statement recognition of earned premiums compared to written, as well as differences in reinsurance ceding rates on the mix of business in-force. Premiums ceded to reinsurers on our insurance business averaged 21.3% of gross premiums written for 2019 compared to 23.7% for 2018. During 2018, we had reserve strengthening that resulted in ceding an additional$17.3 million in premium from prior treaty years related to the variable premium adjustment provisions in our historical reinsurance treaties. In comparison the 2019 period reflected the ceding of only an additional$1.6 million in commercial automobile premium from prior treaty years related to variable premium adjustment provisions in our historical reinsurance treaties. This was partially offset by higher gross premiums written in workers' compensation coverages, which carry a higher reinsurance ceding rate in 2019 compared to 2018. Losses and loss expenses incurred during 2019 increased$2.6 million (0.8%) to$348.5 million compared to$345.9 million in 2018, while the loss ratio decreased to 77.9% for 2019 compared to 79.9% for 2018. The loss ratio is calculated as the percentage of losses and loss expenses incurred to net premiums earned. The increased losses and loss expenses incurred reflected an increase in current accident year losses driven by continued emergence of severity. This current accident year development was partially offset by prior accident year net savings of$0.6 million that developed during 2019, primarily due to favorable loss development in workers' compensation coverages. Including the impact of the additional$1.6 million of ceded premium discussed above, total prior accident years had an unfavorable impact of$1.0 million in 2019. Losses and loss expenses for 2018 reflected reserve adjustments of$16.8 million related to unfavorable prior accident year loss development in commercial automobile coverages. Including the impact of the additional$17.3 million of ceded premium discussed above, total prior accident years had an unfavorable impact of$34.1 million in 2018. Commercial automobile products covered by our reinsurance treaties fromJuly 2013 throughJune 2019 are subject to an unlimited aggregate stop-loss provision. Currently each of these treaty years is reserved at or above the attachment level of these treaties. For every$100 of additional loss, we are only responsible for our$25 retention. The following table illustrates the benefit of these reinsurance treaties based on select theoretical scenarios. For these theoretical scenarios, the net financial loss to the Company is approximately 25% of the gross loss. 5% Increase in 10% Increase in Ultimate Loss Ultimate Loss Ratio Ratio Gross loss expense from further strengthening current reserve position $ 47.2 $ 94.5 Net financial loss $ 11.8 $ 23.6 $/share (after tax) $ 0.64 $ 1.28 Commercial automobile products covered by our reinsurance treaty fromJuly 2019 throughJune 2020 are also subject to an unlimited aggregate stop-loss provision. Once the aggregate stop-loss level is reached, for every$100 of additional loss, we are responsible for our$65 retention. This increase in our retention compared to recent years, reflects the combination of 1) a decreased need for stop loss reinsurance protection resulting from a significant decrease in our commercial automobile subject limits profile, 2) a higher cost for this cover and 3) our confidence in profitability improvements given the limits reductions and rate increases on our commercial automobile products.
Net investment income for 2019 increased 19.1% to
Net realized and unrealized gain on investments of$12.9 million during 2019 were primarily driven by$9.3 million in unrealized gains on equity securities during the period, net realized gains on sales of securities, excluding impairment losses, of$2.5 million and a$1.6 million increase in the value of our limited partnership investments, partially offset by other-than-temporary impairments on our fixed income securities of$0.5 million recognized during the period. Comparative 2018 net realized and unrealized losses on investments of$25.7 million were driven by$9.7 million in unrealized losses on equity securities during the period, a$9.3 million decrease in the value of our limited partnership investments and net realized losses on sales of fixed income and equity securities of$6.6 million . Realized investment gains and losses result from decisions regarding overall portfolio realignment as well as the sale of individual securities, including the change in the aggregate value of limited partnerships and, as such, should not be expected to be consistent from period to period. 36 -------------------------------------------------------------------------------- Other operating expenses for 2019 increased$1.3 million (0.9%), to$138.5 million compared to 2018. The increase was driven primarily by higher commission expenses as a result of premium written mix and higher salary and benefit expenses during 2019, partially offset by a non-cash goodwill impairment charge of$3.2 million recorded in 2018, which did not recur in 2019. The expense ratio was 28.9% during 2019, compared to 28.7% for 2018. Federal income tax expense was$1.3 million for 2019 compared to a federal income tax benefit of$9.8 million in 2018. The effective tax rate for 2019 was 15.3% compared to 22.3% in 2018. The effective federal income tax rate in 2019 differed from the normal statutory rate primarily as a result of tax-exempt investment income and the dividends received deduction.
As a result of the factors discussed above, net income for 2019 was
Critical Accounting Policies
The Company's significant accounting policies that are material and/or subject to significant degrees of judgment are highlighted below.
Investment Valuation
All marketable securities are included in the Company's balance sheets at current fair market value.
Approximately 62% of the Company's assets are composed of investments atDecember 31, 2020 . Approximately 93% of these investments are publicly-traded, owned directly and have readily-ascertainable market values. The remaining 7% of investments are composed primarily of mortgage loans and minority interests in several limited partnerships. These mortgage loans are originated and serviced by a third party of which the Company shares, on a pro-rata basis, in all related cash flows of the underlying mortgage loans. These limited partnerships are engaged in long-short equities, private equity, country-focused funds and real estate development as an alternative to direct equity investments. These partnerships do not have readily-determinable market values themselves. Rather, the values recorded are those provided to the Company by the respective partnerships based on the underlying assets of the limited partnerships. While a substantial portion of the underlying assets are publicly-traded securities, those which are not publicly-traded have been valued by the respective limited partnerships using their experience and judgment. UnderFinancial Accounting Standards Board ("FASB") guidance, if a fixed income security is in an unrealized loss position and the Company has the intent to sell the security, or it is more likely than not that the Company will have to sell the security before recovery of its amortized cost basis, the decline in value is recorded within impairment losses on investments in the consolidated statements of operations. The new cost basis of the investment is the previously amortized cost basis less the impairment recognized. The new cost basis is not adjusted for any subsequent recoveries in fair value. For a fixed income security that the Company does not intend to sell or in cases where it is more likely than not that the Company will not have to sell the security, the Company separates the credit loss component of the impairment from the amount related to all other factors and reports the credit loss component within net realized gains (losses) on investments, excluding impairment losses in the consolidated statements of operations. The impairment related to all other factors (non-credit factors) is reported in other comprehensive income (loss). The allowance is adjusted for any additional credit losses and subsequent recoveries. Upon recognizing a credit loss, the cost basis is not adjusted. The Company considers the extent to which fair value is below amortized cost in determining whether a credit-related loss exists. The Company also considers the credit quality rating of the security, focusing on those below investment grade, with emphasis on securities downgraded below investment grade. The credit loss is determined by comparing the net present value of projected future cash flows with the amortized cost basis of the fixed income security. The net present value is calculated by discounting the Company's best estimate of projected future cash flows at the appropriate effective interest rate. Additionally, the Company may conclude that a qualitative analysis is sufficient to support its conclusion that the present value of the expected cash flows equals or exceeds a security's amortized cost.
Equity securities are recorded at fair value, with unrealized net gains or losses reflected as a component of net unrealized gains (losses) on equity securities and limited partnership investments within the consolidated statements of operations. Realized gains and losses on disposals of equity securities are recorded on the trade date and included in net realized gains (losses) on investments, excluding impairment losses.
The Company reports investment income due and accrued separately from
available-for-sale fixed income securities and has elected not to measure an
allowance for credit losses for investment income due and accrued. Investment
income due and accrued is written off through net realized gains (losses) on
investments, excluding impairment losses at the time the issuer defaults or is
expected to default on payments.
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Reinsurance Recoverable
Reinsurance ceded transactions were as follows for the years endedDecember 31 (dollars in thousands): 2020 2019 2018 Reinsurance recoverable$ 455,564 $ 432,067 $ 392,436 Premium ceded (reduction to premium earned) 113,125 124,446 131,080 Losses ceded (reduction to losses incurred) 105,895 121,963 148,285 Reinsurance ceded credits (reduction to operating expenses) 24,764 25,932 23,124
A discussion of the Company's reinsurance strategies is presented in Part I, Item 1, "Business," of this Annual Report on Form 10-K.
Amounts recoverable under the terms of reinsurance contracts comprised approximately 26% of total Company assets as ofDecember 31, 2020 . In order to be able to provide the high limits required by the Company's insureds, the Company shares a significant amount of the insurance risk of the underlying contracts with various insurance entities through the use of reinsurance contracts. Some reinsurance contracts provide that a loss will be shared among the Company and its reinsurers on a predetermined pro-rata basis ("quota share"), while other contracts provide that the Company will keep a fixed amount of the loss, similar to a deductible, with reinsurers taking all losses above this fixed amount ("excess of loss"). Some risks are covered by a combination of quota share and excess of loss contracts. The computation of amounts due from reinsurers is based upon the terms of the various contracts and follows the underlying estimation process for loss and loss expense reserves, as described below. Accordingly, the uncertainties inherent in the loss and loss expense reserving process also affect the amounts recorded as recoverable from reinsurers. Estimation uncertainties are greatest for claims which have occurred but which have not yet been reported to the Company. Further, the high limits provided by certain of the Company's insurance policies for commercial automobile liability, workers' compensation and professional liability risks provide more variability in the estimation process than lines of business with lower coverage limits. It should be noted, however, that a change in the estimate of amounts due from reinsurers on unpaid claims will not, in itself, result in charges or credits to losses incurred. This is because any change in estimated recovery follows the estimate of the underlying loss. Thus, it is the computation of the gross underlying loss that is critical. As with any receivable, credit risk exists in the recoverability of reinsurance. This may be even more pronounced than in normal receivable situations since recoverable amounts are not generally due until the loss is settled which, in some cases, may be many years after the contract was written. If a reinsurer is unable, in the future, to meet its financial commitments under the terms of the contracts, the Company would be responsible to satisfy the reinsurer's portion of the loss. The financial condition of each of the Company's reinsurers is vetted upon the execution of a given treaty, and only reinsurers with superior credit ratings are utilized. However, as noted above, reinsurers are often not called upon to satisfy their obligations for several years and changes in credit worthiness can occur in the interim period. Reviews of the current financial strength of each reinsurer are made frequently and, should impairment in the ability of a reinsurer be determined to exist, current year operations would be charged in amounts sufficient to provide for the Company's additional liability. Such charges are included in other operating expenses, rather than losses and loss expenses incurred, since the inability of the Company to collect from reinsurers is a credit loss rather than a deficiency associated with the loss reserving process.
Loss and Loss Expense Reserves
The Company's reserves for losses and loss expenses ("reserves") are determined
based on complex estimation processes using historical experience, current
economic information and available industry statistics. The Company's claims
range from routine "fender benders" to the highly complex and costly third-party
bodily injury claims involving large tractor-trailer rigs. Reserving for each
class of claims requires a set of assumptions based upon historical experience,
knowledge of current industry trends and seasoned judgment. The high limits
provided in many of the Company's policies provide for greater volatility in the
reserving process for more serious claims. Court rulings, legislative actions
and trends in jury awards also play a significant role in the estimation process
of larger claims. The Company continuously reviews and evaluates loss
developments subsequent to each measurement date and adjusts its reserve
estimation assumptions, as necessary, in an effort to achieve the best possible
estimate of the ultimate remaining loss costs at any point in time. Changes to
previously established loss and loss expense reserve amounts are charged or
credited to losses and loss expenses incurred in the accounting periods in which
they are determined. See Note C, "Loss and Loss Expense Reserves," to the
Consolidated Financial Statements in Part II, Item 8 of this Annual Report on
Form 10-K for additional information relating to loss and loss expense reserve
development.
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The Company's methods for determining loss and loss expense reserves are essentially identical for interim and annual reporting periods.
A detailed analysis and discussion for each of the above basic reserve categories follows:
Reserves for known losses (Case reserves)
Each known claim, regardless of complexity, is handled by a claims adjuster experienced with claims of a similar nature, and a "case" reserve appropriate for the individual loss occurrence is established. For routine "short-tail" claims, such as physical damage, the Company records an initial reserve that is based upon historical loss settlements adjusted for current trends. As information regarding the loss occurrence is gathered in the claim handling process, the initial reserve is adjusted to reflect the anticipated ultimate cost to settle the claim. For more complex claims, which can tend toward being "long-tail" in nature, an experienced claims adjuster will review the facts and circumstances surrounding the loss occurrence to make a determination of the reserve to be established. Many of the more complex claims involve litigation and necessitate an evaluation of potential jury awards, in addition to the factual information, to determine the value of each claim. Each claim is frequently monitored and the recorded reserve is increased or decreased relative to information gathered during the settlement life cycle.
Reserves for incurred but not reported losses
The Company uses both standard actuarial techniques common to most insurance
companies as well as proprietary techniques developed by the Company in
connection with its specialty business products. For its short-tail lines of
business, the Company uses predominantly the incurred or paid loss development
factor methods. The Company has found that the use of accident quarter loss
development triangles, rather than those based upon accident year, are most
responsive to claim settlement trends and fluctuations in premium exposure for
its short-tail lines. A minimum of 12 running accident quarters is used to
project the reserve necessary for incurred but not reported ("IBNR") losses for
its short-tail lines.
The Company also uses the loss development factor approach for its long-tail
lines of business. A minimum of 15 accident years is included in the loss
development triangles used to calculate link ratios and the selected loss
development factors used to determine the reserves for IBNR losses. A minimum
of 20 accident years is used for long-tail workers' compensation reserve
projections. Significant emphasis is placed on the use of tail factors for the
Company's long-tail lines of business.
For the Company's commercial automobile risks, which are covered by regularly
changing reinsurance agreements and which contain wide-ranging self-insured
retentions ("SIR"), traditional actuarial methods are supplemented by other
methods, as described below, in consideration of the Company's exposures to
loss. In situations where the Company's reinsurance structure, the insured's
SIR selections, policy volume, and other factors are changing, current accident
period loss exposures may not be homogenous enough with historical loss data to
allow for reliable projection of future developed losses. Therefore, the
Company supplements the above-described actuarial methods with loss ratio
reserving techniques developed from the Company's proprietary databases to
arrive at the reserve for IBNR losses for the calendar/accident period under
review. As losses for a given calendar/accident period develop with the passage
of time, management evaluates such development on a monthly and quarterly basis
and adjusts reserve factors, as necessary, to reflect current judgment with
regard to the anticipated ultimate incurred losses. This process continues
until all losses are settled for each period subject to this method.
Reserves for loss adjustment expenses
While certain of the Company's products involve case basis reserving for
allocated loss adjustment expenses, the majority of such reserves are determined
on a bulk basis. The Company uses historical analysis of the ratios of
allocated loss adjustment expenses paid to losses paid on closed claims to
arrive at the expected ultimate incurred loss adjustment expense factors
applicable to each affected product. Once developed, the factors are applied to
the expected ultimate incurred losses, including IBNR, on all open claims. The
resulting ultimate incurred allocated loss adjustment expense is then reduced by
amounts paid to date on all open claims to arrive at the reserve for allocated
loss adjustment expenses to be incurred in the future for the handling of
specific claims.
For those loss adjustment expenses not specific to individual claims (general
claims handling expenses referred to as unallocated loss adjustment expenses),
the Company uses a variation of the standard industry loss adjustment expenses
paid to losses paid (net of reinsurance) ratio analysis that equally weighs paid
and incurred losses to establish the necessary reserves. The selected factors
are applied to 100% of IBNR reserves and to case reserves, with consideration
given for that portion of loss adjustment expense already paid at the reserve
measurement date. Such factors are monitored and revised, as necessary, on a
quarterly basis.
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Sensitivity Analysis - Potential impact on reserve volatility from changes in key assumptions
Management is aware of the potential for variation from the reserves established at any particular point in time. Savings or deficiencies could develop in future valuations of the currently established loss and loss expense reserve estimates under a variety of reasonably possible scenarios. The Company's reserve selections are developed to be a "best estimate" of unpaid losses at a point in time and, due to the unique nature of its exposures, particularly in the large commercial automobile excess product, ranges of reserve estimates are not established during the reserving process. However, basic assumptions that could potentially impact future volatility of the Company's valuations of current loss and loss expense reserve estimates include, but are not limited to, the following:
? Consistency in the individual case reserving processes;
? The selection of loss development factors in the establishment of bulk reserves
for incurred but not reported losses and loss expenses;
? Projected future loss trend; and
? Expected loss ratios for the current book of business, particularly the
Company's commercial automobile products, where the number of accounts insured,
selected SIRs, policy limits and reinsurance structures may vary widely from
period to period. Under reasonably possible scenarios, it is conceivable that the Company's selected loss estimates could be 10% or more redundant or deficient. The majority of the Company's reserves for losses and loss expenses, on a net of reinsurance basis, relate to its commercial automobile products. Perhaps the most significant example of sensitivity to variation in the key assumptions is the loss ratio selection for the Company's commercial automobile products for policies subject to certain major reinsurance treaties. The following table presents the approximate impacts on gross and net loss reserves of both a hypothetical 10 percentage point and a hypothetical 20 percentage point increase or decrease in the loss factors actually utilized in the Company's reserve determination atDecember 31, 2020 for the prior seven treaty periods, which covers exposures earned on policies written betweenJuly 3, 2014 andDecember 31, 2020 . The Company's selection of the range of values presented should not be construed as the Company's prediction of future events, but rather simply an illustration of the impact of such events, should they occur. The variation in impact from loss ratio increases and decreases is attributable to minimum and maximum premium rate factors included in the various reinsurance contracts. In between the minimum and maximum ceded premium provisions within the treaty terms, net premiums earned can be increased or decreased based on a change in loss expectation. The total impact to profitability in the same scenarios is shown below ($ in millions): 10% Loss 10% Loss 20% Loss 20% Loss Ratio Increase Ratio Decrease Ratio Increase Ratio Decrease Gross Reserves $ 114.2$ (114.2 ) $ 228.3$ (220.0 ) Net Reserves $ 39.4 $ (40.8 ) $ 78.8 $ (98.7 ) Net premiums earned $ (2.9 ) $ 16.6 $ (2.9 ) $ 35.7
Cumulative Net Underwriting Income (Loss) $ (42.3 ) $ 57.4 $ (81.7 ) $ 134.4
Federal Income Tax Considerations
The liability method is used in accounting for federal income taxes. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The provision for deferred federal income tax is based on items of income and expense that are reported in different years in the consolidated financial statements and tax returns and are measured at the tax rate in effect in the year the difference originated. OnDecember 22, 2017 , theU.S. Tax Act was signed into law. TheU.S. Tax Act lowered theU.S. corporate income tax rate from 35% to 21% effectiveJanuary 1, 2018 . GAAP requires the impact of tax legislation to be recognized in the period in which the law was enacted. The Company finalized its accounting for the tax effects of theU.S. Tax Act during 2018. No material adjustments to income tax expense (benefit) were recorded in 2018. 40
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Net deferred tax assets (liabilities) reported at
2020 2019
Total deferred tax liabilities
24,063 17,519
Net deferred tax assets (liabilities)
Deferred tax assets atDecember 31, 2020 included approximately$12.9 million related to the timing of deductibility of loss and loss expense reserves, the majority of which relate to policy liability discounts required by the Internal Revenue Code of 1986, as amended, which are perpetual in nature and, in the absence of the termination of the Company's business, will not, in the aggregate, reverse to a material degree in the foreseeable future. The allowance for CECL under ASU 2016-13 represents$3.6 million of deferred tax assets, while unearned premiums discount and deferred ceding commissions represent$2.3 million and$0.5 million of deferred tax assets, respectively. An additional$2.0 million relates to timing differences in the expensing of our stock compensation plans. The balance of deferred tax assets consists of various normal operating expense accruals and is not considered to be material. As ofDecember 31, 2020 and 2019, the Company had no valuation allowance. However, the application of intra-period tax allocation rules to benefits associated with deferred tax assets resulted in a charge to continuing operations as ofDecember 31, 2020 of$1.3 million within the consolidated statement of operations, offset by a corresponding benefit in shareholders' equity within accumulated other comprehensive income. FASB provides guidance for recognizing and measuring uncertain tax positions and prescribes a threshold condition that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the consolidated financial statements. Based on this guidance, management regularly analyzes tax positions taken or expected to be taken in a tax return based on the threshold condition prescribed. Tax positions that do not meet or exceed this threshold condition are considered uncertain tax positions. Interest related to uncertain tax positions, if any, would be recognized in income tax expense. Penalties, if any, related to uncertain tax positions would be recorded in income tax expense (benefit). Impact of Inflation To the extent possible, the Company attempts to recover the impact of inflation on loss costs and operating expenses by increasing the premiums it charges. Within the commercial automobile business, a majority of the Company's accounts are charged as a percentage of an insured's gross revenue, mileage or payroll. As these charging bases increase with inflation, premium revenues are immediately increased. The remaining premium rates charged are adjustable only at periodic intervals and often require state regulatory approval. Such periodic increases in premium rates may lag far behind cost increases. To the extent inflation influences yields on investments, the Company is also affected. The Company's short-term and fixed investment portfolios are structured in direct response to available interest rates over the yield curve. As available market interest rates fluctuate in response to the presence or absence of inflation, the yields on the Company's investments are impacted. Further, as inflation affects current market rates of return, previously committed investments might increase or decline in value depending on the type and maturity of the investment. For additional information, see Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk," in this Annual Report on Form 10-K. Inflation must also be considered by the Company in the creation and review of loss and loss adjustment expense reserves, as portions of these reserves are expected to be paid over extended periods of time. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and loss adjustment expenses. 41
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Contractual Obligations
The table below sets forth the amounts of the Company's contractual obligations atDecember 31, 2020 . Payments Due by Period Less than 1 More Than 5 Total year 1 - 3 Years 3 - 5 Years Years (dollars in millions) Loss and loss expense reserves$ 1,089.7 $ 381.4 $ 359.6 $ 130.8 $ 217.9 Investment commitment 0.4 0.4 - - - Operating leases 0.1 0.1 - - - Borrowings 20.0 20.0 - - - Total$ 1,110.2 $ 401.9 $ 359.6 $ 130.8 $ 217.9 The Company's loss and loss expense reserves do not have contractual maturity dates, and the exact timing of the payment of claims cannot be predicted with certainty. However, based upon historical payment patterns, the above table presents an estimate of when the Company might expect its direct loss and loss expense reserves (without the benefit of reinsurance recoveries) to be paid. Timing of the collection of the related reinsurance recoverable, estimated to be$455.6 million atDecember 31, 2020 , or 42% of the loss and loss expense reserves presented in the above table, would approximate that of the above projected direct reserve payout but could lag behind such payments by several months in some instances.
The investment commitment in the above table relates to a maximum unfunded
capital obligation for a limited partnership investment at
Borrowings made under the Company's line of credit can be called by the lender, under certain circumstances, with short notice. The Company entered into a line of credit onAugust 9, 2018 with an expiration date ofAugust 9, 2022 .
Off-Balance Sheet Arrangements
The Company has no off-balance sheet arrangements.
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