The rally in financial markets during 2009 and 2010 had a highly favorable impact on our value creation ratio, offsetting much of the unfavorable impact of the sharp decline in financial markets during 2008. Should financial markets decline during 2011, which could occur as part of typical market volatility patterns, the related component of our 2011 value creation ratio could also register a weak or negative result.
All securities valued below 100 percent of book value are reported to the asset impairment committee for evaluation. Securities valued between 95 percent and 100 percent of book value are reviewed but not monitored separately by the committee.
Another significant estimate relates to our accrual for property casualty contingent (profit-sharing) commissions. We base the contingent commission accrual estimate on property casualty underwriting results. Contingent commissions are paid to agencies using a formula that takes into account agency profitability, premium volume and other factors, such as prompt monthly payment of amounts due to the company. Due to the complexity of the calculation and the variety of factors that can affect contingent commissions for an individual agency, the amount accrued can differ from the actual contingent commissions paid. The contingent commission accrual of $77 million in 2010 contributed 2.6 percentage points to the property casualty combined ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would affect 2011 net income by $3 million (after tax), or 2 cents per share, and the combined ratio by approximately 0.1 percentage points.
Commission expenses include our profit-sharing, or contingent commissions, which are primarily based on the profitability of an agency’s business. The aggregate profit trend for agencies that earn these profit-based commissions can differ from the aggregate profit trend for all agencies reflected in our consolidated property casualty results. In 2010, lower contingent commissions drove the lower ratio for property casualty commission expenses, and higher contingent commissions drove the increase in 2009.
Most of the commercial lines reserve development on prior accident years reported in years 2008 through 2010 occurred in our commercial casualty line of business. Development by line of business and other trends for commercial lines loss and loss expenses and the related ratios are further analyzed in Commercial Lines of Business Analysis, beginning on Page 58.
Our workers’ compensation reserve analyses completed during the first half of 2009 indicated that loss cost inflation was higher than previously estimated, leading us to make more conservative assumptions about future loss cost inflation when estimating loss reserves, thereby significantly increasing losses incurred. The higher estimates of loss cost inflation derived from analyses during 2009 affected reserves
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the three-year highlights table above on Page 64 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since approximately two-thirds of our personal lines current accident year incurred losses and loss expenses represent net paid losses, the remaining one-third represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 86.3 percent accident year 2009 loss and loss expense ratio reported as of December 31, 2009, developed favorably by 1.8 percentage points to 84.5 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2010. Accident years 2009 and 2008 for the personal lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
During 2010, the life insurance market continued to stabilize from the turmoil it experienced during the financial crisis. Of particular interest to us, 2010 saw decreased rate volatility for term insurance as the cost of reserve financing moderated, albeit at rates substantially higher than before the financial crisis. This higher cost of reserve financing has led a number of large term writers to replace their term portfolios with term-like universal life products. These companies have sacrificed a simple design and the high redundant reserve requirement with a much more complex design and a lower reserve requirement. We believe this offers us a competitive advantage, and we expect to see continued growth in our term business because of our commitment to offering our distribution the most straight-forward products possible, at a reliable and competitive rate.
We made good progress in improving our operational technology in 2010. We remain on track to complete a major administration system consolidation project in 2011. Online illustrations were introduced and are already contributing to savings. Finally, we have other initiatives underway that will make it easier for our agents to do business with us, from flexible compensation arrangements to electronic applications. We fully expect all of these initiatives to contribute additional revenue and/or reduced expenses in 2012 and beyond.
Investment income is a primary source of liquidity for both the parent company and our insurance subsidiary operations. For both, cash in excess of operating requirements and dividends are invested in fixed-maturity and equity securities. Equity securities provide the potential for future increases in dividend income and for capital appreciation. In Item 1, Investments Segment, Page 19, we discuss our investment strategy, portfolio allocation and quality.
Dividends to shareholders -The ability of the company to continue paying cash dividends is subject to factors the board of directors may deem relevant. While the board and management believe there is merit to sustaining the company’s record of dividend increases, our first priority is the company’s financial strength. Over the past 10 years, the company has paid an average of 46.9 percent of net income as dividends. Through 2010, the board had increased our cash dividend for 50 consecutive years. The board decision in August 2010 to increase the dividend demonstrated confidence in the company’s strong capital, liquidity, financial flexibility and initiatives to improve earnings performance.
Gross life policy reserves were $2.034 billion at year-end 2010, compared with $1.783 billion at year-end 2009. The increase was primarily due to reserves for deferred annuities. We establish reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
The Cincinnati Specialty Underwriters Insurance Company, which began issuing insurance policies in 2008, has separate property and casualty reinsurance treaties for 2011 through The Cincinnati Insurance Company. Primary components of the treaties include:
Inability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased, financial strength of reinsurers and the potential for non-payment or delay in payment by reinsurers
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Our actual results could differ from those estimates.
In April 2010, the FASB issued ASU 2010-15, How Investments Held through Separate Accounts Affect an Insurer’s Consolidation Analysis of Those Investments. ASU 2010-15 applies to all insurance entities that have separate accounts that meet the definition and requirements set in the Accounting Standards Codification Manual. ASU 2010-15 clarifies that an insurance entity should not consider any separate account interests held for the benefit of contract holders in an investment to be the insurer’s interests. The insurance entity should not combine those interests with its general account interest in the same investment when assessing the investment for consolidation. The insurance entity may combine those interests when the separate account interests are held for the benefit of a related-party policyholder as defined in the Variable Interest Subsections of Consolidation topic in the Codification Manual. The effective date of the amendments in this update is for interim and annual periods beginning after December 15, 2010, with early adoption permitted. The amendments in this update do not modify the disclosures currently required by GAAP and are not expected to have a material impact on our company’s financial position, cash flows or results of operations.
The following table analyzes cost or amortized cost, gross unrealized gains, gross unrealized losses and fair value for our invested assets, along with the amount of cumulative non-credit OTTI losses transferred to AOCI in accordance with ASC 320-10-65, Recognition and Presentation of Other-Than-Temporary Impairments, for securities that also had a credit impairment:
In accordance with fair value measurements and disclosures, we categorized our financial instruments, based on the priority of the observable and market-based data for valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3). When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used. Our valuation techniques have not changed since December 31, 2009, and ultimately management determines fair value.
All four insurance segments record revenues from insurance premiums earned. Life insurance segment revenues also include separate account investment management fees.