Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building has approximately 1,508,200 total square feet of available space. The property, including land, is carried in our financial statements at $165 million as of December 31, 2009, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (less than 1 percent).
Cincinnati Financial Corporation also owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property. This four-story office building has approximately 124,000 square feet of available space. The property is carried in the financial statements at $6 million as of December 31, 2009, and is classified as an other invested asset. Unaffiliated tenants occupy approximately 8 percent. All unoccupied space is currently available for lease.
The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial condition. Our Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Pages 32 and 33, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 87. We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and stock dividends.
Through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on written premium volume for approximately 2,000 U.S. stock and mutual insurer groups. We market our insurance products through a select group of independent insurance agencies in 37 states as discussed in Item 1, Our Business and Our Strategy, Page 1.
Investment income growth, on a before-tax basis, grew at a compound annual rate of 0.3 percent over the five-year period 2005 through 2009. It grew in each year except 2008 and 2009, when we experienced a dramatic reduction in dividend payouts by financial services companies held in our equity portfolio, a risk we addressed aggressively during 2008, completing that effort in early 2009.
Over the five years ended December 31, 2009, our compound annual equity portfolio return was a negative 5.8 percent compared with a compound annual total return of 0.4 percent for the Index. Our equity portfolio underperformed the market for the five-year period primarily because of the decline in the market value of our previously large holdings in the financial services sector. For the year 2009, our compound annual equity portfolio return was 16.4 percent, compared with 26.5 percent for the Index, as the broad market rally did not favor the higher quality, dividend-paying stocks we prefer.
Manage capital effectively - Continued focus on these initiatives is intended to manage our capital and liquidity so that we can successfully grow our insurance business. A strong capital position provides the capacity to support premium growth and provides the liquidity to pay claims while sustaining our investment in the people and infrastructure needed to implement our other strategic initiatives.
Improve insurance profitability - Implementation of these operational initiatives is intended to support profitable growth for the agencies that represent us and for our company. These initiatives seek to enhance our underwriting or pricing expertise and to provide more advanced technology to our agents, allowing them to serve clients faster and manage expenses better. Some initiatives also streamline our internal processes so we can devote more resources to agent service.
We discuss each of these strategies, along with the metrics we use to assess their progress, in Item 1, Strategic Initiatives, Page 8,
In 2009, our value creation ratio result exceeded our target annual average of 12 percent to 15 percent for the period 2010 through 2014, and in 2008, it was below our target, as discussed in the review of our financial highlights below. For the year 2010, we believe our value creation ratio may be below our long-term target for several reasons.
segment, which represented 75 percent of our 2009 property casualty net written premiums. Property casualty written premium growth also may lag as our growth initiatives need more time to reach their full contribution.
We will incur the cost of continued investment in our business, including technology, entry in new states and process initiatives to create long-term value. In addition, we will not see the full advantage of many of these investments for several years.
We expect the independent insurance agency system to remain strong and viable, with continued agency consolidation, especially as agency margins come under more pressure due to soft pricing and the difficult economic environment. The soft commercial market that has extended into 2010 creates additional risk for agencies. We expect the soft market to continue for much of 2010, particularly in non-catastrophe-event-prone states and lines of business, absent a significant event or events.
Below we review highlights of our financial results for the past three years. Detailed discussion of these topics appears in Results of Operations, Page 46, and Liquidity and Capital Resources, Page 68.
Cash dividends declared per share rose 0.6 percent in 2009, 9.9 percent in 2008 and 6.0 percent in 2007.
Invested assets increased significantly for the year 2009 primarily due to a strong rally in the financial markets, reversing the trend of 2008 from lower fair values for portfolio investments, largely due to economic factors. Entering 2009, the portfolio was substantially more diversified and generally better positioned to withstand short-term fluctuations compared with recent years. The downturn in the economy during 2008 had a particularly adverse effect on our financial sector equity holdings, which made up a significant portion of the portfolio prior to mid-2008. We discuss our investment strategy in Item 1, Investments Segment, Page 18, and results for the segment in Investment Results of Operations, Page 64.
As discussed in Investment Results of Operation, Page 64, security sales led to realized investment gains in all three years, although 2008 gains were tempered by $510 million in other-than-temporary impairment charges. Realized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and for securities with embedded derivatives without actual realization of those gains and losses.
In both 2009 and 2008, our property casualty insurance operations reported an underwriting loss after achieving record profitability in 2007. We measure property casualty underwriting profitability primarily by the combined ratio. Our combined ratio measures the percentage of each earned premium dollar spent on claims plus all expenses related to our property casualty operations. A lower ratio indicates more favorable results and better underlying performance. In 2009, 2008 and 2007, favorable development on reserves for claims that occurred in prior accident years helped offset incurred loss and loss expenses. Reserve development is discussed further in Property Casualty Loss and Loss Expense Obligations and Reserves, Pages 71 through 72. Catastrophe losses fluctuated dramatically over the three-year period, with higher than average contributions to the combined ratio of 5.7 and 6.8 percentage points in 2009 and 2008, respectively, following an unusually low 0.8 points in 2007. Our 10-year historical annual average contribution of catastrophe losses to the combined ratio was 4.2 percentage points as of December 31, 2009. The pension plan settlement increased the 2008 combined ratio by 0.8 percentage points.
During 2009, our excess and surplus lines operations contributed $39 million to net written premiums and $27 million to earned premiums. We began excess and surplus lines operations in 2008, and performance is consistent with expectations, including a modest underwriting loss primarily due to start-up expenses related to technology for processing business.
Our life insurance segment continued to provide a consistent source of profit. We discuss results for the segment in Life Insurance Results of Operations, Page 62. Investment income and realized investment gains from the life insurance investment portfolio are included in Investments segment results.
Our field claims representatives establish case reserves when claims are reported to the company to provide for our unpaid loss and loss expense obligation associated with individual claims. Experienced
headquarters claims supervisors review individual case reserves greater than $35,000 that were established by field claims representatives. Headquarters claims managers also review case reserves greater than $100,000.
Our actuarial staff applies significant judgment in selecting models and estimating model parameters when preparing reserve analyses. In addition, unpaid loss and loss expenses are inherently uncertain as to timing and amount. Uncertainties relating to model appropriateness, parameter estimates and actual loss and loss expense amounts are referred to as model, parameter and process uncertainty, respectively. Our management and actuarial staff control for these uncertainties in the reserving process in a variety of ways.
Paid losses, reported losses and paid allocated loss expenses are subject to random as well as systematic influences. As a result, actual paid losses, reported losses and paid allocated loss expenses are virtually certain to differ from projections. Such differences are consistent with what specific models for our business lines predict and with the related patterns in the historical data used to develop these models. As a result, management does not closely monitor statistically insignificant differences between actual and projected data.
The table below provides standard errors and reserve ranges for lines of business that account for just over 90 percent of our 2009 loss and loss expense reserves as well as the potential effects on our net income, assuming a 35 percent federal tax rate. Standard errors and reserve ranges for assorted groupings of these lines of business cannot be computed by simply adding the standard errors and reserve ranges of the component lines of business, since such an approach would ignore the effects of product diversification. See Range of Reasonable Reserves, Page 72, for more details on our total reserve range. While the table reflects our assessment of the most likely range within which each line's actual unpaid loss and loss expenses may fall, one or more lines' actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
If actual unpaid loss and loss expenses fall within these ranges, our cash flow and fixed maturity investments should provide sufficient liquidity to make the subsequent payments. To date, our cash flow has covered our loss and loss expense payments, and we have never had to sell investments to make these payments. If this were to become necessary, however, our fixed maturity investments should provide us with ample liquidity. At year-end 2009, consolidated fixed maturity investments exceeded total insurance reserves (including life policy reserves) by more than $1.930 billion.
about valuation of our invested assets in Item 8, Note 2 of the Consolidated Financial Statements, Page 100.
When evaluating for other-than-temporary impairments, the committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost. Because of the company's financial strength, management may not impair certain securities even when they are trading below book value.
Securities considered to have a temporary decline would be expected to recover their book value, which may be at maturity. Under the same accounting treatment as fair value gains, temporary declines (changes in the fair value of these securities) are reflected in shareholders’ equity on our balance sheet in accumulated other comprehensive income, net of tax, and have no impact on net income.
Over 99 percent of the $10.562 billion of securities in our investment portfolio measured at fair value are classified as Level 1 or Level 2. Financial assets that fall within Level 1 and Level 2 are priced according to observable data from identical or similar securities that have traded in the marketplace. Also within Level 2 are securities that are valued by outside services or brokers where we have evaluated the pricing methodology and determined that the inputs are observable.
We have a defined benefit pension plan which was modified during 2008; refer to Item 8, Note 13 of the Consolidated Financial Statements, Page 109, for additional information. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates and expected return on plan assets, which are updated annually. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions.
Key assumptions used in developing the 2009 net pension obligation were a 6.10 percent discount rate and rates of compensation increases ranging from 4.00 percent to 6.00 percent. Key assumptions used in developing the 2009 net pension expense were a 6.00 percent discount rate, an 8.00 percent expected return on plan assets and rates of compensation increases ranging from 4.00 percent to 6.00 percent. See Note 13, Page 109 for additional information on assumptions.
Holding all other assumptions constant, a 0.5 percentage-point change in the discount rate would affect our 2010 income before income taxes by $1 million. Likewise, a 0.5 percentage point change in the expected return on plan assets would affect our 2010 income before income taxes by $1 million.
For property casualty policies, deferred acquisition costs are amortized over the terms of the policies. We assess recoverability of deferred acquisition costs at the segment level, consistent with the ways we acquire service, manage and measure profitability. Our standard market insurance operations consist of two segments, commercial lines and personal lines. We also have deferred acquisition costs in our excess and surplus lines operation, which is reported in Other. For life policies, acquisition costs are amortized into income either over the premium-paying period of the policies or the life of the policy, depending on the policy type. We analyze our acquisition cost assumptions periodically to reflect actual experience; we evaluate our deferred acquisition cost for recoverability; and we regularly conduct reviews for potential premium deficiencies or loss recognition.
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 and on supplemental information. 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 $81 million in 2009 contributed 2.8 percentage points to the property casualty combined ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would affect 2010 net income by $3 million (after tax), or 2 cents per share, and the combined ratio by approximately 0.1 percentage points.
At year-end 2009, net unamortized realized losses amounted to $7 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded and charged to the general account. Potentially, losses could be material; however, unrealized losses are approximately $6 million before tax in the separate account portfolio, which had a book value of $541 million at year-end 2009.
Information about recent accounting pronouncements is provided in Item 8, Note 1 of the Consolidated Financial Statements, Page 94. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
We report as Other the non-investment operations of the parent company and its non-insurer subsidiaries, CFC Investment Company and CSU Producers Resources Inc. We also report as Other the results of The Cincinnati Specialty Underwriters Insurance Company, as well as other income of our standard market property casualty insurance subsidiary.
In addition to the factors discussed in Commercial Lines and Personal Lines Insurance Results of Operations, Page 49 and Page 57, overall growth and profitability for our consolidated property casualty insurance operations were affected by a number of common factors. The table below summarizes results of operations for our property casualty operations.
Catastrophe losses contributed 5.7 percentage points to the combined ratio in 2009, down somewhat from the 2008 contribution of 6.8 percentage points, the highest catastrophe loss ratio for our company since 1991. In 2007, catastrophe losses added just 0.8 percentage points, the lowest ratio over the same period. Our 10-year historical annual average contribution of catastrophe losses to the combined ratio was 4.2 percentage points as of December 31, 2009. The following table shows catastrophe losses incurred, net of reinsurance, for the past three years, as well as the effect of loss development on prior period catastrophe reserves.
Our commercial lines statutory combined ratio was 101.8 percent in 2009 compared with 96.6 percent in 2008 and 89.2 percent in 2007. By comparison, the estimated industry commercial lines combined ratio was 101.2 percent in 2009, 107.2 percent in 2008 and 95.1 percent in 2007. Industry commercial lines estimates include mortgage and financial guaranty insurers, which saw a surge in claims following the historically high level of mortgage defaults in 2008, driving an unusually high industry combined ratio for 2008.
Both renewal and new business reflected the effects of the economic slowdown in many regions, as exposures declined and policyholders became increasingly focused on reducing expenses. For commercial accounts, we typically calculate general liability premiums based on sales or payroll volume, while we calculate workers’ compensation premiums based on payroll volume. A change in sales or payroll volume generally indicates a change in demand for a business’s goods or services, as well as a change in its exposure to risk. Policyholders who experience sales or payroll volume changes due to economic factors may be purchasers of other types of insurance, such as commercial auto or commercial property, in addition to general liability and workers’ compensation. Premium levels for these other types of policies generally are not linked directly to sales or payroll volumes.
In 2009, we estimated that policyholders with a contractor-related ISO general liability code accounted for approximately 34 percent of our general liability premiums, which are included in the commercial casualty line of business, and that policyholders with a contractor-related National Council on Compensation Insurance Inc. (NCCI) workers’ compensation code accounted for approximately 46 percent of our workers’ compensation premiums. The market seeking to insure contractors has been more adversely affected by the economic slowdown than some other markets.
For new business, our field associates are frequently in our agents’ offices helping to judge the quality of each account, emphasizing the Cincinnati value proposition, calling on sales prospects with those agents, carefully evaluating risk exposure and providing their best quotes. In 2009, new business premium growth largely was driven by agencies appointed in recent years, which includes Texas agents appointed since late 2008 when we entered that state. Texas agencies generated new business growth of $11 million during
In 2009, other written premiums had less of a downward impact on commercial lines net written premiums than in 2008, primarily due to a lower overall cost for reinsurance and a smaller adjustment for estimated premiums of policies in effect but not yet processed. The adjustment for estimated premiums had an immaterial effect on earned premiums. Higher ceded reinsurance costs were the primary driver of the larger negative effect in 2008, including $5 million for ceded premium to reinstate coverage for our catastrophe reinsurance treaty.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses.
In 2008, we raised the casualty treaty retention to $5 million and raised it to $6 million effective January 1, 2009, when we also raised the property treaty retention to $5 million.
Commercial lines commission expenses as a percent of earned premium remained stable during 2009. The decrease in the commission expenses ratio in 2008 reflected a lower level of our profit-sharing, or contingent commissions, which are primarily based on the profitability of an agency’s aggregate property casualty book of Cincinnati business.
Industrywide commercial lines written premiums are projected to decline approximately 5.6 percent in 2010 with the industry combined ratio estimated at 103.7 percent. As discussed in Item 1, Commercial Lines Property Casualty Insurance Segment, Page 12, over the past several years, renewal and new business pricing has come under steadily increasing pressure, reinforcing the need for more flexibility and careful risk selection. Price competition remains intense and shows no signs of abating in the near term.
In Item 1, Strategic Initiatives, Page 8, we discuss the initiatives we are implementing to achieve our corporate performance objectives. We discuss factors influencing future results of our property casualty insurance operations in the Executive Summary, Page 34.
The calendar year total loss and loss expense ratio increased during 2009 largely because of a lower level, compared with 2008, of favorable development on prior accident year reserves. Factors contributing to the 2008 higher level of favorable prior accident year reserve development included refinements to our IBNR reserve allocation, quarter-to-quarter reductions in actuarial reserve estimates, the introduction of an additional umbrella liability reserving model, sooner-than-expected moderation in the inflation trend of allocated loss expenses and unusual deviations from predictions of reserving methods and models.
Commercial property is our second largest business line. Net written premiums for 2009 increased slightly, largely due to more reinsurance ceded premium in 2008, including $4 million to reinstate coverage for our catastrophe reinsurance treaty. The overall declining trend in premium since 2007 also reflected pricing declines.
Workers’ compensation premiums declined sharply in 2009, primarily due to lower exposures from the weak economy and more selective underwriting and the non-renewal of a number of policies in our worst pricing tier. In addition, premiums resulting from audits of policyholder payroll levels declined $28 million, reflecting the weak economy.
The workers’ compensation business line includes our longest tail exposures, making initial estimates of accident year loss and loss expenses incurred more uncertain. Due to the lengthy payout period of workers’ compensation claims, small shifts in medical cost inflation and payout periods could have a significant effect on our potential future liability compared with our current projections. 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. Prior analyses attributed a larger share of the rise in claim payments for recent accident years to exposure growth rather than loss cost inflation. However, declining claim frequencies reflected in reserving data as of December 31, 2008, indicated that exposure growth was less of a source of the rise in claim payments for recent accident years than was loss cost inflation. The higher estimates of loss cost inflation derived from analyses during 2009 affected reserves estimated for many prior accident years. Accident years 2006 through 2008 had net favorable development of $4 million, largely due to favorable development on the loss expense component of the reserves. Accident years 2000 through 2005 had net unfavorable development of $37 million, and accident years prior to 2000 had net unfavorable development of $15 million. Workers’ compensation prior accident year reserve development for full-year 2009 was unfavorable by $48 million for all prior accident years in total compared with favorable development of $2 million for 2008. As discussed in Property Casualty Insurance Loss and Loss Expense Reserves, including the table on Page 42 showing ranges for estimated reserves, the significant strengthening of reserves during 2009 moved the carried reserves for workers’ compensation into the upper half of the range.
Specialty packages premiums were relatively flat over the three-year period. Our commercial lines policy processing system for businessowners policies, which are included in this business line, already had several of the technology features we recently introduced to our agents with our new commercial lines policy processing system, thereby meeting many of the ease of use requirements of our agencies.
The calendar year and accident year loss and loss expense ratios reflected the volatility in catastrophe losses over the three-year period. In addition, pricing reductions and normal loss cost inflation continued to put upward pressure on the ratios.
Director and officer liability coverage accounted for 60.3 percent of surety and executive risk premiums in 2009 compared with 58.9 percent in 2008 and 62.3 percent in 2007. We have actively managed the potentially high risk of writing director and officer liability by:
Marketing primarily to nonprofit organizations, which accounted for approximately 70 percent of the director and officer liability policies we wrote in 2009.
Providing limits no higher than $10 million with facultative or treaty reinsurance in place in 2010 to cover losses greater than $6 million.
The calendar year and current accident year loss and loss expense ratios rose substantially in 2008 and remained high in 2009, driven by director and officer new losses and case reserve increases greater than $250,000. During 2009, there were 37 new director and officer losses and case reserve increases, compared with 38 in 2008 and 20 in 2007. This added approximately $36 million to loss and loss expenses compared with $43 million in 2008 and $9 million in 2007. The higher level in both 2009 and 2008 was largely from claims related to prior lending practices at financial institutions. To address the potential risk inherent in the financial institutions book of our surety and executive risk business line moving forward, we continue to work with our agents to limit the number of new director and officer policies for financial institutions, in addition to using credit rating and other metrics to carefully re-underwrite in-force policies when they are considered for renewal.
Machinery and equipment premiums continued to rise in 2009. Because of the relatively small size of this business line, the calendar year and accident year loss and loss expense ratios can fluctuate substantially.
Our personal lines statutory combined ratio was 111.4 percent in 2009, 111.6 percent in 2008 and 94.7 percent in 2007. By comparison, the estimated industry personal lines combined ratio was 101.0 percent in 2009, 103.6 percent in 2008 and 96.1 percent in 2007. Our concentration of business in areas hard-hit by catastrophe events contributed to recent results that differed from the overall industry, an issue we are addressing in part through geographic expansion as noted below. The contribution of catastrophe losses to our personal lines statutory combined ratio was 16.1 percentage points in 2009, 14.5 percent points in 2008 and 1.3 percentage points in 2007, compared to an estimated 4.5, 7.5, and 2.1 percentage points, respectively, for the industry.
Personal lines insurance is a strategic component of our overall relationship with many of our agencies and an important component of our agencies’ relationships with their clients. We believe agents recommend Cincinnati personal insurance products for their value-oriented clients who seek to balance quality and price and who are attracted by our superior claims service and the benefits of our package approach.
A.M. Best estimates industrywide personal lines written premiums may rise approximately 1.8 percent in 2010, with the combined ratio estimated at 100.3 percent. With improvement in our new business levels and by maintaining our strong policy retention rate along with rate increases in the homeowner line effected in late 2009, we expect our growth rate to be slightly higher than the industry target for 2010. In Item 1, Strategic Initiatives, Page 8, we discuss the initiatives we are implementing to address the unsatisfactory performance of our personal lines segment, in particular the homeowner line of business. We also describe steps that will enhance our response to the changing marketplace. We are aware that our personal lines pricing and loss activity are at levels that could put achievement of our corporate financial objectives at risk if those trends continue. We discuss our overall outlook for our property casualty insurance operations in the Executive Summary, Page 34.
We prefer to write personal lines coverages within accounts that include both auto and homeowner coverages as well as coverages from the other personal business line. As a result, we believe that the personal lines segment is best measured and evaluated on a segment basis. However, we provide line-of-business data to summarize growth and profitability trends separately for each line. The accident year loss data provides current estimates of incurred loss and loss expenses and corresponding ratios over the most recent three accident years. Accident year data classifies losses according to the year in which the corresponding loss events occur, regardless of when the losses are actually reported, recorded or paid. For 2009, the personal line of business that exhibited the most significant adverse profitability trend was homeowner. As discussed above, we continue to take action to improve pricing per risk and overall rates, which is expected to improve future profitability trends. In addition, we anticipate that the unusually high
Premiums for 2009 were relatively flat compared with 2008. Both years were lower than 2007 and reflected improved new business levels offset by higher reinsurance premiums in both years. Premiums ceded for reinsurance, which reduce premium revenue, were $22 million in 2009; $26 million in 2008,
Other personal premiums increased in 2009 reflecting the growth in our personal auto and homeowner lines before the effects of reinsurance. Most of our other personal coverages are endorsed to homeowner or auto policies.
The calendar year and accident year loss and loss expense ratio for other personal improved in 2009. Reserve development on prior accident years can fluctuate significantly for this business line because personal umbrella liability is a major component of other personal losses.
Profitability - The life insurance segment frequently reports only a small profit or loss because most of its investment income is included in investment segment results. We include only investment income credited to contract holders (interest assumed in life insurance policy reserve calculations) in life insurance segment results. The segment reported a $2 million profit in 2009.
Earned premiums increased in 2009 largely because of growth in our term and universal life insurance business. Earned premiums from term insurance grew $10 million, or 13.4 percent, and earned premiums from universal life insurance grew $4 million, or 17.8 percent.
Over the past several years, we have worked to maintain a portfolio of simple, yet competitive products, primarily under the LifeHorizons banner. Our product development efforts emphasize death benefit protection and guarantees. Distribution expansion within our property casualty insurance agencies remains a high priority. In the past several years, we have added life field marketing representatives for the western, southeastern and northeastern states. Our 32 life field marketing representatives work in partnership with our more than 100 property casualty field marketing representatives. Approximately 70 percent of our term and other life insurance product premiums were generated through our property casualty insurance agency relationships.
Although we exclude most of our life insurance company investment income from investment segment results, we recognize that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life products. On a basis that includes investment income and realized gains or losses from life insurance-related invested assets, the life insurance company reported a net profit of $22 million in 2009, compared with a net loss of $19 million in 2008 and a net profit of $65 million in 2007. The life insurance company portfolio had after-tax realized investment losses of $13 million in 2009, including $15 million in other-than-temporary impairment charges, compared with after-tax realized investment losses of $58 million in 2008, which included $66 million in other-than-temporary impairment charges. Realized investment losses were minimal in 2007, when we reported after-tax realized investment gains of $26 million. Realized investment gains and losses are discussed under Investment Results of Operations, Page 64.
Contract holders’ (policyholders’) benefits incurred related to traditional life and interest-sensitive products accounted for 76.4 percent of 2009 total benefits and expenses compared with 75.7 percent in 2008 and 71.9 percent in 2007. Total benefits and expenses rose due to net death claims that increased but remained within our range of pricing expectations.
Life segment profitability depends largely on premium levels, the adequacy of product pricing, underwriting skill and operating efficiencies. Life segment results include only investment interest credited to contract holders (interest assumed in life insurance policy reserve calculations). The remaining investment income is reported in the investment segment results. The life investment portfolio is managed to earn target spreads between earned investment rates on general account assets and rates credited to policyholders. We consider the value of assets under management and investment income for the life investment portfolio as key performance indicators for the life insurance segment.
Life insurer balance sheets strengthened nicely in 2009 after weathering a difficult 2008. Many companies increased prices or exited selected lines of business to preserve and enhance valuable capital. Our strong surplus position and straight-forward portfolio of products allowed us to maintain our pricing and continue to offer the products and services upon which our agents have come to rely. This strategy led to strong growth in our life and annuity lines in 2009; we expect this trend will continue with respect to life sales but expect some moderation with respect to annuity sales in 2010.
Our property casualty agencies remain the main distribution system for our life insurance segment, and we continue to emphasize securing an increasing share of the life insurance premium produced by these agencies. While other life insurers continue to expand nontraditional distribution channels such as direct sales, we intend to market through agencies affiliated with our property casualty insurance operations or independent life-only agencies. In 2009 our property casualty agencies produced 70 percent and our life-only agencies 30 percent of our life insurance premium. Term insurance continues to fit well with the sales goals of both our property casualty and life-only agencies and remains our largest product line. We continue to introduce new term products with features our agents tell us are important. We will complete a comprehensive review of our term portfolio as well as introduce a new second-to-die universal life product in 2010. We continue to emphasize the cross-serving opportunities of our worksite products for our property casualty agencies’ commercial accounts.
As we seek to improve internal efficiencies, we are consolidating our legacy life insurance administrative systems into a single system. We anticipate this effort will be completed by mid-2011. We are also exploring online initiatives including intelligent electronic applications. We expect these projects to directly affect our ability to increase revenue and reduce expenses.
The National Association of Insurance Commissioners recognizes the problems caused by redundant reserves and is considering a principles-based reserving system rather than the current formulaic one. While still capturing all material risks, a principles-based system would allow a company to use its own experience, subject to credibility standards and appropriate margins for uncertainty. Also, under the proposed principles-based system, the insurer would fully document and disclose all of its assumptions and methods to regulatory officials.
The investment segment contributes investment income and realized gains and losses to results of operations. Investments provide our primary source of pretax and after-tax profits.
Dividend income declined 50.8 percent in 2009 after declining 30.5 percent in 2008 and rising in 2007. During 2008, we reduced the size of our common stock portfolio by more than 50 percent in response to actual or anticipated dividend reductions as well as for the implementation of a risk management program.
We are investing available cash flow in both fixed income and equity securities in a manner that we believe balances current income needs with longer-term growth goals.
We generally purchase fixed income securities with the intention to hold until maturity. Securities that no longer meet our investment criteria, usually due to a change in credit fundamentals, are divested.
We have a small portfolio of convertible preferred stocks and bonds, which have an embedded derivative component. In 2009 we recorded $27 million in fair value realized gains compared with $38 million and $11 million in fair value declines for 2008 and 2007. These changes in fair value were due to the application of ASC 815-15-25, which allows us to account for the entire hybrid financial instrument at fair value, with changes recognized in realized investment gains and losses. The changes in fair values are recognized in net income in the period they occur. See the discussion of Derivative Financial Instruments and Hedging Activities in Item 8, Note 1 of the Consolidated Financial Statements, Page 94, for details on the accounting for convertible security embedded options.
In 2009, we recorded $131 million in write-downs of 50 securities that we deemed had experienced an other-than-temporary decline in fair value versus $510 million for 126 securities in 2008 and $16 million in 2007. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 42. The other-than-temporary impairment charges in 2009 approximated 1.2 percent of our total invested assets at year-end compared with 5.7 percent for 2008. Other-than-temporary impairment charges also include unrealized losses of holdings that we intend to sell but have not yet completed a transaction.
Other-than-temporary impairment charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 18, are summarized below:
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2010, we expect to continue to allocate a portion of cash available for investment to equity securities, taking into consideration corporate liquidity and income requirements, as well as insurance department regulations and ratings agency comments. We discuss our portfolio strategies in Item 1, Investments Segment, Page 18.
We had $150 million of income tax expense in 2009 compared with $111 million in 2008 and $337 million in 2007. The effective tax rate for 2009 was 25.7 percent compared with 20.7 percent in 2008 and 28.3 percent in 2007.
The parent company’s primary means of meeting liquidity requirements are dividends from our insurance subsidiary, investment income and sale proceeds from investments held at the parent company level. The parent company’s primary contractual obligations are interest and principal payments on long- and short-term debt as described under Contractual Obligations, Page 71. Other uses of parent company cash include general operating expenses described under Other Commitments, Page 71, as well as dividends to shareholders and common stock repurchases. As of December 31, 2009, the parent company had $998 million in cash and marketable securities, providing strong liquidity to fund uses of cash.
Through 2009, the board had increased our cash dividend for 49 consecutive years. The board decision in August 2009 to increase the dividend demonstrated confidence in the company’s strong capital, liquidity, financial flexibility and initiatives to improve earnings performance. 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.
Our insurance subsidiary’s primary means of meeting liquidity requirements are investment income, sale proceeds from investments held at the subsidiary level and collection of insurance premiums. Property casualty insurance premiums generally are received before losses are paid under the policies purchased with those premiums. While first-year life insurance expenses normally exceed first-year premiums, subsequent premiums are used to generate investment income until the policy benefits are paid or the policy term expires.
Income from our investments is the most important investment contribution to cash flow. While we have never sold investments to make claims payments, the sale of investments could provide an additional source of liquidity at either the parent company or insurance subsidiary level, if required, although we follow a buy-and-hold investment philosophy seeking to compound cash flows over the long-term. In addition to possible sales of investments, proceeds of call or maturities of fixed maturities also can provide liquidity. During the next five years, $2.135 billion, or 28.4 percent, of our fixed-maturity portfolio will mature. At year-end 2009, total unrealized gains in the investment portfolio, before deferred income taxes, were $1.026 billion, up from $588 million at year-end 2008. Net unrealized gains in 2009 nearly doubled from year-end 2008, even after a significant amount of gains was realized during 2009. Further, financial resources of the parent company also could be made available to our insurance subsidiaries, if circumstances required. This flexibility would include our ability to access the capital markets and short-term bank borrowings.
We had $790 million of long-term debt and $49 million in borrowings on our short-term lines of credit at year-end 2009. We generally have minimized our reliance on debt financing although we may use lines of credit to fund short-term cash needs.
At December 31, 2009, we had two lines of credit with commercial banks amounting to $225 million, with $49 million borrowed. Access to these lines of credit requires compliance with various covenants, including maintaining a minimum consolidated net worth and not exceeding a certain debt-to-capital ratio. As of December 31, 2009, we were well within compliance with all of the covenants under the credit agreements.
Our $75 million unsecured line of credit with PNC Bank, N.A. was established more than five years ago and was renewed effective August 31, 2009, for a one-year term to expire on August 29, 2010. CFC Investment Company, a subsidiary of Cincinnati Financial Corporation, also is a borrower under this line of credit. At year-end 2008, $49 million was outstanding on this line of credit, which was repaid in 2009. PNC Bank is a subsidiary of PNC Financial Services Group, Inc. (NYSE:PNC).
The line of credit includes a swing line sub-facility for same-day borrowing in the amount of $35 million. The credit agreement provides alternative interest charges based on the type of borrowing and our debt rating. The interest rate charged for an advancement is adjusted LIBOR plus the applicable margin. Based on our debt ratings at year-end 2009, interest for Eurodollar rate advances is adjusted LIBOR plus 33 basis points, and for floating rate advances is adjusted LIBOR. Utilization and commitment fees based on Cincinnati Financial Corporation’s current debt rating are 5 basis points and 8 basis points, respectively. CFC Investment Company, a subsidiary of Cincinnati Financial Corporation, is a co-borrower under the agreement.
Further, parent company liquidity could be constrained by State of Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay. During 2010, total dividends that our insurance subsidiary can pay to our parent company without regulatory approval are approximately $365 million.
Commissions - We expect commission payments to generally track with written premiums. We discuss commission trends in the Commercial Lines and Personal Lines Insurance Results of Operations, Page 49 and Page 57.
Other operating expenses - Many of our operating expenses are not contractual obligations but reflect the ongoing expenses of our business. Technology - In addition to contractual obligations for hardware and software discussed below, we anticipate capitalizing approximately $20 million in spending for key technology initiatives in 2010. Technology projects are discussed in Item 1, Strategic Initiatives, Page 8. Capitalized development costs related to key technology initiatives totaled $28 million in 2009 and $38 million in 2008. These activities are conducted at our discretion, and we have no material contractual obligations for activities planned as part of these projects.
Our most significant contractual obligations are discussed in conjunction with related insurance reserves in Gross Property Casualty Loss and Loss Expense Payments and Gross Life Insurance Policyholder Obligations on Page 71 and Page 78, respectively. Other future contractual obligations include:
Profit-sharing commissions - Profit-sharing, or contingent, commissions are paid to agencies using a formula that takes into account agency profitability and other factors. We estimate 2010 contingent commission payments of approximately $81 million. We discuss commission expense trends in Commercial Lines and Personal Lines Insurance Results of Operations, Page 49 and Page 57.
Computer hardware and software - We expect to need approximately $25 million over the next three years for current material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discussed above the non-contractual expenses we anticipate for computer hardware and software in 2010.
Our estimate of future gross property casualty loss and loss expense payments of $4.096 billion is lower than loss and loss expense reserves of $4.142 billion as of year-end 2009. The $46 million difference is
Our estimates of gross property casualty loss and loss expense payments also do not include reinsurance receivables or ceded losses. As discussed in 2010 Reinsurance Programs, Page 79, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance unpaid receivables of $435 million at year-end 2009 are an offset to our gross property casualty loss and loss expense obligations. Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claim severity or frequency due to a catastrophic event. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover losses under our reinsurance agreements depends on the financial viability of the reinsurers.
The low point of each year’s range corresponds to approximately one standard error below each year’s mean reserve estimate, while the high point corresponds to approximately one standard error above each year’s mean reserve estimate. We discussed management’s reasons for basing reasonably likely reserve ranges on standard errors in Critical Accounting Estimates, Reserve Estimate Variability, Page 41.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2009 and 2008. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
Management’s best estimate of total loss and loss expense reserves as of year-end 2009 was consistent with the corresponding actuarial best estimate. Management’s best estimate of total loss and loss expense reserves as of year-end 2008 also was consistent with the corresponding actuarial best estimate.
The table on the following page shows the development of estimated reserves for loss and loss expenses for the past 10 years.
the estimated amount of unpaid loss and loss expenses for claims arising in the indicated calendar year and all prior accident years at the balance sheet date, including losses that were incurred but not yet reported to the company.
Section B shows the cumulative net amount paid with respect to the previously recorded reserve as of the end of each succeeding year. For example, as of December 31, 2009, we had paid $1.567 billion of loss and loss expenses in calendar years 2000 through 2009 for losses that occurred in accident years 1999 and prior. An estimated $201 million of losses remained unpaid as of year-end 2009 (net re-estimated reserves of $1.768 billion from Section C less cumulative net paid loss and loss expenses of $1.567 billion).
Differences between the property casualty reserves reported in the accompanying consolidated balance sheets (prepared in accordance with GAAP) and those same reserves reported in the annual statements (filed with state insurance departments in accordance with statutory accounting practices - SAP), relate principally to the reporting of reinsurance recoverables, which are recognized as receivables for GAAP and as an offset to reserves for SAP.
Due to these considerations, our actuarial staff elected to use a paid survival ratio method to estimate reserves for incurred but not yet reported asbestos and environmental claims. Although highly uncertain, reserve estimates obtained via this method have developed in a reasonably stable fashion since 2004. Between 2006 and 2009, total asbestos and environmental reserves decreased 9.6 percent. Since our exposure to such claims is limited, we believe the paid survival ratio method is sufficient.
Overall favorable development for commercial lines reserves of $147 million in 2009 illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. Favorable reserve development of $154 million for the commercial casualty line exceeded the segment total in 2009, while adverse reserve development for the workers’ compensation line reduced segment favorable reserve development by $48 million. Drivers of commercial casualty and workers’ compensation reserve development are discussed below.
Refinement in commercial/personal umbrella liability IBNR Reserve Allocation - A 2009 study indicated that personal umbrella coverages had been allocated too large a portion of the total IBNR reserve for all umbrella coverages. As a result, $7 million of personal umbrella IBNR reserves was shifted to commercial umbrella, partially offsetting the favorable reserve development detailed in the first four points above.
2010 Reinsurance Programs, Page 79, we purchase reinsurance to mitigate our life insurance risk exposure. At year-end 2009, ceded death benefits represented approximately 49.0 percent of our total policy face amounts in force.
These estimated cash outflows are undiscounted with respect to interest. As a result, the sum of the cash outflows for all years of $3.502 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy reserves and separate accounts for future policy benefits and claims of $2.399 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $2 million of separate accounts liabilities.
Currently participating on our standard market property and casualty per-risk and per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of which have A.M. Best insurer financial strength ratings of A (Excellent) or A+ (Superior). Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and the European markets.
Primary components of the 2010 property and casualty reinsurance program include:
Casualty per occurrence treaty - The casualty treaty provides capacity up to $25 million. Similar to the property treaty, it provides sufficient capacity to cover the vast majority of casualty accounts we insure and also includes protection for extra-contractual liability coverage losses. We retain the first $6 million
Casualty excess treaties - We purchase a casualty reinsurance treaty that provides an additional $25 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $50 million of protection for workers’ compensation, extra-contractual liability coverage and clash coverage losses, which would apply when a single occurrence involves multiple policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated at $2 million in 2010, similar to the premium we paid in 2009.
Property catastrophe treaty - To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, we purchase property catastrophe reinsurance with a limit up to $500 million. For the 2010 treaty, ceded premiums are estimated at $49 million, similar to the $50 million in 2009 and $41 million in 2008. We retain the first $45 million of any loss and varying shares of losses up to $500 million:
Individual risks with insured values in excess of $25 million, as identified in the policy, are handled through a different reinsurance mechanism. We typically reinsure property coverage for individual risks with insured values between $25 million and $65 million under an automatic facultative treaty. For risks with property values exceeding $65 million, we negotiate the purchase of facultative coverage on an individual certificate basis. For casualty coverage on individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis.
A form of reinsurance is also provided through The Terrorism Risk Insurance Act of 2002 (TRIA). TRIA was originally signed into law on November 26, 2002, and extended on December 22, 2005, in a revised form, and extended again on December 26, 2007. TRIA provides a temporary federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. TRIA now is scheduled to expire December 31, 2014. Under regulations promulgated under this statute, insurers are required to offer terrorism coverage for certain lines of property casualty insurance, including property, commercial multi-peril, fire, ocean marine, inland marine, liability, aircraft and workers’ compensation. In the event of a terrorism event defined by TRIA, the federal government would reimburse terrorism claim payments subject to the insurer’s deductible. The deductible is calculated as a percentage of subject written premiums for the preceding calendar year. Our deductible in 2009 was $383 million (20 percent of 2008 subject premiums), and we estimate it is $369 million (20 percent of 2009 subject premiums) in 2010.
Delays in adoption and implementation of underwriting and pricing methods that could increase our pricing accuracy, underwriting profit and competitiveness
Changing consumer insurance-buying habits and consolidation of independent insurance agencies that could alter our competitive advantages
Actions of insurance departments, state attorneys general or other regulatory agencies, including a change to a federal system of regulation from a state-based system, that:
Difficulties with technology or data security breaches could negatively affect our ability to conduct business and our relationships with agents, policyholders and others
The audit committee meets periodically with management, our independent registered public accounting firm and our internal auditors to discuss how each is handling responsibilities. The audit committee reports its findings to the board of directors. The audit committee recommends to the board the annual appointment of the independent registered public accounting firm. The audit committee reviews with this firm the scope of the audit assignment and the adequacy of internal controls and procedures.
The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2009, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment was based on the criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and was designed to provide reasonable assurance that the company maintained effective internal control over financial reporting as of December 31, 2009. The assessment led management to conclude that, as of December 31, 2009, the company’s internal control over financial reporting was effective based on those criteria.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the company) as of December 31, 2009 and 2008, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the financial statement schedules listed in the Index at Item 15(c). We also have audited the company’s internal control over financial reporting as of December 31, 2009, based on criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedules and an opinion on the company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
The two complementary subsidiaries are CSU Producer Resources Inc., which offers insurance brokerage services to our independent agencies so their clients can access our excess and surplus lines insurance products, and CFC Investment Company (CFC-I), which offers commercial leasing and financing services to our agents, their clients and other customers.
Net income per common share is based on the weighted average number of common shares outstanding during each of the respective years. We calculate net income per common share (diluted) assuming the exercise of stock-based awards. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2009.
We grant qualified and non-qualified share-based compensation under authorized plans. The stock options vest ratably over three years following the date of grant and are exercisable over 10-year periods. In 2008, the committee approved a mix of stock options and restricted stock units for stock-based awards. Stock options granted had similar terms but generally were awarded for fewer shares compared with previous years to accommodate new awards of service-based and performance-based restricted stock units.
We sponsor a defined benefit pension plan that was modified during 2008. We froze entry into the pension plan, and only participants 40 years of age or older could elect to remain in the plan. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method. Refer to Note 13, Employee Retirement Benefits, Page 109 for more information regarding our defined benefit pension plan.
A premium deficiency is recorded when the sum of expected loss and loss adjustment expenses, expected policyholder dividends, unamortized acquisition costs and maintenance costs exceeds the total of unearned premiums and anticipated investment income. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium
Certain workers’ compensation policies include the possibility of a policyholder earning a return of a portion of its premium in the form of a policyholder dividend. The dividend generally is calculated by determining the profitability of a policy year along with the associated premium. We reserve for all probable future policyholder dividend payments.
We offer several types of life and health insurance, and we account for each according to the duration of the contract. Short-duration contracts are written to cover claims that arise during a short, fixed term of coverage. We generally have the right to change the amount of premium charged or cancel the coverage at the end of each contract term. Group life insurance is an example. We record premiums for short-duration contracts similarly to property casualty contracts.
Effective in the second quarter 2009, we changed our presentation of underwriting expenses in our consolidated statements of income. We have summarized commissions, insurance operating expenses, increase in deferred acquisition costs and taxes, licenses and fees to a single caption, “Underwriting, acquisition and insurance expenses.”
Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holder, and we do not include them in the Consolidated Statements of Income. Revenues and expenses related to separate accounts consist of contractual fees and mortality, surrender and expense risk charges. Also, each separate account BOLI includes a negotiated gain and loss sharing arrangement with the company. A percentage of each separate account’s realized gain and loss representing contract fees and assessments accrues to us and is transferred from the separate account to our general account and is recognized as revenue or expense.
Our portfolio investments are primarily in publicly traded fixed-maturity, equity and short-term investments. Fixed-maturity investments (taxable bonds, tax-exempt bonds, redeemable preferred stocks and collateralized mortgage obligations) and equity investments (common and non-redeemable preferred stocks) are classified as available for sale and recorded at fair value in the consolidated financial
ASC 320 does not allow retrospective application of the new other-than-temporary impairment model. Our Consolidated Statements of Income for the year ended December 31, 2009, are not measured on the same basis as prior period amounts and, accordingly, these amounts are not comparable.
Included within our other invested assets are life policy loans, venture capital fund investments and investment in real estate. Life policy loans are carried at the receivable value. We use the equity method of accounting for venture capital fund investments. The venture capital funds provide their financial statements to us and generally report investments on their balance sheets at fair value. Investment in real estate consists of one office building that is carried at cost less accumulated depreciation.
We account for our investment portfolio at fair value and apply fair value measurements as defined by ASC 820, Fair Value Measurements and Disclosures, to financial instruments. Fair value is applicable to ASC 320, Investments-Debt and Equity Securities, ASC 815, “Derivatives and Hedging,” and ASC 825, Financial Instruments.
For the purpose of ASC 825 disclosure, we estimate the fair value for liabilities of investment contracts and annuities. We also estimate the fair value for assets arising from policyholder loans on insurance contracts. These estimates are developed using discounted cash flow calculations across a wide range of economic interest rate scenarios with a provision for our own credit risk. We base fair value for long-term senior notes
on the quoted market prices for such notes. We base fair value for notes payable on our year-end outstanding balance.
During the third quarter of 2008, we terminated our securities lending program.
In April 2009, the FASB issued ASC 820-10-50, Interim Disclosures about Fair Value of Financial Instruments. ASC 820-10-50 is an amendment of ASC 825-10-50, Disclosures about Fair Value of Financial Instruments and ASC 270, Interim Financial Reporting. ASC 820-10-50 expands the fair value disclosures for all financial instruments within the scope of ASC 825-10-50 to interim reporting periods. We have adopted ASC 820-10-50, and it is effective for interim reporting periods ending after June 15, 2009. It did not have an impact on our company’s financial position, cash flows or results of operations as it focuses on additional disclosures.
In April 2009, the FASB issued ASC 320, Recognition and Presentation of Other-Than-Temporary Impairments effective for interim and annual reporting periods ending after June 15, 2009. ASC 320 is an amendment of ASC 320-10, Accounting for Certain Investments in Debt and Equity Securities and ASC 958-320, Accounting for Certain Investments Held by Not-for-Profit Organizations. ASC 320 amends the other-than-temporary impairment guidance for debt securities and expands the presentation and disclosure of other-than-temporary impairments on debt and equity securities in the financial statements. We adopted this ASC as of April 1, 2009.
In May 2009, the FASB issued ASC 855, Subsequent Events. ASC 855 provides guidance on the disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The date through which any subsequent events have been evaluated and the basis for that date must be disclosed. ASC 855 requires that we disclose the analysis of subsequent events through the date that our Financial Statements are issued. ASC 855 also defines the circumstances under which an entity should recognize such events or transactions and the related disclosures of such events or transactions that occur after the balance sheet date. We adopted this ASC, which is effective for interim or annual financial periods ending after June 15, 2009. It did not have an impact on our company’s financial position, cash flows or results of operations.
In August 2009, the FASB issued ASU 2009-05, Measuring Liabilities at Fair Value. ASU 2009-05 is an amendment of ASC 820, Fair Value Measurements and Disclosures. ASU 2009-05 applies to all entities that measure liabilities at fair value within the scope of ASC 820, Fair Value Measurements and Disclosures. ASU 2009-05 provides guidance on measuring fair value of liabilities under circumstances in which a quoted price in an active market for the identical liability is not available. We have adopted this ASU, which is effective for the first interim or annual reporting period beginning after August 28, 2009. It did not 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, fair value and other-than-temporary impairments (OTTI) in accumulated other comprehensive income (AOCI) for our investments:
With the adoption of ASC 320 in the second quarter of 2009, we recognized a cumulative effect adjustment of $106 million, net of tax, to reclassify the non-credit component of previously recognized impairments by increasing retained earnings and reducing accumulated other comprehensive income. ASC 320 does not allow retrospective application of the new OTTI model. Our Consolidated Statements of Income for the year ended December 31, 2009, are not measured on the same basis as prior period amounts and, accordingly, these amounts are not comparable.
For each of our equity securities in an unrealized loss position at December 31, 2009, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong surplus, liquidity and cash flow, provides us the ability to hold these investments through what we believe to be slightly longer recovery periods occasioned by the recession and historic levels of market volatility. Each quarter we review the expected recovery period for each individual security. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is impaired.
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). Our valuation techniques have not changed from December 31, 2008, and ultimately management determines fair value.
For the year ended December 31, 2009, two preferred equity securities totaling $15 million were transferred from Level 3 to Level 2. There was also a $3 million OTTI of one preferred equity during the first quarter of 2009. As a result of the change in use of observable or unobservable inputs throughout 2009,
corporate fixed-maturity securities decreased $28 million as nine securities totaling $35 million transferred from Level 3 to Level 2 and two securities totaling $7 million transferred from Level 2 to Level 3. At December 31, 2009, total fair value of assets priced with broker quotes and other non-observable market inputs for the fair value measurements and disclosures was $36 million.
This table summarizes our consolidated property casualty loss and loss expense reserves:
We use actuarial methods, models, and judgment to estimate, as of a financial statement date, the property casualty loss and loss expense reserves required to pay for and settle all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date. The actuarial estimate is subject to review and adjustment by an inter-departmental committee that includes actuarial management and is familiar with relevant company and industry business, claims, and underwriting trends, as well as general economic and legal trends, that could affect future loss and loss expense payments.
At December 31, 2009 and 2008, we had two lines of credit with commercial banks with an aggregate borrowing capacity of $225 million. Our note payable balance, which approximates fair value, was $49 million at year-end 2009 and at year-end 2008. The $75 million line of credit expires August of 2010. The $150 million line of credit with a $49 million balance expires July of 2012. We had no compensating balance requirements on short-term debt for either 2009 or 2008. Interest rates charged on borrowings ranged from 2.58 percent to 6.86 percent during 2009.
The fair value of our senior debt approximated $740 million at year-end 2009 compared with $595 million at year-end 2008. Fair value for 2009 and 2008 was determined under ASC 820 based on market pricing of these or similar debt instruments that are actively trading. Fair value can vary with macro economic concerns. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt was reduced slightly from year-end 2008. None of the notes are encumbered by rating triggers.
As of December 31, 2009, 7.7 million shares of common stock were available for future equity award grants.
Declared cash dividends per share were $1.57, $1.56 and $1.42 for the years ended December 31, 2009, 2008 and 2007, respectively.
Our consolidated statements of income incurred consolidated property casualty insurance loss and loss expenses on assumed and ceded business:
The provision for federal income taxes is based upon filing a consolidated income tax return for the company and its subsidiaries. As of December 31, 2009, we had no operating or capital loss carry forwards.
As a result of positions taken in our 2008 federal tax return filed with the IRS, we believe it is more likely than not that tax positions for which we previously carried a liability for unrecognized tax benefits will be sustained upon examination by the IRS.
The IRS has begun the audit of tax years 2007 and 2008. It is reasonably possible that a change in our liability for unrecognized tax benefits may occur once the examination phase of this audit has concluded. At this time, we can neither estimate the settlement date of, nor quantify an estimated range for any potential change to our liability for unrecognized tax benefits relating to these years.
Basic earnings per share are computed based on the weighted average number of shares outstanding. Diluted earnings per share are computed based on the weighted average number of common and dilutive potential common shares outstanding. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2009.
The current sources of dilution of our common shares are certain equity-based awards as discussed in Note 17 Stock-Based Associate Compensation Plans, Page 113. The above table shows the number of anti-dilutive stock-based awards at year-end 2009, 2008 and 2007. We did not include these stock-based awards in the computation of net income per common share (diluted) because their exercise would have anti-dilutive effects.
Matching contributions to our sponsored 401(k) plan, which we began making during 2008, totaled $7 million and $3 million during the years 2009 and 2008. Associates who are not accruing benefits under the pension plan are eligible to receive the company match of up to 6 percent of cash compensation. We also pay all operating expenses for the 401(k) plan. Participants vest in the company match for the 401(k) plan and Top Hat Savings Plan after three years of eligible service.
Key assumptions used in developing the 2009 net pension obligation were a 6.10 percent discount rate and rates of compensation increases ranging from 4.00 percent to 6.00 percent. To determine the discount rate, the plan’s particular liability characteristics - the amounts, timing and interest sensitivity of expected benefit payments - were evaluated and then matched to a yield curve based on actual high-quality corporate bonds across a full maturity spectrum. Once the plan’s projected cash flows matched the yield curve, a present value was developed, which was then calibrated to a single-equivalent discount rate. That discount rate, when applied to a single sum, would generate the necessary cash flows to pay benefits when due. We increased the rate by 0.10 percentage points due to market interest rate conditions at year-end 2009. We based the rates of compensation increase on the company’s historical data.
Key assumptions used in developing the 2009 net pension expense were a 6.00 percent discount rate, an 8.00 percent expected return on plan assets and rates of compensation increases ranging from 4.00 percent to 6.00 percent. The 8.00 percent return on plan assets assumption is consistent with current expectations of inflation and based partially on the fact that our common stock holdings pay dividends. We believe this rate is representative of the expected long-term rate of return on these assets. These assumptions were consistent with the prior year, except that the discount rate was decreased by 0.25 percentage points due to market interest rate conditions at the beginning of the year.
The pension plan assets are managed to maximize total return over the long term while providing sufficient liquidity and current return to satisfy the cash flow requirements of the plan. The plan’s day-to-day investment decisions are managed by our internal investment department; however, overall investment strategies are agreed upon by our employee benefits committee.
Reflecting the long-term time horizon of pension obligations, during 2009 we allocated 60 percent to 65 percent of the pension portfolio to domestic equity investments, which are priced from highly observable and actively traded markets. The remainder of the portfolio is allocated to domestic fixed-maturity investments and cash. Our corporate bond portfolio is investment grade. The plan does not engage in derivative transactions.
actively traded are valued based on pricing models which the inputs have been corroborated by market data at December 31, 2009 and 2008.
The plan, which ultimately determines fair value, categorized its 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).
The following table illustrates the fair value hierarchy for those assets measured at fair value on a recurring basis for period ended December 31, 2009. The pension plan does not have any assets categorized as Level 3. During 2008, plan assets held were 83 percent equity securities, 4 percent fixed maturities and 13 percent cash and cash equivalents.
deferred income taxes based on differences in statutory and taxable income.
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $6 million, $6 million and $7 million on premium volume of approximately $36 million, $38 million and $37 million for 2009, 2008 and 2007, respectively.
In the ordinary course of conducting business, the company and its subsidiaries are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving the company’s insurance subsidiaries in which the company is either defending or providing indemnity for third-party claims brought against insureds who are litigating first-party coverage claims. The company accounts for
Options exercised during the year ended December 31, 2009, had no intrinsic value. The total intrinsic value of options exercised during the years ended December 31, 2008 and 2007 was $1 million and $8 million, respectively. (Intrinsic value is the market price less the exercise price.) Options vested during the years ended December 31, 2009, 2008 and 2007, had no intrinsic value.
During 2009, we issued our common stock to eligible associates under our Holiday Stock Bonus Plan. No stock options, service-based or performance-based restricted stock units were granted to associates during 2009. The following weighted average assumptions were used for grants issued during 2008 and 2007 in determining fair value of share-based compensation:
Options outstanding and exercisable consisted of the following at December 31, 2009:
The weighted-average remaining contractual life for exercisable awards as of December 31, 2009, was 3.7 years. A total of 16.9 million shares are authorized to be granted under the shareholder-approved plans. At December 31, 2009, 7.7 million shares were available for future issuance under the plans. During the second quarter of 2009, our shareholders approved the Directors’ Stock Plan of 2009, which authorizes 300,000 shares to be granted to our directors. During 2009, we granted 23,944 shares of common stock under the expiring plan to our directors for 2008 board service fees. We currently issue new shares or use treasury shares for stock-based compensation award issues or exercises.
Service-based and performance-based restricted stock units are granted to associates at fair value of the shares on the date of grant less the present value of the dividends that holders of restricted stock units will not receive on the shares underlying the restricted stock units during the vesting period. Service-based restricted stock units cliff vest three years after the date of grant.
Here is a summary of restricted stock unit information for 2009:
We report as Other the non-investment operations of the parent company and its non-insurer subsidiaries, CFC Investment Company and CSU Producers Resources Inc. We also report as Other the results of The Cincinnati Specialty Underwriters Insurance Company, as well as other income of our standard market property casualty insurance subsidiary. Also included in 2009, 2008 and 2007 results for this segment are the operations of a former subsidiary, CinFin Capital Management.
All three insurance segments record revenues from insurance premiums earned. Life insurance segment revenues also include separate account investment management fees.
Other revenues are primarily finance/lease income and, for 2009 and 2008, earned premiums from The Cincinnati Specialty Underwriters Insurance Company.
Loss before income taxes for the Other category is primarily due to interest expense from debt of the parent company, operating expenses of our headquarters and, for 2009 and 2008, loss and loss expenses and underwriting expenses from The Cincinnati Specialty Underwriters Insurance Company.
Note: The sum of the quarterly reported per share amounts may not equal the full year as each is computed independently.
Revenues include realized investment gains and losses, which are integral to our financial results over the long term may cause this value to fluctuate substantially because we have substantial discretion in the timing of investment sales. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 64.