Cincinnati Financial Corporation owns our headquarters building located on 102 acres of land in Fairfield, Ohio. This building has 1,508,200 square feet of total space. The property, including land is recorded in our financial statements at $130 million at December 31, 2017, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies 6,750 square feet (less than 1 percent). This property is used for the operations described in the Consolidated Financial Statements and accompanying Notes.
Through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on net written premium volume for the first nine months of 2017, among approximately 2,000 U.S. stock and mutual insurer groups. We market our insurance products through a select group of independent insurance agencies in 42 states as discussed in Item 1, Our Business and Our Strategy.
* Book value per share is calculated by dividing end of period total shareholders' equity by end of period shares outstanding
Combined ratio - We believe our underwriting philosophy and initiatives can drive performance to achieve our underwriting profitability target of a GAAP combined ratio over any five-year period that consistently averages within the range of 95 percent to 100 percent. Our GAAP combined ratio averaged 94.6 percent over the five-year period 2013 through 2017, better than the performance target range. Performance as measured by the combined ratio is discussed in Consolidated Property Casualty Insurance Results. Our statutory combined ratio averaged 94.0 percent over the five-year period 2013 through 2017, compared with an estimated 99.6 percent for the property casualty industry. The industry’s ratio again excludes its mortgage and financial guaranty lines of business.
The board of directors is committed to rewarding shareholders directly through cash dividends and share repurchase authorizations. Through 2017, the company has increased the annual cash dividend rate for 57 consecutive years, a record we believe is matched by only eight other publicly traded U.S. companies. In addition to regular dividends, strong capital and excellent company performance provided opportunities to further reward shareholders with special dividends paid in December 2017 and in December 2015. The board regularly evaluates relevant factors in dividend-related decisions, and the 2017 increase to the regular dividend reflected confidence in our strong capital, liquidity and financial flexibility, as well as progress through our initiatives to
Net income in 2017 increased $454 million or 77 percent compared with 2017, including a $495 million benefit from net deferred income tax liability revaluation due to U.S. tax reform, a $15 million increase in net realized investment gains after taxes and a $13 million increase in investment income after taxes. The 2017 increase in net income was partially offset by a decrease in property casualty underwriting income of $74 million after taxes, including $3 million from higher catastrophe losses, as discussed below. Our investment operation’s performance is discussed further in Investments Results.
As discussed in Investments Results, sales of securities that had appreciated in value led to realized investment gains in all three years. Realized and unrealized 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, also the gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process.
Manage insurance profitability - Implementation of these initiatives is intended to enhance underwriting expertise and knowledge, thereby increasing our ability to manage our business while also gaining efficiency. Better profit
Financial markets continued to display volatility in recent years, and some predict more turbulence in the future from effects such as changes in government policy, growth challenges for emerging country economies or other geopolitical events that could also affect the U.S. economy and markets. Should financial markets decline temporarily, which could occur as part of typical market volatility patterns, the related book value component of our value creation ratio could also register a weak or negative result.
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 known claims. Field claims managers supervise and review all claims with case reserves less than $100,000. Additionally, a headquarters supervisor and regional claims manager review all claims under $100,000 if litigation or a certain specialty claim is involved. All claims with case reserves of $100,000 or greater are reviewed and approved by an experienced headquarters supervisor and regional claims manager. Upper-level headquarters claims managers also review case reserves of $175,000 or more.
For events designated as natural catastrophes resulting in losses incurred related to direct premiums, we calculate IBNR reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Once case reserves are established for a catastrophe event, we reduce the IBNR reserves. Our claims department management coordinates the assessment of these events and prepares the related IBNR reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the affected geographic area and of available claims intelligence.
For events designated as natural catastrophes resulting in losses incurred related to our reinsurance assumed operations, Cincinnati Re, we calculate IBNR reserves for losses incurred separately from losses related to direct premiums. That process begins with a review of our occurrence and aggregate in-force reinsurance limits for our portfolio of ceding companies likely to be affected by such events. Using third party catastrophe models combined with our own proprietary adjustments, we model a range of stochastic and scenario events for each ceding company to make an initial estimate of potential losses. Consideration of industry loss estimates promulgated by a variety of third parties provides a base to perform a market share loss analysis for each ceding company. We obtain loss estimates from ceding companies based on their view of losses, which includes their claim reports, actual claim payments and reserve estimates. Based on these data points, we estimate ultimate losses that we reinsure for each ceding company. We then benchmark individual ceding company reports against what we expected and use this information across our portfolio to refine our ultimate loss estimates. Once known payments and reserves are reported by individual ceding companies, we establish case reserves by reinsurance treaty. IBNR reserves are then calculated as the difference between the estimate of the ultimate loss and loss expenses incurred for each catastrophe event, reduced by the sum of total loss and loss expense payments and total case reserves. Incurred losses from catastrophe events for our reinsurance assumed operations can include non-U.S. experience reported by the ceding companies, in addition to events designated as catastrophes by PCS.
These trends and measures also support the estimation of expected accident year loss ratios needed for applying the Bornhuetter-Ferguson methods and for assessing the reasonability of all IBNR reserve estimates computed. Our actuarial staff reviews these trends and measures quarterly, updating parameters derived from them as necessary.
Management believes that the standard error of a reserve estimate, a measure of the estimate’s variability, provides the most appropriate measure of the estimate’s sensitivity. The reserves we establish depend on the models we use and the related parameters we estimate in the course of conducting reserve analyses. However, the actual amount required to settle all outstanding insured claims, including IBNR claims, as of a financial statement date depends on stochastic, or random, elements as well as the systematic elements captured by our models and estimated model
Securities that have previously been other-than-temporarily impaired are evaluated based on their adjusted cost or amortized cost and further written down if deemed appropriate. We provide detailed information about securities fair valued in a continuous loss position at year-end 2017 in Item 7A, Application of Asset Impairment Policy.
For each of our equity securities in an unrealized loss position at December 31, 2017, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Based on the individual quantitative and qualitative 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 other-than-temporarily impaired. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong statutory capital and surplus, liquidity and cash flow, provide us the ability to hold these investments through what we believe to be slightly longer recovery periods during times of historic levels of market volatility.
At December 31, 2017, total Level 3 assets were less than 1 percent of our investment portfolio measured at fair value. Financial assets that fall within the Level 3 hierarchy are valued based upon unobservable market inputs, normally because they are not actively traded on a public market. Pricing for each Level 3 security is based upon inputs that are market driven, including quotes from brokers or other external sources. We placed in the Level 3 hierarchy securities for which we were unable to obtain the pricing methodology or we could not consider the price provided as binding. Pricing for securities classified as Level 3 could not be corroborated by similar securities priced using observable inputs.
Key assumptions used in developing the 2017 net pension expense for our qualified plan were a 4.30 percent discount rate, a 7.25 percent expected return on plan assets and rates of compensation increases ranging from 2.75 percent to 3.25 percent.
In 2017, the net pension expense was $7 million. In 2018, we expect the net pension expense to be approximately $3 million.
Holding all other assumptions constant, a 0.5 percentage-point decrease in the discount rate would decrease our 2018 income before income taxes by approximately $1 million. A 0.5 percentage-point decrease in the expected return on plan assets would decrease our 2018 income before income taxes by approximately $2 million.
We establish a deferred asset for expenses associated with successfully acquiring property casualty and life insurance policies, primarily commissions, premium taxes and underwriting costs. Underlying assumptions are updated periodically to reflect actual experience, and we evaluate our deferred acquisition cost recoverability.
Earned and net written premiums for our consolidated property casualty operations grew in 2017, reflecting average renewal price increases, a higher level of insured exposures and strategic initiatives for targeted growth. A key measure of property casualty profitability is underwriting profit or loss. Our 2017 underwriting profit of $128 million was $114 million less than in 2016, caused in part by a $4 million unfavorable effect from a higher amount of natural catastrophe losses, mostly caused by severe weather. An increase in payments and reserves for losses and loss expenses, largely for our commercial casualty line of business, was responsible for much of the 2017 underwriting profit decrease, largely offsetting benefits of higher pricing, and our ongoing initiatives to improve pricing precision and loss experience related to claims and loss control practices. Underwriting profit trends are discussed further below and includes prior accident year loss experience before catastrophes during 2017 that was less favorable than in 2016.
Growth initiatives also favorably affect growth in subsequent years, particularly as newer agency relationships mature over time.
Other written premiums consist primarily of premiums ceded to reinsurers as part of our ceded reinsurance program and in total contributed $5 million more in 2017 to net written premiums than in 2016. An increase in ceded premiums, other than Cincinnati Re premiums, reduced net written premium growth by $2 million in 2017, compared with 2016.
Our statutory combined ratio was 97.2 percent in 2017 compared with 94.5 percent in 2016 and 90.6 percent in 2015. The estimated statutory combined ratio for the property casualty industry, with the industry’s ratio excluding its mortgage and financial guaranty lines of business, was 105.1 percent in 2017, 100.9 percent in 2016 and 98.3 percent in 2015. The contribution of catastrophe losses to our statutory combined ratio was 7.2 percentage points in 2017, 7.5 percentage points in 2016 and 3.7 percentage points in 2015, compared with industry estimates of 8.8, 4.7 and 3.5 percentage points, respectively. Components of the combined ratio are discussed below.
Catastrophe loss trends are an important factor in assessing trends for overall underwriting results. Our 10-year historical annual average contribution of catastrophe losses to the combined ratio was 6.8 percentage points at December 31, 2017. Our five-year average was 5.7 percentage points.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. For all property casualty lines of business in aggregate, net loss and loss expense reserves at December 31, 2017, were $295 million higher than at year-end 2016, including $192 million for incurred but not reported (IBNR) reserves. The $295 million reserve increase raised year-end 2017 net loss and loss expense reserves by 6 percent, compared with a 5 percent increase in 2017 earned premiums.
The 61.1 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2017 increased 1.3 percentage points compared with the 59.8 percent accident year 2016 ratio measured as of December 31, 2016. Contributors to the increase included more current accident year losses of $1 million or more per claim, shown in the table below.
Reserve development on prior accident years continued to net to a favorable amount in 2017, and was primarily
In 2017, total large losses incurred increased by $103 million, or 50 percent, net of reinsurance. The corresponding ratio increased 1.9 percentage points. Our analysis of large losses incurred indicated no unexpected concentration of these losses and reserve increases by geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
Consolidated property casualty commission expenses rose $47 million, or 6 percent, in 2017, with profit-sharing commissions for agencies increasing by $5 million. Commission expenses as a percent of earned premiums resulted in a 2017 ratio that matched 2016. The 2017 ratio for other underwriting expenses increased by 0.1 percentage-point compared with 2016, as earned premiums rose at a pace slightly less than other underwriting expenses. During 2017, we continued to carefully manage expenses while also making strategic investments that include enhancement of underwriting expertise, such as personal lines staff additions to support high net worth market expansion.
Our largest commercial line of business, commercial casualty, drove the paid component of the increase in the commercial lines segment ratio for loss and loss expenses from prior accident years before catastrophe losses, reflecting paid losses emerging at levels higher than we previously expected. Despite a significant increase in prior accident year paid losses, our commercial casualty 2017 loss and loss expense ratio remained below 64 percent, indicating an underwriting profit of approximately $40 million once underwriting expenses are considered.
expected for commercial casualty. Considering that new data at December 31, 2017, we estimated commercial casualty IBNR reserves for accident year 2017 at levels more likely to be adequate, $47 million higher than accident year 2016 estimates at the end of 2016. The increase in IBNR reserves for commercial casualty was largely responsible for the 1.8 percentage-point increase in the commercial lines ratio for current accident year losses and loss expenses before catastrophes.
Premiums resulting from audits of actual sales or payrolls that confirmed or adjusted initial premium estimates have had a mixed effect on premium trends in recent years. On an earned premium basis for our commercial lines insurance segment, audits contributed negative $7 million to the $77 million earned premiums increase in 2017, negative $5 million to the $93 million earned premiums increase in 2016 and $23 million to the $140 million earned premiums increase in 2015. On a net written premium basis, audits contributed negative $5 million to the $81 million net written premiums increase in 2017, negative $1 million to the $97 million net written premiums increase in 2016 and $20 million to the $103 million net written premiums increase in 2015. These net written premium amounts are included with agency renewal written premiums in the Commercial Lines Insurance Premiums table above.
In 2017, our commercial lines new business premiums written by our agencies increased $25 million, or 7 percent, compared with 2016. New business premium volume in recent years has been significantly influenced by new agency appointments. Agencies appointed since the beginning of 2016 produced commercial lines new business written premiums of $36 million, in aggregate, during 2017, up $28 million from what they produced during 2016. All other agencies contributed the remaining $361 million, down $3 million from the $364 million they produced in 2016.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. For our commercial casualty and commercial auto lines of business in 2017, we experienced higher volumes in paid losses and loss expenses than we expected for certain accident years. As a result, we increased our actuarial best estimate of ultimate loss and loss expense ratios for a number of accident years within those lines at year-end 2017, compared with year-end 2016. Net loss and loss expense reserves for commercial casualty at December 31, 2017, were $126 million, or 7 percent, higher than at year-end 2016. The IBNR portion of the reserve increase was $99 million. Net loss and loss expense reserves for commercial auto at December 31, 2017, were $83 million, or 15 percent, higher than at year-end 2016. The IBNR portion of the reserve increase was $55 million.
The 61.1 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2017 increased 1.8 percentage points compared with the 59.3 percent accident year 2016 ratio measured as of December 31, 2016. Higher commercial casualty IBNR reserves in 2017, noted above, contributed to the increase. Large losses, described below, and the corresponding ratios for new losses above $1 million, contributed a 0.4 percentage-point increase to the 2017 ratio. Those unfavorable contributions offset the favorable effects from initiatives, such as those to improve pricing precision and loss experience related to claims and loss control practices.
Commercial lines reserve development on prior accident years of $73 million in 2017 continued to net to a favorable amount, but provided a smaller benefit than the $129 million recognized in 2016. The $56 million net decrease in 2017 included $31 million from our commercial casualty line of business. Most of our commercial lines net favorable reserve development on prior accident years recognized during 2017 occurred in our commercial property and workers’ compensation lines of business, with workers' compensation representing 74 percent. Favorable development recognized during 2016 was mostly from our commercial casualty, commercial property and workers’ compensation lines of business. Favorable development recognized during 2015 was mostly from our commercial casualty and workers’ compensation lines of business. Development by accident year and other trends for commercial lines loss and loss expenses and the related ratios are further discussed in Liquidity and Capital Resources, Property Casualty Insurance Development of Estimated Reserves by Accident Year.
Net written premiums for the commercial lines industry in 2018 may grow approximately 1 percent, according to A.M. Best projections, with the industry statutory combined ratio estimated at approximately 101 percent, excluding its mortgage and financial guaranty lines of business. Over the past several years, renewal and new business pricing has experienced significant competitive pressure, reinforcing the need for more pricing analytics and careful risk selection. While competition remains intense, industrywide commercial lines market pricing turned positive toward the end of 2011 and continued to firm for a period of time, according to several industry surveys. Average renewal pricing for our commercial lines insurance segment generally followed a similar trend. Commentary regarding the commercial lines market within the property casualty insurance industry indicates commercial lines pricing in 2018 may be generally similar to 2017. Despite challenging market conditions from strong competition, we believe we can manage our business and execute strategic initiatives to offset market pressures to some extent and profitably grow our commercial lines insurance segment.
We intend to keep marketing our products to a broad range of business classes with a package approach, while also continuing to improve our pricing precision and further segmenting among commercial lines policies. We intend to maintain our underwriting selectivity and carefully manage our rate levels as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions about rates, the use of three-year commercial policies and other policy conditions on a case-by-case basis, even in lines and classes of business that are under competitive pressure. For our commercial auto line of business, we will continue to improve premium rate classification and the use of other rating variables in risk selection and pricing. We believe that our initiatives to improve pricing precision and lower loss costs will continue to benefit commercial lines profitability during 2017, and that recent-year premium growth initiatives will continue to grow commercial lines premiums at a rate exceeding the industry.
Combined ratio - The 2017 combined ratio rose 1.6 percentage points, compared with 2016, driven by a 1.5 percentage-point increase in the ratio for 2017 natural catastrophe losses. The total large loss ratio for losses of $1 million or more per claim, shown in the table below, increased by 3.1 percentage points, largely due to higher losses for homeowner claims and personal umbrella claims related to auto accidents.
We have increased our pricing precision and implemented numerous rate increases in recent years to improve our personal lines insurance segment results. In addition, we have made greater use of higher minimum loss deductibles and enhanced our property inspection processes to verify condition and insurance to value. We have worked to improve our geographic diversification by expanding our personal lines operation to several states less prone to catastrophes.
Personal lines insurance is a strategic component of our overall relationship with most of our agencies and is an important component of our agencies’ relationships with their clients. We believe agents recommend our personal insurance products to their clients who seek to balance quality and price and who are attracted by our superior claims service and the benefits of our package approach. We also believe our continuing efforts to improve pricing precision are helping us attract and retain more of our agencies’ preferred business, while also obtaining higher rates for more thinly priced business. Our progress toward broader geographic diversification is reflected in part through premium growth trends. Personal lines earned premiums in our five highest volume states increased in aggregate by 3 percent in 2017, while premiums for the remaining states, including our newer areas of operation, increased 11 percent in aggregate.
Personal lines new business written premiums grew $39 million, or 32 percent, during 2017, compared with 2016. That growth was driven by policies from high net worth clients of our agencies. Personal lines new business written premiums from our high net worth policies totaled approximately $58 million for 2017, compared with approximately $28 million for 2016, an increase of $30 million. The remaining increase of approximately $9 million in new business written premiums came from the part of our personal lines segment we sometimes refer to as middle market business and includes the effect of various premium rate increases and additional marketing efforts directed toward our agencies. Marketing efforts included assisting agencies with processing qualified policies expiring from other insurance companies, sometimes referred to as “book rolls”. Similar to recent years, such processing has not materially contributed to 2017 increases or decreases in personal lines new business written premiums. Some of what we report as new business came from accounts that were not new to our agents. We believe our agents’ seasoned accounts tend to be priced more accurately than business that may be less familiar to them.
Personal lines loss and loss expense reserve development on prior accident years recognized in 2017 was favorable by $14 million, in aggregate, compared with $4 million in 2016. The 2017 net favorable reserve development included $11 million for our homeowner line of business, primarily for accident year 2016. In 2016, our personal auto line of business prior accident year net reserve development was unfavorable by $18 million, partially offsetting favorable development in our homeowner and other personal lines of business. Development by accident year and other trends for personal lines loss and loss expenses and the related ratios are further discussed in Liquidity and Capital Resources, Property Casualty Insurance Development of Estimated Reserves by Accident Year.
Personal lines commission expense as a percent of earned premiums in 2017 matched 2016, as earned premiums rose at a pace similar to the rate of increase in commission expenses. Likewise, other underwriting expenses as a percent of earned premiums in 2017 matched 2016.
New business written premiums rose $11 million, largely due to an increase in our marketing efforts. Other written premiums in 2017 were similar to amounts in 2016. Other written premiums are primarily premiums that are ceded to reinsurers and that lower our net written premiums.
The 54.0 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2017 decreased 0.4 percentage points compared with the 54.4 percent accident year 2016 ratio measured as of December 31, 2016. The improvement included a 0.2 percentage-point decrease in the ratio for current accident year losses of $1 million or more per claim, shown in the table below.
We believe the loss and loss expense reserves for our excess and surplus lines business are adequate. The amount of outstanding reserves for our excess and surplus lines operation can be seen in a table in Liquidity and Capital Resources, Property Casualty Loss and Loss Expense Obligations and Reserves. One indication of how long it takes for most of the outstanding reserves to be settled is to measure outstanding reserves by accident year at different points in time, using Item 8, Note 4 of the Consolidated Financial Statements. For example, for accident years 2012 and 2011, in aggregate, after subtracting cumulative paid amounts from incurred amounts at December 31, 2012, reserves for estimated unpaid losses, plus the portion of loss expenses known as ALAE, equaled $91 million. For those same accident years, at December 31, 2017, the reserve estimate for the remaining unpaid amount can be calculated as $6 million. The inherent uncertainty in estimating reserves is discussed in Liquidity and Capital Resources, Property Casualty Insurance Loss and Loss Expense Obligations and Reserves. Development trends by accident year are further discussed in Property Casualty Insurance Development of Estimated Reserves by Accident Year.
In 2017, total large losses incurred increased by $1 million or 33 percent, net of reinsurance. The ratio for 2017 large losses as a percent of earned premiums increased 0.5 percentage points. That ratio for 2016 trended in the opposite direction, due to 2016 total large losses decreasing from 2015. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
The excess and surplus lines market is expected to see the magnitude of rate increases continue to decline on several classes of business due to increased capacity in the market. Competition is expected to remain strong, especially on large accounts, due primarily to standard market insurance companies insuring businesses that previously were written by excess and surplus lines insurers. Firming is expected to continue for specific classes of business where loss costs are exceeding rates, such as habitational for property coverages and general liability for liquor liability coverages and hired and non-owned auto liability.
Our strategy of providing superior service is expected to continue to grow our excess and surplus lines insurance segment and to achieve profitability despite challenging market conditions. We intend to keep carefully selecting and pricing risks, providing prompt delivery of insurance quotes and policies and giving outstanding claims and loss control service from local field representatives who also handle the standard lines business for their assigned agencies. These local representatives are supported by headquarters underwriters and claims managers who specialize in excess and surplus lines.
Revenues - Earned premiums rose 2 percent for the year 2017, as shown in the table below that includes details by major line of business. Our largest life insurance product line, term life insurance, rose 6 percent. Net in-force policy face amounts rose 8 percent to $61.177 billion at year-end 2017 from $56.808 billion at year-end 2016 and $52.735 billion at year-end 2015.
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. Our 34 life field marketing representatives work in partnership with our 140 property casualty field marketing representatives. Approximately 62 percent of our term and other life insurance product premiums were generated through our property casualty insurance agency relationships.
Contract holders’ benefits incurred, related to traditional life and interest-sensitive products, accounted for 76.1 percent of 2017 total benefits and expenses compared with 76.4 percent in 2016 and 78.1 percent in 2015. Total contract holders’ benefits increased as net death claims were higher in 2017, compared with 2016.
Net death claims increased from 2016, and were below our mortality projections while remaining within our range of pricing expectations.
Underwriting expenses incurred, net of deferred acquisition costs, accounted for 23.9 percent of 2017 total benefits and expenses compared with 23.6 percent in 2016 and 21.9 percent in 2015. Expenses in 2017 increased 4 percent, 2 percentage points more than the 2 percent growth in earned premiums, primarily due to increased operating expenses related to premium growth. In 2016, the percentage increase for expenses was 6 percentage points more than growth in earned premiums.
Our new term product provides for instant confirmation of coverage. It allows our property casualty agents to offer life insurance in a selling process that makes them more comfortable. We also have made progress at enhancing how regularly underwritten business is submitted. In addition to more streamlined electronic applications, we are building a new business platform that will allow for more automated decision making. We expect this new system to lead to significant improvements in our turnaround time and lower our per unit underwriting expense.
We believe it is useful to analyze our overall investment performance by using total investment return over several years. Total investment return considers changes in unrealized gains and losses, which are not included in net income, in addition to net investment income and realized investment gains and losses that are included in net income. Changes in unrealized gains and losses shown in the table below include other invested assets. Considering investment gains and losses, both realized and unrealized, over several years helps evaluate performance since gains and losses may experience typical variability during shorter periods of time.
Total investment return of 10.5 percent in 2017 was significantly more than in 2016. The 2017 contribution from all three components of total investment return was higher than in 2016. Investment income rose $14 million, realized investment gains rose $24 million and the invested assets net change in unrealized gains and losses rose $388 million. The base component of the return calculation, annual average invested assets, was up 8 percent in 2017. For 2016 compared with 2015, total investment return rose 8.4 percentage points, reflecting an increase in the contribution of investment income, realized investment gains and the net change in unrealized gains and losses. The base component of the return calculation, annual average invested assets, decreased less than 1 percent in 2016.
Dividend income rose $9 million, or 6 percent, in 2017, after rising 7 percent in 2016. Increases in dividend payment rates for most of the holdings in our common stock portfolio during both 2017 and 2016 drove the increases in dividend income. A small net decrease in funds invested in that portfolio, during both 2017 and 2016, also affected dividend income.
In 2017, we continued to invest available cash flow in both fixed income and equity securities in a manner that we believe balances current income needs with longer-term invested asset growth goals. While our bond portfolio more than covers our insurance reserve liabilities, we believe our diversified common stock portfolio of mainly blue chip, dividend-paying companies represents one of our best investment opportunities for the long term. We position our portfolio with consideration to both the challenges presented by the current low interest rate environment and the risks presented by potential future inflation. As bonds in our generally laddered portfolio mature or are called over the near term, we will be challenged to replace their current yield. The table below summarizes pretax yield to amortized costs excluding any book value adjustments due to impairment for bonds in our fixed-maturity portfolio by various maturity periods.
The average pretax yield of 3.61 percent for fixed-maturity securities acquired during 2017, shown in the table below, was lower than the 4.40 percent average yield-to-amortized cost of the fixed-maturity securities portfolio at the end of 2017.
As appropriate, we buy, hold or sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. We generally purchase fixed-maturity securities with the intention to hold until maturity. If they no longer meet our investment criteria, they are divested. Sales of fixed-maturity securities are usually due to a change in credit fundamentals. Pretax realized investment gains in the past three years largely were due to the sale of equity holdings. Additional information about realized and unrealized investment gains or losses is included in Item 8, Note 2 of the Consolidated Financial Statements.
Interest rates were flat to down slightly in 2017 while corporate credit spreads continued their tightening trend. With available yields below long-term market norms it has been a challenge to invest new money at levels to match the embedded yield in the fixed income portfolio as well as that of securities we have lost to calls and maturities.
Other loss in the table below represents losses before income taxes. For each year shown, Other loss was largely driven by interest expense from debt of the parent company. Net results of Cincinnati Re were an underwriting loss of approximately $20 million in 2017, reflecting an increase in losses for natural catastrophes, following an underwriting profit of approximately $8 million in 2016 and approximately $1 million in 2015.
We had a $315 million income tax benefit in 2017 compared with $221 million of income tax expense in 2016 and $247 million in 2015. Our corporate effective tax rate for 2017 was negative 43.2 percent compared with 27.2 percent in 2016 and 28.0 percent in 2015.
The change in our effective tax rate was primarily due to the revaluation of our net deferred tax liability, due to the enactment of the Tax Cuts and Jobs Act (the “Tax Act”) on December 22, 2017. Changes in pretax income from underwriting results, realized investment gains and losses and the current year tax benefit under ASU 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, with immaterial changes in the amount of permanent book-tax differences, also had an impact on our effective tax rate.
Historically, we have pursued a strategy of investing some portion of cash flow in tax-advantaged, fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. See Item 1, Our Segments, Tax-Exempt Fixed Maturities, for further discussion on municipal bond purchases in our fixed-maturity investment portfolio. For our property casualty insurance subsidiaries, approximately 85 percent of interest from tax-advantaged fixed-maturity investments and approximately 60 percent of dividends from qualified equities are exempt from federal tax after applying proration from the 1986 Tax Reform Act. Our noninsurance companies own an immaterial amount of tax-advantaged, fixed-maturity investments. For our noninsurance companies, the dividend received deduction exempts 70 percent of dividends from qualified equities. Our life insurance company does not own tax-advantaged, fixed maturity investments or equities subject to the dividend received deduction.
At December 31, 2017, the parent company had $2.511 billion in cash and marketable securities, providing strong liquidity to fund cash outflows, as needed. The payment of dividends to shareholders is largely based upon receiving subsidiary dividends. Alternatively, we could sell investments or use our line of credit to support the dividend payment.
The parent company’s insurance subsidiary is largely the operations of the property casualty segments. The primary sources of cash inflows are collection of premiums, investment income, maturity of fixed-income securities and sale proceeds from investments. Property casualty insurance premiums generally are received before losses are paid under the policies purchased with those premiums. Cash outflows are primarily loss and loss expenses, commissions, salaries, taxes, operating expenses and investment purchases. Over the three-year period ended December 31, 2017, premium receipts and investment income have been more than sufficient to pay claims and operating expenses. Excess cash flows were partially used to pay dividends to the parent company. We are not aware of any known trends that would materially change historical cash flow results other than fluctuations in catastrophe claims and other large losses either individually or in aggregate.
We provide details of our three long-term notes in Item 8, Note 8 of the Consolidated Financial Statements. None of the notes are encumbered by rating triggers. The total principal amount of our long-term debt at December 31, 2017, was $793 million and included:
The company’s senior debt is rated investment grade by independent rating firms. None of the four rating agencies made changes to our debt ratings in 2017. In early 2018, A.M. Best revised its outlook of our debt rating from stable to positive. Our debt ratings at February 22, 2018, were: a- from A.M. Best, A- from Fitch Ratings, A3 from Moody’s Investors Service and BBB+ from Standard & Poor’s.
Common stock repurchase - Generally, our board believes that share repurchases can help fulfill our commitment to enhancing shareholder value. Consequently, the board has authorized the repurchase of outstanding shares, giving management discretion to purchase shares at reasonable prices in light of circumstances at the time of purchase. Our approach has been to hold capital adequate to support future growth of our insurance operations and repurchase shares at management's discretion. Repurchases are intended to offset the issuance of shares through equity compensation plans, primarily due to vesting of service-based restricted stock units of equity awards granted in the past. The amount of future repurchases may be more, or less, than the past, depending on circumstances and discretion exercised by management. Our corporate Code of Conduct restricts repurchases during certain time periods. The details of the repurchase authorizations and activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
We pay obligations to customers, suppliers and associates in the normal course of our business operations. Some are contractual obligations that define the amount, circumstances and/or timing of payments. We have other commitments for business expenditures; however, the amount, circumstances and/or timing of our other commitments are not dictated by contractual arrangements.
At December 31, 2017, we believe our most significant other commitments were:
Other invested assets - We expect to fund approximately $38 million for our private equity investments over the next several years.
Our estimate of future gross property casualty loss and loss expense payments of $5.219 billion is lower than loss and loss expense reserves of $5.273 billion reported on our balance sheet at December 31, 2017. The $54 million difference is due to certain life and health loss reserves. Reserving practices are discussed in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves.
For the business lines in the commercial and personal lines insurance segments, and in total for the excess and surplus lines insurance segment, the following table details gross reserves among case, IBNR and loss expense reserves, net of salvage and subrogation. The $184 million increase in total gross reserves was primarily due to a $120 million increase in IBNR loss reserves and a $51 million increase in loss expense reserves. Total gross reserves for our commercial auto line of business rose $82 million, for our commercial casualty line of business they rose $34 million and for our Cincinnati Re reinsurance assumed operation they rose $86 million.
We carried $84 million of net loss and loss expense reserves for asbestos and environmental claims and $45 million of reserves for mold claims at year-end 2017, compared with $85 million and $45 million, respectively, for such claims at year-end 2016. The asbestos and environmental claims amounts for each respective year constituted 1.7 percent and 1.8 percent of total net loss and loss expense reserves at these year-end dates.
The company established a reasonably likely range for net loss and loss expense reserves of $4.709 billion to $5.155 billion at year-end 2017, with the company carrying net reserves of $5.032 billion. The likely range was $4.449 billion to $4.894 billion at year-end 2016, with the company carrying net reserves of $4.738 billion. Our loss and loss expense reserves are not discounted for the time-value of money, but we have reduced the reserves by an estimate of the amount of salvage and subrogation payments we expect to recover.
Workers’ compensation - We continue to see favorable reserve development, for all prior accident years in aggregate. During 2017, the trend for estimated payments to be made in future calendar years was stable compared to 2016. However, we continue to monitor this line closely, as a sudden increase in trend for future payments has a highly leveraged effect.
Our estimates of gross life, annuity and disability obligations do not reflect net recoveries from reinsurance agreements. Ceded life reinsurance receivables were $238 million at year-end 2017. As discussed in 2018 Reinsurance Programs, we purchase reinsurance to mitigate our life insurance risk exposure. At year-end 2017, ceded death benefits represented approximately 38.7 percent of our total gross 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 $5.355 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy and investment contract reserves and separate accounts for future policy benefits and claims of $3.498 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $11 million of separate accounts liabilities.
The following table shows our five largest property casualty reinsurance receivable amounts by reinsurer at year-end 2017 and 2016. Michigan Catastrophic Claims Association is a mandatory non-profit association which runs a reinsurance program funded by an annual premium assessment per vehicle. This assessment covers Michigan’s automobile no-fault policies which provide unlimited lifetime coverage for medical expenses resulting from auto accidents. Third Point Reinsurance is one of several reinsurers that Cincinnati Re transacts business with to cede part of its risk to unaffiliated reinsurance companies through retrocessions. The A.M. Best insurer financial strength ratings as of the end of the two most recent years are also shown for each of those reinsurers that are rated by Best.
Primary components of the 2018 property and casualty reinsurance program are summarized below. The premium estimates below occurred near the beginning of each respective year, when direct written premiums that were subject to applicable reinsurance treaties were also estimated.
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 $10 million of each loss. Losses between $10 million and $25 million are reinsured at 100 percent. The 2018 ceded premium estimate was $12 million, essentially unchanged from the 2017 estimate.
Casualty excess treaty - We purchase a casualty reinsurance treaty that provides an additional $45 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $70 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 2018 ceded premium estimate was approximately $3 million, essentially unchanged from the 2017 estimate.
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 several occasions, including the most recent extension on January 12, 2015. TRIA provides a temporary federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. 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 2017 was $529 million (20 percent of 2016 subject premiums), and we estimate it is $541 million (20 percent of 2017 subject premiums) for 2018.
Reinsurance protection for the company’s surety business is covered under a separate treaty with many of the same reinsurers that write the property casualty working treaties.
Cincinnati Life, our life insurance subsidiary, purchases reinsurance under separate treaties with many of the same reinsurers that write the property casualty working treaties. Our corporate retention is $1 million on a single life. For most of our core term life insurance line of business, we retain no more than a $500,000 exposure on a single policy, ceding the balance using excess over retention mortality coverage, and retaining the policy reserve. Because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of our capital. Effective November 1, 2015, we increased our retention to $1 million for issue ages up to 61 years on new term life insurance sales. For issue ages 61 years or older, our retention remains $500,000. For term life insurance business written prior to 2005, we retain 10 percent to 25 percent of each term policy, not to exceed $500,000, ceding the balance of mortality risk and policy reserve.
We also have catastrophe reinsurance coverage on our life insurance operations that reimburses us for covered net losses in excess of $10 million. Our recovery is capped at $75 million for losses involving our associates.
Significant or prolonged decline in the fair value of a particular security or group of securities and impairment of the asset(s)
Delays, inadequate data developed internally or from third parties, or performance inadequacies from ongoing development and implementation of underwriting and pricing methods, including telematics and other usage-based insurance methods, or technology projects and enhancements expected to increase our pricing accuracy, underwriting profit and competitiveness
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2017, in accordance with accounting principles generally accepted in the United States of America (GAAP).
Deloitte & Touche LLP, our independent registered public accounting firm, audited the consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2017. Deloitte & Touche LLP met with our audit committee to discuss the results of its examination. They have the opportunity to discuss the adequacy of internal controls and the quality of financial reporting without management present.
The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2017, 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 (2013) 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, 2017. The assessment led management to conclude that, as of December 31, 2017, the company’s internal control over financial reporting was effective based on those criteria.
The company’s independent registered public accounting firm has issued an audit report on our internal control over financial reporting as of December 31, 2017.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the "Company") as of December 31, 2017 and 2016, the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and the schedules listed in the Index at Item 15(c) (collectively referred to as the “financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Impairment charges for fixed maturities are recorded for other-than-temporary declines in value if fair value is below amortized cost and, in the asset impairment committee’s judgment, the fair value is not expected to be recouped within a designated recovery period. Our invested asset impairment policy also states that fixed maturities below their amortized cost that the company (1) intends to sell or (2) more likely than not will be required to sell before recovery of their amortized cost basis are deemed to be other-than-temporarily impaired (OTTI). The amortized cost of any such securities is reduced to fair value as the new cost basis, and a realized loss is recorded in the period in which it is recognized. When these two criteria are not met, and the company believes that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount with the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the period in which it occurred. The difference between the fair value and the net present value of the cash flows of the security, the noncredit loss, is recognized in other comprehensive income as an unrealized loss. We had no fixed-maturity securities with a noncredit loss for the years ended 2017, 2016 and 2015.
Included within our other invested assets were $31 million and $31 million of life policy loans, $35 million and $23 million of private equity investments and $37 million and $27 million of real estate through direct property ownership and development projects in the United States at December 31, 2017 and 2016, respectively. Life policy loans are carried at the receivable value. The private equity investments provide their financial statements to us and generally report investments on their balance sheets at fair value. We use the equity method of accounting for private equity and real estate development investments.
For the purpose of ASC 825 disclosure, we estimate the fair value of our long-term senior notes on market pricing of similar debt instruments that are actively trading. We estimate the fair value of our note payable on the year-end outstanding balance because it is short term and tied to a variable interest rate. We estimate the fair value of liabilities for investment contracts and annuities using discounted cash flow calculations across a wide range of economic interest rate scenarios with a provision for our nonperformance risk. We estimate the fair value for policyholder loans on insurance contracts using a discounted cash flow model. Determination of fair value for structured settlements assumes the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December 31, 2017, to account for nonperformance risk. See Note 3, Fair Value Measurements, for further details.
The consolidated property casualty companies actively write property casualty insurance through independent agencies in 42 states. Our 10 largest states generated 59.7 percent and 61.4 percent of total earned premiums in 2017 and 2016, respectively. Ohio, our largest state, accounted for 16.2 percent and 16.8 percent of total earned premiums in 2017 and 2016, respectively. Illinois, Georgia, Indiana, North Carolina, Pennsylvania and Michigan each accounted for between 5 percent and 7 percent of total earned premiums in 2017. Our largest single agency relationship accounted for approximately 0.8 percent of our total property casualty earned premiums in 2017. No aggregate agency relationship locations under a single ownership structure accounted for
more than 4 percent of our total property casualty earned premiums in 2017. We record revenues for installment charges as fee revenues in the consolidated statements of income.
We establish reserves to cover the expected cost of claims, losses and expenses related to investigating, processing and resolving claims. Although the appropriate amount of reserves is inherently uncertain, we base our decisions on past experience and current facts. Reserves are based on claims reported prior to the end of the year and estimates of unreported claims. We regularly review and update reserves using the most current information available. Any resulting adjustments are reflected in current calendar year insurance losses and policyholder benefits. We estimate that we may recover some of our costs through salvage and subrogation.
Long-duration contracts are written to provide coverage for an extended period of time. Traditional long-duration contracts require policyholders to pay scheduled gross premiums, generally not less frequently than annually, over the term of the coverage. Premiums for these contracts, such as whole life insurance and disability income insurance, are recognized as revenue when due. Some traditional long-duration contracts, such as ten-pay whole life insurance, have premium payment periods shorter than the period over which coverage is provided. For these contracts, the excess of premium over the amount required to pay expenses and benefits is recognized over the term of the coverage rather than over the premium payment period.
Universal life contracts are long-duration contracts for which contractual provisions are not fixed, unlike whole life insurance. Universal life contracts allow policyholders to vary the amount of premium, within limits, without our consent. However, we may vary the mortality, expense charges and the interest crediting rate, within limits, used to accumulate policy values. We do not record universal life premiums as revenue. Instead we recognize as revenue the mortality charges, administration charges and surrender charges when received. Some of our universal life contracts assess administration charges in the early years of the contract that are compensation for services we will provide in the later years of the contract. These administration charges are deferred and are recognized over the period when we provide those future services. We maintain a policy reserve liability equal to the policyholder account value. There is no provision for adverse deviation. Some of our universal life policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance, based on expected no-lapse guarantee benefits and expected policy assessments.
We capitalize acquisition costs associated with successfully acquiring universal life long-duration contracts. We charge these capitalized costs to expenses over the term of coverage of the contract in accordance with the recognition of gross profit from the contract. When we charge deferred policy acquisition costs to expenses, we use assumptions based on our best estimates of long-term experience. We review and modify these assumptions on a regular basis.
We carry the assets of separate account BOLIs at fair value. The liabilities on separate account BOLIs primarily are the contract holders’ claims to the related assets and are carried at an amount equal to the contract holders’ account value. At December 31, 2017, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders’ account value by approximately $29 million. If the BOLI projected fair value were to fall below the value we guaranteed, a liability would be established with a corresponding charge to the company’s earnings.
The Cincinnati Insurance Company offers reinsurance assumed for casualty and specialty (predominantly domestic exposure) and property (worldwide exposure). Treaties are written on a pro rata and excess of loss basis. We also continue to assume risk with limited exposure as a reinsurer for involuntary state pools.
Written premium is recorded, net of contract specific retrocessions, on an ultimate estimate basis and earned on a pro rata basis over the coverage period of the treaty. Expenses are recorded as per contract terms and deferred over the earning period of the premium.
The Tax Cuts and Jobs Act (the “Tax Act”) was enacted on December 22, 2017, and reduced U.S. corporate income tax rates from 35 percent to 21 percent. The effect of the rate change was recorded as a one-time noncash benefit to income tax expense in our consolidated statements of income for the year ended December 31, 2017. See Note 11, Income Taxes, for further detail on the Tax Act, our uncertain tax positions and other income tax items.
We grant qualified and nonqualified share-based compensation under authorized plans. The stock options generally vest on a graded scale over three years following the date of grant and are exercisable over 10-year periods. We grant service-based restricted stock units that cliff vest three years after the date of grant as well as service-based restricted stock units that vest ratably over the three-year vesting term. We also grant performance-based restricted stock units that vest if certain market conditions are attained. In 2017, the CFC compensation committee approved share-based awards including incentive stock options, nonqualified stock options, service-based restricted and performance-based restricted stock units. See Note 17, Share-Based Associate Compensation Plans, for further details.
In March 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-07, Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting. ASU 2016-07 eliminates the requirement to retroactively adjust an investment, results of operations, and retained earnings once an investment qualifies for use of the equity method. It requires the equity method investor to add the cost of acquiring the additional interest in the investee to the current basis of the investor's previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting without retroactive adjustment. The effective date of ASU 2016-07 was for interim and annual reporting periods beginning after December 15, 2016, and was applied prospectively. The company adopted this ASU effective January 1, 2017, and it did not have a material impact on our company's consolidated financial position, cash flows or results of operations.
In March 2016, the FASB issued ASU 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. ASU 2016-09 simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The effective date of ASU 2016-09 was for interim and annual reporting periods beginning after December 15, 2016. The recognition and classification of the excess tax benefit provisions were applied prospectively in the results of operations and statement of cash flows. This adoption resulted in excess tax benefits of $7 million for the year ended December 31, 2017, which reduced our current provision for income taxes in our results of operations. The statutory tax withholding classification, which are cash payments made to taxing authorities for shares withheld, were applied retrospectively and reclassified the statutory
tax withholding requirements in the statement of cash flows from Other liabilities in operating activities to Other in financing activities. This statutory tax withholding reclassification resulted in $13 million, $12 million and $11 million being included in financing activities for the years ended December 31, 2017, 2016 and 2015, respectively. There were no cumulative effect adjustments upon adoption of this ASU.
ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
In February 2018, the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“AOCI”). ASU 2018-02 eliminates the stranded tax effects within AOCI resulting from the application of current GAAP in response to the change in the U.S. corporate income tax rate from 35 percent to 21 percent as part of the Tax Act. Stranded tax effects unrelated to the Tax Act are released from AOCI using the security-by-security approach. The effective date of ASU 2018-02 is for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years with early adoption permitted for public entities for which financial statements had not yet been issued. The company elected to early adopt ASU 2018-02 effective for the year ended December 31, 2017, and applied the provisions retrospectively within our consolidated balance sheets and statements of shareholders' equity. This adoption resulted in a one-time reclassification of the effect of remeasuring deferred tax liabilities related to items, primarily unrealized gains and losses on investments, within AOCI to retained earnings resulting from the change in the U.S. corporate income tax rate. This reclassification resulted in an increase to AOCI and a decrease to retained earnings in the amount of $492 million for the year ended December 31, 2017, with no net impact to total shareholders' equity.
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers. ASU 2014-09 requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. Insurance contracts do not fall within the scope of this ASU. The effective date of ASU 2014-09 is for interim and annual reporting periods beginning after December 15, 2017. The ASU has not yet been adopted and will not have a material impact on our company’s consolidated financial position, cash flows or results of operations.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 revises the accounting related to the classification and measurement of investments in equity securities and the presentation of certain fair value changes for financial liabilities measured at fair value. Our results of operations will be impacted as changes in fair value of equity securities will be reported in net income instead of other comprehensive income. The effective date of ASU 2016-01 is for interim and annual reporting periods beginning after December 15, 2017, and will be applied prospectively. The ASU has not yet been adopted. Upon adoption of this ASU on January 1, 2018, $2.503 billion of after-tax unrealized gains on equity securities will be reclassified from AOCI to retained earnings.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. ASU 2016-15 addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The effective date of ASU 2016-15 is for interim and annual reporting periods beginning after December 15, 2017. The ASU has not yet been adopted; however, it will not have a material impact on our company's consolidated financial position, cash flows or results of operations.
ASU 2017-07, Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost
In March 2017, the FASB issued ASU 2017-07, Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Postretirement Benefit Costs. ASU 2017-07 provides guidance on how to present the components of net periodic benefit costs in the income statement for pension plans and other post-retirement benefit plans. The effective date of ASU 2017-07 is for interim and annual reporting periods beginning after December 15, 2017. The ASU has not yet been adopted; however, it will not have a material impact on our company's consolidated financial position, cash flows or results of operations.
In March 2017, the FASB issued ASU 2017-08, Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. ASU 2017-08 amends guidance on the amortization period of premiums on certain purchased callable debt securities. The amendments shorten the amortization period of premiums on certain purchased callable debt securities to the earliest call date. The amendments should be applied on a modified retrospective basis through a cumulative-effect adjustment to beginning retained earnings. The effective date of ASU 2017-08 is for interim and annual reporting periods beginning after December 15, 2018. The ASU has not yet been adopted; however, it will not have a material impact on our company's consolidated financial position, cash flows or results of operations.
In the normal course of investing activities, the company enters into investments in limited partnerships, including private equity and real estate investments, and asset-backed securities issued by third-parties. The company’s maximum exposure to loss with respect to these investments is limited to the investment carrying values included in the company’s consolidated balance sheets and any unfunded commitments.
The following table provides investment income and realized investment gains and losses:
During 2017, we other-than-temporarily impaired six securities. At December 31, 2017, 249 fixed-maturity investments with a total unrealized loss of $18 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity investments had fair values below 70 percent of amortized cost. There were no equity security investments in an unrealized loss position for 12 months or more as of December 31, 2017.
During 2015, we other-than-temporarily impaired 20 securities. At December 31, 2015, 69 fixed-maturity investments with a total unrealized loss of $37 million had been in an unrealized loss position for 12 months or more. Of that total, five fixed-maturity investments had fair values below 70 percent of amortized cost. There were no equity security investments in an unrealized loss position for 12 months or more as of December 31, 2015.
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 from those used at December 31, 2016, and ultimately management determines fair value. Financial instruments reported at fair value in our consolidated financial statements are categorized based upon the following characteristics or inputs to the valuation techniques:
The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2017 and 2016. We do not have any liabilities carried at fair value. There were no transfers between Level 1 and Level 2.
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is identified in the following tables by security type with a summary of changes in fair value for the years ended December 31, 2017 and 2016. Total Level 3 assets continue to be less than 1 percent of financial assets measured at fair value in the consolidated balance sheets. Assets presented in the table below were valued based primarily on broker/dealer quotes for which there is a lack of transparency as to inputs used to develop the valuations. Transfers into Level 3 included situations where a fair value quote was not provided by the company's nationally recognized pricing vendor and as a result the price was stale or had been replaced with a broker quote where the inputs had not been corroborated to be market observable resulting in the security being classified as Level 3. Transfers out of Level 3 included situations where a broker quote was used without observable inputs or data that could not be corroborated by our pricing vendors in the prior period and significant observable inputs were identified in the current period.
Outstanding principal and interest for these life policy loans totaled $31 million at December 31, 2017 and 2016. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates, as nonperformance risk is minimal; and (2) the loan repayment rate by which policyholders pay off their loan balances is in line with past experience.
The following table shows fair value of our deferred annuities and structured settlements included in life policy and investment contract reserves:
Fair values for deferred annuities were calculated based upon internally developed models because active markets and observable inputs do not exist. To determine the fair value, we made the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December 31, 2017 and 2016, to account for nonperformance risk; (2) the rate of interest credited to policyholders is the portfolio net earned interest rate less a spread for expenses and profit; and (3) additional lapses occur when the credited interest rate is exceeded by an assumed competitor credited rate, which is a function of the risk-free rate of the economic scenario being modeled.
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, claims, underwriting, loss prevention and accounting management. This committee 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. The amount we will actually have to pay for claims can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate.
For events designated as natural catastrophes resulting in losses incurred related to direct premiums, we calculate IBNR reserves directly as a result of an estimated claim counts and estimated average dollar amount per claim for each event. Once individual case reserves are established for a catastrophe event, we reduce the IBNR reserves.
Our actuarial staff uses generally accepted actuarial methods and models to derive ultimate loss and IBNR reserve estimates. The time interval between a claims occurrence and its settlement is one of the crucial attributes when estimating ultimate losses and IBNR reserves.
In 2017, 2016 and 2015, the reserve for loss and loss expense in the consolidated balance sheets also included $54 million, $50 million and $58 million, respectively, for certain life and health loss and loss expense reserves. Additional disclosures for reserves related to these health claims are not material and therefore not provided.
$33 million for the commercial property line and $30 million for the other commercial lines due to reduced uncertainty of prior accident year loss and loss expense for these lines. This illustrates the potential for revisions inherent in estimating reserves, especially for long-tail lines such as workers’ compensation. We recognized unfavorable reserve development of $33 million for the commercial auto line due to higher loss cost effects in recent accident years, resulting in an increase of our reserve estimate for claims that have not yet been settled. Commercial casualty developed unfavorably by $11 million due to paid losses or re-estimates of case reserves at higher than expected levels.
During 2015, we experienced $184 million of favorable development on prior accident years including $154 million of favorable development in commercial lines, $5 million of adverse development in personal lines and
$93 million for the workers’ compensation line, largely due to more favorable 2015 workers' compensation trends for estimated payments to be made in future calendar years that were down slightly from 2014. We recognized favorable development of $63 million for the commercial casualty line. Development for products liability was favorable for most prior accident years and development of prior years for commercial umbrella coverage improved slightly better than expected. Therefore, estimated ultimate losses were lowered. Our commercial auto line experienced $31 million of adverse development due to higher loss cost effects in recent accident years, resulting in an increase of our reserve estimate for claims that have not yet been settled.
Included in our lines of business are asbestos and environmental claims. We carried $84 million and $85 million of net loss and loss expense reserves for asbestos and environmental claims at December 31, 2017 and 2016, respectively. The asbestos and environmental claims amounts for each respective year constituted less than
In the following tables, commercial casualty and workers' compensation each disclose 10 accident years of loss and ALAE reserves and nine accident years of the cumulative number of reported claims. In 2009, we refined our claim count logic such that the definition of an open claim, a closed claim and a claim that closes without payment
The following table shows the average annual percentage payout of incurred losses for the commercial auto line of business. Commercial auto includes both physical damage and liability losses. A majority of the incurred losses paid after year 2 are the result of liability losses.
The following table shows the average annual percentage payout of incurred losses for the personal auto line of business. Personal auto includes both physical damage and liability losses. A majority of the incurred losses paid after year 2 are the result of liability losses.
The following table shows the homeowner incurred and paid losses and ALAE development by accident year. The table also shows the IBNR reserves plus expected development on reported losses and claim frequency:
We establish the reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates, timing of claim presentation 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 as well as for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
Capital lease obligations, excluding an insignificant amount of interest, totaled $40 million and $39 million in 2017 and 2016, respectively. Below are the expected capital lease obligations that we expect to pay over the next six years:
Declared cash dividends per share were $2.50, $1.92 and $2.30 for the years ended December 31, 2017, 2016 and 2015, respectively.
Additionally, as a result of the early adoption of ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income, included in the table below is the reclassification of $492 million which increased AOCI and decreased retained earnings. See Note 1, Summary of Significant Accounting Policies for further explanation of this ASU.
The significant components of deferred tax assets and liabilities included in the consolidated balance sheets at December 31 were as follows:
Deferred tax assets are reduced by a valuation allowance when management believes it is more likely than not that some, or all, of the deferred tax assets will not be realized. After considering all positive and negative evidence of taxable income in the carryback and carryforward periods as permitted by law, we believe it is more likely than not that all of the deferred tax asset will be realized. As a result, we have no valuation allowance as of December 31, 2017 and 2016.
The Tax Act was enacted on December 22, 2017, and represented one of the most comprehensive changes in U.S. corporate income taxation since 1986. The Tax Act revises the U.S. corporate income tax by lowering the corporate income tax rate from a top marginal rate of 35 percent to a flat rate of 21 percent. In addition to lowering tax rates, changes were made to the amount of the dividends received deduction and the required proration addback for qualified dividend income and tax exempt municipal interest. The Tax Act is effective January 1, 2018. The reduction in corporate income tax rate decreased our net deferred tax liability as of December 22, 2017, by $495 million. The effect of the rate change was recorded as a one-time noncash benefit to income tax expense in our consolidated statements of income for the year ended December 31, 2017, with an effective tax rate benefit of 67.8 percent. This benefit results from re-measuring our net deferred tax liability at the newly enacted corporate income tax rate of 21 percent (the rate at which the deferred items are expected to be reversed) versus the 35 percent rate at which the net deferred tax benefits were previously carried. Of this $495 million benefit, $492 million relates to net unrealized gains on investments and other AOCI amounts. The remainder relates to differences in the recognition of deferred acquisition costs, unearned premiums, insurance reserves and basis differences in the carrying value of investments held. We expect to complete determination of the effects of the Tax Act on our deferred tax assets and liabilities as part of the annual income tax return filing process which is expected to be completed in the fourth quarter of 2018.
As a result of positions either taken in our 2014 through 2016 federal tax returns filed with the IRS or expected to be taken in the 2017 filing, we believe it is more likely than not that our tax liability will be sustained upon examination by the IRS. We therefore carry no amount for unrecognized tax benefits for the years ended 2014 through 2017.
The statute of limitations for federal tax purposes has closed for tax years 2013 and earlier. There are no federal returns under examination and we have not been notified of any upcoming IRS examinations.
We sponsor a defined contribution plan (401(k) plan) with matching company contributions totaling $16 million,
We maintain a supplemental executive retirement plan (SERP) with a benefit obligation of $9 million at
To determine the discount rate for each plan, a theoretical settlement portfolio of high-quality rated corporate bonds was chosen to provide payments approximately matching the plan’s projected benefit payments. A single interest rate for each plan was determined resulting in a discounted value of the plan's benefit payments that equates to the market value of the selected bonds. The discount rate is reflective of current market interest rate conditions and our plan's liability characteristics. Based on this analysis, we decreased the rate from the prior year by 0.57 percentage points for the qualified pension plan and by 0.49 percentage points for the SERP. Compensation increase assumptions reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases. The mortality assumption is updated annually to reflect the updated scale. The RP-2014 Employee Mortality Tables and RP-2014 Annuitant Mortality Tables for males and females projected generationally with Scale MP-2017, Scale MP-2016 and Scale MP-2015 were used for the years 2017, 2016 and 2015, respectively. The updated mortality table did not have a significant impact on our consolidated financial statements as our qualified plan assumes the majority of benefits will be paid in the form of lump sums.
The discount rate was decreased by 0.25 percentage points for the qualified pension plan and 0.20 percentage points for the SERP due to market interest rate conditions at the beginning of 2017. The discount rate assumptions for our benefit obligation generally track with high-quality rated corporate bond yields chosen in our theoretical settlement portfolio, and yearly adjustments reflect any changes to those bond yields. We believe the expected return on plan assets is representative of the expected long-term rate of return on these assets, which is consistent with 2017 expectations of interest rates and based partially on the fact that the plan’s common stock holdings pay dividends. We review historical actual return on plan assets when determining our expected long-term rate of return. Total portfolio return for 2017 was 17.4 percent and for 2016 was 16.6 percent. Our compensation increase assumptions in 2017 reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases.
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 discussed with our employee benefits committee. Our investment strategy, currently driven by the low interest rate environment, is to weight our portfolio towards large-cap, high-quality, dividend-growing equities that we have historically favored. As our plan matures and interest rates normalize, we expect a greater allocation to fixed-income securities to better align asset and liability market risks. Our fixed-maturity bond portfolio is investment grade. The plan does not engage in derivative transactions.
Excluding cash, during 2017 we held approximately 80 percent of our pension portfolio in domestic common equity investments. The remainder of the portfolio consisted of 9 percent in states, municipalities and taxable political subdivisions fixed-maturity investments and 11 percent in domestic corporate fixed-maturity investments. Our common equity portfolio consisted of 22 percent in both the the information technology sector and financial sector, 15 percent in the healthcare sector, 13 percent in the consumer discretionary sector and 12 percent in the industrial sector at year-end 2017. No additional sectors accounted for 10 percent or more of our common equity portfolio balance at year-end 2017.
Investments in securities are valued based on the fair value hierarchy outlined in Note 3, Fair Value Measurements. The pension plan did not have any liabilities carried at fair value during the years ended December 31, 2017 and 2016. There have been no transfers between Level 1 and Level 2 for the years ended December 31, 2017 and 2016. The following table shows the fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2017 and 2016. Excluded from the table below is cash on hand of $18 million and $11 million at December 31, 2017 and 2016, respectively.
Statutory net income (loss) and capital and surplus are determined in accordance with SAP prescribed or permitted by insurance regulatory authorities for five legal entities, our insurance subsidiary and its four insurance subsidiaries. Statutory capital and surplus for our insurance subsidiary, The Cincinnati Insurance Company, includes capital and surplus of its four insurance subsidiaries. All capital and surplus amounts exceed statutory risk-based capital requirements. The statutory net income (loss) and statutory capital and surplus are presented below:
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of
on the company's consolidated results of operations or cash flows. Based on our most recent review, our estimate for any other matters for which the risk of loss is not probable, but more than remote, is immaterial.
Four equity compensation plans currently permit us to grant various types of equity awards. We currently grant incentive stock options, nonqualified stock options, service-based restricted stock units and performance-based restricted stock units to associates, including some with market-based performance objectives under our shareholder-approved plans. We also have a Holiday Stock Plan that permits annual awards of one share of common stock to each full-time associate for each full calendar year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant stock to our outside directors as a component of their annual compensation. We used treasury shares for share-based compensation award issues or exercises during 2017 and 2016.
$8 million, and $6 million for the years ended December 31, 2017, 2016 and 2015, respectively. Options exercised during the years ended December 31, 2017, 2016 and 2015, had intrinsic value of $19 million, $25 million and $15 million, respectively. Intrinsic value is the market price less the exercise price. Options vested during the years ended December 31, 2017, 2016 and 2015, had total intrinsic value of $8 million, $11 million and $7 million, respectively.
As of December 31, 2017, we had $28 million of unrecognized total compensation cost related to nonvested stock options and restricted stock unit awards. That cost will be recognized over a weighted-average period of 1.7 years.
Below is a summary of option information for the year 2017:
Service-based restricted stock units granted to associates are valued at fair value of the shares on the date of grant less the present value of the dividends that holders of restricted stock units do not receive on the shares underlying the restricted stock units during the vesting period. Service-based restricted stock units generally cliff vest three years after the date of grant. We also grant restricted stock units which vest on a three year ratable vesting schedule. Service-based restricted stock units vested during the year had an intrinsic value of $23 million, $23 million and $26 million for the years ended December 31, 2017, 2016 and 2015, respectively.
Other revenues are primarily finance income and earned premiums of Cincinnati Re.
The sum of the quarterly reported per share amounts may not equal the full year as each is computed independently. Revenues including 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.