Cincinnati Financial Corporation owns our headquarters building located on 100 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, 2016, 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 all operations reported in the Consolidated Financial Statements and accompanying Notes.
Cincinnati Financial Corporation owns Gilmore Pointe, located on the northwest corner of our headquarters property. This four-story building contains approximately 103,000 square feet of usable space. The property is recorded in the financial statements at $6 million at December 31, 2016, and is classified as investment property in Other Invested Assets, net. At December 31, 2016, unaffiliated tenants occupied 77 percent, Cincinnati Financial affiliates occupy 12 percent, and the remaining 11 percent was in a lease negotiation with a current unaffiliated tenant.
The Cincinnati Insurance Company owns the CFC Winton Center used for multiple operations with approximately 48,000 square feet of total space, located approximately six miles from our headquarters. The property, including land, is recorded in our financial statements at $9 million at December 31, 2016, and is classified as land, building and equipment, net, for company use.
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 2016, 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 41 states as discussed in Item 1, Our Business and Our Strategy.
We believe our value creation ratio, a non-GAAP measure, is a useful supplement to GAAP information. With the continuation of economic and market uncertainty in recent years, the long-term nature of this measure provides a meaningful measure of our long-term progress in creating shareholder value. A reconciliation of this non-GAAP measure to comparable GAAP measures is shown in the table below.
* Change in book value divided by the beginning of year book value
Investment contribution - We believe our investment philosophy and initiatives can drive investment income growth and lead to a total return on our equity investment portfolio over a five-year period that exceeds the five-year total return of the Standard & Poor’s 500 Index.
Total investments grew 7 percent during 2016 on a fair value basis, with an increase in our securities portfolio valuation that added to the 4 percent increase in its cost basis. Entering 2017, we believe the portfolio continues to be well diversified and is well positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, and results for the segment in Investments Results. Total assets rose 8 percent. Shareholders’ equity and book value per share each grew by 10 percent, for reasons discussed in the preceding Executive Summary.
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, the gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process.
We measure property casualty underwriting profitability primarily by the combined ratio. Our combined ratio measures the percentage of each earned premium dollar spent on claims plus all expenses related to our property casualty operations, all on a pretax basis. A lower ratio indicates more favorable results and better underlying performance. A ratio below 100 percent represents an underwriting profit. Initiatives to improve our combined ratio are discussed in Item 1, Our Business and Our Strategy, Strategic Initiatives. In 2016, 2015 and 2014, favorable development on reserves for claims that occurred in prior accident years helped offset other incurred losses and loss expenses. Reserve development is discussed further in Property Casualty Loss and Loss Expense Obligations and Reserves. Losses from weather-related catastrophes are another important item influencing the combined ratio and are discussed along with other factors in Financial Results for our property casualty business and related segments.
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 margins can arise from additional information and more focused action on underperforming product lines,
We expect the independent insurance agency system to remain strong, with continued agency consolidation. If soft insurance market conditions return in the near term, it will create additional risk for agencies.
Cincinnati Financial Corporation’s financial statements are prepared using U.S. GAAP. These principles require management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ materially from those estimates.
Our claims representatives base their case reserve estimates primarily upon case-by-case evaluations that consider:
We also establish IBNR reserves to provide for all unpaid loss and loss expenses not accounted for by case reserves:
For events designated as natural catastrophes, we calculate bulk 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 bulk reserves. Our claims department management coordinates the assessment of these events and prepares the related bulk reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the
For loss expenses that pertain primarily to salaries and other costs related to our claims department associates, also referred to as adjusting and other expense or AOE, we calculate reserves based on an analysis of the relationship between paid losses and paid AOE. Reserves for AOE are allocated to company, line of business and accident year based on a claim count algorithm. Claim counts reported and used in the reserving process are primarily measured by insurance coverages that are triggered when a loss occurs and a reserve is established. Coverages are defined as unique combinations of certain attributes such as line of business and cause of loss. Claims that are opened and closed without payment are included in the reported claim counts. Claim counts are presented on a direct basis only and do not reflect any assumed or ceded reinsurance. 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 was uniform amongst all of our systems, including legacy systems.
All securities valued below 100 percent of cost or amortized cost are reported to the asset impairment committee for evaluation. Securities valued between 95 percent and 100 percent of cost or amortized cost are reviewed but not monitored separately by the committee. When evaluating for OTTI, the committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost.
Impairment charges are recorded for other-than-temporary declines in value if fair value is below cost or amortized cost and, in the asset impairment committee’s judgment, the fair value is not expected to be recouped within a designated recovery period. When determining OTTI charges for our fixed-maturity portfolio, management places significant emphasis on whether issuers of debt are current on contractual payments and whether future contractual amounts are likely to be paid. Our invested asset impairment policy 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 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
For each of our equity securities in an unrealized loss position at December 31, 2016, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is 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.
Securities considered to have a temporary decline would be expected to recover their cost or amortized cost, which may be at maturity. Under the same accounting treatment as fair value gains, temporary declines (changes in the fair value of these securities) are reflected in shareholders’ equity on our Consolidated Balance Sheets in accumulated other comprehensive income (AOCI), net of tax, and have no impact on net income.
Over 99 percent of the $15.419 billion of securities in our investment portfolio at year-end 2016, measured at fair value, are classified as Level 1 or Level 2. Financial assets that fall within Level 1 and Level 2 are priced according to observable data from identical or similar securities that have traded in the marketplace. Also within Level 2 are securities that are valued by outside services or brokers where we have evaluated and verified the pricing methodology and determined that the inputs are observable.
Key assumptions used in developing the benefit obligation at year-end 2016 for our qualified plan were a 4.30 percent discount rate and rates of compensation increases ranging from 2.75 percent to 3.25 percent. To determine the discount rate, 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 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.
Holding all other assumptions constant, a 0.5 percentage-point decrease in the discount rate would decrease our 2017 income before income taxes by $1 million. A 0.5 percentage-point decrease in the expected return on plan assets would decrease our 2017 income before income taxes by $1 million.
The fair value of the plan assets exceeded the accumulated benefit obligation by $6 million and were less than the accumulated benefit obligation by $15 million at year-end 2016 and 2015, respectively. The fair value of the plan assets were $25 million and $45 million less than the projected plan benefit obligation at year-end 2016 and at year-end 2015, respectively. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. During the first quarter of 2017, we contributed $5 million to our qualified plan.
For property casualty insurance policies, deferred acquisition costs are amortized over the terms of the policies. These costs are principally agent commissions, premium taxes and certain underwriting costs related to successful contract acquisition, which are deferred and amortized into net income as premiums are earned. We assess recoverability of deferred acquisition costs at the segment level, consistent with the ways we acquire, service, manage and measure profitability. Deferred acquisition costs track with the change in premiums.
We measure profit or loss for our commercial lines, personal lines and excess and surplus lines and life insurance segments based upon underwriting results (profit or loss), which represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also evaluate results for our consolidated property casualty insurance operations. That is the total of our standard market segments (commercial lines and personal lines), our excess and surplus lines insurance segment and our reinsurance assumed operations. For analysis of our consolidated property casualty insurance results, it is important to include our reinsurance assumed operations earned premiums, loss and loss expenses and also underwriting expenses reported as Other. Underwriting results and segment pretax operating income are not substitutes for net income determined in accordance with GAAP.
Net written premiums increased $38 million in 2016 from expansion of reinsurance assumed operations, known as Cincinnati ReSM. Cincinnati Re assumes risks through reinsurance treaties and in some cases cedes part of the risk and related premiums to one or more unaffiliated reinsurance companies through transactions known as retrocessions. In 2016, earned premiums for Cincinnati Re totaled $49 million.
Combined ratio - The 2016 combined ratio increased 3.7 percentage points compared with 2015, reflecting a 3.8 percentage-point increase in the ratio for natural catastrophe losses. The 2016 ratio for current accident year losses and loss expenses before catastrophes decreased by 0.6 percentage points, and reflects our belief that our loss experience is improving due to recent-year initiatives to improve pricing precision and claims and loss control practices. The remainder of the 2016 combined ratio increase included 0.4 percentage-points less benefit in the ratio for prior accident year losses and loss expenses before catastrophes. We further discuss ratios related to reserve development in the sections that follow the Catastrophe Losses Incurred table below.
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, 2016, were $358 million higher than at year-end 2015, including $218 million for incurred but not reported (IBNR) reserves. The $358 million reserve increase raised year-end 2016 net loss and loss expense reserves by 8 percent, compared with a 5 percent increase in 2016 earned premiums.
Most of the incurred losses and loss expenses shown in the consolidated property casualty insurance results three-year highlights table are for the respective current accident years, with reserve development on prior accident years shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid amounts, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 64.5 percent accident year 2015 loss and loss expense ratio reported as of December 31, 2015, developed favorably by 2.1 percentage points to 62.4 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2016. Accident years 2015 and 2014 have both developed favorably, as indicated by the progression over time for the ratios in the table.
Our largest commercial line of business, commercial casualty, drove the IBNR component of the increase in the commercial lines segment ratio for loss and loss expenses from prior accident years before catastrophe losses. That higher estimate for IBNR reserves reflected paid loss trends emerging at levels higher than we previously expected. Despite the reserve increase, our commercial casualty 2016 loss and loss expense ratio remained below 58 percent, indicating a healthy underwriting profit once underwriting expenses are considered.
Our commercial lines statutory combined ratio was 93.9 percent in 2016, compared with 88.3 percent in 2015 and 94.3 percent in 2014. The estimated commercial lines combined ratio for the industry was 98.2 percent in 2016, 97.5 percent in 2015 and 97.1 percent in 2014. The industry’s ratio excludes its mortgage and financial guaranty lines of business. The contribution of catastrophe losses to our commercial lines statutory combined ratio was 7.1 percentage points in 2016, 3.1 percentage points in 2015 and 4.3 percentage points in 2014, compared with industry estimates of 3.2, 2.1 and 2.4 percentage points, respectively.
commercial lines pricing change we report reflects a blend of policies that did not expire and other policies that did expire during the measurement period.
For only those commercial lines policies that did expire and were then renewed during 2016, we estimate that the average price increase was near the high end of the low-single-digit range, compared with near the low end of the mid-single-digit range in 2015. During 2016, we continued to further segment our commercial lines policies, emphasizing identification and retention of policies we believed had relatively stronger price adequacy. Conversely, we continued to seek more aggressive renewal terms and conditions on policies we believed had relatively weaker pricing, in turn retaining fewer of those policies. As a result, the average change in commercial lines renewal pricing tended to be lower than in 2015.
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 $5 million to the $93 million earned premiums increase in 2016, $23 million to the $140 million earned premiums increase in 2015 and $5 million to the $220 million earned premiums increase in 2014. On a net written premium basis, audits contributed negative $1 million to the $97 million net written premiums increase in 2016, $20 million to the $103 million net written premiums increase in 2015 and $9 million to the $162 million net written premiums increase in 2014. These net written premium amounts are included with agency renewal written premiums in the Commercial Lines Insurance Premiums table above.
Other written premiums primarily consist of premiums that are ceded to reinsurers and that lower our net written premiums. An increase in ceded premiums contributed negative $1 million to net written premium growth for 2016, compared with 2015. Other written premiums also included a more favorable adjustment for 2016, compared with 2015, for estimated direct written premiums of policies in effect but not yet processed in our commercial lines insurance segment. This written premium adjustment has an immaterial effect on earned premiums.
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 2016, we experienced a rising trend in paid losses and loss expenses that was more than we expected for certain accident years. As a result, we increased our actuarial best estimate of ultimate loss and loss expense ratios for several accident years within those lines at the end of 2016, compared with year-end 2015. Net loss and loss expense reserves for commercial casualty at December 31, 2016, were $132 million, or 7 percent, higher than at year-end 2015. The IBNR portion of the reserve increase was $103 million. Net loss and loss expense reserves for
commercial auto at December 31, 2016, were $77 million, or 16 percent, higher than at year-end 2015. The IBNR portion of the reserve increase was $34 million.
Most of the incurred losses and loss expenses shown in the commercial lines insurance segment three-year highlights table are for the respective current accident years, with reserve development on prior accident years shown separately. Since less than half of our commercial lines insurance segment current accident year incurred losses and loss expenses represents net paid amounts, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 62.1 percent accident year 2015 loss and loss expense ratio reported as of December 31, 2015, developed favorably by 2.1 percentage points to 60.0 percent due to claims settling for less than previously estimated, or due to updates to reserve estimates for unpaid claims, as of December 31, 2015. Accident years 2015 and 2014 for the commercial lines insurance segment have both developed favorably, as indicated by the progression over time of the ratios in the table.
In 2016, total large losses incurred increased by $24 million, or 14 percent, net of reinsurance. The corresponding ratio increased 0.7 percentage points. The 2016 increases on both a dollar and ratio basis were primarily due to higher amounts for our commercial casualty and commercial property lines of business. In 2015, total large losses incurred and the corresponding ratio was lower than it was in 2014, largely due to a lower amount of large losses for our commercial casualty and commercial property lines of business. Our analysis 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.
Commercial lines commission expenses as a percent of earned premiums decreased slightly in 2016, compared with 2015, reflecting a decrease in the ratio for agency profit-sharing commissions. The ratio for 2015 matched 2014. In 2016, other underwriting expenses as a percent of earned premiums also increased compared with 2015, as strategic investments that include enhancement of underwriting expertise offset the favorable effects of higher earned premiums and ongoing expense management efforts. In 2015, the ratio matched 2014.
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 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.
Premiums - Earned premiums and net written premiums continued to grow in 2016, primarily due to higher renewal written premiums that included price increases. Renewal written premiums rose $58 million, or 6 percent, in 2016, compared with 2015.
Combined ratio - The 2016 combined ratio rose 0.1 percentage points, compared with 2015, driven by a 3.2 percentage-point increase in the ratio for 2016 natural catastrophe losses. The total large loss ratio for losses of $1 million or more per claim, shown in the table below, decreased by 3.0 percentage points, largely due to lower losses for homeowner claims and personal umbrella claims related to auto accidents.
Personal auto, representing 47 percent of 2016 earned premiums for our personal lines insurance segment, was the only major line of business in that segment with a 2016 total loss and loss expense ratio significantly higher than we desired. During 2016, our personal auto policies experienced premium rate increases averaging near the high end of the mid-single-digit range. We believe rate increase and other actions to improve pricing precision and reduce loss costs will improve future profitability. A similar approach was used to improve the total loss and loss expense ratio for our homeowner line of business to a satisfactory result in recent years.
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 nonrenewed policies in select areas more prone to natural catastrophes. We have worked to improve our geographic diversification by expanding our personal lines operation to several states less prone to catastrophes.
The 6 percent increase in agency renewal written premiums in 2016 largely reflected various rate changes. We estimate that premium rates for our personal auto line of business increased at average percentages near the high end of the mid-single-digit range during 2016, with some individual policies experiencing lower or higher rate changes based on enhanced pricing precision enabled by predictive models. For our homeowner line of business, we estimate that rate increases during 2016 averaged in the mid-single-digit range. Similar to our personal auto line of business, that average varied widely by state, and some individual policies experienced lower or higher rate changes based on pricing precision and current rate level indications that help determine appropriate premium rates.
Personal lines new business written premiums grew $11 million, or 10 percent, during 2016, compared with 2015. 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 $30 million for 2016, compared with $17 million for 2015. The decrease of approximately $2 million in new business written premiums for the part of our personal lines segment we sometimes refer to as middle market business is largely a reflection of a slight decline in policy retention due to significant premium rate increases for our personal auto policies during 2016. 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 new business written premiums grew significantly in 2015, compared with 2014. Key factors contributing to that increase included an increase in larger-sized policy submissions due to underwriting appetite and pricing changes made to our existing personal lines products, increased visibility of underwriters and additional marketing efforts directed toward our agencies. In addition, in 2014 we began rolling out advanced quote discounts for home and auto and new home purchase discounts in most states, allowing us to compete more effectively in the comparative rater environment.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. For our personal auto line of business in 2016, we experienced a rising trend in paid losses and loss expenses that was more than we expected. As a result, we increased our actuarial best estimate of ultimate loss and loss expense ratios for that line at the end of 2016, compared with year-end 2015. Net loss and loss expense reserves for our personal auto line of business at December 31, 2016, were $43 million, or 18 percent, higher than at year-end 2015. The IBNR portion of the reserve increase was $27 million.
homeowner line 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.
In 2016, personal lines total large losses incurred decreased by $33 million, or 73 percent, compared with 2015, net of reinsurance. The ratio for 2016 large losses as a percent of earned premiums decreased 3.0 percentage points. The 2016 decreases on both a dollar and ratio basis were largely due to lower amounts for homeowner claims and personal umbrella claims related to auto accidents. In 2015, total large losses increased, compared with 2014, primarily due to higher amounts of personal umbrella claims related to auto accidents. 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.
A.M. Best projections for 2017 indicate personal lines written premiums for the U.S. property casualty industry may grow approximately 3 percent, with an industry statutory combined ratio estimated at approximately 100 percent. We believe our growth rate will likely be higher than the industry projection for 2017, driven by our rate increases, stable policy retention rate, accelerated pace of new agency appointments in recent years and increased focus on the high net worth personal lines market. Our high net worth initiative, along with various other actions to improve performance in our personal lines insurance segment, is discussed in greater detail in Item 1, Our Business and Our Strategy, Strategic Initiatives and Personal Lines Insurance Results. Our personal lines pricing trends need to exceed loss trends to improve personal lines profitability, thereby helping to achieve our corporate financial targets. We discuss our overall outlook for our property casualty insurance operations in the Executive Summary.
Premiums - Earned premiums and net written premiums continued to grow during 2016. Growth was driven by higher renewal written premiums that included average renewal price increases near the high end of the low-single-digit range. New business written premiums grew 2 percent in 2016, a slower rate than in 2015, as we continued to carefully underwrite each policy in a highly competitive market. Within the excess and surplus lines market during 2016, some standard market carriers sought to increase market share by writing policies for larger risks formerly considered excess and surplus lines business.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses, as well as the associated loss expenses. The majority of the total incurred losses and loss expenses shown above in the three-year highlights table are for the respective current accident years, with reserve development on prior accident years shown separately. Since less than 20 percent of our 2016 excess and surplus lines current accident year incurred losses and loss expenses represents net paid amounts, a large majority represents reserves for our estimate of unpaid losses and loss expenses. These reserves develop over time, and we update our estimates of previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 62.6 percent accident year 2015 loss and loss expense ratio reported as of December 31, 2015, developed favorably by 8.7 percentage points to 53.9 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2016. Accident years 2015 and 2014 for this segment have both developed favorably, as indicated by the progression over time of the ratios in the table.
The 54.4 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2016 decreased 7.7 percentage points compared with the 62.1 percent accident year 2015 ratio measured as of December 31, 2015. We also recognized significant favorable reserve development on prior accident years during both 2016 and 2015, with a ratio effect of approximately 20 percentage points for each year.
2016 favorable development was for accident years 2015 and 2014 in aggregate, and was primarily due to lower-than-anticipated loss emergence on known claims.
In 2016, total large losses incurred decreased by $4 million or 57 percent, net of reinsurance. The ratio for 2016 large losses as a percent of earned premiums decreased 2.7 percentage points. That ratio for 2015 trended in the opposite direction, due to 2015 total large losses increasing from 2014. 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.
Revenues - Earned premiums rose 9 percent for the year 2016, as shown in the table below that includes details by major line of business. Our largest life insurance product line, term life insurance, rose 10 percent. Net in-force policy face amounts rose 8 percent to $56.808 billion at year-end 2016 from $52.735 billion at year-end 2015 and $50.356 billion at year-end 2014.
Profitability - The life insurance segment frequently reports only a small profit or loss because most of its investment income is included in the investments segment results. We include only investment income credited to contract holders (interest assumed in life insurance policy reserve calculations) in life insurance segment results. The segment reported a $1 million profit in 2016, following losses of $2 million in 2015 and $5 million in 2014. It has averaged a profit of less than $1 million over the past five years.
Contract holders’ benefits incurred, related to traditional life and interest-sensitive products, accounted for 76.4 percent of 2016 total benefits and expenses compared with 78.1 percent in 2015 and 78.4 percent in 2014. Total contract holders’ benefits increased as life policy reserves were higher in 2016, compared with 2015.
To further capitalize on this disruption, we recently piloted a new term product that allows our property casualty agents to quickly market and sell life insurance to our personal lines customers using accelerated underwriting through a predictive model. We expect to expand this initiative in 2017 and will continue to look for ways to improve the overall buying experience that we believe has contributed to the decline in ownership rates.
We are implementing statutory principle-based reserves for our core term product in 2017. We expect that action will begin to give us the ability to better manage the economic capital that is currently supporting the statutory reserves for our term book of business. While many term writers have used a variety of captive reinsurance solutions to deal with this statutory issue, we chose to carry the full reserve amounts on our balance sheet. That action has resulted in tremendous balance sheet strength and GAAP equity growth. It also, however, has made it difficult to achieve high rates of return.
We are cautiously optimistic about the potential for corporate tax reform. Should significant reform be implemented, we believe that our product pricing would be more favorably impacted than the industry.
The investments segment contributes investment income and realized gains and losses to results of operations. Investments provide our primary source of pretax and after-tax profits.
Investment income - Pretax investment income grew $23 million, or 4 percent, in 2016, with increases from interest and dividends contributing nearly equal dollar amounts. Dividend income reflected rising dividend rates and net purchases of equity securities from available funds. Interest income also rose, as net purchases of fixed-maturity securities offset the continuing effects on bond yields of the low interest rate environment. Pretax investment income also rose 4 percent in 2015, reflecting increases in both dividend income and interest income. Average yields in the investment income table below are based on the average invested asset and cash amounts indicated in the table using fixed-maturity securities valued at amortized cost and all other securities at fair value.
Interest income rose $12 million, or 3 percent, in 2016. The average fixed-maturity pretax yield declined by approximately 10 basis points but was offset by a larger average fixed-maturity portfolio that rose 5 percent on an amortized cost basis. Interest income also increased 3 percent in 2015 when that yield declined by approximately 6 basis points while the portfolio rose 5 percent on an amortized cost basis.
Dividend income rose $11 million, or 7 percent, in 2016, after rising 9 percent in 2015. Increases in dividend payment rates for most of the holdings in our common stock portfolio during both 2016 and 2015, plus a slight net increase in funds invested in that portfolio for both years, drove the increases in dividend income.
In 2016, 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 3.75 percent for fixed-maturity securities acquired during 2016, shown in the table below, was lower than the 4.54 percent average yield-to-amortized cost of the fixed-maturity securities portfolio at the end of 2016.
Net realized investment gains and losses totaling $124 million for the year ended December 31, 2016, included:
In 2014, the $133 million net realized investment gains and losses were primarily due to $136 million in net realized gains from equity security sales and $18 million from fixed-maturity security sales and calls, partially offset by $24 million of OTTI charges for six securities.
At December 31, 2016, the parent company had $2.133 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.
Cash in excess of operating requirements is invested in fixed-maturity and equity securities. Cash generated from investment income provides an important investment contribution to cash flow and liquidity. The sale of investments could provide an additional source of liquidity at either the parent company or insurance subsidiary level, if required. In addition to possible sales of investments, proceeds of call or maturities of fixed-maturity securities also can provide liquidity. During the five-year period beginning in 2017, fair value of $3.604 billion, or 35.7 percent, of our fixed-maturity portfolio is scheduled to mature. At year-end 2016, total unrealized gains in the investment portfolio, before deferred income taxes, were $2.625 billion. Liquidity sourced from our investment portfolio is not materially at risk from European-based securities. At the end of 2016 this totaled $314 million on a fair value basis, or 2.0 percent of our total investments. We own no European sovereign debt. Our European-based securities are summarized by country in Item 7A, Qualitative and Quantitative Disclosures About Market Risk.
At December 31, 2016, we had a $225 million line of credit with commercial banks, with $20 million borrowed. That line of credit had a $35 million balance at December 31, 2015. During 2016, we repaid $15 million as part of routine cash management. Access to this line of credit requires compliance with various covenants, including maintaining a minimum consolidated net worth and not exceeding a 30 percent debt-to-total capital ratio, as defined by the agreement. At December 31, 2016, we had approximately $1.0 billion in net worth compared with our covenant net worth requirement. We are considerably within compliance with all covenants under the credit agreement, and believe we will remain in compliance. The credit agreement provides alternative interest charges based on the type of borrowing and our debt rating. The interest rate charged is adjusted LIBOR plus an applicable margin.
Capital resources consisting of shareholders’ equity and total debt represent our overall financial strength to support current obligations and growth in our insurance businesses. At December 31, 2016, we had total capital of $7.867 billion. Shareholders’ equity was $7.060 billion, an increase of $633 million, or 10 percent, from the prior year. Our total debt was $807 million, down $14 million from a year ago. We seek to maintain a solid financial position and provide capital flexibility by keeping our ratio of debt to total capital moderate. We target a ratio below 20 percent. At year-end 2016, the ratio was 10.3 percent, compared with 11.3 percent at year-end 2015.
Dividends to shareholders -The ability of our company to continue paying cash dividends is subject to factors the board of directors deem relevant. While the board and management believe there is merit to sustaining the company’s long record of dividend increases, our first priority is the company’s financial strength. Over the past 10 years, the company has paid an average of 66 percent of net income as dividends. Through 2016, the board had increased our cash dividend for 56 consecutive years. The board decision in January 2017 to increase the dividend demonstrated confidence in the company’s strong capital, liquidity, financial flexibility and initiatives to grow earnings.
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 since mid-2008 has been to hold capital adequate to support future growth of our insurance operations and repurchase a minimal amount of shares. Those repurchases were intended to partially 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. 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.
At December 31, 2016, we estimated our future contractual obligations as follows:
At December 31, 2016, we believe our most significant other commitments were:
Other operating expenses - Many of our operating expenses are not contractual obligations but reflect the ongoing expenses of our business. For example, we anticipate capitalizing development costs for approximately $6 million in spending for key technology initiatives in 2017, compared with actual capitalization totaling $8 million in 2016 and $6 million in 2015. These activities are conducted at our discretion, and we have no material contractual obligations for activities planned as part of these projects.
In any year, we consider the most likely source of pressure on liquidity would be an unusually high level of catastrophe loss payments within a short period of time. There could be additional obligations for our insurance operations due to increasing severity or frequency of noncatastrophe claims. To address the risk of unusually large insurance loss obligations including catastrophe events, we maintain property casualty reinsurance contracts with highly rated reinsurers, as discussed under 2017 Reinsurance Ceded Programs. We also monitor the financial condition of our reinsurers because their insolvency could jeopardize a portion of our $545 million reinsurance recoverable asset at December 31, 2016. Parent-company liquidity could also be constrained by Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay.
Reserving data for asbestos and environmental claims has characteristics that limit the usefulness of the methods and models used to analyze loss and loss expense reserves for other claims. Specifically, asbestos and environmental loss and loss expenses for different accident years do not emerge independently of one another as loss development and Bornhuetter-Ferguson methods assume. In addition, asbestos and environmental loss and loss expense data available to date did not reflect a well-defined tail, greatly complicating the identification of an appropriate probabilistic trend family model. At year-end 2016, we used a weighted average of a paid survival ratio method and report year method to estimate reserves for IBNR asbestos and environmental claims. Our exposure to such claims is limited; we believe a weighted average of both methods produces a sufficient level of reserves.
Our estimates of gross property casualty loss and loss expense payments do not include reinsurance receivables or ceded losses. As discussed in 2017 Reinsurance Ceded Programs, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance unpaid receivables of $298 million at year-end 2016 are an offset to our gross property casualty loss and loss expense obligations. Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claim severity or frequency due to a catastrophic event. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover losses under our reinsurance agreements depends on the financial viability of the reinsurers.
We direct our associates and agencies to settle claims and pay losses as quickly as is practical, and we made $2.503 billion of net claim payments during 2016. At year-end 2016, total net property casualty reserves of $4.738 billion reflected $2.331 billion in unpaid amounts on reported claims (case reserves), $1.011 billion in loss expense reserves and $1.396 billion in estimates of claims that were incurred but had not yet been reported (IBNR). The specific amounts and timing of obligations related to case reserves and associated loss expenses are not set contractually. The amounts and timing of obligations for IBNR claims and related loss expenses are unknown. We discuss our methods of establishing loss and loss expense reserves and our belief that reserves are adequate in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves.
The historical pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The effective duration of our consolidated property casualty fixed-maturity portfolio was 5.0 years at year-end 2016. By contrast, the duration of our loss and loss expense reserves was approximately 4.1 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow from operations is sufficient to meet these obligations. In addition, investment holdings could be sold, if necessary, to meet higher than anticipated loss and loss expenses.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2016 and 2015. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
In evaluating the development of our estimated reserves for loss and loss expenses for the past 10 years, note that each amount includes the effects of all changes in amounts for prior periods. For example, payments or reserve adjustments related to losses settled in 2016 but incurred in 2010 are included in the cumulative deficiency or redundancy amount for 2010 and each subsequent year. In addition, this table presents calendar year data, not accident or policy year development data, which readers may be more accustomed to analyzing. Conditions and trends that affected development of reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future reserve development based on this data.
Overall favorable development for consolidated property casualty reserves of $168 million in 2016 illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. As noted in Critical Accounting Estimates, Key Assumptions Loss Reserving, our models predict that actual loss and loss expense emergence will differ from projections, and we do not attempt to monitor or identify such normal variations. The table in Property Casualty Loss and Loss Expense Obligations and Reserves shows reserves by segment and lines of business and the components of gross reserves among case, IBNR and loss expense reserves.
Favorable reserve development of $69 million for our workers’ compensation line accounted for approximately 53 percent of our commercial lines insurance segment net total in 2016, while favorable reserve development of $20 million for our commercial casualty line of business accounted for approximately 16 percent. Our commercial auto line of business experienced $31 million of unfavorable reserve development on prior accident years recorded during 2016, and that 2016 measure for our personal auto line of business was also unfavorable at $18 million. Drivers of significant reserve development typically reflect loss emergence on known claims that was more favorable or less favorable than previously anticipated for various lines of business and are discussed below.
Commercial casualty - During 2016, we experienced favorable development on prior accident years in total for this line of business. However, results varied between component coverages and by accident year within coverage. For example, our commercial multi-peril liability coverage within commercial casualty experienced favorable results for some prior accident years and adverse development on other accident years to end the calendar year flat on all prior years combined. Commercial umbrella coverage developed adversely for accident year 2007, but developed favorably for all prior years combined.
Workers’ compensation - We continue to see favorable reserve development, for all prior accident years in aggregate. During 2016, the trend for estimated payments to be made in future calendar years was stable compared to 2015. However, we continue to monitor this line closely, as a sudden increase in trend for future payments has a highly leveraged effect.
For the excess and surplus lines insurance segment, the table showing reserves by segment and lines of business in Property Casualty Loss and Loss Expense Obligations and Reserves, shows the components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were up $14 million from year-end 2015 primarily due to the increase in premiums and exposures for this segment, as we discussed in Excess and Surplus Lines Insurance Results. Favorable development during 2016 of $34 million for excess and surplus lines insurance segment reserves, shown in the table above, illustrates the potential for revisions inherent in estimating reserves.
A single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event is a risk to the company's liquidity and financial strength. In an effort to control such losses, we avoid marketing property casualty insurance in specific geographic areas and monitor our exposure in certain coastal regions. An example of this is the reduction in recent years of our homeowner policies in the southeastern U.S. coastal region. Loss exposures in that area had been identified as a major contributor to our catastrophe probable maximum loss estimates shown in the table below. Those estimates were subsequently reduced, in large part due to less exposure from southeastern U.S. homeowner policies. We also continually review aggregate exposures to huge disasters and purchase reinsurance protection to cover these exposures. For business other than Cincinnati Re, we use the Risk Management Solutions (RMS) and Applied Insurance Research (AIR) models to evaluate exposures to a once-in-a-100-year and a once-in-a-250-year event to help determine appropriate reinsurance coverage programs. In conjunction with these activities, we also continue to evaluate information provided by our reinsurance broker. Examples include deterministic modeling of probable maximum loss contribution from growth in new geographic territories.
To help determine appropriate reinsurance coverage for hurricane, earthquake and tornado/hail exposures, for business other than Cincinnati Re we use the RMS and AIR models to estimate the probable maximum loss from a single event or multiple events occurring in a one-year period. The models are proprietary in nature, and the vendors that provide them periodically update the models, sometimes resulting in significant changes to their estimate of probable maximum loss. As of the end of 2016, both models indicated that a hurricane event represents our largest amount of exposure to losses. The table below summarizes estimated probabilities and the corresponding probable maximum loss from a single hurricane event occurring in a one-year period, and indicates the effect of such losses on consolidated shareholders’ equity at December 31, 2016. Net losses are net of reinsurance and income taxes, and assume our 2017 reinsurance programs apply.
The modeled losses according to RMS in the table are based on its RiskLink version 16.0 catastrophe model and use a long-term storm catalog methodology. The modeled losses according to AIR in the table are based on its AIR Touchstone version 4.0 catastrophe model and use a long-term methodology. The AIR storm catalog includes decades of documented weather events used in simulations for probable maximum loss projections.
The following table shows our five largest property casualty reinsurance receivable amounts by reinsurer at the end of 2016 and at the end of 2015. USAIG is a joint underwriting association of individual insurance companies that collectively functions as a worldwide aviation insurance market. We terminated our participation in the association after policy year 2002. 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.
Property per risk treaty - The primary purpose of the property treaty is to provide capacity up to $25 million, adequate for the majority of the risks we write. It 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 2017 ceded premium estimate was $18 million, essentially unchanged from the 2016 estimate.
Beginning in 2013 we added an alternative reinsurance structure to protect against certain catastrophic events, and a similar structure is in place for 2017 through 2019. For certain exposures in the United States, we arranged for the purchase of collateralized reinsurance funded through the issuance of collateralized risk-linked securities, known as catastrophe bonds. The catastrophe bond arrangements generally provide reinsurance coverage for specific types of losses in specific geographic locations. They are generally designed to supplement coverage provided under the property catastrophe treaty. Effective January 2017, we have a catastrophe bond arrangement providing up to $200 million in earthquake reinsurance protection or $80 million in severe convective storm coverage or various combinations of those coverages. It expires in January 2019. The earthquake coverage is countrywide, excluding California, and the severe convective storm coverage territory is also countrywide, excluding Florida. The storm coverage provides loss recovery when storm losses for all events in aggregate exceed $190 million, after an $8 million deductible per event.
After reinsurance, and before any applicable benefit from our catastrophe bond, our maximum exposure to a catastrophic event that causes $600 million in covered losses in 2017 would be $125 million, matching our retention for 2016. The largest catastrophe loss event in our history occurred during 2011 from a May 20-27 storm system that included a tornado in Joplin, Missouri, and also significant losses from hail in the Dayton, Ohio, area. Our losses from that storm were estimated at December 31, 2016, to be $223 million before reinsurance.
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 2016 was $514 million (20 percent of 2015 subject premiums), and we estimate it is $529 million (20 percent of 2016 subject premiums) for 2017.
Property per risk treaty - The property treaty provides limits up to $5 million, which is adequate capacity for the risk profile we insure. It also includes protection for extra-contractual liability coverage losses. Cincinnati Specialty Underwriters retains the first $500,000 of any policy loss. Losses between $500,000 and $5 million are reinsured at 100 percent by The Cincinnati Insurance Company.
Property catastrophe treaty - As a subsidiary of The Cincinnati Insurance Company, Cincinnati Specialty Underwriters is a named insured under our corporate property catastrophe treaty, and for our collateralized reinsurance funded through the issuance of catastrophe bonds. All terms and conditions of this reinsurance coverage apply to policies underwritten by Cincinnati Specialty Underwriters.
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2016, in accordance with accounting principles generally accepted in the United States of America (GAAP).
The company’s independent registered public accounting firm has issued an audit report on our internal control over financial reporting as of December 31, 2016.
Cincinnati Financial Corporation (CFC) operates through our insurance group and two complementary subsidiary companies.
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 2016 and 2015.
When determining OTTI charges for our equity portfolio, our invested asset impairment policy considers qualitative and quantitative factors, including facts and circumstances specific to individual securities; asset classes; the
Certain property casualty policies are not entered into policy underwriting systems as of the effective date of coverage. An estimate is recorded for these unprocessed written premiums. A large majority of the estimate is unearned and has no material impact on earned premiums.
We offer several types of life insurance and disability income insurance, and we account for each according to the duration of the contract. Short-duration life and health contracts are written to cover claims that arise during a short, fixed term of coverage. We generally have the right to change the amount of premium charged or cancel the coverage at the end of each contract term. We record premiums for short-duration life and health contracts similarly to property casualty contracts.
We capitalize acquisition costs for traditional long-duration contracts. We charge these capitalized costs associated with successfully acquiring traditional long-duration contract insurance policies over the premium-paying period of the policies. We use the same assumptions used in establishing the liability for the contract. We update our
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, 2016, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders’ account value by approximately $16 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.
During 2015, The Cincinnati Insurance Company expanded in the area of reinsurance assumed. Approximately half of the business written includes treaties that provide coverage for property catastrophe events on a worldwide basis. Treaties are written on a pro rata and excess of loss basis. Premiums are primarily earned on a pro rata basis over the coverage period of the treaty. We also assume risk with limited exposure as a reinsurer for other insurance companies, reinsurers and involuntary state pools.
We reduce risk and uncertainty by buying property casualty reinsurance and retrocessional reinsurance as well as life reinsurance. Reinsurance and retrocessional reinsurance contracts do not relieve us from our obligation to policyholders, but rather help protect our financial strength to perform that duty. All of these ceded reinsurance contracts transfer the economic risk of loss.
Historically, our claims with reinsurers have been paid. We establish an insignificant allowance for uncollectible reinsurance.
We calculate deferred income tax liabilities and assets using tax rates in effect when temporary differences in the consolidated financial statement income and taxable income are expected to reverse. We recognize deferred income taxes for numerous temporary differences between our taxable income and consolidated financial statement income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains and losses on investments and differences in the recognition of deferred acquisition costs, unearned premium and insurance reserves. We charge deferred income taxes associated with balances that impact other comprehensive income, such as unrealized appreciation and depreciation of investments (except the amounts related to the effect of income tax rate changes), to shareholders’ equity in AOCI. We charge deferred taxes associated with other differences to income.
See Note 11, Income Taxes, for further detail on our uncertain tax positions. Although no Internal Revenue Service (IRS) penalties currently are accrued, if incurred, they would be recognized as a component of income tax expense.
We record land at cost, and record building and equipment at cost less accumulated depreciation. Equipment held under capital leases also is classified as property and equipment with the related lease obligations recorded as liabilities. We capitalize and amortize costs for internally developed computer software during the application development stage. These costs generally consist of external consulting, internal payroll and payroll-related costs. Our depreciation is based on estimated useful lives (ranging from three years to 39.5 years) using straight-line and accelerated methods. Depreciation expense was $30 million for 2016, $36 million for 2015 and $37 million for 2014. We review our accumulated depreciation for our building, equipment and software assets and write off fully depreciated assets for obsolesce and nonuse. We monitor land, building and equipment and software assets for potential impairments. Potential impairments may include a significant decrease in the fair values of the assets, considerable cost overruns on projects, a change in legal factors or business climate or other factors that indicate that the carrying amount may not be recoverable or useful. There were no recorded land, building and equipment impairments for 2016, 2015 or 2014.
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 2016, 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 June 2014, the FASB issued ASU 2014-12, Compensation-Stock Compensation: Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. ASU 2014-12 requires that performance targets that affect vesting and that could be achieved after the requisite service period be treated as performance conditions. The effective date of ASU 2014-12 was for interim and annual reporting periods beginning after December 15, 2015. The company adopted this ASU and it did not have a material impact on our company’s consolidated financial position, cash flows or results of operations.
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 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.
ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities
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
ASU 2016-07, Investments - Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting
In March 2016, the FASB issued ASU 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. ASU 2016-09 simplifies and improves 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 is for interim and annual reporting periods beginning after December 15, 2016. 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 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 is not expected to have a material impact on our company's consolidated financial position, cash flows or results of operations.
fixed-maturity investments with amortized cost of $74 million and fair value of $77 million were on deposit with various states in compliance with regulatory requirements.
During 2014, we other-than-temporarily impaired six securities. At December 31, 2014, 144 fixed-maturity investments with a total unrealized loss of $10 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 three equity security investments in an unrealized loss position for 12 months or more with a total unrealized loss of $1 million as of December 31, 2014. Of that total, no equity security investments had fair values below 70 percent of cost.
Level 1 - Financial assets and liabilities for which inputs are observable and are obtained from reliable quoted prices for identical assets or liabilities in active markets. This is the most reliable fair value measurement and includes, for example, active exchange-traded equity securities.
The Level 2 nonredeemable preferred equities technique used is the application of market based modeling. The inputs used, similar to those used by the pricing vendor for our fixed-maturity securities, include relevant market information, trade activity of like securities, yield to maturity, corporate action notices and economic events. All of the Level 2 nonredeemable preferred equities are priced by a nationally recognized pricing vendor.
The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2016 and 2015. We do not have any liabilities carried at fair value. There were no transfers between Level 1 and Level 2.
The following table provides the change in Level 3 assets during 2016 and 2015:
With the exception of the above table, additional disclosures for the Level 3 category are not material.
Fair value of the note payable was determined based upon the outstanding balance at December 31, 2016 and 2015, because it is short term and tied to a variable interest rate. Fair value of the long-term debt was determined under the fair value measurements and disclosure accounting rules based on market pricing of similar debt instruments that are actively trading. We determine fair value for our debt the same way that we value corporate fixed maturities in our investment portfolio. Fair value can vary with macroeconomic conditions. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt is $793 million at both December 31, 2016 and 2015. None of the long-term debt is encumbered by rating triggers. The note payable and long-term debt were classified as Level 2 as an active market does not exist, but fair value is determined based on observable inputs.
Outstanding principal and interest for these life policy loans totaled $31 million at December 31, 2016 and 2015. 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.
Recorded reserves for the deferred annuities were $861 million and $860 million at December 31, 2016 and 2015, respectively. Recorded reserves for the structured settlements were $170 million and $174 million at December 31, 2016 and 2015, respectively.
Our field claims representatives establish case reserves when claims are reported to provide for our unpaid loss and loss expense obligation associated with individual claims.
For events designated as natural catastrophes, we calculate IBNR reserves directly as a result of 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.
The reserve for loss and loss expense in the consolidated balance sheets also included $50 million, $58 million and $47 million, respectively, for certain life and health loss and loss expense reserves. Additional disclosures for reserves related to these health claims are not material.
During 2016, we experienced $168 million of favorable development on prior accident years including $129 million of favorable development in commercial lines, $4 million of favorable development in personal lines, $34 million of favorable development in excess and surplus lines and $1 million of favorable development in our reinsurance assumed operations. We recognized favorable development of $69 million for the workers' compensation line,
$29 million for the commercial property line, $20 million for the commercial casualty line and $42 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 $31 million for the commercial auto line and
Included in our lines of business are asbestos and environmental claims. We carried $85 million of net loss and loss expense reserves for asbestos and environmental claims and $45 million of reserves for mold claims at December 31, 2016, compared with $84 million and $45 million, respectively, at December 31, 2015. The asbestos and environmental claims amounts for each respective year constituted 1.8 percent and 1.9 percent of total net loss and loss expense reserves at these year-end dates.
combinations of certain attributes such as line of business and cause of loss. Claims that are opened and closed without payment are included in the reported claim counts. Claim counts are presented on a direct basis only and do not reflect any assumed or ceded reinsurance.
In the following tables, commercial casualty and workers' compensation each disclose 10 accident years of loss and ALAE reserves and eight 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 was uniform amongst all of our systems, including legacy systems. Therefore, consistent definitions are only available for accident year 2009 and forward. We will increase the commercial casualty and workers’ compensation cumulative number of reported claims by one year in future periods, not to exceed 10 years. Commercial auto, commercial property, personal auto and homeowner each disclose five accident years of loss and ALAE reserves and cumulative number of reported claims as each of these lines have five year cumulative average annual percentage payouts in excess of 95 percent. The excess and surplus lines began operations in 2008 with earned premiums and loss and ALAE reserves being immaterial prior to 2011. Accordingly, we initially disclose six accident years of loss and ALAE reserves and cumulative number of reported claims for the excess and surplus lines, and will disclose additional accident years, not to exceed 10 years.
The following table shows the excess and surplus 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 have one line of credit in 2016 and 2015 through multiple commercial banks with a borrowing capacity of
Capital lease obligations, excluding an insignificant amount of interest, totaled $39 million and $35 million in 2016 and 2015, respectively. Below are the expected capital lease obligations that we expect to pay over the next six years:
Our change in ceded incurred compared to prior years resulted primarily from increased retrocessions of Cincinnati Re.
The differences between the 35 percent statutory federal income tax rate and our effective income tax rate were as follows:
The provision for federal income taxes is based upon filing a consolidated income tax return for the company and its subsidiaries. As of December 31, 2016, 2015 and 2014, we had no operating or capital loss carryforwards.
Income taxes paid in our consolidated statements of cash flows are shown net of refunds received of $2 million in 2016 and an immaterial amount in 2015 and 2014.
Basic earnings per share are computed based on the weighted average number of common shares outstanding. Diluted earnings per share are computed based on the weighted average number of common and dilutive potential common shares outstanding using the treasury stock method. The table shows calculations for basic and diluted earnings per share:
We sponsor a defined contribution plan (401(k) plan) with matching company contributions totaling $14 million,
$12 million and $11 million during the years 2016, 2015 and 2014, respectively. Associates who are not accruing benefits under the pension plan are eligible to receive the company match of up to 6 percent of cash compensation. We also pay operating expenses for the 401(k) plan. Participants vest in the company match for the 401(k) plan after three years of eligible service.
We maintain a supplemental executive retirement plan (SERP) with a benefit obligation of $15 million at
year-end 2016 and $14 million at year-end 2015, which is included in the projected benefit obligation. The company also makes available to a select group of associates the CFC Top Hat Savings Plan, a nonqualified deferred compensation plan, which had a fair value of $24 million and $21 million at December 31, 2016 and 2015, respectively.
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 0.25 percentage points for the qualified pension plan and by 0.20 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 was updated in 2014 to the RP-2014 Employee Mortality Tables and RP-2014 Annuitant Mortality Tables for males and females projected generationally with Scale MP-2014. During 2016 and 2015, the 2014 mortality assumption was updated to include the generational projection using Scale MP-2016 and Scale MP-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 increased by 0.30 percentage points for the qualified pension plan and 0.25 percentage points for the SERP due to market interest rate conditions at the beginning of 2016. 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 2016 expectations of interest rates and based partially on the fact that the plan’s common stock holdings pay dividends. We believe this rate is representative of the expected long-term rate of return on these plan assets. We review historical actual return on plan assets when determining our expected long-term rate of return. Total portfolio return for 2016 was 16.6 percent and for 2015 was 0.6 percent. Our compensation increase assumptions in 2016 reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases.
Our unfunded status improved for 2016 primarily due to better-than-expected return on plan assets offset by an increase in actuarial losses resulting largely from decreases in discount rate and lump sum rates.
The total recognized in net periodic benefit cost and other comprehensive income (loss) was a net gain of
$7 million, net cost of $21 million, and a net cost of $31 million for the years ended December 31, 2016, 2015 and 2014, respectively. The 2016 change in the amount recognized in other comprehensive income from 2015 is largely due to better-than-expected investment return partially offset with decreases in discount and lump sum rates. The estimated costs to be amortized from AOCI into net periodic benefit cost over the next year for our plans are
Our pension plan assets included 232,113 and 267,113 shares of the company’s common stock at December 31, 2016 and 2015, which had a fair value of $18 million and $16 million at December 31, 2016 and 2015, respectively. The defined benefit pension plan did not purchase any shares of our common stock during 2016 and 2015. During 2016 and 2015, the pension plan sold 35,000 shares and 200,000 shares of the company’s common stock, respectively. The company paid less than $1 million in 2016 and $1 million in 2015 in cash dividends on our common stock to the pension plan.
We contributed $5 million to our qualified plan during the first quarter of 2017 and estimate $12 million of benefit payments from the SERP during 2017. We expect to make the following benefit payments for our qualified plan and SERP, reflecting expected future service:
$7 million in 2016, 2015 and 2014, on premium volume of $44 million, $42 million and $41 million for 2016, 2015 and 2014, respectively.
On a quarterly basis, we review these outstanding matters. Under current accounting guidance, we establish accruals when it is probable that a loss has been incurred and we can reasonably estimate its potential exposure. The company accounts for such probable and estimable losses, if any, through the establishment of legal expense reserves. Based on our quarterly review, we believe that our accruals for probable and estimable losses are reasonable and that the amounts accrued do not have a material effect on our consolidated financial condition or results of operations. However, if any one or more of these matters results in a judgment against us or settlement for an amount that is significantly greater than the amount accrued, the resulting liability could have a material effect
Share-based compensation cost after tax was $15 million, $14 million and $13 million for the years ended
December 31, 2016, 2015 and 2014, respectively. The related income tax benefit recognized was $8 million for the year ended December 31, 2016 and $6 million for both the years ended December 31, 2015 and 2014, respectively. Options exercised during the years ended December 31, 2016, 2015 and 2014, had intrinsic value of $25 million, $15 million and $13 million, respectively. Intrinsic value is the market price less the exercise price. Options vested during the years ended December 31, 2016, 2015 and 2014, had total intrinsic value of $11 million, $7 million and $9 million, respectively.
Weighted-average expected term is based on historical experience of similar awards with consideration for current exercise trends.
Dividend yield is determined by dividing the annualized per share dividend by the stock price on the date of grant.
Cash received from the exercise of options was $21 million, $24 million and $22 million for the years ended December 31, 2016, 2015 and 2014, respectively. We acquired 186,097, 292,414 and 378,276 shares totaling
$13 million, $16 million and $19 million, respectively, from associates in consideration for option exercises during 2016, 2015 and 2014. The weighted-average remaining contractual life for options expected to vest as of December 31, 2016, was 8.44 years.
Under all active shareholder approved plans, a total of 17.3 million shares were authorized to be granted. At December 31, 2016, 13.0 million shares remained available for future issuance under the plans. During 2016, we granted 18,769 shares of common stock to our directors for 2015 board service fees.
three year ratable vesting schedule. Service-based restricted stock units vested during the year had an intrinsic value of $23 million, $26 million and $14 million for the years ended December 31, 2016, 2015 and 2014, respectively.
10 peers in our 2013 peer group. We issued 103,586 shares of performance-based restricted stock units during 2015 at the target-level performance hurdle for the three-year performance period ended December 31, 2014, as we achieved a three-year total shareholder return that exceeded six of 10 peers in our 2012 peer group. Performance-based awards vested during the year had an intrinsic value of $6 million, $6 million and $3 million for the years ended December 31, 2016, 2015 and 2014, respectively.
Correlation coefficients are based upon the stock price data used to calculate the historical volatilities. The correlation coefficients are used to model the way the price of each entity's stock tends to move in relation to each other.
Dividend yield has been modeled assuming dividends are reinvested in the issuing entity on a continuous basis and the holder of the award is not entitled to receive dividends paid during the performance period.
Below is a summary of service-based and performance-based share information, assuming a target payout for performance-based shares, for the year 2016:
We report as Other the noninvestment operations of the parent company and its noninsurer subsidiary, CFC Investment Company and Cincinnati Re, our reinsurance assumed operations.
Income before income taxes for the investments segment is net investment income plus realized investment gains and losses for investments of the entire company, minus investment interest credited to contract holders of the life insurance segment.
Loss before income taxes for the Other category is primarily due to interest expense from debt of the parent company, operating expenses of our headquarters and, beginning in 2015, premiums earned minus loss and loss expenses and underwriting expenses of Cincinnati Re.