Cincinnati Financial Corporation also owns Gilmore Pointe, formerly known as the Fairfield Executive Center, which is located on the northwest corner of our headquarters property. This four-story office building has approximately 124,000 square feet of total space. The property is carried in the financial statements at $7 million as of December 31, 2014, and is classified as land, building and equipment, net, for company use. Unaffiliated tenants occupy 6 percent. This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
We begin with an executive summary of our results of operations, followed by other highlights, an overview of our strategy, an outlook for future performance and details on critical accounting estimates. In several instances, we refer to estimated industry data so that we can provide information on our performance within the context of the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory accounting basis. When we provide our results on a comparable statutory accounting basis, we label it as such; all other company data is presented in accordance with accounting principles generally accepted in the United States of America (GAAP).
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 2014, 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 39 states as discussed in Item 1, Our Business and Our Strategy.
For the period 2013 through 2017, we are targeting an annual value creation ratio averaging 10 percent to 13 percent. We were within that range for 2014, and for the five-year period that ended in 2014. For the period 2009 through 2012, our annual value creation ratio averaged 12.4 percent, within the 12 percent to 15 percent five-year target range established in early 2009, soon after the U.S. credit crisis. For several years following the credit crisis, interest rates generally declined and credit spreads tightened, increasing the contribution of valuation gains from our fixed-maturity securities to the VCR. Those gains contributed between 2 percent and 3 percent annually to VCR during 2010 through 2012. While that contribution is not expected to occur in the
Over the five years ended December 31, 2014, our equity portfolio compound annual total return was 14.1 percent compared with a compound annual total return of 15.4 percent for the Index. By design, our equity portfolio is comprised of larger capitalization, high-quality dividend-growing stocks. Therefore we would generally expect its return to lag during the type of extended, lower-quality rally that has occurred since early 2009. For the year 2014, our annual equity portfolio total return was 12.3 percent, compared with 13.7 percent for the Index.
In addition to the value creation ratio discussion and analysis in the Executive Summary, we further analyze our financial results in the sections below.
The amount of our debt obligations decreased by $54 million in 2014, compared with 2013. Our ratio of debt to total capital (debt plus shareholders’ equity) decreased by 1.5 percentage points in 2014 and remains comfortably within our target range.
Property casualty net written premiums grew 6 percent in 2014 and earned premiums grew 9 percent, largely due to higher pricing and premium growth initiatives. That growth lagged the trend experienced in 2013, largely due to pricing increases that were not as strong in 2014. Trends and related factors are discussed in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results, respectively.
Our property casualty insurance operations generated underwriting profits for each of the three years ending in 2014, following underwriting losses for each of the preceding four years. The $47 million decrease in 2014, compared with 2013, included a $32 million increase in losses from natural catastrophe events and $52 million increase in weather-related losses. The $96 million improvement for 2013, compared with 2012, included a $162 million decrease in losses from natural catastrophe events.
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 2014, 2013 and 2012, 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.
Other factors that could influence our ability to achieve our targets include:
For the year 2015, we believe our value creation ratio could be below our long-term target for several reasons.
The rally in financial markets during recent years had a favorable impact on our value creation ratio, offsetting the unfavorable impact of the sharp decline in financial markets during 2008. Financial markets continued to display volatility during 2014, and some predict more turbulence in 2015 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 during 2015, which could occur as part of typical market volatility patterns, the related book value component of our 2015 value creation ratio could also register a weak or negative result.
A return of soft insurance market pricing could significantly affect growth rates and earned premium levels into 2015 and for some time into the future, depending on insurance market conditions. After several years of market conditions that weakened loss ratios and hampered near-term profitability, conditions affecting property casualty insurance markets have improved since late 2011. In the future, economic factors, including inflation, may increase our claims and settlement expenses related to medical care, litigation and construction.
Our field claims representatives establish case reserves when claims are reported to the company to provide for our unpaid loss and loss expense obligation associated with individual claims. Field claims managers supervise and review all claims with case reserves less than $100,000. Additionally, a headquarters supervisor and regional 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, and that threshold amount was $35,000 for several years prior to 2015. Upper-level headquarters claims managers also review case reserves of $175,000 or more, a threshold amount that was $100,000 for several years prior to 2015.
Our actuarial staff uses diagnostics provided by stochastic reserving software to evaluate the appropriateness of the models and methods listed above. The software’s diagnostics have indicated that the appropriateness of these
The determination of management’s best estimate, like the preparation of the reserve analysis that supports it, involves considerable judgment. Changes in reserving data or the trends and factors that influence reserving data may signal fundamental shifts or may simply reflect single-period anomalies. Even if a change reflects a fundamental shift, the full extent of the change may not become evident until years later. Moreover, since our methods and models do not explicitly relate many of the factors we consider directly to reserve levels, we typically cannot quantify the precise impact of such factors on the adequacy of reserves prospectively or retrospectively.
Consequently, a sensitivity measure that ignores process uncertainty would provide an incomplete picture of the reserve estimate’s sensitivity. Since a reserve estimate’s standard error accounts for both process and parameter uncertainty, it reflects the estimate’s full sensitivity to a range of reasonably likely scenarios.
The table below provides standard errors and reserve ranges by major property casualty lines of business and in total for net loss and loss expense reserves as well as the potential effects on our net income, assuming a 35 percent federal tax rate. Standard errors and reserve ranges for assorted groupings of these lines of business cannot be computed by simply adding the standard errors and reserve ranges of the component lines of business, since such an approach would ignore the effects of product diversification. See Liquidity and Capital Resources, Property Casualty Loss and Loss Expense Obligations and Reserves, Range of Reasonable Reserves, for more details on our total reserve range. While the table reflects our assessment of the most likely range within which each line’s actual unpaid loss and loss expenses may fall, one or more lines’ actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
Our fixed-maturity and equity investment portfolios are our largest assets. The company’s asset impairment committee continually monitors the holdings in these portfolios and all other assets for signs of other-than-temporary or permanent impairment. The committee monitors decreases in the fair value of invested assets; an accumulation of company costs in excess of the amount originally expected to acquire or construct an asset; uncollectability of all receivable assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure
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 fixed-maturity invested asset impairment policy states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed-maturity security; (2) if it is more likely than not we will be required to sell the fixed-maturity security before recovery of its amortized cost basis; or (3) if the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. If we intend to sell or it is more likely than not we will be required to sell, the amortized cost of any such securities is reduced to fair value as the new amortized cost basis, and a realized loss is recorded in the quarter in which it is recognized. When we believe 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 to 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 quarter in which it occurs. 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.
For each of our equity securities in an unrealized loss position at December 31, 2014, 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,
Over 99 percent of the $14.318 billion of securities in our investment portfolio, measured at fair value, are classified as Level 1 or Level 2. Financial assets that fall within Level 1 and Level 2 are priced according to observable data from identical or similar securities that have traded in the marketplace. Also within Level 2 are securities that are valued by outside services or brokers where we have evaluated and verified the pricing methodology and determined that the inputs are observable.
Key assumptions used in developing the 2014 benefit obligation for our qualified plan were a 4.25 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 2015 income before income taxes by $1 million. A 0.5 percentage point decrease in the expected return on plan assets would decrease our 2015 income before income taxes by $1 million.
The fair value of the plan assets exceeded the accumulated benefit obligation by $4 million and $23 million at year-end 2014 and 2013, respectively. The fair value of the plan assets was $31 million less than the projected plan benefit obligation at year-end 2014 and $4 million less at year-end 2013. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. During the first quarter of 2015, we contributed $5 million to our qualified plan.
For life insurance policies, acquisition costs are amortized into income either over the premium-paying period of the policies or the life of the policy, depending on the policy type. These costs are principally agent commissions and underwriting costs related to successful contract acquisition. We analyze our acquisition cost assumptions periodically to reflect actual experience; we evaluate our deferred acquisition cost for recoverability; and we regularly conduct reviews for potential premium deficiencies or loss recognition. Changes in the amounts or timing of estimated future profits could result in adjustments to the accumulated amortization of these costs.
Information about recent accounting pronouncements is provided in Item 8, Note 1 of the Consolidated Financial Statements. We have determined that recent accounting pronouncements have not had, nor are they expected to have, any material impact on our consolidated financial statements.
Investments held by the parent company and the investment portfolios for the insurance subsidiaries are managed and reported as the investments segment, separate from the underwriting businesses. Net investment income and net realized investment gains and losses for our investment portfolios are discussed in the Investments Results.
Earned and net written premiums for our consolidated property casualty operations grew in 2014, reflecting higher pricing and strategic initiatives for targeted growth. A key measure of property casualty profitability is underwriting profit or loss. Our 2014 underwriting profit of $186 million was $47 million less than in 2013. The decrease included a $32 million increase in natural catastrophe losses, mostly from severe weather. It also included a $52 million increase from weather-related losses not identified as part of designated catastrophe events for the property casualty industry, typically referred to as noncatastrophe weather losses. The unfavorable effects of those higher weather-related losses in aggregate during 2014 offset the benefits of higher pricing and our ongoing initiatives to improve pricing precision and loss experience related to claims and loss control practices. Prior accident year loss experience before catastrophes during 2014 was favorable but less so than in 2013. The less favorable experience was primarily due to re-estimates of losses and loss expenses incurred but not reported (IBNR), particularly for our commercial casualty line of business, as discussed in Commercial Lines Insurance Results.
The table below analyzes premium revenue components and trends. Premium trends by segment are further discussed for the respective property casualty segments.
Combined ratio - The 2014 combined ratio rose 1.8 percentage points compared with 2013, as higher weather-related losses largely offset our recent-year initiatives to improve pricing precision and loss experience related to claims and loss control practices. Compared with 2013, the 2014 ratio for natural catastrophe losses rose 0.5 points while the ratio for noncatastrophe weather losses rose 1.0 points. In addition, higher estimates of incurred but not reported (IBNR) losses and loss expenses for our commercial casualty line of business increased our 2014 consolidated property casualty combined ratio by 1.5 points, compared with 2013. We further discuss those ratios and ones related to reserve development in the sections that follow our discussion below in Catastrophe Losses Incurred.
Our statutory combined ratio was 95.1 percent in 2014 compared with 92.7 percent in 2013 and 95.4 percent in 2012. 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 97.2 percent in 2014, 96.4 percent in 2013 and 102.5 percent in 2012. The contribution of catastrophe losses to our statutory combined ratio was 5.1 percentage points in 2014, 4.6 percentage points in 2013 and 10.0 percentage points in 2012, compared with an industry estimate of 4.4, 3.9 and 8.0 percentage points, respectively. Components of the combined ratio are discussed below, followed by additional discussion by segment.
The following table shows catastrophe losses incurred, net of reinsurance, for the past three years, as well as the effect of loss development on prior period catastrophe reserves. We individually list declared catastrophe events for which our incurred losses reached or exceeded $10 million.
Catastrophe loss trends, discussed above, account for much of the movement in current accident year loss and loss expense ratios for years 2012 to 2013, while noncatastrophe weather and higher commercial casualty IBNR, noted above, account for most of the change between 2013 to 2014. Catastrophe losses added 5.7 percentage points in 2014, 5.4 points in 2013 and 11.1 points in 2012 to the respective consolidated property casualty current accident year loss and loss expense ratios in the table above.
Reserve development on prior accident years continued to net to a favorable amount in 2014. We recognized $98 million in favorable development in 2014, less benefit than $147 million in 2013 and $396 million in 2012. Of the $49 million decrease in 2014, compared with 2013, $74 million was attributable to our commercial casualty line of business. Approximately 87 percent of our net favorable reserve development on prior accident years recognized during 2014 occurred in our workers’ compensation and commercial property lines of business. In 2013, our commercial casualty and workers' compensation lines of business were responsible for approximately 57 percent of the favorable reserve development. As discussed in Liquidity and Capital Resources, Property Casualty Loss and Loss Expense Obligations and Reserves, Property Casualty Insurance Development of Estimated Reserves by Accident Year, commercial casualty and workers' compensation are considered long-tail lines with potential for revisions inherent in estimating reserves. Favorable development recognized during 2012 was also primarily from our commercial casualty and workers’ compensation lines of business. Development by line of business is further analyzed in Property Casualty Insurance Development of Estimated Reserves by Accident Year.
3 percent increase in those expenses. During 2014, we continued to carefully manage expenses by keeping growth of other underwriting expenses at a pace slower than premium growth.
Our commercial lines statutory combined ratio was 94.3 percent in 2014 compared with 91.8 percent in 2013 and 92.1 percent in 2012. The estimated commercial lines combined ratios for the industry were 97.7 percent in 2014, 98.3 percent in 2013 and 104.4 percent in 2012. The industry’s ratios exclude its mortgage and financial guaranty lines of business. The contribution of catastrophe losses to our commercial lines statutory combined ratio was 4.3 percentage points in 2014, 3.7 percentage points in 2013 and 8.2 percentage points in 2012, compared with industry estimates of 3.5, 3.5 and 7.4 percentage points, respectively.
For only those commercial lines policies that did expire and were then renewed during 2014, we estimate that the average price increase was in the mid-single-digit range, slightly lower than in 2013, with smaller commercial property policies again experiencing average renewal price percentage increases near the upper end of the high-single-digit range. During 2014, 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 2013.
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 $5 million to the $220 million earned premiums increase in 2014, negative $3 million of the $253 million earned premiums increase in 2013 and $35 million of the $186 million earned premiums increase in 2012. On a net written premium basis, audits contributed $9 million of the $162 million net written premiums increase in 2014, $12 million of the $301 million net written premiums increase in 2013 and $30 million of the $241 million net written premiums increase in 2012.
Other written premiums - primarily premiums ceded to our reinsurers as part of our reinsurance program - in total reduced our 2014 commercial lines net written premiums by $14 million more than in 2013. A decrease in ceded premiums contributed $19 million to net written premium growth for 2014, compared with 2013. Other written premiums also included a less favorable adjustment for 2014, compared with 2013, for estimated direct written premiums of policies in effect but not yet processed. This written premium adjustment had an immaterial effect on earned premiums.
reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 64.1 percent accident year 2013 loss and loss expense ratio reported as of December 31, 2013, developed favorably by 1.2 percentage points to 62.9 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2014. Accident years 2013 and 2012 for the commercial lines insurance segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results, explain much of the movement in current accident year loss and loss expense ratios for accident years 2012 through 2014. Catastrophe losses added 4.8 percentage points in 2014, 4.3 points in 2013 and 8.9 points in 2012 to the respective commercial lines current accident year loss and loss expense ratios in the table above.
The 60.7 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2014 rose 0.9 percentage points compared with the 59.8 percent accident year 2013 ratio measured as of December 31, 2013. Noncatastrophe weather losses, noted above, accounted for much of the increase and helped offset favorable effects from initiatives to improve pricing precision and loss experience related to claims and loss control practices. Large losses, described below, and the corresponding ratios for new losses above $1 million, contributed a 0.3 percentage-point increase to the 2014 ratio.
Commercial lines reserve development on prior accident years of $57 million in 2014 continued to net to a favorable amount, but represented a smaller benefit than the $95 million recognized in 2013. The $38 million decrease in 2014 included $74 million from our commercial casualty line of business. More than 85 percent of our commercial lines reserve net favorable development on prior accident years recognized during 2014 occurred in our workers’ compensation line of business. Favorable development recognized during 2013 and 2012 was mostly from our commercial casualty and workers’ compensation lines of business. Development by line of business and other trends for commercial lines loss and loss expenses and the related ratios are further analyzed in Commercial Lines of Business Analysis and in Liquidity and Capital Resources, Property Casualty Insurance Development of Estimated Reserves by Accident Year.
Commercial lines commission expenses as a percent of earned premiums were slightly lower in 2014, compared with 2013. The ratio increased slightly during 2013, compared with 2012. The 2014 and 2013 ratios for other underwriting expenses each decreased by 0.5 percentage points, as earned premiums grew faster than expenses.
For 2014, commercial casualty, our largest line of business representing over 30 percent of earned premiums for our commercial lines insurance segment, continued to be profitable, based on the total loss and loss expense ratio. Commercial auto, representing approximately 18 percent of earned premiums for our commercial lines insurance segment, was the only commercial line of business with a 2014 total loss and loss expense ratio significantly higher than we desired. As discussed below, we are taking actions to improve commercial auto pricing to benefit future profitability trends.
Commercial casualty has experienced a satisfactory total loss and loss expense ratio for many years. Premium growth continued in 2014, largely due to higher pricing and an increase in premiums from audits that confirmed or adjusted initial premium estimates. Premium growth in 2013 was largely due to the same factors as in 2014, plus help from new business written premiums that increased more than 15 percent.
The total loss and loss expense ratio improved 1.4 percentage points in 2014, compared with 2013, primarily due to more favorable development on prior accident year reserves before catastrophe losses. Higher pricing and profit improvement initiatives described below contributed to the ratio improvement, but were somewhat offset by a 2.9 percentage point increase in the ratio for noncatastrophe weather losses. The total loss and loss expense ratio improved 10.9 percentage points in 2013, compared with 2012, primarily due to lower catastrophe losses.
In addition to ongoing improvements in pricing precision and segmentation, we believe our property loss and loss expense ratio improvement is in part due to increased use of property inspections and similar loss control efforts. More specialization among selected claims associates and increased use of higher minimum loss deductible amounts, including per-building and wind or hail deductibles, also contributed to the improvement of those ratios.
Commercial auto net written premiums and earned premiums rose in 2014 and 2013, largely due to higher pricing in both years. New business written premiums rose nearly 15 percent in 2013, reflecting premium growth initiatives.
The 2014 total loss and loss expense ratio rose 8.2 percentage points in 2014, compared with 2013. That increase was largely due to an increase of 7.0 points in unfavorable development on prior accident year reserves before catastrophe losses, including 4.7 points attributable to case incurred experience on known claims and 2.3 points attributable to IBNR reserves. As part of the U.S. economic recession of a few years ago, slowing business activity influenced our estimates of reserves for ultimate losses and loss expenses during that period. As the economy slowly recovered, we believe we were slow to recognize some of the higher loss cost effects in current accident
year reserve estimates for at least part of that period. As claims that occurred during that period have become more mature, paid and reported loss cost trends resulted in us increasing our reserve estimates for claims that have not yet been settled. The 2013 ratio improved, compared with 2012, primarily due to a lower ratio for current accident year losses and loss expenses. We believe that reflected better pricing precision and other initiatives to improve profitability.
During 2013 and 2014, a multi-department, multi-disciplinary taskforce studied and began implementing initiatives to improve our commercial auto profitability, similar to the approach we used to improve workers’ compensation results. Important initiatives include additional education for underwriting associates and more focus on factors to improve pricing precision. These factors include improving premium rate classification and using other rating variables in risk selection and pricing, plus further automating collection of key rating variables.
The 2014 total loss and loss expense ratio improved compared with 2013, primarily due to more benefit from favorable development on prior accident year reserves. We believe our workers' compensation results continue to reflect ongoing benefits of profit improvement initiatives that began in 2009, including using a predictive modeling tool to improve risk selection and pricing precision, adding staff specializing in workers’ compensation risks and direct reporting of workers’ compensation claims. Direct reporting allows us to quickly obtain detailed information from policyholders to promptly assign the appropriate level of claims handling expertise to each case. Obtaining more information sooner for specific claims allows for medical care appropriate to the nature of each injury, benefiting injured workers, employers and agents while ultimately lowering overall loss costs. In addition, our medical provider bill review process continues to provide significant savings compared with initial charges by providers.
The 2013 total loss and loss expense ratio rose, compared with 2012, reflecting less benefit from favorable development on prior accident year reserves. Reserves were added during 2013 for older, pre-2009 accident years, reflecting paid loss data indicating it is taking longer to pay out older claims. Because some open workers’ compensation claims extend beyond 30 years, a small assumption change for the average life of a claim can add up to a considerable reserve amount recognized in any given period.
Other commercial lines includes policies with various insurance coverages, including various specialty packages designed for certain classes of business. Also included are policies providing management liability or surety coverages, in addition to policies with specific coverages for machinery and equipment. In recent years prior to 2014, we separately reported more detailed results for these various types of policies.
Net written premiums and earned premiums for our other commercial lines decreased in 2014, driven by a decrease in our specialty packages policies. Premiums for specialty packages decreased largely due to the introduction of CinciPak, a newer program designed to replace many of our specialty products. Premiums for CinciPak are included in our commercial casualty or commercial property lines of business.
Net written premiums for the commercial lines industry, excluding its mortgage and financial guaranty lines of business, are projected to increase approximately 3 percent in 2015, with the industry statutory combined ratio estimated at approximately 100 percent. 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 in 2012 and 2013, according to several industry surveys. Average renewal pricing for our commercial lines insurance segment generally followed a similar trend. Opinions continue to vary, according to a variety of reports that focus on the commercial lines market, regarding the sustainability of improved pricing. According to A.M. Best, commercial lines pricing is expected to continue experiencing pressure during 2015. Despite challenging market conditions, 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.
In Item 1, Our Business and Our Strategy, Strategic Initiatives, we discuss the initiatives we are implementing to achieve our corporate performance objectives. We discuss factors influencing future results of our property casualty insurance operations in the Executive Summary.
Premiums - Earned premiums and net written premiums continued to grow in 2014, primarily due to higher renewal written premiums that included price increases. Renewal written premiums rose 8 percent in 2014, following an increase of 11 percent in 2013.
we are addressing in part through gradual geographic expansion. The contribution of catastrophe losses to our personal lines statutory combined ratio was 7.8 percentage points in 2014, 7.7 percentage points in 2013 and 15.9 percentage points in 2012, compared with an industry estimate of 5.5, 4.3 and 7.4 percentage points, respectively.
The 8 percent increase in agency renewal written premiums in 2014 and the 11 percent increase in 2013 largely reflected various rate changes during recent years. Beginning in the fourth quarter of 2014, rate increases for our homeowner line of business averaged approximately 4 percent. That average varied widely by state, according to current rate level indications that help determine appropriate premium rates. The increases followed rate changes over several successive years averaging percentages in a high-single-digit range for states representing the majority of our personal lines business.
In 2014, we implemented rate changes for our personal auto line of business in the majority of the 30 states where we market personal auto policies. The average rate change was an increase near the high end of the low-single-digit range, with some individual policies experiencing lower or higher rate changes based on enhanced pricing precision enabled by predictive models. Rate changes for personal auto implemented in several recent years, beginning in 2010, each represented an annual average rate increase in the low-single-digit range.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the personal lines insurance segment three-year highlights table are for the respective current accident years, with reserve development on prior accident years shown separately. Since approximately two-thirds of our personal lines current accident year incurred losses and loss expenses represent net paid amounts, the remaining one-third represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 70.7 percent accident year 2013 loss and loss
expense ratio reported as of December 31, 2013, developed favorably by 1.6 percentage points to 69.1 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2014. Accident years 2013 and 2012 for the personal lines insurance segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
The 63.4 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2014 rose 1.5 percentage points compared with the 61.9 percent accident year 2013 ratio measured as of December 31, 2013. Noncatastrophe weather losses, noted above, largely accounted for the increase.
Personal lines commission expense as a percent of earned premiums decreased in 2014 compared with both 2013 and 2012. The decrease is primarily due to changes in commission rates for some products in our personal lines insurance segment. Other underwriting expenses as a percent of earned premiums were at similar levels for 2014, 2013 and 2012. During those years, other underwriting expenses increased roughly in proportion to earned premiums.
We prefer to write personal lines coverages within accounts that include both auto and homeowner coverages as well as coverages from the other personal business line. As a result, we believe that the personal lines insurance segment is best measured and evaluated on a segment basis. However, we provide line-of-business data to analyze growth and profitability trends separately for each line.
Net written premiums for personal auto increased in 2014 and 2013, with both years reflecting recent-year rate increases, ongoing high levels of policy retention and a higher level of insured exposures.
We continue efforts to improve pricing precision through predictive analytics, which we believe will help to maintain long-term profitability. Rate increases in recent years, discussed in Personal Lines Insurance Premiums, should help lower loss ratios as the rate increases are earned. That includes the 2014 effects of our fifth round of homeowner rate increases, averaging approximately 10 percent during the first three quarters of 2014, with some individual policy rate increases lower or higher based on each insured exposure’s specific risk characteristics. Homeowner rate changes for the five most recent prior years represented an average annual rate increase in the high-single-digit range. Rate changes effective beginning the last quarter of 2014 averaged approximately 4 percent. Other profit-improvement initiatives, beginning in 2013, include increasing our use of higher loss deductibles and actual cash value claims settlement for insured damage to older roofs and increasing the number of property inspections conducted as homeowner policies renew. Inspections provide more opportunities for underwriting or pricing actions on a case-by-case basis. We also continue our gradual expansion into states less prone to catastrophe losses, which we believe will reduce variability in the long-term future catastrophe loss ratio.
Loss and loss expense ratios in 2014 continued at a profitable level, in part due to lower catastrophe losses, compared with 2012. Reserve development on prior accident years did not benefit these ratios in 2014, following a significant benefit in both 2013 and 2012. Reserve development can fluctuate significantly for this business line because personal umbrella liability coverage is a major component of other personal losses.
Combined ratio - The combined ratio improved 8.4 percentage points in 2014, due to larger amounts of favorable reserve development on prior accident years.
The $17 million increase in 2014 renewal premiums reflected the opportunity to renew many policies for the first time as well as higher renewal pricing. Average renewal pricing increases were in the mid-single-digit range during 2014, down from a high-single-digit range during 2013. December 2014 was the 52nd consecutive month of positive average price changes for this segment of our property casualty business. We measure average changes in excess and surplus lines renewal pricing as the rate of change in renewal premium for the new policy period compared with the premium for the expiring policy period, assuming no change in the level of insured exposures or policy coverage between those periods for respective policies.
Other written premiums are primarily premiums that are ceded to reinsurers and that lower our net written premiums. Ceded premium volume for 2014 increased relative to 2013, reflecting higher written premiums subject to reinsurance.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results, explain some of the movement in current accident year loss and loss expense ratios for accident years 2012 through 2014.
Catastrophe losses added 1.8 percentage points in 2014, following 0.7 percentage points in 2013 and 2.1 percentage points in 2012, to the respective excess and surplus lines current accident year loss and loss expense ratios in the table above.
Excess and surplus lines reserve development on prior accident years continued to net to a favorable amount in 2014 as $29 million was recognized, compared with $13 million in 2013. Nearly two-thirds of the 2014 favorable development was for accident years 2013 and 2012 in aggregate, and related primarily to lower than anticipated loss emergence on known claims.
In 2014, total large losses incurred decreased by $2 million or 50 percent, net of reinsurance, helping to lower the corresponding ratio by 2.1 percentage points, compared with 2013. The ratio for 2013 trended in the opposite direction, as earned premium growth lagged the rate of growth in total large losses. 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.
Excess and surplus lines commission expense as a percent of earned premiums was fairly stable during the three-year period ending in 2014. Other underwriting expenses declined in 2014 and 2013 as a percent of earned premiums, primarily due to earned premiums rising faster than those expenses.
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 and lessors-risk classes for property coverages and also lawyers professional in errors and omissions coverages. The slowly recovering U.S. economy, another major factor in demand for insurance products, is also expected to contribute to premiums during 2015 for the excess and surplus lines industry.
Revenues - Earned premiums rose 5 percent for the year 2014, as shown in the table below. The largest life insurance product line, term life insurance, rose 7 percent. Net in-force policy face amounts rose 5 percent to $50.356 billion at year-end 2014 from $48.063 billion at year-end 2013 and $45.126 billion at year-end 2012.
Profitability - The life insurance segment frequently reports only a small profit or loss because most of its investment income is included in 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 $5 million loss in 2014, following $9 million of profit in 2013 and a $3 million loss in 2012. It has averaged a $1 million profit over the past five years.
Earned premiums rose $9 million in 2014, primarily due to growth in our term life insurance business, as shown in the table below. Growth in 2013 was also primarily due to term life insurance.
Contract holders’ benefits incurred, related to traditional life and interest-sensitive products, accounted for 78.4 percent of 2014 total benefits and expenses compared with 77.3 percent in 2013 and 70.1 percent in 2012. Total contract holders’ benefits increased as life policy reserves and net death claims were higher in 2014 compared with 2013. Net death claims increased over 2013, exceeding our projections while remaining within our range of pricing expectations.
Underwriting expenses incurred, net of deferred acquisition costs, accounted for 21.6 percent of 2014 total benefits and expenses compared with 22.7 percent in 2013 and 29.9 percent in 2012. Expenses in 2014 increased 5 percent, matching the percentage increase in earned premiums. In 2013, expenses decreased, primarily due to the impact of unlocking of actuarial assumptions for our universal life insurance contracts.
We recognize that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life products. On a basis that includes investment income and realized gains or losses from life insurance-related invested assets, the life insurance company reported a net profit of $39 million in 2014, compared with a net profit of $48 million in 2013 and a net profit of $38 million in 2012. The life insurance company portfolio had after-tax net realized investment gains of $3 million in 2014, compared with $4 million each in 2013 and 2012. Realized investment gains and losses are discussed under Investments Results. We exclude most of our life insurance company investment income from investments segment results.
Disruption in the global oil industry and other foreign market upheaval led to a surge in demand for U.S. Treasury securities and a corresponding drop in yield. While decreased investment income is a concern, our focus on mortality products insulates us to some degree from the impact of low interest rates. We expect the life insurance industry will be waiting and watching to see what transpires with interest rates later in 2015 before making any major pricing moves.
Another much-discussed threat to the life insurance industry is changing buyer habits. Life insurance ownership is at historic lows, and we view this as an opportunity. We remain committed to emphasizing life insurance sales through our property casualty distribution. Our agents give us access to middle market customers who are now more likely to need individual life insurance. Also, as predictive modeling begins to enhance and make more efficient the life insurance underwriting process, we are uniquely positioned to benefit due to our existing personal and commercial lines customers.
On the regulatory front, we expect the implementation of principle-based statutory reserves to be a long-term positive development, granting us greater flexibility with capital management. Recent legislative action indicates that we may be able to start using the new rules for new business by January 1, 2017. Term insurance remains our core product and stands to benefit the most under the new reserving rules.
Investment income - Pretax investment income rose 4 percent in 2014, primarily due to higher dividend income. Dividend income reflected rising dividend rates and net purchases of equity securities from available funds. Interest income rose modestly, as net purchases of fixed-maturity securities offset the continuing effects on bond yields of the low interest rate environment. Pretax investment income decreased less than 1 percent in 2013, as lower interest income essentially offset higher dividend 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.
Dividend income rose $16 million or 13 percent in 2014, after rising 6 percent in 2013. Increases in dividend payment rates for most of the holdings in our common stock portfolio during both 2014 and 2013, plus a net increase in funds invested in that portfolio for both years, drove the increases in dividend income. In addition, several of our common stock holdings, in total, issued an additional $5 million in 2012 dividends not typically paid in the fourth quarter, as a result of anticipated dividend tax rate changes effective for 2013.
In 2014, 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 yield data for bonds in our fixed-maturity portfolio by various maturity periods.
The average pretax yield of 3.88 percent for fixed-maturity securities acquired during 2014, shown in the table below, was lower than the 4.76 percent average yield to amortized cost of the fixed-maturity securities portfolio at the end of 2014.
Net realized investment gains and losses totaling $133 million for the year ended December 31, 2014, included:
$18 million in net realized gains from fixed-maturity security sales and calls.
$24 million in OTTI charges to write down six holdings of equity and fixed-maturity securities.
The $83 million net realized investment gains and losses in 2013 were mostly due to $64 million in net realized gains from equity security sales.
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2015, we expect to continue to allocate a portion of cash available for investment to equity securities, taking into consideration corporate liquidity and income requirements, as well as insurance department regulations and rating agency comments. We discuss our portfolio strategies in Item 1, Our Segments, Investments Segment.
At December 31, 2014, the parent company had $1.784 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, 2014, 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.
Cash in excess of operating requirements and shareholder dividends 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. However, we follow a buy-and-hold investment philosophy, seeking to compound cash flows over the long-term. In addition to possible sales of investments, proceeds of call or maturities of fixed-maturity securities also can provide liquidity. During the five-year period beginning in 2015, $4.138 billion, or 43.7 percent, of our fixed-maturity portfolio is scheduled to mature. At year-end 2014, total unrealized gains in the investment portfolio, before deferred income taxes, were $2.719 billion. Liquidity sourced from our investment portfolio is not materially at risk from European-based securities, as our total exposure to such securities at the end of 2014 was $417 million on a fair value basis, or 2.9 percent of our total invested assets. 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, 2014, we had a $225 million line of credit with commercial banks, with $49 million borrowed. That line of credit had a $104 million balance at December 31, 2013. During 2014, we repaid $55 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, 2014, we had in excess of $1.1 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.
The $225 million unsecured revolving line of credit is administered by PNC Bank, N.A., a subsidiary of The PNC Financial Services Group Inc. (NYSE:PNC). The agreement was established in 2012, extended for two years in 2014, and will expire in May 2019. Our subsidiary CFC Investment Company also is a borrower under this line of credit. PNC Bank is the lead participant bookrunner with a $65 million share. Fifth Third Bancorp (Nasdaq:FITB) is
Commissions - We expect commission payments to generally track with written premiums.
Other operating expenses - Many of our operating expenses are not contractual obligations but reflect the ongoing expenses of our business. In addition to contractual obligations for software disclosed above, we anticipate capitalizing approximately $5 million in spending for key technology initiatives in 2015. Capitalized development costs related to key technology initiatives totaled $5 million in 2014 and $4 million in 2013. These activities are conducted at our discretion, and we have no material contractual obligations for activities planned as part of these projects.
At December 31, 2014, we had $591 million in cash and cash equivalents. That strong liquidity and our consistent cash flows give us the flexibility to meet current obligations and commitments while building value by prudently investing where we see potential for both current income and long-term return. They also provide adequate financial cushion when short-term operating results do not meet our objectives.
casualty reinsurance contracts with highly rated reinsurers, as discussed under 2015 Reinsurance 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, 2014.
Our estimate of future gross property casualty loss and loss expense payments of $4.438 billion is lower than loss and loss expense reserves of $4.485 billion reported on our balance sheet at December 31, 2014. The $47 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 increase in total gross reserves was primarily due to a $120 million increase in IBNR reserves, including $77 million for our commercial casualty line of business and $28 million for our workers' compensation line of business. Total gross reserves for our excess and surplus lines insurance segment rose $45 million, reflecting a 28 percent increase in earned premiums.
Additionally, since 2002, we have revised policy terms where permitted by state regulation to limit our exposure to mold claims prospectively and further reduce our exposure to other environmental claims generally. Finally, we have not engaged in any mergers or acquisitions through which such a liability could have been assumed. We
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 2014, 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 2015 Reinsurance Programs, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance unpaid receivables of $282 million at year-end 2014 are an offset to our gross property casualty loss and loss expense obligations. Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claim severity or frequency due to a catastrophic event. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover losses under our reinsurance agreements depends on the financial viability of the reinsurers.
The company established a reasonably likely range for net loss and loss expense reserves of $3.922 billion to $4.296 billion at year-end 2014, with the company carrying net reserves of $4.156 billion. The likely range was $3.727 billion to $4.078 billion at year-end 2013, with the company carrying net reserves of $3.942 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.
The table below shows the development of estimated reserves for loss and loss expenses for the past 10 years.
Section D, cumulative net reserve development, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 2004, had developed favorably by $292 million over 10 years, net of reinsurance, which was reflected in income over the 10 years. The table shows favorable reserve development as a negative number. Favorable reserve development on prior accident years, which represents a negative expense, is favorable to income. The “One year later” line in the table shows the effects on income before income taxes in 2014, 2013 and 2012 of changes in estimates of the reserves for loss and loss expenses for all accident years. The effect was favorable to pretax income for those three years by $98 million, $147 million, and $396 million, respectively.
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 2014 but incurred in 2008 are included in the cumulative deficiency or redundancy amount for 2008 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.
Development of Estimated Reserves for Property and Casualty Loss and Loss Expenses
The following table shows net reserve changes at year-end 2014, 2013 and 2012 by property casualty segment and accident year:
Reserve development on all prior accident years for our commercial casualty line of business netted to an unfavorable $5 million. Favorable reserve development of $51 million for the workers’ compensation line accounted for nearly 90 percent of our commercial lines insurance segment net total in 2014. Our commercial property line of business experienced $34 million of favorable reserve development on prior accident years recorded during 2014, including $13 million for catastrophe losses. Our commercial auto line of business experienced $39 million of unfavorable reserve development on prior accident years recorded during 2014. Drivers of significant reserve development for various lines of business are discussed below.
The modeled losses according to RMS in the table are based on its RiskLink version 13.1 catastrophe model and use a medium-term storm catalog methodology. The medium-term storm catalog theory is a more conservative approach and places a higher weighting on the increased hurricane activity of the past several years, thus producing higher probable maximum loss projections than a longer-term view. The modeled losses according to AIR in the table are based on its AIR Clasic/2 version 15 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.
Primary components of the 2015 property and casualty reinsurance program include:
Property catastrophe treaty - To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, we purchased property catastrophe reinsurance with a limit up to $600 million. Losses from the same occurrence can now be aggregated into one limit over an 120 hour period and applied to the treaty towards recovery. This is an expansion in coverage over the previous treaty’s 96-hour limitation. The treaty contains one reinstatement provision. For the 2015 treaty, ceded premiums are estimated at $42 million, down from $50 million for 2014, reflecting a $25 million increase in our retention per event, lower rates and minor changes in our share of losses described below. We retain the first $100 million of any loss, and a share of losses up to $600 million, as indicated below:
Individual risks with insured values in excess of $50 million, as identified in the policy, are handled through a different reinsurance mechanism. We typically reinsure property coverage for individual risks with insured values between $50 million and $65 million under an automatic facultative agreement. For risks with property values exceeding $65 million, we negotiate the purchase of facultative coverage on an individual certificate basis. For casualty coverage on individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis. For risks with casualty limits that are between $25 million and $27 million, we sometimes forego facultative reinsurance and retain an additional $2 million of loss exposure.
Terrorism coverage at various levels has been secured in most of our reinsurance agreements. The broadest coverage for this peril is found in the property and casualty working treaties, the property per risk treaty and the casualty per occurrence treaty, which provide coverage for commercial and personal risks. Our property catastrophe treaty provides terrorism coverage for personal risks, and coverage for commercial risks with total insured values of $13 million or less. For insured values between $13 million and $50 million, there also may be coverage in the property working treaty.
Property catastrophe treaty - As a subsidiary of Cincinnati Insurance, 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.
The following table shows our five largest life reinsurance receivable amounts by reinsurer at year-end 2014 and 2013. The A.M. Best insurer financial strength ratings as of the end of the two most recent years are also shown for each those reinsurers that are rated by Best.
Delays 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
Inability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased, financial strength of reinsurers and the potential for nonpayment or delay in payment by reinsurers
The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2014, 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, 2014. The assessment led management to conclude that, as of December 31, 2014, 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, 2014.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2014 and 2013 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
The Cincinnati Insurance Company leads our standard market property casualty insurance group that also includes two subsidiaries: The Cincinnati Casualty Company and The Cincinnati Indemnity Company. This group markets a broad range of standard market commercial and personal policies. The group focuses on delivery of quality customer service to our select group of 1,466 independent insurance agencies with 1,884 reporting locations across 39 states. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life and disability income insurance and fixed annuities, and The Cincinnati Specialty Underwriters Insurance Company, which offers excess and surplus lines property casualty insurance products.
The two CFC complementary subsidiaries are CSU Producer Resources Inc., which provides insurance brokerage services to our independent agencies so their clients can access our excess and surplus lines insurance products, and CFC Investment Company (CFC-I), which offers commercial leasing and financing services to our agents, their clients and other customers.
We account for share-based compensation in accordance with Accounting Standards Codification (ASC) 718, Compensation - Stock Compensation. We grant qualified and nonqualified share-based compensation under authorized plans. The stock options vest ratably over three years following the date of grant and are exercisable over 10-year periods. We grant service-based restricted stock units that cliff vest three years after the date of grant. We also grant performance-based restricted stock units that vest if certain market conditions are attained. In 2014, 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.
premiums in 2014 and 2013, respectively. Illinois, Indiana, Pennsylvania, Georgia, Michigan and North Carolina each accounted for between 5 percent and 8 percent of total earned premiums in 2014. Our largest single agency relationship accounted for approximately 0.8 percent of our total property casualty earned premiums in 2014. No aggregate agency relationship locations under a single ownership structure accounted for more than 2.1 percent of our total property casualty earned premiums in 2014. We record revenues for installment charges as Fee revenues in the consolidated statements of income.
Certain property casualty policies are not entered into policy underwriting systems as of the effective date of coverage. An actuarial estimate is made to determine the amount of these unprocessed written premiums. A large majority of the estimate is unearned and has no material impact on earned premiums.
Certain workers’ compensation policies include the possibility of a policyholder earning a return of a portion of its premium in the form of a policyholder dividend. The dividend generally is calculated by determining the profitability of a policy year along with the associated premium. We reserve for all probable future policyholder dividend payments. We record policyholder dividends as other underwriting expenses.
We establish a liability for traditional long-duration contracts as we receive premiums. The amount of this liability is the present value of future expenses and benefits less the present value of future net premiums. Net premium is the portion of gross premium required to provide for all expenses and benefits. We estimate future expenses and benefits and net premium using assumptions for expected expenses, mortality, morbidity, withdrawal rates and investment income. We include a provision for deviation, meaning we allow for some uncertainty in making our assumptions. We establish our assumptions when the contract is issued, and we generally maintain those assumptions for the life of the contract. We use both our own experience and industry experience, adjusted for
We capitalize acquisition costs for 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, 2014, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders’ account value by approximately $47 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.
Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holder, and we do not include them in the consolidated statements of income. Revenues and expenses related to separate accounts consist of contractual fees and mortality, surrender and expense risk charges. Also, each separate account BOLI includes a negotiated capital gain and loss sharing arrangement between the company and the bank. A percentage of each separate account’s realized capital gain and loss representing contract fees and assessments accrues to us and is transferred from the separate account to our general account and is recognized as revenue or expense. We record as revenues separate account investment management fees in Fee revenues of the consolidated statements of income.
We calculate deferred income tax liabilities and assets using tax rates in effect when temporary differences in financial statement income and taxable income are expected to reverse. We recognize deferred income taxes for numerous temporary differences between our taxable income and 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.
Our leasing subsidiary provides auto and equipment direct financing (leases and loans) to commercial and individual clients. We generally transfer ownership of the property to the client as the terms of the leases expire. Our lease contracts contain bargain purchase options. We account for these leases and loans as direct financing-type leases. We capitalize and amortize lease or loan origination costs over the life of the financing, using the effective interest method. These costs may include, but are not limited to finder fees, broker fees, filing fees and the cost of credit reports. We record income in the Other revenues of the consolidated statements of income over the financing term using the effective interest method. Finance receivables are reviewed for impairment on a quarterly basis and considered insignificant to our consolidated financial condition, results of operations and cash flows.
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 is for interim and annual reporting periods beginning after December 15, 2015. 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.
The net unrealized investment gains in our fixed-maturity portfolio are primarily the result of the continued low interest rate environment that has increased the fair value of our fixed-maturity portfolio. The seven largest net unrealized investment gains in our common stock portfolio are from Exxon Mobil Corporation (NYSE:XOM), The Procter & Gamble Company (NYSE:PG), Honeywell International Incorporated (NYSE:HON), BlackRock Inc. (NYSE:BLK), Genuine Parts Company (NYSE:GPC), RPM International (NYSE:RPM) and Johnson and Johnson (NYSE:JNJ), which had a combined net gain position of $619 million. At December 31, 2014, Apple Inc. (Nasdaq:AAPL) was our largest single combined stock holding with a fair value of 3.3 percent of our publicly traded common stock portfolio and 1.1 percent of the total investment portfolio.
Actual maturities may differ from contractual maturities when there is a right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 2014, fixed-maturity investments with amortized cost of $75 million and fair value of $78 million were on deposit with various states in compliance with regulatory requirements. At December 31, 2013, fixed-maturity investments with amortized cost of $80 million and fair value of $84 million were on deposit with various states in compliance with regulatory requirements.
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, 2013, 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:
Quotes from brokers or other external sources that are not considered binding;
The technique used for the Level 2 fixed-maturity securities and taxable fixed maturities in separate accounts is the application of matrix pricing. The inputs used include relevant market information by asset class, trade activity of like securities, yield to maturity and economic events. All of the Level 2 fixed-maturity securities are priced by a nationally recognized pricing vendor.
The quantitative detail of these unobservable inputs is neither provided nor reasonably available to us.
Fair Value Disclosure for Assets and Liabilities Not Carried at Fair Value
Fair value of the note payable was determined based upon the outstanding balance at December 31, 2014 and 2013, because it is short term and tied to a variable interest rate. The note payable was classified as Level 2 as a market does not exist.
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, 2014 and 2013. None of the long-term debt is encumbered by rating triggers.
Recorded outstanding principal and interest for these life policy loans were $31 million and $36 million at December 31, 2014 and 2013, respectively. 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 $863 million and $862 million at December 31, 2014 and 2013, respectively. Recorded reserves for the structured settlements were $182 million and $189 million at December 31, 2014 and 2013, respectively.
During 2013, we experienced $147 million of favorable development on prior accident years including $95 million
development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $70 million for the commercial casualty line, $22 million for the commercial property line, $14 million for the workers' compensation line and $19 million for the homeowner line, due to reduced uncertainty of prior accident year loss and loss adjustment expense for these lines.
The change in amortized shadow deferred policy acquisition costs in 2013 compared with 2014 and 2012 was the result of rising interest rates. No premium deficiencies were recorded in the consolidated statements of income in 2014, 2013 and 2012, as the sum of the anticipated loss and loss adjustment expenses, policyholder dividends and unamortized deferred acquisition expenses did not exceed the related unearned premiums and anticipated investment income.
We have one line of credit in 2014 and 2013 through multiple commercial banks with a borrowing capacity of
$225 million and an additional $50 million accordion feature. Our unsecured revolving credit facility has a term of five years that expires May 13, 2019. We had no compensating balance requirements on short-term debt for either 2014 or 2013. At December 31, 2014, $49 million was drawn on the line of credit. At December 31, 2013,
$104 million was drawn on the line of credit. The interest rate charged on our borrowings on this credit agreement ranged from 1.15 percent to 1.30 percent during 2014 and ranged from 1.30 percent to 1.35 percent during 2013.
Capital lease obligations, excluding an insignificant amount of interest, totaled $36 million and $45 million in 2014 and 2013, respectively. Below are the expected capital lease obligations that we expect to pay over the next six years:
Declared cash dividends per share were $1.76, $1.655 and $1.62 for the years ended December 31, 2014, 2013 and 2012, respectively.
Reinsurance mitigates the risk of highly uncertain exposures and reduces the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions about the appropriate level of risk retention are affected by various factors, including changes in our underwriting practices, capacity to retain risks and reinsurance market conditions.
Primary components of our property and casualty reinsurance program include a property per risk treaty, property excess treaty, casualty per occurrence treaty, casualty excess treaty, property catastrophe treaty and catastrophe bonds.
Our life insurance company purchases reinsurance for protection of a portion of the risk that is written. Primary components of our life reinsurance program include individual mortality coverage, aggregate catastrophe and accidental death coverage in excess of certain deductibles.
As a result of positions either taken in our 2011 through 2013 federal tax returns filed with the IRS or expected to be taken in the 2014 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 2011 through 2014.
$1 million in both 2014 and 2013 and $11 million in 2012.
The current sources of dilution of our common shares are certain equity-based awards as discussed in Note 17, Share-Based Associate Compensation Plans. The above table includes the number of anti-dilutive stock-based awards at year-end 2014, 2013 and 2012. We did not include these stock-based awards in the computation of net income per common share (diluted) because their exercise would have anti-dilutive effects.
$10 million and $9 million during the years 2014, 2013 and 2012, 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 all operating expenses for the 401(k) plan. Participants vest in the company match for the 401(k) plan after three years of eligible service.
The discount rate was increased by 0.95 percentage points for the qualified pension plan and 0.85 percentage points for the SERP due to market interest rate conditions in 2014. 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 2014 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 2014 was 11.7 percent and for 2013 was 24.0 percent. Our compensation increase assumptions in 2014 reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases.
The change in the amount recognized in other comprehensive income is largely due to the decrease in discount rate and corresponding decreases in assumed lump sum rates.
Our pension plan assets included 467,113 shares of the company’s common stock at both December 31, 2014 and 2013, which had a fair value of $24 million at both December 31, 2014 and 2013. The defined benefit pension plan did not purchase any shares of our common stock during 2014 and 2013. No shares of our common stock were sold during 2014. During 2013, the pension plan sold 100,000 shares of the company’s common stock for a realized gain of $5 million. The company paid $1 million in cash dividends on our common stock to the pension plan in both 2014 and 2013.
We contributed $5 million to our qualified plan during the first quarter of 2015 and expect to pay out $3 million of benefit payments from the SERP during 2015. We expect to make the following benefit payments for our qualified plan and SERP, reflecting expected future service:
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 on the company’s consolidated results of operations or cash flows. Based on our most recent review, our estimate for any other matter for which the risk of loss is more than remote is less than $1 million.
Share-based compensation cost after tax was $13 million, $12 million and $11 million for the years ended
December 31, 2014, 2013 and 2012, respectively. The related income tax benefit recognized was $6 million,
$6 million and $5 million for the years ended December 31, 2014, 2013 and 2012, respectively. Options exercised during the years ended December 31, 2014, 2013 and 2012, had intrinsic value of $13 million,
$17 million, and $6 million, respectively. Intrinsic value is the market price less the exercise price. Options vested during the years ended December 31, 2014, 2013 and 2012, had total intrinsic value of $9 million, $15 million and $5 million, respectively.
As of December 31, 2014, we had $21 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.
Cash received from the exercise of options was $22 million, $25 million and $10 million for the years ended December 31, 2014, 2013 and 2012, respectively. We acquired 378,276, 577,745 and 311,524 shares totaling
$19 million, $28 million and $12 million, respectively, from associates in consideration for option exercises during 2014, 2013 and 2012. The weighted-average remaining contractual life for options expected to vest as of December 31, 2014, was 8.4 years.
The weighted-average remaining contractual life for exercisable awards as of December 31, 2014, was 3.4 years. Under all active shareholder approved plans, a total of 17.3 million shares were authorized to be granted. At December 31, 2014, 6.2 million shares remained available for future issuance under the plans. During 2014, we granted 20,760 shares of common stock to our directors for 2013 board service fees.
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 cliff vest three years after the date of grant. Service-based restricted stock units vested during the year had an intrinsic value of $14 million, $15 million and less than $1 million for the years ended December 31, 2014, 2013 and 2012, respectively.
Correlation coefficients are based upon the price data used to calculate the historical volatilities. The correlation coefficients are used to model the way each entity tends to move in relation to each other.
Expected volatility is based on our stock price over a historical period that approximates the remainder of the performance period. We have used the historical volatilities of 2.88 percent for 2014 grants and 2.87 percent for 2013 grants.
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. Dividend yields of 3.74 percent for 2014 grants and 3.63 percent for 2013 grants were used.
This table includes unaudited quarterly financial information for the years ended December 31, 2014 and 2013: