Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building has approximately 1,508,200 total square feet of available space. The property, including land, is carried in our financial statements at $159 million as of December 31, 2010, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (less than 1 percent).
Cincinnati Financial Corporation also owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property. This four-story office building has approximately 124,000 square feet of available space. The property is carried in the financial statements at $5 million as of December 31, 2010, and is classified as an other invested asset. Unaffiliated tenants occupy approximately 5 percent. All unoccupied space is currently available for lease.
Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2010.
We begin with an executive summary of our results of operations and outlook, as well as details on critical accounting policies and estimates. Periodically, we refer to estimated industry data so that we can give information on our performance within the context of the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best, 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 2009 written premium volume for approximately 2,000 U.S. stock and mutual insurer groups. We market our insurance products through a select group of independent insurance agencies in 39 states as discussed in Item 1, Our Business and Our Strategy, Page 3.
To measure our progress, we have defined a measure of value creation that we believe captures the contribution of our insurance operations, the success of our investment strategy and the importance we place on paying cash dividends to shareholders. We refer to this measure as our value creation ratio, or VCR, and it is made up of two primary components: (1) our rate of growth in book value per share plus (2) the ratio of dividends declared per share to beginning book value per share. For the period 2010 through 2014, an annual value creation ratio averaging 12 percent to 15 percent is our primary performance target. Management believes this non-GAAP measure is a useful supplement to GAAP information. With heightened economic and market uncertainty since 2008, we believe the long-term nature of this ratio is an appropriate way to measure our long-term progress in creating shareholder value.
Premium growth - We believe over any five-year period our agency relationships and initiatives can lead to a property casualty written premium growth rate that exceeds the industry average. The compound annual growth rate of our net written premiums was negative 0.7 percent over the five-year period 2006 through 2010, slightly lower than the negative 0.5 percent estimated growth rate for the property casualty insurance industry.
Combined ratio - We believe our underwriting philosophy and initiatives can generate a GAAP combined ratio over any five-year period that is consistently below 100 percent. Our GAAP combined ratio has averaged 98.3 percent over the five-year period 2006 through 2010. Our combined ratio was below 100 percent in 2006 and 2007, but was above 100 percent for 2008 through 2010, when we averaged 102.3 percent, including an average catastrophe loss ratio that was 2.1 percentage points higher than the average for the 10-year period prior to 2008. Performance as measured by the combined ratio is discussed in Consolidated Property Casualty Insurance Results of Operations, Page 49 . Our statutory combined ratio averaged 98.2 percent over the five-year period 2006 through 2010 compared with an estimated 99.5 percent for the property casualty industry.
Over the five years ended December 31, 2010, our compound annual equity portfolio return was a negative 3.0 percent compared with a compound annual total return of 2.3 percent for the Index. Our equity portfolio underperformed the market for the five-year period primarily because of the 2008 decline in the market value of our previously large holdings in the financial services sector. For the year 2010, our compound annual equity portfolio return was 11.0 percent, compared with 15.1 percent for the Index, as the broad market rally did not favor the higher quality, dividend-paying stocks we prefer.
The board of directors is committed to rewarding shareholders directly through cash dividends and through authorizing share repurchases. The board also has periodically declared stock dividends and splits. Through 2010, the company has increased the indicated annual cash dividend rate for 50 consecutive years, a record we believe is matched by only 10 other publicly traded companies. The board regularly evaluates relevant factors in dividend-related decisions, and the increase reflects confidence in our strong capital, liquidity and financial flexibility, as well as progress through our initiatives to improve earnings performance. We discuss our financial position in more detail in Liquidity and Capital Resources, Page 78 .
Improve insurance profitability - Implementation of these initiatives is intended to improve pricing capabilities for our property casualty business, increasing our ability to manage our business while also enhancing our efficiency. Improved pricing capabilities through the use of technology and analytics can lead to better profit margins. Improved planning for growth and profitability plans can enhance our ability to achieve objectives at all levels in the organization. Improved internal processes with additional performance metrics can help us be more efficient and effective. These initiatives also support the ability of the agencies that represent us to grow profitably by allowing them to serve clients faster and to more efficiently manage agency expenses.
Drive premium growth - Implementation of these initiatives is intended to further penetrate each market we serve through our independent agency network. Strategies aimed at specific market opportunities, along with service enhancements, can help our agents grow and increase our share of their business. Diversified growth also may reduce variability of losses from weather-related catastrophes.
We discuss these strategic initiatives, along with related metrics to assess progress, in Item 1, Strategic Initiatives, Page 9 ,
In 2010, our value creation ratio of 11.1 percent was slightly below our target annual average of 12 percent to 15 percent for the period 2010 through 2014. In 2009, the ratio exceeded our target and in 2008, it was below our target, as discussed in the review of our financial highlights below. For the year 2011, we believe our value creation ratio may be below our long-term target for several reasons.
Lingering effects of soft insurance market pricing are expected to affect growth rates and earned premium levels into 2011 and for some time into the future, depending on insurance market conditions. Current conditions continue to weaken loss ratios and hamper near-term profitability. Economic factors, including inflation, may increase our claims and settlement expenses related to medical care, litigation and construction.
The slowly recovering economy is expected to continue to affect policyholders by minimizing growth in value of their business and personal insurable assets. Until the economy significantly strengthens, we may experience only modest premium growth for the property casualty industry or our commercial lines segment, which represented approximately 73 percent of our 2010 property casualty net written premiums. Property casualty written premium growth also may lag as some of our growth initiatives require more time to reach their full contribution.
Our view of the value we can create over the next five years relies on two assumptions about the external environment. First, we anticipate some firming of commercial insurance pricing by the end of 2011. Second, we assume that the economy can continue on a growth track during 2011. If those assumptions prove to be inaccurate, we may not be able to achieve our performance targets even if we accomplish our strategic objectives.
We expect the independent insurance agency system to remain strong and viable, with continued agency consolidation, especially as agency margins come under more pressure due to soft pricing and the difficult economic environment. The soft commercial market that has extended into 2011 creates additional risk for agencies. We expect the soft market to continue for much of 2011, or perhaps longer, particularly in non-catastrophe-event-prone states and lines of business, absent a significant event or events.
We discuss in our Item 1A, Risk Factors, Page 24, many potential risks to our business and our ability to achieve our qualitative and quantitative objectives. These are real risks, but their probability of occurring may not be high. We also believe that our risk management programs generally could mitigate their potential effects, in the event they would occur. We continue to study emerging risks, including climate change risk and its potential financial effects on our results of operation and those we insure. These effects include deterioration in credit quality of our municipal or corporate bond portfolios and increased losses without sufficient corresponding increases in premiums. As with any risk, we seek to identify the extent of the risk exposure and possible actions to mitigate potential negative effects of risk, at an enterprise level.
Invested assets grew significantly during both 2010 and 2009 primarily due to strong performance in the financial markets, reversing the trend of 2008 from lower fair values for portfolio investments, largely due to economic factors. Entering 2011, the portfolio continues to be well-diversified and we believe it is well-positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, Page 19, and results for the segment in Investment Results of Operations, Page 75.
Net income in 2010 was $55 million or 13 percent lower than in 2009, due primarily to the after-tax effects of net realized investment gains that were $114 million lower, partially offset by a $53 million improvement from property casualty underwriting results plus $9 million growth in investment income. Net income increased $3 million in 2009, reflecting the after-tax net effect of three major contributing items: a $132 million increase from net realized investment gains, partially offset by a $48 million decrease from investment income and a $74 million decrease from property casualty underwriting results.
Property casualty written premiums grew 2 percent in 2010, reversing the trend of 3 percent declines in both 2009 and 2008. Earned premiums also reversed the prior year trend, growing slightly in 2010. Trends and related factors discussed in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 54, Page 64 and Page 70, respectively.
Our property casualty insurance operations reported an underwriting loss in each of the last three years, but the amount of loss in 2010 was less than half that of 2009. We measure property casualty underwriting profitability primarily by the combined ratio. Our combined ratio measures the percentage of each earned premium dollar spent on claims plus all expenses related to our property casualty operations. A lower ratio indicates more favorable results and better underlying performance. Our combined ratio was over 100 percent in each of the last three years. Initiatives to improve our combined ratio are discussed in Item 1, Strategic Initiatives, Page 9. In 2010, 2009 and 2008, favorable development on reserves for claims that occurred in prior accident years helped offset other incurred loss and loss expenses. Reserve development is discussed further in Property Casualty Loss and Loss Expense Obligations and Reserves, beginning on Page 82. Losses from weather-related catastrophes are another important item influencing the combined ratio and are discussed along with other factors in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 54, Page 64 and Page 70, respectively.
The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 of the Consolidated Financial Statements, Page 105 In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company’s critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate.
For some lines of business that we write, a considerable and uncertain amount of time can elapse between the occurrence, reporting and payment of insured claims. The amount we will actually have to pay for such claims also can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. Gross loss and loss expense reserves were $4.137 billion at year-end 2010 compared with $4.096 billion at year-end 2009.
For weather events designated as catastrophes, we calculate IBNR reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Once case reserves are established for a weather event we reduce the IBNR reserves. Our claims department management coordinates the assessment of these events and prepares the related IBNR reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the storm, of policyholder exposures within the affected geographic area and of available claims intelligence. Depending on the nature of the event, available claims intelligence could include surveys of field claims associates within the affected geographic area, feedback from a catastrophe claims team sent into the area, as well as data on claims reported as of the financial statement date. We generally use the catastrophe definition provided by Property Claims Service (PCS), a division of Insurance Services Office (ISO). PCS defines a catastrophe as an event that causes countrywide damage of $25 million or more in insured property losses and affects a significant number of policyholders and insureds.
For asbestos and environmental claims, we calculate IBNR reserves by deriving an actuarially based estimate of total unpaid loss and loss expenses. We then reduce the estimate by total case reserves. We discuss the reserve analysis that applies to asbestos and environmental reserves in Asbestos and Environmental Reserves, Page 84.
The table below provides standard errors and reserve ranges by property casualty line of business and in total for 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
The application of our impairment policy resulted in OTTI charges that reduced our income before income taxes by $36 million in 2010, $131 million in 2009 and $510 million in 2008. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, the value is not expected to be recouped within a designated recovery period. OTTI losses represent non-cash charges to income and are reported as realized investment losses.
taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing organization. Managers review quantitative measurements such as a declining trend in fair value, the extent of the fair value decline and the length of time the value of the security has been depressed, as well as qualitative measures such as pending events, credit ratings and issuer liquidity. We are even more proactive when these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and market conditions. We provide information about valuation of our invested assets in Item 8, Note 2 of the Consolidated Financial Statements, Page 111.
When evaluating for OTTI, the committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost. Because of the company's financial strength and other factors discussed below, management may not impair certain securities even when they are trading below book value.
For each of our equity securities in an unrealized loss position at December 31, 2010, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong surplus, liquidity and cash flow, provide us the ability to hold these investments through what we believe to be slightly longer recovery periods occasioned by the recession and historic levels of market volatility. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is impaired.
Securities that have previously been impaired are evaluated based on their adjusted book value and written down further, if deemed appropriate. We provide detailed information about securities trading in a continuous loss position at year-end 2010 in Item 7A, Application of Asset Impairment Policy, Page 96. An other-than-temporary decline in the fair value of a security is recognized in net income as a realized investment loss.
Valuation of financial instruments, primarily securities held in our investment portfolio, is a critical component of our year-end financial statement preparation. Fair Value Measurements and Disclosures, ASC 820-10, defines fair value as the exit price or the amount that would be (1) received to sell an asset or (2) paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. When determining an exit price, we must, whenever possible, rely upon observable market data. Prior to the adoption of ASC 820-10, we considered various factors such as liquidity and volatility but primarily obtained pricing from various external services, including broker quotes.
The fair value measurement and disclosure exit price notion requires our valuation also to consider what a marketplace participant would pay to buy an asset or receive to assume a liability. Therefore, while we can consider pricing data from outside services, we ultimately determine whether the data or inputs used by these outside services are observable or unobservable.
Key assumptions used in developing the 2010 net pension obligation for our qualified plan were a 5.85 percent discount rate and rates of compensation increases ranging from 3.50 percent to 5.50 percent. Key assumptions used in developing the 2010 net pension expense for our qualified plan were a 6.10 percent discount rate, an 8.00 percent expected return on plan assets and rates of compensation increases ranging from 4.00 percent to 6.00 percent. See Note 13, Page 121 for additional information on assumptions.
In 2010, the net pension expense was $12 million. In 2011, we expect the net pension expense to be $13 million.
At year-end 2010, net unamortized realized losses amounted to $2 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded and charged to the general account. Potentially, losses could be material; however, unrealized losses are approximately $7 million before tax in the separate account portfolio, which had a book value of $583 million at year-end 2010.
Information about recent accounting pronouncements is provided in Item 8, Note 1 of the Consolidated Financial Statements, Page 105. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
The calculations of segment data are described in more detail in Item 8, Note 18 of the Consolidated Financial Statements, Page 127. The following sections review results of operations for each of the five segments. Commercial Lines Insurance Results of Operations begins on Page 54, Personal Lines Insurance Results of Operations begins on Page 64, Excess and Surplus Lines Insurance Results of Operations begins on Page 70, Life Insurance Results of Operations begins on Page 73, and Investment Results of Operations begins on Page 75. We begin with an overview of our consolidated property casualty operations.
In addition to the factors discussed in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 54, Page 64 and Page 70, respectively, overall growth and profitability for our consolidated property casualty insurance operations were affected by a number of common factors. Targeted growth, seeking to grow premiums where we believe profit margins are acceptable, has been an area of strategic focus in recent years. Development and use of enhanced technology has also been emphasized, helping us to grow premiums as agencies embrace greater ease of use of our policy administration software. Better technology also can improve efficiency for agencies and associates, helping to lower expenses. Careful expense management, spending more in areas of strategic importance and trimming costs in other areas, kept the 2010 expense ratio flat. Slightly lower losses from weather-related catastrophes and a slowly recovering economy also benefited our operating results. The table below highlights property casualty results of operations, with analysis and discussion in the sections that follow.
Premiums - Higher 2010 renewal and new business written premiums were driven by growth in our personal lines and excess and surplus lines segments. Changes in written and earned premiums over the past three years generally reflected intense price competition partially offset by fairly stable policy retention rates for renewal business and growth in new business. New business written premiums increased in each of the past three years, largely due to the contribution of new agency appointments - in both new and existing states of operation; the contribution of our excess and surplus lines business; and more competitive personal lines pricing that included net rate increases since late 2009. Other written premiums primarily include premiums ceded to our reinsurers as part of our reinsurance program. The table below analyzes premium revenue components and trends. Premium trends by segment are further discussed beginning on Page 12, Page 15 and Page 16, for the respective property casualty segments.
Our statutory combined ratio was 101.8 percent in 2010 compared with 104.4 percent in 2009 and 100.4 percent in 2008. As a comparison, the estimated property casualty industry combined ratio was 103.0 percent in 2010, 101.2 percent in 2009 and 105.1 percent in 2008.
Catastrophe losses contributed 5.1 percentage points to the combined ratio in 2010, down 0.6 points from 2009. Catastrophe losses in 2008 contributed 6.8 percentage points, the highest catastrophe loss ratio for our company since 1991, largely due to Hurricane Ike. Our 10-year historical annual average contribution of catastrophe losses to the combined ratio was 4.4 percentage points as of December 31, 2010. 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.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the three-year highlights table on Page 49 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid losses, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 78.1 percent accident year 2009 loss and loss expense ratio reported as of December 31, 2009, developed favorably by 6.5 percentage points to 71.6 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2010. Accident years 2009 and 2008 have both developed favorably, as indicated by the progression over time for the ratios in the table.
The trend for our current accident year loss and loss expense ratio before catastrophe losses over the past three years reflected normal loss cost inflation as well as softer pricing for much of our property casualty business that began in 2005 and continued through 2010. Refinements made to the allocation of IBNR reserves by accident year, totaling $69 million, contributed 2.3 percentage points to the 2008 ratio.
In 2010, total large losses incurred decreased by $112 million or 16 percent, helping to lower the corresponding ratio by 4.0 percentage points. Large loss trends are further analyzed in the segment discussion below. Our analysis indicated no unexpected concentration of these losses and reserve increases by geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs. Beginning in 2009, we raised the casualty treaty retention to $6 million from $5 million and raised the property treaty retention to $5 million from $4 million.
In 2010, non-commission expenses were up $13 million or 3 percent, primarily due to a first-quarter 2010 provision for matters involving prior years and related to Note 16, Commitments and Contingent Liabilities, Page 125. The increase outpaced earned premiums, which grew less than 1 percent. In 2009, non-commission expenses declined $14 million, primarily due to a change in our pension plan that added 0.5 percentage points to the 2008 non-commission underwriting expense ratio.
The small increase in the 2010 and 2009 ratios for current accident year before catastrophe losses largely reflects loss cost trends that outpaced earned premium trends. The ratio increase for 2009 was less than it would have been if 2008 had not included approximately $49 million, or 2.1 percentage points, from refinements made to the allocation of IBNR reserves by accident year. We discuss factors affecting the combined ratio and reserve development by line of business below.
Our commercial lines statutory combined ratio was 99.6 percent in 2010 compared with 101.8 percent in 2009 and 96.6 percent in 2008. By comparison, the estimated industry commercial lines combined ratio was 108.5 percent in 2010, 103.0 percent in 2009 and 107.4 percent in 2008. Industry commercial lines estimates include mortgage and financial guaranty insurers, which saw a surge in
claims following the historically high level of mortgage defaults in 2008, driving an unusually high industry combined ratio for 2008.
In addition to targeting adequate premium per exposure, we also pursue non-pricing means of enhancing longer-term profitability. Non-pricing means have included deliberate reviews to assess each risk, determine limits of insurance and establish appropriate terms and conditions. We continue to adhere to our underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions, leveraging the local presence of our field staff. Our field marketing representatives continue to underwrite new business and meet with local agencies to reaffirm agreements regarding the extent of frontline renewal underwriting that agents will perform. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. To assist underwriters, field claims representatives prepare full reports on their first-hand observations of risk quality.
In recent years, both renewal and new business premium volume reflected the effects of the economic slowdown in many regions, as exposures declined and policyholders became increasingly focused on reducing insurance costs and other expenses. Insured exposures for overall commercial lines were estimated to be down somewhat for the year 2010, but appeared to be flattening by the end of the year. For commercial accounts, we usually calculate general liability premiums based on sales or payroll volume, while we calculate workers’ compensation premiums based on payroll volume. A change in sales or payroll volume generally indicates a change in demand for a business’s goods or services, as well as a change in its exposure to risk. Policyholders who experience sales or payroll volume changes due to economic factors may also have other exposures requiring insurance, such as commercial auto or commercial property, in addition to general liability and workers’ compensation. Premium levels for these other types of coverages generally are not linked directly to sales or payroll volumes.
The 2 percent decline in 2010 agency renewal written premiums largely reflects pricing and exposure declines, while policy retention rates remained fairly stable. Our headquarters underwriters talk regularly with agents about renewal business. Our field teams are available to assist headquarters underwriters by conducting inspections and holding renewal review meetings with agency staff. These activities can help verify that a commercial account retains the characteristics that caused us to write the business initially. We measure average changes in commercial 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. For policies renewed during both 2010 and 2009, the typical pricing decline on average was in the low-single-digit range. For larger accounts, we typically experienced more significant premium declines and for smaller accounts we sometimes saw little if any premium change at renewal. The 2009 average represented an improvement from the mid-single-digit range average pricing decline experienced in 2008.
In addition to pricing pressures, premiums resulting from audits that confirmed or adjusted premiums based on initial estimates of policyholder sales and payrolls affected premium trends in recent years. Written premiums from audits decreased $29 million and $5 million, respectively, for the years 2010 and 2009,
The table below summarizes the Texas and Colorado agents’ contribution to our commercial lines new business and net written premiums. Net written premiums are earned over the term covered by insurance policies and are an important leading indicator of earned premium revenue trends.
In both 2010 and 2009, other written premiums had less of a downward effect on commercial lines net written premiums compared with the prior year. Written premiums ceded to reinsurers were approximately the same for both years. Both 2010 and 2009 had a more favorable adjustment, compared with the prior year, for estimated premiums of policies in effect but not yet processed. The adjustment for estimated premiums had an immaterial effect on earned premiums.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 49, explain some of the movement in accident year loss and loss expense ratios among years 2008 through 2010. Catastrophe losses added 4.7 percentage points for 2010, 3.0 points for 2009 and 4.6 points for 2008 to the respective commercial lines accident year loss and loss expense ratios in the table above.
Commercial lines reserve development on prior accident years continued to net to a favorable amount in 2010, as $269 million was recognized, similar to $273 million in 2008. During 2009, the $147 million of net favorable development recognized was lower, due primarily to unfavorable development of workers’ compensation reserves totaling $48 million, including strengthening of reserves by $49 million in first half of the year, as discussed in Commercial Lines Insurance Results of Operations, Commercial Lines of Business Analysis, Page 58.
Commercial lines commission expenses as a percent of earned premium declined during 2010, primarily due to lower agency contingent commissions. Non-commission underwriting expenses rose 2 percent in 2010 but were lower than the 2008 level. The 2010 ratio rose primarily due to lower earned premiums.
Commercial property is our second largest line of business. Net written premiums for 2010 were up, largely due to an $8 million or 14 percent increase in new business written premiums.
The 2010 calendar year total loss and loss expense ratio was higher than the very profitable level of 2009, primarily due to higher catastrophe losses and large losses for fires and non-catastrophe weather.
The decline in commercial auto premiums over the three-year period reflected the downward pressure exerted by the market on the pricing of commercial accounts. Commercial auto is one of the business lines that we renew and price annually, so market trends may be reflected for this line of business sooner than for other lines. Commercial auto also experiences pricing pressure because it often represents the largest portion of insurance costs for many commercial policyholder accounts.
Since we pay a lower commission rate on workers’ compensation business, this line has a higher calendar year loss and loss expense breakeven point than our other commercial business lines. Nonetheless, the ratio was at an unprofitable level in each of the last three years, and management continues to work to improve financial performance for this line. During 2009, we began using a predictive modeling tool to improve risk selection and pricing adequacy. Predictive modeling increases pricing adequacy and precision so that our agents can better compete for the most desirable workers’ compensation business. We also added to our staff of loss control field representatives, premium audit field representatives and field claims representatives specializing in workers’ compensation risks. In early 2010, we implemented direct reporting of workers’ compensation claims, allowing us to quickly obtain detailed information 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.
The 2010 accident year loss and loss expense ratio of 106.5 percent was down slightly from accident year 2009 of 108.8 percent estimated as of December 31, 2009. We believe the improvement is due to initiatives begun early in 2010 as mentioned above. Reserve development is further discussed in Commercial Lines Insurance Segment Reserves, beginning on Page 85.
Marketing primarily to nonprofit organizations, which accounted for approximately 72 percent of the policies and 40 percent of the premium volume for director and officer liability new business written in 2010.
Closely monitoring our for-profit policyholders - At year-end 2010, our in-force director and officer liability policies provided coverage to 13 non-financial publicly traded companies, including two Fortune 1000 companies. We also provided this coverage to approximately 500 banks, savings and loans and other financial institutions. The majority of these financial institution policyholders are smaller community banks, and we believe they have no unusual exposure to credit-market concerns, including subprime mortgages. Based on new policy data or information from the most recent policy renewal, only 15 of our bank and savings and loan policyholders have assets greater than $2 billion; only 23 have assets from $1 billion to $2 billion; and 54 have assets from $500 million to $1 billion.
The calendar year total loss and loss expense ratio improved during 2010 due to lower losses for accident year 2010 that were partially offset by unfavorable development on prior accident year reserves.
The 2010 accident year loss and loss expense ratio improved compared with accident year 2009 due in part to a lower level of large losses. Both the calendar year and current accident year loss and loss expense ratios for 2009 were relatively high, primarily due to director and officer large losses from claims related to prior lending practices at financial institutions. To address the potential risk inherent in the financial institutions book of our surety and executive risk business line moving forward, we continue to work with our agents to limit the number of new director and officer policies for financial institutions, in addition to using credit rating and other metrics to carefully re-underwrite in-force policies when they are considered for renewal.
Machinery and equipment premiums continued to rise over the three year period, reflecting our superior service, including experienced specialist who support agencies in writing this line of business. The calendar year and accident year loss and loss expense ratios were low for 2010 and 2009, although they can fluctuate substantially due to the relatively small size of this business line.
Industrywide commercial lines written premiums are projected to increase less than 1 percent in 2011 with the industry statutory combined ratio estimated at approximately 110 percent. As discussed in Item 1, Commercial Lines Property Casualty Insurance Segment, Page 12, over the past several years, renewal and new business pricing has come under steadily increasing pressure, reinforcing the need for more pricing analytics and careful risk selection. While competition remains intense, pricing changes seem to be leveling off. Despite challenging market conditions, we believe we can manage our business and execute strategic initiatives to offset market pressures to some extent and still profitably grow our commercial lines segment.
Our personal lines policy retention and new business levels have remained at higher levels following introduction in recent years of a limited program of policy credits for personal auto and homeowner pricing in most of the states in which we operate. The program provided credits for eligible new and renewal policyholders identified as above-average quality risks. Additional pricing and credit changes were implemented in early 2009, further improving pricing for the best accounts, which should help us retain and attract more of our agents’ preferred business.
Personal lines commission expense as a percent of earned premium increased slightly in 2010 and 2009, primarily due to higher agency contingent commissions.
The calendar year total loss and loss expense ratio rose slightly over the three-year period. In recent years, we have seen generally higher costs for liability claims, including severe injuries, and we have sought rate increases for liability coverages that partially offset price decreases for physical damage coverages. Pricing precision is being improved through use of the recently deployed predictive modeling tool. In addition to using the tool as part of rate changes implemented in the fourth quarter of 2010, we expect another round of rate changes, representing another net increase in rates on average, effective late 2011.
The current accident year loss and loss expense ratio before catastrophe losses remained high in 2010, in part due to the same non-catastrophe weather related losses and other large losses that affected the calendar year result.
Other personal premiums increased in 2010 and 2009, generally tracking with the growth in our personal auto and homeowner lines before the effects of reinsurance. Most of our other personal coverages are endorsed to homeowner or auto policies.
A.M. Best projects industrywide personal lines written premiums may rise approximately 3 percent in 2011, with an industry statutory combined ratio estimated at 98.5 percent. With our improvement in new business levels and our strong policy retention rate, along with rate increases effected in late 2010, we expect our growth rate to be higher than the industry projection for 2011. In Item 1, Strategic Initiatives, Page 9, we discuss the initiatives we are implementing to address the unsatisfactory performance of our personal lines segment, in particular the homeowner line of business. We also describe steps to enhance our response to the changing marketplace. Our personal lines pricing and loss activity are at levels that could put achievement of our corporate financial objectives at risk if those trends continue. We discuss our overall outlook for our property casualty insurance operations in the Executive Summary, Page 36.
Combined ratio - The combined ratio improved in 2010, primarily due to lower underwriting expenses. The total loss and loss expense ratio increased primarily due to higher large losses, claims exceeding $250,000 of insured loss, that outpaced growth in earned premiums.
Competition for new business increased during 2010 as we observed more instances of business being written by standard market commercial lines insurers seeking additional growth opportunities. In many cases we saw policy terms and conditions being offered that were less restrictive than those we observed in the past for similar risks, without a corresponding premium for the broadened insurance coverage. As a result, we declined to write many of those new business and some renewal business opportunities, leading to a significantly slower rate of new business growth for 2010 at 9 percent compared with 129 percent in 2009.
Our first excess and surplus lines policies were written in 2008 and reserves for estimated unpaid losses and loss expenses were $5 million as of December 31, 2008, for losses that occurred in 2008. As of December 31, 2010, an estimated $2 million remained unpaid for those same loss events that occurred in 2008. Due to the limited history of settled claims for our excess and surplus lines business it is difficult to draw meaningful inferences about claim settlement patterns or trends in loss and loss expense experience based on data in the table above.
Excess and surplus lines reserve development on prior accident years netted to a favorable amount in 2010, $1 million, resulting in a loss and loss expenses ratio effect similar to 2009. Development trends are further analyzed in Excess and Surplus Lines Insurance Segment Reserves, Page 89.
Excess and surplus lines commission expense at 16.5 percent of earned premiums for 2010 is expected to remain near that level in the future.
Non-commission underwriting expenses declined in 2010 primarily due to the reduction of various start-up costs during 2008 and 2009 as our excess and surplus lines began operations in 2008. The primary category of expense reduction was development costs for our rating and policy administration system.
Separate account investment management fee income contributed $1 million to total revenue in 2010, compared with less than $1 million contribution in 2009 and $2 million in 2008. These fees increased primarily because of the net realized capital gain and loss sharing agreement between the separate account and the general account.
Over the past several years, we have worked to maintain a portfolio of simple, yet competitive products, primarily under the LifeHorizons banner. Our product development efforts emphasize death benefit protection and guarantees. Distribution expansion within our property casualty insurance agencies remains a high priority. In the past several years, we have added life field marketing representatives for the western, southeastern and northeastern states. Our 31 life field marketing representatives work in partnership with our 117 property casualty field marketing representatives. Approximately 69 percent of our term and other life insurance product premiums were generated through our property casualty insurance agency relationships.
Although we exclude most of our life insurance company investment income from investment segment results, we recognize that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life products. On a basis that includes investment income and realized gains or losses from life insurance-related invested assets, the life insurance company reported a net profit of $39 million in 2010, compared with a net profit of $22 million in 2009 and a net loss of $19 million in 2008. The life insurance company portfolio had after-tax net realized investment gains of $2 million in 2010, compared with after-tax net realized investment losses of $13 million in 2009, which included $15 million in OTTI charges. Net realized investment losses were $58 million in 2008, including $66 million in OTTI charges. Realized investment gains and losses are discussed under Investment Results of Operations, Page 75.
Our property casualty agencies remain the main distribution system for our life insurance segment, and we continue to emphasize securing an increasing share of the life insurance premium produced by these agencies. While other life insurers continue to expand nontraditional distribution channels such as direct sales, we intend to market through agencies affiliated with our property casualty insurance operations or independent life-only agencies. In 2010, our property casualty agencies produced 69 percent and our life-only agencies 31 percent of our life insurance premium. Term insurance continues to fit well with the sales goals of both our property casualty and life-only agencies and remains our largest product line. We continue to emphasize the cross-serving opportunities of our worksite products for our property casualty agencies’ commercial accounts, and in 2010 we introduced a new worksite term product with a return of premium feature. Also in 2010, we introduced a second-to-die universal life product. We believe this product helps satisfy an important need that is heightened by an aging boomer population and a fluctuating federal estate tax situation.
Realized investment gains and losses - We reported realized investment gains in all three years, largely due to investment sales that were discretionary in timing and amount. Those sales were somewhat offset by OTTI charges. The $510 million impairment for the write-down of 126 securities in 2008 largely offset gains from investment sales.
As appropriate, we buy, hold or sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. Pretax realized investment gains in the past three years largely were due to the sale of equity holdings.
Net realized investment gains and losses totaling $185 million for the year ended December 31, 2010, reflected:
$36 million in OTTI charges to write down holdings of equities and fixed maturities.
OTTI charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 19, are summarized below:
The decrease in OTTI charges for both 2010 and 2009 was largely due to the improvement in values as asset markets rebounded. The higher level of OTTI charges in 2008 was largely due to write-downs of holdings of
bonds and common and preferred stocks of financial services issuers, reflecting our historical weighting in this sector and the decline in overall stock market values during 2008.
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2011, 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, Investments Segment, Page 19.
We believe that a weak or prolonged recovery from current economic conditions could heighten the risk of renewed pressure on securities markets, which could lead to additional OTTI charges. Our asset impairment committee continues to monitor the investment portfolio. The current asset impairment policy is described in Critical Accounting Estimates, Asset Impairment, Page 44.
Revenues in 2010 for our Other businesses nearly equaled 2009. Other includes non-investment operations of the parent company and its subsidiary, CFC Investment Company, and former subsidiary CinFin Capital Management Company. Losses before income taxes for Other were largely driven by interest expense from debt of the parent company.
We had $124 million of income tax expense in 2010 compared with $150 million in 2009 and $111 million in 2008. The effective tax rate for 2010 was 24.8 percent compared with 25.7 percent in 2009 and 20.7 percent in 2008.
Our insurance subsidiary’s primary means of meeting liquidity requirements are collection of premiums, investment income, and sale proceeds from investments held at the subsidiary level. Property casualty insurance premiums generally are received before losses are paid under the policies purchased with those premiums. Our insurance subsidiary’s expenditures are property casualty loss and loss expenses, commissions, salaries and other ongoing operating expenses. Over the past three years, cash receipts from property casualty along with investment income, have been more than sufficient to pay claims and operating expenses. Excess cash flow was 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. We discuss the factors that affected insurance operations in Commercial Lines and Personal Lines Insurance Results of Operations, Page 54 and Page 64.
This table shows a summary of operating cash flow for property casualty insurance (direct method):
At December 31, 2010, we had two lines of credit with commercial banks amounting to $225 million, with $49 million borrowed. There was no change in the amount of the $49 million short-term debt during 2010 or 2009. Access to these lines of credit requires compliance with various covenants, including maintaining a minimum consolidated net worth and not exceeding a 20 percent debt-to-capital ratio. As of December 31, 2010, we were well within compliance with all of the covenants under the credit agreements and believe we will remain in compliance.
The second line of credit is an unsecured $150 million revolving line of credit administered by The Huntington National Bank. It was established in 2007 and will mature in 2012. CFC Investment Company also is a borrower under this line of credit. At year-end 2010, there was $49 million outstanding on this line of credit. The Huntington National Bank, a subsidiary of Huntington Bancshares Inc. (NASDAQ:HBAN), is the lead participant with a $75 million share. U.S. Bancorp (NYSE:USB), Bank of America Corporation (NYSE:BAC) and Northern Trust Corporation (NASDAQ:NTRS) also participate, each providing $25 million of capacity.
This line of credit includes a swing line sub-facility for same-day borrowing in the amount of $35 million. The credit agreement provides alternative interest charges based on the type of borrowing and our debt rating. The interest rate charged for an advancement is adjusted LIBOR plus the applicable margin. Based on our debt ratings at year-end 2010, interest for Eurodollar rate advances is adjusted LIBOR plus 33 basis points, and for floating rate advances is adjusted LIBOR. Utilization and commitment fees based on Cincinnati Financial Corporation’s year-end 2010 debt rating are 5 basis points and 8 basis points, respectively.
Capital resources represent our overall financial strength to support writing and growing our insurance businesses. At December 31, 2010, we had total shareholders’ equity of $5.032 billion, an increase of $272 million, or 6 percent, from the prior year. Our total debt was $839 million, unchanged from a year ago. We seek to maintain a solid financial position and provide capital flexibility by keeping our ratio of debt to total capital moderate. We target a ratio below 20 percent. At year-end 2010, the ratio was 14.3 percent compared with 15.0 percent at year-end 2009. The decrease in the debt-to-total-capital ratio was due entirely to the increase in shareholders’ equity at year-end 2010.
Common stock repurchase - Generally, our board believes that share repurchases can help fulfill our commitment to enhancing shareholder value. Consequently, the board has authorized the repurchase of outstanding shares, giving management discretion to purchase shares at reasonable prices in light of circumstances at the time of purchase, pursuant to U.S. Securities and Exchange Commission (SEC) regulations.
Our two most significant contractual obligations are discussed in conjunction with related insurance reserves in Gross Property Casualty Loss and Loss Expense Payments and Gross Life Insurance Policyholder Obligations beginning on Pages 82 and 89, respectively. Other future contractual obligations include:
Computer hardware and software - We expect to spend $45 million over the next three years for current material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discuss below the non-contractual expenses we anticipate for computer hardware and software in 2011.
As of December 31, 2010, we believe our most significant other commitments are:
A long-term perspective governs our liquidity and capital resources decisions, with the goal of benefiting our policyholders, agents, shareholders and associates over time. While our insurance results for 2010 and 2009 did not meet our combined ratio objective of being consistently below 100 percent, our improved capital position since year-end 2008 provided adequate cushion. We have taken the necessary steps to protect our capital and are confident in our strategies to return our insurance operations to growth and profitability.
Our consistent cash flows and prudent cash balances continue to create strong liquidity. As of December 31, 2010, we had $385 million in cash and cash equivalents. That strong liquidity and our consistent cash flows gives 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.
Further, parent company liquidity could be constrained by State of Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay. During 2011, total dividends that our insurance subsidiary can pay to our parent company without regulatory approval are approximately $378 million.
Our estimates of gross property casualty loss and loss expense payments do not include reinsurance receivables or ceded losses. As discussed in 2011 Reinsurance Programs, Page 90, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance unpaid receivables of $326 million at year-end 2010 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.
adequate in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 82.
The company established a reasonably likely range for net loss and loss expense reserves of $3.571 billion to $3.952 billion at year-end 2010, with the company carrying net reserves of $3.811 billion. The likely range was $3.459 billion to $3.774 billion at year-end 2009, with the company carrying net reserves of $3.661 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. We provide a reconciliation of the property casualty reserves with the loss and loss expense reserve as shown on the balance sheet in Item 8, Note 5 of the Consolidated Financial Statements, Page 117.
Management’s best estimate of total loss and loss expense reserves as of year-end 2010 was consistent with the corresponding actuarial best estimate. Management’s best estimate of total loss and loss expense reserves as of year-end 2009 also was consistent with the corresponding actuarial best estimate.
We reconcile the beginning and ending balances of our reserves for loss and loss expenses at December 31, 2010, 2009 and 2008, in Item 8, Note 5 of the Consolidated Financial Statements, Page 117. The reconciliation of our year-end 2009 reserve balance to net incurred losses one year later recognizes approximately $304 million of favorable reserve development.
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, 2000, had developed favorably by $148 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 2010, 2009 and 2008 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 $304 million, $188 million, and $323 million, respectively. Our annual review has led us to add to income in each of the past 22 years due to favorable development of reserves on prior accident years.
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 2010 but incurred in 2004 are included in the cumulative deficiency or redundancy amount for 2004 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.
1990s, commercial lines grew as a percentage of our overall business and our exposure to asbestos and environmental claims grew accordingly. Over that period, we endorsed to or included in most policies an asbestos and environmental exclusion.
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 continue to monitor our claims for evidence of material exposure to other mass tort classes such as silicosis, but we have found no such credible evidence to date.
Moderation in commercial casualty trend selections - We saw moderating loss cost trends continue in several commercial casualty coverages, most notably for umbrella coverage. A number of factors seem to have played a role, including a slow economic recovery, favorable court decisions, policy form restrictions, and claims department initiatives. Accordingly, it is not entirely clear whether these moderating loss cost trends will persist, and our actuaries have responded cautiously to these changes, electing to recognize improvements in trends used for estimating reserves in a progressive, incremental fashion.
An examination of factors contributing to the remaining $9 million of commercial lines favorable reserve development, not accounted for by the commercial casualty, commercial auto and workers’ compensation lines, did not turn up any abnormal or unexpected variations. As noted in Critical Accounting Estimates, Key Assumptions - Loss Reserving, Page 43, our models predict that actual loss and loss expense emergence will differ from projections, and we do not attempt to monitor or identify such normal variations.
Favorable development for personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. Several factors discussed in Commercial Lines Insurance Segment Reserves, Page 85, that contributed to commercial lines segment reserve development in 2010 also contributed to personal lines favorable reserve development, most notably the factors related to umbrella coverage in the other personal line of business.
These estimated cash outflows are undiscounted with respect to interest. As a result, the sum of the cash outflows for all years of $3.848 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy reserves and separate accounts for future policy benefits and claims of $2.692 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $3 million of separate accounts liabilities.
A single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event could present us with a liquidity risk. In an effort to control such losses, we avoid marketing property casualty insurance in specific geographic areas and monitor our exposure in certain coastal regions. An example of this would be our recent depopulation of homeowner policies in the southeastern coastal region. This area was identified as a major contributor to our catastrophe probable maximum loss estimates and has subsequently been greatly reduced. We also continually review aggregate exposures to huge disasters and purchase reinsurance protection to cover these exposures. We use the Risk Management Solutions (RMS) and Applied Insurance Research (AIR) models to evaluate exposures to a once-in-a-100 year and a once-in-a-250 year event to help determine appropriate reinsurance coverage programs. In conjunction with these activities, we also continue to evaluate information provided by our reinsurance broker. These various sources explore and analyze credible scientific evidence, including the impact of global climate change, which may affect our exposure under insurance policies.
To help determine appropriate reinsurance coverage for hurricane, earthquake, and tornado/hail exposures, we use the RMS and AIR models to estimate the probable maximum loss from a single event occurring in a one-year period. The models are proprietary in nature, and the vendors that provide them periodically update the models, sometimes resulting in significant changes to their estimate of probable maximum loss. As of the end of 2010, both models indicated a hurricane event represents our largest amount of exposure to losses. The table below summarizes estimated probabilities and the corresponding probable maximum loss from a single event occurring in a one-year period for that exposure, and indicates the effect of such losses on consolidated shareholders’ equity as of December 31, 2010. Net losses are net of reinsurance and income taxes. The modeled losses according to RMS in the table are based on their RiskLink version 10.0 catastrophe model and utilize a near-term storm catalog methodology. The near-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 their AIR Clasic/2 version 12 catastrophe model and utilize a long-term methodology. The AIR storm catalog includes decades of documented weather events used in simulations for probably maximum loss projections.
Property per risk treaty - The primary purpose of the property treaty is to provide capacity up to $25 million, adequate for the majority of the risks we write. It also includes protection for extra-contractual liability coverage losses. We retain the first $6 million of each loss. Losses between $6 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $32 million for 2011, compared with $36 million in 2010 and $35 million in 2009. The lower ceded premium for 2011 compared with 2010 is largely due to raising our loss retention of each loss from $5 million to $6 million.
premium is estimated at $37 million in 2011, similar to the $37 million paid in 2010 and $38 million in 2009.
Casualty excess treaties - We purchase a casualty reinsurance treaty that provides an additional $25 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $50 million of protection for workers’ compensation, extra-contractual liability coverage and clash coverage losses, which would apply when a single occurrence involves multiple policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated at approximately $2 million in 2011, similar to the premium we paid in 2010 and 2009.
We purchase a second casualty excess treaty, which provides an additional $20 million in casualty loss coverage. This treaty also provides catastrophic coverage for workers’ compensation and extra-contractual liability coverage losses. The ceded premium is estimated at approximately $1 million for 2011, similar to the premium we paid in 2010 and 2009.
Property catastrophe treaty - To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, we purchase property catastrophe reinsurance with a limit up to $500 million. For the 2011 treaty, ceded premiums are estimated at $49 million, similar to the $49 million in 2010 and $50 million in 2009. We retain the first $45 million of any loss and varying shares of losses up to $500 million:
Property per risk treaty - The property treaty provides limits up to $5 million, which is adequate capacity for the risk profile we insure. It also includes protection for extra-contractual liability coverage losses. The Cincinnati Specialty Underwriters Insurance Company retains the first $1 million of any policy loss. Losses between $1 million and $5 million are reinsured at 100 percent by The Cincinnati Insurance Company.
For property risks with limits exceeding $5 million or casualty risks with limits exceeding $6 million, underwriters place facultative reinsurance coverage on an individual certificate basis.
Cincinnati Life, our life insurance subsidiary, purchases reinsurance under separate treaties with many of the same reinsurers that write the property casualty working treaties. In 2005, we modified our reinsurance protection for our term life insurance business due to changes in the marketplace that affected the cost and availability of reinsurance for term life insurance. We are retaining no more than a $500,000 exposure, ceding the balance using excess over retention mortality coverage, and retaining the policy reserve. Retaining the policy reserve has no direct impact on GAAP results. However, because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of our capital. We also have catastrophe reinsurance coverage on our life insurance operations that reimburses us for covered net losses in excess of $9 million. Our recovery is capped at $75 million for losses involving our associates. For term life insurance business written prior to 2005, we retain 10 percent to 25 percent of each term policy, not to exceed $500,000, ceding the balance of mortality risk and policy reserve.
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2010, in accordance with accounting principles generally accepted in the United States of America (GAAP).
The company’s independent registered public accounting firm has issued an audit report on our internal control over financial reporting as of December 31, 2010. This report appears on Page 100.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Cincinnati Financial Corporation operates through our insurance group and two complementary subsidiary companies.
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 business, homeowner and auto policies. The group provides quality customer service to our select group of 1,245 independent insurance agencies with 1,544 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 annuities, and The Cincinnati Specialty Underwriters Insurance Company, which began offering excess and surplus lines property and casualty insurance products in 2008.
In the fourth quarter of 2010, we changed our presentation of other income in our consolidated statements of income. We have allocated the portion that primarily represents premium installment fees into a separate single caption, “Fee revenues.” Also, the remaining amount from the historic single caption, “Other income,” is presented as “Other revenues.”
Net income per common share is based on the weighted average number of common shares outstanding during each of the respective years. We calculate net income per common share (diluted) assuming the exercise of stock-based awards. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2010.
We grant qualified and non-qualified stock-based compensation under authorized plans. The stock options vest ratably over three years following the date of grant and are exercisable over 10-year periods. In 2010, the committee approved a mix of stock options and restricted stock units for stock-based awards. See Note 17, Stock-Based Associate Compensation Plans, Page 125, for further details.
A premium deficiency is recorded when the sum of expected loss and loss adjustment expenses, expected policyholder dividends, unamortized acquisition costs and maintenance costs exceeds the total of unearned premiums and anticipated investment income. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency. We did not record a premium deficiency for the three years ended 2010, 2009 and 2008.
We offer several types of life insurance and disability income insurance, and we account for each according to the duration of the contract. Short-duration contracts are written to cover claims that arise during a short, fixed term of coverage. We generally have the right to change the amount of premium charged or cancel the coverage at the end of each contract term. Group life insurance is an example. We record premiums for short-duration contracts similarly to property casualty contracts.
Long-duration contracts are written to provide coverage for an extended period of time. Traditional long-duration contracts require policyholders to pay scheduled gross premiums, generally not less frequently than annually, over the term of the coverage. Premiums for these contracts are recognized as revenue when due.
When we issue a traditional long-duration contract, we capitalize acquisition costs. Acquisition costs are costs that vary with, and are primarily related to, the production of new business. We then charge these deferred policy acquisition costs to expenses over the premium-paying period of the contract, and we use the same assumptions that we use when we establish the liability for the contract. We update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate our deferred acquisition cost for recoverability.
Universal life contracts are long-duration contracts for which contractual provisions are not fixed, unlike whole life insurance. Universal life contracts allow policyholders to vary the amount of premium, within limits, without our consent. However, we may vary the mortality and expense charges, within limits, and the interest crediting rate used to accumulate policy values. We do not record universal life premiums as revenue. Instead we recognize as revenue the mortality charges, administration charges and surrender charges when received. Some of our universal life contracts assess administration charges in the early years of the contract that are compensation for services we will provide in the later years of the contract. These administration charges are deferred and are recognized over the period when we provide those future services.
When we issue a universal life long-duration contract, we capitalize acquisition costs. We then charge these capitalized costs to expenses over the term of coverage of 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.
Cash and cash equivalents are highly liquid instruments that include liquid debt instruments with original maturities of less than three months. These are carried at cost and approximate fair value.
Our portfolio investments are primarily in publicly traded fixed-maturity, equity and short-term investments. Fixed-maturity investments (taxable bonds, tax-exempt bonds and redeemable preferred stocks) and equity investments (common and non-redeemable preferred stocks) are classified as available for sale and recorded at fair value in the consolidated financial statements. The number of fixed-maturity securities trading below 100 percent of book value can be expected to fluctuate as interest rates rise or fall. Because of our strong surplus and long-term investment horizon, our general intent is to hold fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values.
ASC 320 does not allow retrospective application of the new other-than-temporary impairment model. Our consolidated statements of income for the year ended December 31, 2010 and 2009, are not measured on the same basis as December 31, 2008 and, accordingly, these amounts are not comparable.
Fair Value Measurements defines fair value as the exit price or the amount that would be (1) received to sell an asset or (2) paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. When determining an exit price, we rely upon observable market data whenever possible. We primarily base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on prices from FT Interactive Data, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. When a price is not available from these sources, as in the case of securities that are not publicly traded, we determine the fair value using various inputs including quotes from independent brokers. The fair value of investments not priced by FT Interactive Data is less than 1 percent of the fair value of our total investment portfolio. See Note 3, Fair Value Measurements, Page 114, for further details.
For the purpose of ASC 825 disclosure, we estimate the fair value for liabilities of investment contracts and annuities. We also estimate the fair value for assets arising from policyholder loans on insurance contracts. These estimates are developed using discounted cash flow calculations across a wide range of economic interest rate scenarios with a provision for our own credit risk. We base fair value for long-term senior notes on the quoted market prices for such notes. We base fair value for notes payable on our year-end outstanding balance.
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 record income over the financing term using the effective interest method. Finance receivables are reviewed for impairment on a quarterly basis. Impairment of our finance receivables are considered insignificant to our consolidated financial condition, results of operations and cash flows.
We record land at cost, and record building and equipment at cost less accumulated depreciation. Certain equipment held under capital leases also is classified as property and equipment with the related lease obligations recorded as liabilities. Our depreciation is based on estimated useful lives (ranging from three years to 39½ years) using straight-line and accelerated methods. Depreciation expense was $40 million in 2010, $48 million in 2009, and $35 million in 2008. We monitor land, building and equipment for potential impairments. Potential impairments may include a significant decrease in the fair values of the assets, considerable cost overruns on projects or a change in legal factors or business climate, or other factors that indicate that the carrying amount may not be recoverable. There were no recorded land, building and equipment impairments for 2010, 2009 or 2008.
We capitalize and amortize costs for internally developed computer software during the application development stage. These costs generally consist of external consulting, payroll and payroll-related costs.
In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures. ASU 2010-06 applies to all entities that are required to make disclosures about recurring or nonrecurring fair value measurements. ASU 2010-06 requires separate disclosures of the activity in the Level 3 category related to any purchases, sales, issuances and settlements on a gross basis. The effective date of the disclosures regarding Level 3 category purchases, sales, issuances and settlements is for interim and annual periods beginning after December 15, 2010. The portion of ASU 2010-06 that we have not yet adopted will not have a material impact on our company’s financial position, cash flows or results of operations as it focuses on additional disclosures.
In February 2010, the FASB issued ASU 2010-08, Technical Corrections to Various Topics. ASU 2010-08 does not change any of the fundamentals of GAAP, but it does explain certain clarifications made to the guidance on embedded derivatives and hedging. We have adopted ASU 2010-08, effective for the first reporting period after issuance and for fiscal years beginning after December 15, 2009. It did not have a material impact on our company’s financial position, cash flows or results of operations.
The following table analyzes investment income, realized investment gains and losses and the change in unrealized investment gains and losses:
At December 31, 2010, contractual maturity dates for fixed-maturity and short-term investments were:
At December 31, 2010, investments with book value of $81 million and fair value of $85 million were on deposit with various states in compliance with regulatory requirements.
The table below provides fair values and unrealized losses by investment category and by the duration of the securities’ continuous unrealized loss position:
Net realized gains were $159 million for the year ended December 31, 2010 compared with net realized gains of $336 million and $138 million in 2009 and 2008, respectively. The net realized investment gains
for the year ended December 31, 2010 were largely due to the sale of Verisk (NYSE: VRSK), contributing $128 million.
of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is impaired.
For the year ended December 31, 2010, one Level 3 corporate fixed-maturity security was purchased for $5 million and two corporate fixed-maturity securities were sold for approximately $1 million. There were also two corporate fixed-maturity securities that matured during the period for approximately $7 million. As a result of these purchases, sales, issuances and settlements, corporate fixed-maturity securities decreased $3 million.
There were no premium deficiencies recorded in the reported consolidated statements of income, as the sum of the anticipated loss and loss adjustment expenses, policyholder dividends, maintenance expenses and underwriting expenses did not exceed the related unearned premiums and anticipated investment income.
Because of changes in estimates of insured events in prior years, we decreased the provision for prior accident years’ loss and loss expenses by $304 million, $188 million and $323 million in calendar years 2010, 2009 and 2008. These decreases are partly due to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for amounts less than expected. The reserve for loss and loss expenses in the consolidated balance sheets also includes $63 million at December 31, 2010, and $46 million for both 2009 and 2008, for certain life and health loss reserves.
policyholders is the portfolio net earned interest rate less a spread for expenses and profit; and (3) additional lapses occur when the credited interest rate is exceeded by an assumed competitor credited rate, which is a function of the risk-free rate of the economic scenario being modeled. The fair value of life policy loans outstanding principal and interest approximated $46 million, compared with book value of $40 million reported in the consolidated balance sheets at December 31, 2010. The fair value of life policy loans outstanding principal and interest approximated $44 million, compared with book value of $40 million reported in the consolidated balance sheets as of December 31, 2009.
At December 31, 2010 and 2009, we had two lines of credit with commercial banks with an aggregate borrowing capacity of $225 million. Our note payable balance, which approximates fair value, was $49 million at year-end 2010 and at year-end 2009. The $75 million line of credit expires August of 2011. The $150 million line of credit with a $49 million balance expires July of 2012. We had no compensating balance requirements on short-term debt for either 2010 or 2009. The interest rate charged on our borrowings was a fixed 2.58 percent during 2010.
Our insurance subsidiary declared dividends to the parent company of $220 million in 2010, $50 million in 2009 and $160 million in 2008. State regulatory requirements restrict the dividends insurance subsidiaries can pay. Generally, the most our insurance subsidiary can pay without prior regulatory approval is the greater of 10 percent of policyholder surplus or 100 percent of statutory net income for the prior calendar year. Dividends exceeding these limitations may be paid only with approval of the insurance department of the domiciliary state. During 2011, the total that our lead subsidiary may pay in dividends is approximately $378 million.
Declared cash dividends per share were $1.59, $1.57 and $1.56 for the years ended December 31, 2010, 2009 and 2008, respectively.
Our consolidated statements of income include earned consolidated property casualty insurance premiums on assumed and ceded business:
Our consolidated statements of income include life insurance contract holders’ benefits incurred on assumed and ceded business:
Deferred tax assets and liabilities reflect temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amount recognized for tax purposes. The significant components of deferred tax assets and liabilities included in the consolidated balance sheets at December 31 were as follows:
The provision for federal income taxes is based upon filing a consolidated income tax return for the company and its subsidiaries. As of December 31, 2010, we had no operating or capital loss carry forwards.
The current sources of dilution of our common shares are certain equity-based awards as discussed in Note 17 Stock-Based Associate Compensation Plans, Page 125. The above table shows the number of anti-dilutive stock-based awards at year-end 2010, 2009 and 2008. We did not include these stock-based awards in the computation of net income per common share (diluted) because their exercise would have anti-dilutive effects.
Matching contributions to our sponsored 401(k) plan, which we began making during 2008, totaled $8 million, $7 million and $3 million during the years 2010, 2009 and 2008. Associates who are not accruing benefits under the pension plan are eligible to receive the company match of up to 6 percent of cash compensation. We also pay all operating expenses for the 401(k) plan. Participants vest in the company match for the 401(k) plan and Top Hat Savings Plan after three years of eligible service.
We also maintain a supplemental executive retirement plan (SERP) with liabilities of approximately $6 million at year-end 2010 and $5 million at year-end 2009, which are included in the obligation and expense amounts. The company also makes available to a select group of associates the Cincinnati Financial Corporation Top Hat Savings Plan, a non-qualified deferred compensation plan.
For SERP participants who chose to leave the defined benefit pension plan, SERP benefit accruals were frozen as of December 31, 2008. During 2009, the frozen accrued SERP benefit for those participants, collectively amounting to approximately $1 million, transferred to the Top Hat Savings Plan. Beginning in 2009, for these associates, the company began matching deferrals to the Top Hat Savings Plan up to the first 6 percent of an associate’s compensation that exceeds the compensation limit specified by the Internal Revenue Code of 1986, as amended.
Key assumptions used in developing the 2010 net pension obligation were a 5.85 percent discount rate for the qualified plan and a 5.55 percent discount rate for our SERP and rates of compensation increases ranging from 3.50 percent to 5.50 percent. To determine the discount rate for each plan, a hypothetical diversified portfolio of actual domestic Aa rated bonds were chosen to provide payments approximately matching the plan’s expected benefit payments. A single interest rate for each plan was determined based on the anticipated yield of the constructed portfolio. We decreased the rate by 0.25 percentage points for the qualified plan and by 0.55 percentage points for the SERP due to market interest rate conditions at year-end 2010. Compensation increase assumptions reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases.
Here are the components of our net periodic benefit cost, as well as other changes in plan assets and benefit obligations recognized in other comprehensive income for our qualified plan and SERP at December 31:
Excluding cash, during 2010 we allocated approximately 70 percent of the pension portfolio to highly observable domestic equity investments, which reflect the long-term time horizon of pension obligations. The remainder of the portfolio is allocated approximately 16 percent to domestic fixed-maturity investments and approximately 12 percent to taxable municipal bonds. The remaining 2 percent is allocated to preferred equities. At December 31, 2010, we had $9 million of cash on hand, with carrying value approximating fair value. Our shift to fixed maturities during the year was to increase the duration of the portfolio, diversify the types of credit risk and to better match our liability risks which is consistent with our strategy. Our corporate and municipal bond portfolio is investment grade. The plan does not engage in derivative transactions.
Investments in securities traded on a national securities exchange are valued at the last reported sales price on the last business day of the year. Investments in securities that are traded in active markets are valued on quoted market prices at December 31, 2010 and 2009. Investments in securities that are not actively traded are valued based on pricing models for which the inputs have been corroborated by market data at December 31, 2010 and 2009.
The plan, which ultimately determines fair value, categorized its financial instruments, based on the priority of the observable and market-based data for valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3). 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.
Refer to Note 3, Fair Value Measurements, Page 114 for valuation techniques and categorization of financial instruments within the pension plan assets. The methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement.
The following table illustrates the fair value hierarchy for those assets measured at fair value on a recurring basis for period ended December 31, 2010 and 2009. The pension plan does not have any assets categorized as Level 3. There have been no transfers between Level 1 and Level 2 for the period ended December 31, 2010 and 2009.
Our pension plan assets included 642,113 shares of the company’s common stock, which had a fair value of $20 million and $17 million at December 31, 2010 and 2009, respectively. The defined benefit pension plan did not purchase or sell any shares of our common stock during 2010 and 2009. The company paid $1 million in cash dividends on our common stock to the pension plan in both 2010 and 2009.
Insurance companies use statutory accounting practices (SAP) as prescribed by regulatory authorities. The primary differences between SAP and GAAP include:
Statutory net income and capital and surplus are determined in accordance with SAP prescribed or permitted by insurance regulatory authorities for five legal entities, our insurance subsidiary and its four insurance subsidiaries. Statutory capital and surplus for our insurance subsidiary, The Cincinnati Insurance Company, includes capital and surplus of its four insurance subsidiaries. The statutory net income and statutory surplus are presented below:
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 quarterly review, for any other matter for which the risk of loss is more than remote we are unable to reasonably estimate the potential loss or establish a reasonable range of loss.
Stock-based compensation cost after tax was $8 million, $7 million and $11 million for the years ended December 31, 2010, 2009 and 2008, respectively. Options exercised during the year ended December 31, 2010 and 2009, had intrinsic value less than $1 million. The total intrinsic value of options exercised during the year ended December 31, 2008, was $1 million. (Intrinsic value is the market price less the exercise price.) Options vested during the year ended December 31, 2010, had total intrinsic value of $1 million. Options vested during the years ended 2009 and 2008 had intrinsic value less than $1 million.
generally vest ratably over a three-year period. In determining the share-based compensation amounts, we estimate the fair value of each option granted on the date of grant using the binomial option-pricing model. We make assumptions in four areas to develop the binomial option-pricing model:
During 2010, we granted stock-based awards to associates and issued our common stock to eligible associates under our Holiday Bonus Plan. No stock based awards were granted to associates during 2009. The following weighted average assumptions were used for option grants issued during 2010 and 2008 in determining fair value:
Cash received from the exercise of options was less than $1 million for the years ended December 31, 2010 and 2009 and $4 million for the year ended December 31, 2008. We did not realize a tax benefit on options exercised for the years ended December 31, 2010, 2009 and 2008.
Options outstanding and exercisable consisted of the following at December 31, 2010:
Service and performance-based restricted stock units are granted to associates at fair value of the shares on the date of grant less the present value of the dividends that holders of restricted stock units will not receive on the shares underlying the restricted stock units during the vesting period. Service-based restricted stock units cliff vest three years after the date of grant.
Expected volatility is based on our stock price over a historical period that approximates the expected term. We have used the historical volatilities over a range of 2.76-2.86 years for 2010 grants and 3.13 years for 2008 grants.
Risk-free rates are equal to the yield, as of the measurement date, of the zero-coupon U.S. Treasury bill that is commensurate with the performance period. Risk free rates used range from 1.43%-1.50% for 2010 grants and 1.58% for 2008 grants.
Here is a summary of restricted stock unit information for 2010:
As discussed in Note 1, we revised our reportable segments during the fourth quarter of 2010 to establish a separate reportable segment for excess and surplus lines. This will allow readers to view this business in a manner similar to how it is managed internally when making operating decisions. This new segment includes results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources. Historically, the excess and surplus lines results were reflected in Other. Prior period data included in this annual report has been adjusted to represent this new segment.
For commercial lines, personal lines and excess and surplus insurance segments, we calculate underwriting income or loss by recording premiums earned minus loss and loss expenses and underwriting expenses incurred.
Loss before income taxes for the Other category is primarily due to interest expense from debt of the parent company and operating expenses of our headquarters.
Revenues including realized investment gains and losses, which are integral to our financial results over the long term, may cause this value to fluctuate substantially because we have substantial discretion in the timing of investment sales. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 75.