The Cincinnati Insurance Company owns a building used for business continuity, with approximately 48,000 square feet of available space, located approximately six miles from our headquarters. The property, including land, is carried on our financial statements at $10 million as of December 31, 2012, and is classified as land, building and equipment, net, for company use. This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2012.
* Realized investment gains and losses are integral to our financial results over the long term, but our substantial discretion in the timing of investment sales may cause this value to fluctuate substantially. 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 79.
The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial condition. Our Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Page 37, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 108. We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and stock dividends.
We begin with an executive summary of our results of operations and outlook, followed by details on critical accounting estimates. In several instances, we refer to estimated industry data so that we can provide information on our performance within the context of the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory accounting basis. When we provide our results on a comparable statutory accounting basis, we label it as such; all other company data is presented in accordance with accounting principles generally accepted in the United States of America (GAAP).
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. This measure, intended to be all-inclusive regarding changes in book value per share, uses originally reported book value per share in cases where book value per share has been adjusted, such as the adoption of Accounting Standards Updates with a cumulative effect of a change in accounting. VCR trends are shown in the table below.
For the period 2013 through 2017, an annual value creation ratio averaging 10 percent to 13 percent is our primary performance target. For the period 2009 through 2012, our annual value creation ratio averaged 12.4 percent, within the 12 percent to 15 percent five-year target range established in early 2009, soon after the U.S. credit crisis. Since the credit crisis, interest rates have generally declined and credit spreads have tightened, increasing the VCR contribution from valuation gains from our fixed-maturity securities. As indicated in the table below, those gains contributed between 2 percent and 3 percent to VCR in the past three years. That contribution is not expected to occur in the next five-year period, but management believes the company will produce strong underwriting results.
· Combined ratio - We believe our underwriting philosophy and initiatives can drive performance to achieve our underwriting profitability target of a GAAP combined ratio over any five-year period that is consistently within the range of 95 percent to 100 percent. Our GAAP combined ratio has averaged 102.4 percent over the five-year period 2008 through 2012. Our combined ratio was below 100 percent in 2012, but above 100 percent for 2008 through 2011, when our average catastrophe loss ratio of 7.7 percentage points was 4.0 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 52. Our statutory combined ratio averaged 102.2 percent over the five-year period 2008 through 2012 compared with an estimated 102.9 percent for the property casualty industry. The industry’s ratio again excludes its mortgage and financial guaranty lines of business.
· Investment contribution - We believe our investment philosophy and initiatives can drive investment income growth and lead to a total return on our equity investment portfolio over a five-year period that exceeds the five-year return of the Standard & Poor’s 500 Index.
o Investment income growth, on a before-tax basis, had a compound annual rate of 2.0 percent over the three-year period 2010 through 2012. It has grown since 2009, when we experienced a dramatic reduction in dividend payouts by financial services companies held in our equity portfolio.
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 2012, the company has increased the indicated annual cash dividend rate for 52 consecutive years, a record we believe is matched by only nine 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 83.
· Improve insurance profitability - Implementation of these initiatives is intended to enhance underwriting expertise and knowledge, thereby increasing our ability to manage our business while also gaining efficiency. Additional information and more focused action on underperforming product lines, plus expanding pricing capabilities through the use of technology and analytics, can lead to better profit margins. Improved internal processes with additional performance metrics can help us be more efficient and effective. These initiatives also support the ability of the independent agencies that represent us to grow profitably by allowing them to serve clients faster and to more efficiently manage agency expenses.
We discuss these strategic initiatives, along with related metrics to assess progress, in Item 1, Strategic Initiatives, Page 10. Below is a review of highlights of our financial results for the past three years. Detailed discussion of these topics appears in Results of Operations, Page 51, and Liquidity and Capital Resources, Page 83.
The value creation ratio discussed in the Executive Summary, Page 38, included contributions from the major components shown in the table below.
The 2012 value creation ratio benefited from improved operating results as well as a strong contribution from generally higher valuations in securities markets. The contribution from operating results rose 5.3 percentage points in 2012, compared with 2011, while the contribution from realized gains plus the change in unrealized gains from our investment portfolios rose 1.5 points. The 2011 value creation ratio was depressed primarily due to unusually high catastrophe losses that lowered the ratio by 3.3 percentage points compared with 2010, and also drove a 56 percent decline in net income. Higher valuations for our investment portfolio in recent years benefited the value creation ratio in addition to earnings.
The amount of our debt obligations did not change in 2012. Our ratio of debt to total capital (debt plus shareholders’ equity) decreased by 1 percentage point in 2012 and remains comfortably within our target range.
As discussed in Investment Results of Operations, Page 79, sales of securities that had appreciated in value led to realized investment gains in all three years. Realized and unrealized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that are recognized in any period. That discretion
Higher dividend income was largely responsible for 1 percent growth in both 2012 and 2011 pretax investment income. In addition to a larger common stock portfolio generating more dividend income in 2012, both 2012 and 2011 benefited from higher average dividend payment rates.
Property casualty net written premiums grew 12 percent in 2012 and earned premiums grew 10 percent, largely due to higher pricing and premium growth initiatives. Trends and related factors are discussed in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 57, Page 68 and Page 74, respectively.
Our property casualty insurance operations generated an underwriting gain in 2012 after reporting an underwriting loss in each of the preceding four years. The $415 million improvement for 2012, compared with 2011, included a $68 million decrease in losses from natural catastrophe events. A 10 percent rise in 2012 earned premiums drove most of the improvement as noncatastrophe losses and underwriting expenses in total for 2012 were within 1 percent of 2011. The $229 million change in underwriting loss for 2011, compared with 2010, was driven by a $254 million rise in losses from natural catastrophe events.
Our life insurance segment reported a small loss because most of its investment income is included in our investments segment results. We discuss results for the segment in Life Insurance Results of Operations, Page 77. In addition to investment income, realized investment gains from the life insurance investment portfolio are also included in our investments segment results.
Our view of the shareholder value we can create over the next five years relies largely on two assumptions about the external environment. First, we anticipate continued firming of commercial and personal insurance pricing throughout 2013. Second, we assume that the economy can maintain a growth track during 2013. 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, with continued agency consolidation. If soft insurance market conditions return in 2013, it will create additional risk for agencies.
· We expect initiatives that make it easier for agents to do business with us will continue to be a significant factor in agency relationships, with technology being a major driver. Policyholders will increasingly demand online services and access from agents or carriers.
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 on 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.
For the year 2013, we believe our value creation ratio may be below our long-term target for several reasons.
· The rally in financial markets during recent years had a favorable impact on our value creation ratio, offsetting the unfavorable impact of the sharp decline in financial markets during 2008. Financial markets continued to display volatility during 2012, and some predict more turbulence in 2013 from effects of events such as the sovereign debt crisis in several European countries or other geopolitical events that could also affect the U.S. economy and markets. Should financial markets decline during 2013, which could occur as part of typical market volatility patterns, the related component of our 2013 value creation ratio could also register a weak or negative result.
· A return of soft insurance market pricing in recent years could significantly affect growth rates and earned premium levels into 2013 and for some time into the future, depending on insurance market conditions. After several years of market conditions that weakened loss ratios and hampered near-term profitability, conditions affecting property casualty markets improved in 2012. In the future, economic factors, including inflation, may increase our claims and settlement expenses related to medical care, litigation and construction.
· The slowly recovering economy helped increase the value of business and personal insurable assets owned by policyholders in 2012. If the economy falters, we may experience low or no premium growth for the property casualty industry. Property casualty written premium growth also may lag as some of our growth initiatives require more time to reach their full contribution.
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 $4.169 billion at year-end 2012 compared with $4.280 billion at year-end 2011.
Our field claims representatives establish case reserves when claims are reported to the company to provide for our unpaid loss and loss expense obligation associated with individual claims. Field claims
managers supervise and review all claims with case reserves less than $35,000. Experienced headquarters claims supervisors review individual case reserves greater than $35,000 that were established by field claims representatives. Headquarters claims managers also review case reserves greater than $100,000.
· For weather events designated as catastrophes, we calculate bulk reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Once case reserves are established for a weather event, we reduce the bulk reserves. Our claims department management coordinates the assessment of these events and prepares the related bulk reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the 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. To determine whether an event is designated as a catastrophe, 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.
The determination of management's best estimate, like the preparation of the reserve analysis that supports it, involves considerable judgment. Changes in reserving data or the trends and factors that influence reserving data may signal fundamental shifts or may simply reflect single-period anomalies. Even if a change reflects a fundamental shift, the full extent of the change may not become evident until years later. Moreover, since our methods and models do not explicitly relate many of the factors we consider directly to reserve levels, we typically cannot quantify the precise impact of such factors on the adequacy of reserves prospectively or retrospectively.
· Emergence of loss and defense and cost containment expenses on an accident year basis. Historical paid loss, reported loss and paid defense and cost containment expense data for the business lines we analyze contain patterns that reflect how unpaid losses, unreported losses and unpaid defense and cost containment expenses as of a financial statement date will emerge in the future on an accident year basis. Unless our actuarial staff or management identifies reasons or factors that invalidate the extension of historical patterns into the future, these patterns can be used to make projections necessary for estimating IBNR reserves. Our actuaries significantly rely on this assumption in the application of all methods and models mentioned above.
· Calendar year inflation. For long-tail and mid-tail business lines, calendar year inflation trends for future paid losses and paid defense and cost containment expenses do not vary significantly from a stable, long-term average. Our actuaries base reserve estimates derived from probabilistic trend family models on this assumption.
The table below provides standard errors and reserve ranges by major property casualty lines 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 business cannot be computed by simply adding the standard errors and reserve ranges of the component lines of business, since such an approach would ignore the effects of product diversification. See Range of Reasonable Reserves, Page 89, for more details on our total reserve range. While the table reflects our assessment of the most likely range within which each line's actual unpaid loss and loss expenses may fall, one or more lines' actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
If actual unpaid loss and loss expenses fall within these ranges, our cash flow and fixed-maturity investments should provide sufficient liquidity to make the subsequent payments. To date, our operating cash flow has covered our loss and loss expense payments, and we have never had to sell investments to make these payments. If this were to become necessary, however, our fixed-maturity investments should provide us with ample liquidity. At year-end 2012, consolidated fixed-maturity investments exceeded total insurance reserves (including life policy reserves) by $2.568 billion.
Our fixed-maturity and equity investment portfolios are our largest assets. The company’s asset impairment committee continually monitors the holdings in these portfolios and all other assets for signs of other-than-temporary or permanent impairment. The committee monitors decreases in the fair value of invested assets; an accumulation of costs in excess of the amount originally expected to acquire or construct an asset; uncollectability of all receivable assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure to pay interest or dividends; signs indicating that the receivable carrying amount may not be recoverable; and changes in legal factors or in the business climate.
Our internal investment portfolio managers monitor their assigned portfolios. If a security is valued below cost or amortized cost, the portfolio managers undertake additional reviews. Such declines often occur in conjunction with events 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 118.
Securities that have previously been other-than-temporarily impaired are evaluated based on their adjusted cost or amortized cost and further written down, if deemed appropriate. We provide detailed information about securities fair valued in a continuous loss position at year-end 2012 in Item 7A, Application of Asset Impairment Policy, Page 102.
Securities considered to have a temporary decline would be expected to recover their cost or amortized cost, which may be at maturity. Under the same accounting treatment as fair value gains, temporary declines (changes in the fair value of these securities) are reflected in shareholders’ equity on our balance sheet in accumulated other comprehensive income (AOCI), net of tax, and have no impact on net income.
Financial assets and liabilities recorded on the Consolidated Balance Sheets are categorized based on the inputs to the valuation techniques as described in Item 8, Note 3, Page 121.
Key assumptions used in developing the 2012 net pension expense for our qualified plan were a 5.10 percent discount rate, a 7.50 percent expected return on plan assets and rates of compensation increases ranging from 3.50 percent to 5.50 percent. See Note 13, Page 130 for additional information on assumptions.
In 2012, the net pension expense was $18 million. In 2013, we expect the net pension expense to remain unchanged at $18 million.
We establish an accrual for property casualty profit-sharing commissions. We calculate the profit-sharing commission accrual estimate based on property casualty underwriting results. Profit-sharing commissions are paid to agencies using a formula that takes into account agency profitability over one-year and three-year periods and premium volume. Due to the complexity of the calculation, timing of the accrual determination and the variety of allocation factors that can affect profit-sharing commissions for an individual agency, the amount accrued can differ from the actual profit-sharing commissions paid. The profit-sharing commission accrual of $102 million in 2012 contributed 3.1 percentage points to the property casualty combined ratio. If profit-sharing commissions paid were to vary from that amount by 5 percent, it would affect 2013 net income by $2 million (after tax), or 1 cent per share, and the combined ratio by approximately 0.1 percentage point.
The calculations of segment data are described in more detail in Item 8, Note 18, of the Consolidated Financial Statements, Page 137. The following sections provide analysis and discussion of results of operations for each of the five segments. Commercial Lines Insurance Results of Operations begins on Page 57, Personal Lines Insurance Results of Operations begins on Page 68, Excess and Surplus Lines Insurance Results of Operations begins on Page 74, Life Insurance Results of Operations begins on Page 77, and Investment Results of Operations begins on Page 79. We begin with an overview of our consolidated property casualty operations.
The table below analyzes premium revenue components and trends. Premium trends by segment are further discussed beginning on Page 58, Page 69 and Page 74, for the respective property casualty segments.
The combined ratio before catastrophe losses and prior year reserve development also improved significantly in 2012, benefiting from recent-year initiatives to improve pricing precision and loss experience related to claims and loss control practices.
Our statutory combined ratio was 95.4 percent in 2012 compared with 108.9 percent in 2011 and 101.8 percent in 2010. The estimated statutory combined ratio for the property casualty industry, with the industry’s ratio excluding its mortgage and financial guaranty lines of business, was 106.2 percent in 2012, 106.5 percent in 2011 and 101.0 percent in 2010. The contribution of catastrophe losses to our statutory combined ratio was 10.0 percentage points in 2012, 13.3 percentage points in 2011 and 5.1 percentage points in 2010, compared with an estimated 9.4, 9.6 and 4.5 percentage points, respectively, for the industry. Components of the combined ratio are discussed below, followed by additional discussion by segment.
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 consolidated property casualty insurance results three-year highlights table on Page 52 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 86.4 percent accident year 2011 loss and loss expense ratio reported as of December 31, 2011, developed favorably by 4.9 percentage points to 81.5 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2012. Accident years 2011 and 2010 have both developed favorably, as indicated by the progression over time for the ratios in the table.
The 64.6 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2012 declined 8.4 percentage points compared with the 73.0 percent accident year 2011 ratio measured as of December 31, 2011. Large losses described below and the corresponding ratios for new losses above $250,000 caused a 1.9 percentage-point decrease in the 2012 ratio. The effect of the $42 million ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 1.0 percentage point. A refinement to our line of business allocation process for loss expenses reduced the 2011 accident year loss and loss expenses before catastrophes ratio by approximately 1.5 percentage points. We believe the remaining 7.0 percentage points of the reduction is largely due to initiatives to improve pricing precision and loss experience related to claims and loss control practices, somewhat offset by normal loss cost inflation.
In 2012, total large losses incurred increased by $28 million or 4 percent, net of reinsurance. The corresponding ratio decreased 1.3 percentage points, as earned premium growth more than doubled the rate of growth in total large losses. Large loss trends are further analyzed in the segment discussion and analysis that follows discussion of consolidated property casualty results. Our analysis of large losses incurred indicated no unexpected concentration of these losses and reserve increases by geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
Other underwriting expenses as a percent of earned premium for 2012 decreased, as higher earned premiums offset an 8 percent increase in expenses. In 2011, other underwriting expenses were down $9 million or 2 percent, primarily due to a first-quarter 2010 provision for matters involving contingent liabilities.
· Premiums - Earned premiums and net written premiums rose in 2012, primarily due to a $166 million increase in renewal written premiums that continued to reflect improved pricing. Premium growth initiatives that helped new business written premiums grow $45 million in 2012 also contributed to earned and net written premium growth. Other written premiums also helped increase 2012 earned and net written premiums, largely due to the effect in 2011 of $24 million for ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty.
We continue to increase our use of predictive analytics tools to improve pricing precision in response to highly competitive commercial lines markets. These tools better align individual insurance policy pricing to risk attributes, and provide our underwriters with enhanced abilities to target profitability and to discuss pricing impacts with agency personnel. We also continue to leverage our local relationships with agents through the efforts of our teams that work closely with them. We believe our field focus is unique and has several advantages, including providing us with quality intelligence on local market conditions. We seek to maintain appropriate pricing discipline for both new and renewal business as management emphasizes the importance of our agencies and underwriters assessing account quality to make careful decisions on a case-by-case basis whether to write or renew a policy. Rate credits may be used to retain renewals of quality business and to earn new business, but we do so selectively in order to avoid commercial accounts that we believe have insufficient profit margins.
Our 8 percent increase in 2012 agency renewal written premiums largely reflected higher pricing and improving economic conditions. 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. In 2012, our standard commercial lines policies averaged an estimated pricing change that increased in a mid-single-digit range. The average pricing change for policies renewed during 2011 was slightly positive, near the low end of the low-single-digit range. For policies renewed during both 2010 and 2009, the typical pricing change was a decline, on average in the low-single-digit range, representing an improvement from the mid-single-digit range average pricing decline experienced in 2008.
In recent years prior to 2011, our agency renewal written premium trends included an unfavorable effect from the economic downturn and slow recovery in various regions. In 2012 and 2011, the effect was favorable. Changes in the economy affect insured exposures that directly relate to premium amounts for any given policy. For commercial accounts, we usually calculate initial estimates for general liability premiums based on estimated sales or payroll volume, while we calculate workers’ compensation premiums based on estimated 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.
Premiums resulting from audits of actual sales or payrolls that confirmed or adjusted initial premium estimates significantly affected premium trends in recent years. On an earned premium basis, audits contributed $35 million of the $186 million earned premiums increase in 2012 and $46 million of the $43 million earned premiums increase in 2011. On a net written premium basis, audits contributed $30 million of the $241 million net written premiums increase in 2012 and $34 million of the $63 million net written premiums increase in 2011.
New business premium volume in recent years has been significantly influenced by new agency appointments. All agencies appointed since the beginning of 2011 generated commercial lines new business written premiums of $39 million during 2012, up $26 million from 2011, while all other agencies contributed the remaining $313 million, up $19 million from 2011.
Other written premiums, primarily premiums that are ceded to reinsurers and that lower our net written premiums, had a more favorable effect in 2012 than in 2011. The $30 million change for 2012, compared with 2011, was largely due to $24 million of additional ceded premiums in 2011 for our property catastrophe reinsurance treaty, a result of reinstatement premiums following two large catastrophe events during 2011, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 52.
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 commercial lines segment three-year highlights table on Page 57 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than half of our commercial lines insurance segment 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 82.1 percent accident year 2011 loss and loss expense ratio reported as of December 31, 2011, developed favorably by 4.2 percentage points to 77.9 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2012. Accident years 2011 and 2010 for the commercial lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 52, explain much of the movement in current accident year loss and loss expense ratios for accident years 2010 through 2012. Catastrophe losses added 8.9 percentage points for 2012, 10.3 points for 2011 and 4.7 points for 2010 to the respective commercial lines accident year loss and loss expense ratios in the table above.
The 62.9 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2012 declined 8.9 percentage points compared with the 71.8 percent accident year 2011 ratio measured as of December 31, 2011. Large losses, described below, and the corresponding ratios for new losses above $250,000 caused a 2.6 percentage-point decrease in the 2012 ratio. A refined line of business allocation process for loss expenses reduced the 2011 ratio by approximately 3 percentage points, and was partially offset by a 0.8-percentage-point effect of the $24 million ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty. We believe the remainder of the reduction is largely due to initiatives to improve pricing precision and loss experience related to claims and loss control practices, somewhat offset by normal loss cost inflation.
Commercial lines reserve development on prior accident years continued to net to a favorable amount in 2012, as $292 million was recognized, higher than $234 million in 2011. More than 85 percent of our commercial lines reserve development on prior accident years recognized during 2012 occurred in our commercial casualty and workers’ compensation lines of business, with approximately 60 percent occurring in commercial casualty. Development recognized during 2011 was also mostly from our commercial casualty and workers’ compensation lines of business. In 2010, favorable development was mostly from our commercial casualty line of business. Development by line of business and other trends for commercial lines loss and loss expenses and the related ratios are further analyzed in Commercial Lines of Business Analysis, beginning on Page 60, and in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92.
In 2012, total large losses incurred increased by $15 million or 3 percent, net of reinsurance. The corresponding ratio decreased 1.3 percentage points, as earned premium growth more than doubled the rate of growth in total large losses. An increase in large losses for commercial auto and general liability claims more than offset decreases for commercial fire and workers’ compensation claims. In 2011 the total large losses incurred ratio was higher than it was in 2010, primarily due to higher incurred losses for fires and commercial auto claims. Our analysis indicated no unexpected concentration of these losses and reserve increases by geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
Commercial lines commission expenses as a percent of earned premium decreased slightly during 2012, largely due to higher earned premiums that offset the effect of higher agency profit-sharing commissions.
Other underwriting expenses as a percent of earned premium for 2012 also decreased slightly, as higher earned premiums offset an increase in expenses.
For 2012, commercial casualty, our largest line of business representing over 30 percent of earned premiums for our commercial lines segment, continued to be very profitable, based on the total loss and loss expense ratio. Commercial property and specialty packages had 2012 total loss and loss expense ratios significantly higher than we desired, largely due to unusually high weather-related losses in recent years. As discussed below, we are taking actions to improve pricing and reduce loss costs to benefit future profitability trends. Profitability trends for workers’ compensation continued to improve, reflecting the results of initiatives to improve pricing and reduce loss costs. An approach similar to the one we used to improve workers’ compensation results is being used to address profitability challenges for commercial auto and
Commercial casualty is our largest line of business and has in recent years maintained a very satisfactory total loss and loss expense ratio. Premiums grew in 2012, compared with 2011, largely due to higher pricing and premium growth initiatives that helped new business written premiums grow nearly 20 percent. During 2011, our underwriters began fully using predictive modeling tools for general liability coverages in our commercial package accounts, and we believe these tools are improving our pricing precision.
The 2012 total loss and loss expense ratio improved by 10.2 percentage points, largely due to lower current accident year losses and loss expenses and higher earned premiums. Favorable development on prior accident year reserves continued in 2012 at a significant level, reflecting further moderation in loss cost trends, particularly for umbrella liability coverage included in many commercial package accounts. Development trends are further discussed in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92.
Commercial property net written premiums and earned premiums rose in 2012, reflecting higher pricing and premium growth initiatives that helped new business written premiums increase nearly 25 percent.
The 2012, total loss and loss expense ratio improved, largely due to lower current accident year losses and loss expenses and higher earned premiums. The ratio components from catastrophe losses were nearly the same in 2012 as in 2011, and favorable development on prior accident year reserves before catastrophe losses decreased slightly.
In 2012 we formed a multi-department, multi-disciplinary taskforce that has been reviewing our property book of business and continues to seek ways to improve profitability, similar to the approach we used to improve workers’ compensation results. Several profit improvement initiatives are already underway and some are already completed. Some of the more important initiatives include increasing specialization among selected claims and loss control associates, increasing the number of commercial property inspections for both new and renewal business, applying wind and hail deductibles in areas prone to convective storm losses and implementing new guidelines for underwriting and pricing hail risk.
The 2011 total loss and loss expense ratio rose 16.3 percentage points primarily due to a 16.1 point increase in catastrophe losses. In addition, the ratio increased 5.2 percentage points from higher large losses related to fires, and it also rose from other weather-related losses that were not identified as part of designated catastrophe events for the property casualty industry, typically referred to as noncatastrophe weather losses. The effect of the $13 million ceded to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 2.2 percentage points. The refined line of business allocation process for loss expenses reduced the 2011 total loss and loss expense ratio by 3.5 percentage points and also had the effect of decreasing the ratio for current accident year before catastrophe losses.
The 2011 current accident year loss and loss expense ratio before catastrophe losses also rose, compared with accident year 2010, largely due to higher large losses from fires and increased losses from noncatastrophe weather.
The 2012 total loss and loss expense ratio increased, primarily due to lower favorable development on prior accident year reserves that was partially offset by an improved ratio for current accident year losses and loss expenses.
The 2011 total loss and loss expense ratio rose 6.7 percentage points, largely due to a 3.6-point increase from higher large losses. The refined line of business allocation process for loss expenses contributed 1.7 percentage points to the 2011 total loss and loss expense ratio and also contributed to the increase in the ratio for the current accident year before catastrophe losses.
Specialty packages net written premiums and earned premiums rose in 2012, primarily due to lower ceded premiums. In 2011, ceded premiums included $10 million to reinstate coverage layers of our property catastrophe reinsurance treaty. New business written premiums from agencies accounted for less than $1 million of the $16 million increase in net written premiums, in part reflecting our efforts to increase price adequacy.
The 2011 total loss and loss expense ratio rose 51.2 percentage points primarily due to a 39.3-point increase in catastrophe losses. It also rose from other weather-related losses that were not identified as part of designated catastrophe events for the property casualty industry, typically referred to as noncatastrophe weather losses. The effect of the $10 million in premiums ceded to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 8.4 percentage points.
The 2012 total loss and loss expense ratio improved 36.4 percentage points due to a 32.6-point decrease from unfavorable development on prior accident year reserves, returning to a level close to 2010.
The 2011 total loss and loss expense ratio rose 26.8 percentage points due to a 29.6-point increase from unfavorable development on prior accident year reserves. Included in the unfavorable development was $13 million or 13.1 percentage points for the refined line of business allocation process for loss expenses. The refined allocation had a negligible effect on the ratio for the current accident year before catastrophe losses. Most of the remainder of unfavorable development on prior accident year reserves was for four claims from accident year 2008, two for director and officer liability and two for fidelity bonding due to fraud or lending practices at financial institutions.
We continue to address the potential risk inherent in the financial institutions portion of our surety and executive risk business line as we work with our agents to identify the strongest financial institutions, in addition to using credit rating and other metrics to carefully re-underwrite in-force policies when they are considered for renewal.
· Writing on a claims-made basis, which normally restricts coverage to losses reported during the policy term.
· Providing limits no higher than $10 million with facultative or treaty reinsurance in place in 2013 to cover losses greater than $7 million.
Machinery and equipment premiums continued to rise over the three-year period, reflecting higher pricing and our superior service, including experienced local specialists who support agencies in writing this line of business. The total and accident year loss and loss expense ratios remain at profitable levels, although they can fluctuate substantially due to the relatively small size of this business line.
We intend to continue marketing our products to a broad range of business classes with a package approach, while improving our pricing precision. We intend to maintain our underwriting selectivity and carefully manage our rate levels as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions about rates, the use of three-year commercial policies and other policy conditions on a case-by-case basis, even in lines and classes of business that are under competitive pressure. We believe our initiatives to improve pricing precision and lower loss costs will continue to benefit commercial lines profitability during 2013, and that recent-year premium growth initiatives will continue to increase commercial lines premiums.
· Premiums - Earned premiums and net written premiums grew significantly in 2012, primarily due to higher renewal written premiums that included price increases. The 2012 growth in earned and net written premiums was aided by the suppressing effect in 2011 from $18 million for ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty.
Our personal lines statutory combined ratio was 104.0 percent in 2012, 124.2 percent in 2011 and 107.1 percent in 2010. By comparison, the estimated industry personal lines combined ratio was 105.0 percent in 2012, 106.1 percent in 2011 and 100.4 percent in 2010. Our concentration of business in areas affected by catastrophe events contributed to recent-year results that differed from the overall industry, an issue we are addressing in part through gradual geographic expansion. The contribution of catastrophe losses to our personal lines statutory combined ratio was 15.9 percentage points in 2012, 22.7 percentage points in 2011 and 8.1 percentage points in 2010, compared with an estimated 9.5, 10.4 and 5.3 percentage points, respectively, for the industry.
Personal lines insurance is a strategic component of our overall relationship with most of our agencies and is an important component of our agencies’ relationships with their clients. We believe agents recommend Cincinnati personal insurance products for their value-oriented clients who seek to balance quality and price and who are attracted by our superior claims service and the benefits of our package approach. We also believe our efforts to continue improving pricing precision are helping us attract and retain more of our agencies’ preferred business, while also obtaining higher rates for more thinly-priced business.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the personal lines segment three-year highlights table on Page 68 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since approximately two-thirds of our personal lines current accident year incurred losses and loss expenses represent net paid losses, the remaining one-third represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 100.3 percent accident year 2011 loss and loss expense ratio reported as of December 31, 2011, developed favorably by 7.8 percentage points to 92.5 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2012. Accident years 2011 and 2010 for the personal lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 52, explain much of the movement in current accident year loss and loss expense ratios for accident years 2010 through 2012. Catastrophe losses added 18.4 percentage points for 2012, 23.6 points for 2011 and 8.8 points for 2010 to the respective personal lines accident year loss and loss expense ratios in the table above. Personal lines catastrophe losses for 2012 and 2011 were much higher than our 8.7 percent 10-year annual average for the years 2001 through 2010. Personal lines catastrophe losses also are inherently volatile, as discussed above and in Consolidated Property Casualty Insurance Results of Operations, Page 52.
The 68.2 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2012 improved 8.5 percentage points compared with the 76.7 percent accident year 2011 ratio measured as of December 31, 2011. The effect of the $18 million ceded in 2011 to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 1.8 percentage points. Noncatastrophe weather losses for our homeowner line of business alone were approximately $10 million lower during 2012 compared with 2011, reducing the 2012 ratio for personal lines by approximately 1 percentage point, compared with 2011. Higher new large losses incurred described below increased the 2012 ratio by 0.6 percentage points, offsetting much of the benefit of lower noncatastrophe losses. We believe the majority of the 8.5 percentage points of improvement was largely due to initiatives to improve pricing precision, somewhat offset by normal loss cost inflation.
For 2012, the homeowner line of business continued to have a total loss and loss expense ratio significantly higher than desired. As discussed in the overview section of Personal Lines Insurance Results of Operations, Page 68, and below, we are taking actions to improve pricing and reduce loss costs that we expect to benefit future profitability trends.
As discussed in Personal Lines Insurance Premiums, Page 69, we continue to implement rate changes to continue to improve results for our personal auto line of business.
The total loss and loss expense ratio over the past three years largely fluctuated with catastrophe losses, noncatastrophe weather-related losses and other large losses. For the five-year period 2008 through 2012, the homeowner catastrophe loss ratio averaged 34.5 percent, approximately double the 17.4 percent 10-year average for the years 1998 through 2007. The 34.4 percentage-point improvement in the 2012 total loss and loss expense ratio included a decrease of 17.9 points for catastrophe losses, compared with 2011. Noncatastrophe weather losses were approximately $10 million lower during 2012, improving the 2012 loss ratio by 7.0 percentage points compared with 2011. The effect of the $16 million ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty added 6.4 percentage points the 2011 ratio.
Favorable development on prior accident year reserves rose in 2012, primarily due to reduction in case reserves for losses. Development trends are further discussed in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92.
Loss and loss expense ratios returned to a more profitable level, reversing the aberration of 2011 that was driven by higher catastrophes and noncatastrophe weather. Reserve development on prior accident years recognized during 2012 was somewhat higher than in recent years, although it can fluctuate significantly for this business line because personal umbrella liability coverage is a major component of other personal losses. Development trends are further discussed in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92.
· Combined ratio - The combined ratio rose 8.8 percentage points in 2012, primarily due to unusually large net favorable reserve development on prior accident years during 2011. Most of this increase was from higher loss expenses. The loss ratio component rose 2.5 points, including 1.3 points from higher large losses, as shown on the Excess and Surplus Lines Insurance Losses by Size table on Page 76.
The $24 million increase in 2012 renewal premiums reflected the opportunity to renew many policies for the first time as well as higher renewal pricing. Average renewal pricing rose in the high-single-digit range during each quarter of 2012, improving over the mid-single-digit range for the last quarter of 2011. We measure average changes in excess and surplus lines renewal pricing as the rate of change in renewal premium for the new policy period compared with the premium for the expiring policy period, assuming no change in the level of insured exposures or policy coverage between those periods for respective policies.
Catastrophe losses for our commercial lines and personal lines segments were lower in 2012 compared with 2011. For the excess and surplus lines segment, catastrophe losses were higher, but the resulting ratio for the catastrophe loss component of the loss and loss expense ratio remained level due to higher earned premiums. Catastrophe losses added 2.1 percentage points for 2012 and 2011, following 1.2 percentage points for 2010, to the respective excess and surplus lines accident year loss and loss expense ratios in the table above.
Excess and surplus lines reserve development on prior accident years continued to net a favorable amount in 2012 as $5 million was recognized, compared with $9 million in 2011. The 2011 favorable development was primarily due to beginning to place more reliance on claims experience emergence patterns from our excess and surplus lines business for IBNR loss and loss expense estimates, with relatively less reliance on historical claims experience emergence patterns from similar lines of business for our standard commercial lines business.
We believe the loss and loss expenses reserves for our excess and surplus lines business are adequate. We establish case reserves in a manner consistent with standard lines coverages, despite the more restrictive terms and conditions for excess and surplus lines policies. Our first excess and surplus lines policies were written in 2008. After two years of operation, reserves for estimated unpaid losses and loss expenses were $18 million as of December 31, 2009, for losses that occurred in 2008 and 2009. As of December 31, 2012, only an estimated $5 million remained unpaid for loss events that occurred in 2008 and 2009. The inherent uncertainty in estimating reserves is discussed in Property Casualty Insurance Loss and Loss Expense Reserves, Page 43. Development trends are further analyzed in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92.
Excess and surplus lines commission expense as a percent of earned premiums rose in 2012, primarily due to higher agency profit-sharing commissions.
Other underwriting expenses declined in 2012 and 2011 as a percent of earned premiums primarily due to earned premiums rising faster than expenses.
· Revenues - Earned premiums rose 8 percent for the year 2012. The largest life insurance product line, term life insurance, continued to grow earned premiums at a strong pace, up 10 percent in 2012. Gross in-force policy face amounts rose 5 percent to $81.467 billion at year-end 2012 from $77.691 billion at year-end 2011 and $74.124 billion at year-end 2010.
Earned premiums rose by $13 million in 2012, primarily due to growth in our term life insurance business. Earned premiums from term life insurance grew $10 million, or 10 percent.
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 $38 million in 2012, compared with a net profit of $20 million in 2011 and a net profit of $38 million in 2010. The life insurance company portfolio had after-tax net realized investment gains of $4 million in 2012, compared with after-tax net realized investment losses of $12 million in 2011, which included $20 million in OTTI charges. Net realized investment gains after taxes were $2 million in 2010. Realized investment gains and losses are discussed under Investment Results of Operations, Page 79.
· Contract holders’ benefits incurred, related to traditional life and interest-sensitive products, accounted for 70.1 percent of 2012 total benefits and expenses compared with 75.3 percent in 2011 and 73.4 percent in 2010. Total contract holders’ benefits decreased as the increase in life policy reserves was lower in 2012 compared with 2011. Partially offsetting the lower policy reserve increase were net death claims that increased over 2011, but remained within our range of pricing expectations.
· Operating expenses incurred, net of deferred acquisition costs, accounted for 29.9 percent of 2012 total benefits and expenses compared with 24.7 percent in 2011 and 26.6 percent in 2010. Expenses in 2012 increased, primarily due to the unlocking of actuarial assumptions for our universal life insurance contracts.
We expect 2013 to be another challenging year for the life insurance industry as interest rates appear unlikely to move significantly from their historic lows. Interest rate margins will continue to compress as maturing fixed income assets are replaced with lower yielding securities. Application activity was relatively flat in 2012 at approximately 1 percent growth and 2013 ushered in higher taxes on all Americans, meaning less disposable income to purchase life insurance.
· Investment income - Pretax investment income increased 1 percent in 2012, primarily because of higher dividends that reflected rising dividend rates and a greater asset allocation of available funds into equity securities. Interest income declined slightly due to both a decrease in asset allocation into fixed-maturity securities and the continuing investment yield effects of the low interest rate environment. Average yields in the investment income table below are based on the average invested asset and cash amounts indicated in the table, using fixed-maturity securities valued at amortized cost and all other securities at fair value.
· 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 gains were somewhat offset by OTTI charges.
· Interest income declined 1 percent in 2012 as the average fixed-maturity pretax yield declined by approximately 16 basis points, offsetting a larger fixed-maturity portfolio that rose 2 percent on an amortized cost basis. It was essentially flat in 2011 as a larger portfolio offset declining average yield.
· $37 million in net realized gains from equity security sales.
· $3 million in other net realized gains, including changes in the valuation of securities with embedded derivatives described below.
We have a small portfolio of convertible preferred stocks and bonds that have an embedded derivative component. In 2012, we recorded $1 million in fair value realized losses compared with fair value realized gains of $1 million in 2011 and $10 million in 2010. These changes in fair value were due to the application of ASC 815-15-25, which allows us to account for the entire hybrid financial instrument at fair value, with changes recognized in realized investment gains and losses. The changes in fair values are recognized in net income in the period they occur.
In 2012, we recorded $33 million in write-downs for 13 securities that we deemed had experienced an other-than-temporary decline in fair value compared with $57 million for 12 securities in 2011 and $36 million for 15 securities in 2010. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 47. The OTTI charges in 2012, 2011 and 2010 were each 1 percent or less of our investment portfolio at year-end. OTTI charges also include unrealized losses of holdings that we intend to sell but have not yet completed a transaction.
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2013, 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 20.
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 47.
The change in our effective tax rate was primarily due to changes in pretax income from underwriting results, changes in investment income and the amount of realized investment gains and losses. Changes to tax-exempt interest and the dividend received deduction in the current year compared with prior years also contributed to the change.
Historically, we have pursued a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. See Item 1, Tax-Exempt Fixed Maturities, Page 22, for further discussion on municipal bond purchases in our fixed-maturity investment portfolio. For our insurance subsidiaries, approximately 85 percent of income from tax-advantaged fixed-maturity investments is exempt from federal tax. Our noninsurance companies own an immaterial amount of tax-advantaged fixed-maturity investments. For our insurance subsidiaries, the dividend received deduction, after the dividend proration of the 1986 Tax Reform Act, exempts approximately 60 percent of dividends from qualified equities from federal tax. For our noninsurance subsidiaries, the dividend received deduction exempts 70 percent of dividends from qualified equities. Details about our effective tax rate are found on Note 11, Page 129.
Cash generated from investment income is the most important investment contribution to cash flow. While we have never sold investments to make claim payments, the sale of investments could provide an additional source of liquidity at either the parent company or insurance subsidiary level, if required. However, we follow a buy-and-hold investment philosophy, seeking to compound cash flows over the long-term. In addition to possible sales of investments, proceeds of call or maturities of fixed-maturity securities also can provide liquidity. During the next five years, $3.747 billion, or 41.2 percent, of our fixed-maturity portfolio will mature. At year-end 2012, total unrealized gains in the investment portfolio, before deferred income taxes, were $1.875 billion. Liquidity sourced from our investment portfolio is not materially at risk from European-based securities, as our total exposure to such securities at the end of 2012 was $504 million on a fair value basis, or 4.0 percent of our total invested assets. We own no European sovereign debt. Our European-based securities are summarized by country in Item 7A, Qualitative and Quantitative Disclosures About Market Risk, Page 100.
We provide details of our three long-term notes in Item 8, Note 8, of the Consolidated Financial Statements, Page 127. None of the notes are encumbered by rating triggers. The total principal amount of our long-term debt at December 31, 2012, was $793 million and included:
· $374 million aggregate principal amount of 6.125% senior debentures due 2034.
Capital resources consisting of shareholders’ equity and total debt represent our overall financial strength to support writing and growing our insurance businesses. At December 31, 2012, we had total capital of $6.347 billion. Shareholders’ equity was $5.453 billion, an increase of $420 million, or 8 percent, from the prior year. Our total debt was $894 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 2012, the ratio was 14.1 percent compared with 15.1 percent at year-end 2011.
· Dividends to shareholders -The ability of the company to continue paying cash dividends is subject to factors the board of directors deem relevant. While the board and management believe there is merit to sustaining the company’s long record of dividend increases, our first priority is the company’s financial strength. Over the past 10 years, the company has paid an average of 57 percent of net income as dividends. Through 2012, the board had increased our cash dividend for 52 consecutive years. The board decision in August 2012 to increase the dividend demonstrated confidence in the company’s strong capital, liquidity, financial flexibility and initiatives to improve earnings performance.
Our approach since mid-2008 has been to preserve capital and repurchase a minimal amount of shares. Those repurchases were intended to partially offset the issuance of shares through equity compensation plans, primarily due to vesting of service-based restricted stock units of equity awards granted in the past. Our corporate Code of Conduct restricts repurchases during certain time periods. The details of the repurchase authorizations and activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 34.
· Interest on long-term debt - We expect total interest expense to be $52 million in 2013. We discuss outstanding debt in Additional Sources of Liquidity, Page 84.
Our estimate of future gross property casualty loss and loss expense payments of $4.169 billion is lower than loss and loss expense reserves of $4.230 billion reported on our balance sheet at December 31, 2012. The $61 million difference is due to certain life and health loss reserves.
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.
Due to these considerations, our actuarial staff reviewed additional reserving methods and elected to use a weighted average of a paid survival ratio method and report year method to estimate reserves for IBNR asbestos and environmental claims. The result is a decrease of approximately 10 percent in the indicated reserve as derived from the 2003 survival ratio analysis alone. Our exposure to such claims is limited; we believe moving to weighted average of both methods produces a sufficient level of reserves.
Our estimates of gross property casualty loss and loss expense payments do not include reinsurance receivables or ceded losses. As discussed in 2013 Reinsurance Programs, Page 95, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance unpaid receivables of $356 million at year-end 2012 are an offset to our gross property casualty loss and loss expense obligations. Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claim severity or frequency due to a catastrophic event. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover losses under our reinsurance agreements depends on the financial viability of the reinsurers.
We direct our associates and agencies to settle claims and pay losses as quickly as is practical, and we made $2.229 billion of net claim payments during 2012. At year-end 2012, total net property casualty reserves of $3.813 billion reflected $2.015 billion in unpaid amounts on reported claims (case reserves), $888 million in loss expense reserves and $910 million in estimates of claims that were incurred but had not yet been reported (IBNR). The specific amounts and timing of obligations related to case reserves and associated loss expenses are not set contractually. The amounts and timing of obligations for IBNR claims and related loss expenses are unknown. We discuss our methods of establishing loss and loss expense reserves and our belief that reserves are adequate in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 43.
The historical pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The effective duration of our consolidated property casualty fixed-maturity portfolio was 4.2 years at year-end 2012. By contrast, the duration of our loss and loss expense reserves was approximately 4.32 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow from operations is sufficient to meet these obligations. In addition, investment holdings could be sold, if necessary, to meet higher than anticipated loss and loss expenses.
The company established a reasonably likely range for net loss and loss expense reserves of $3.598 billion to $3.918 billion at year-end 2012, with the company carrying net reserves of $3.813 billion. The likely range was $3.677 billion to $4.056 billion at year-end 2011, with the company carrying net reserves of $3.905 billion. Our loss and loss expense reserves are not discounted for the time-value of money, but we have reduced the reserves by an estimate of the amount of salvage and subrogation payments we expect to recover.
The low point of each year’s range corresponds to approximately one standard error below each year’s mean reserve estimate, while the high point corresponds to approximately one standard error above each year’s mean reserve estimate. We discussed management’s reasons for basing reasonably likely reserve ranges on standard errors in Critical Accounting Estimates, Reserve Estimate Variability, Page 46.
Management’s best estimate of total loss and loss expense reserves as of year-end 2012 was consistent with the corresponding actuarial best estimate. Management’s best estimate of total loss and loss expense reserves as of year-end 2011 also was consistent with the corresponding actuarial best estimate.
· Section B shows the cumulative net amount paid with respect to the previously recorded reserve as of the end of each succeeding year. For example, as of December 31, 2012, we had paid $2.040 billion of loss and loss expenses in calendar years 2003 through 2012 for losses that occurred in accident years 2002 and prior. An estimated $263 million of losses remained unpaid as of year-end 2012 (net re-estimated reserves of $2.303 billion from Section C less cumulative net paid loss and loss expenses of $2.040 billion).
Overall favorable development for consolidated property casualty reserves of $396 million in 2012 illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. As noted in Critical Accounting Estimates, Key Assumptions - Loss Reserving, Page 46, our models predict that actual loss and loss expense emergence will differ from projections, and we do not attempt to monitor or identify such normal variations. The table showing reserves by segment and lines of business in Property Casualty Loss and Loss Expense Obligations and Reserves, Page 88, shows the components of gross reserves among case, IBNR and loss expense reserves.
Favorable reserve development of $177 million for the commercial casualty line accounted for approximately 60 percent of the commercial lines insurance segment total in 2012, while favorable reserve development of $74 million for the workers’ compensation line accounted for approximately 25 percent of the segment total in 2012. Drivers of significant reserve development are discussed below.
· Moderation in commercial casualty trend selections - We saw moderating loss cost trends continue in several commercial casualty coverages, most notably for umbrella liability 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.
Favorable development of personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. We continued to see favorable reserve development related to umbrella liability
The following table shows our five largest property casualty reinsurance receivable amounts by reinsurer at year-end 2012 and 2011. USAIG is a joint underwriting association of individual insurance companies that collectively functions as a worldwide aviation insurance market. We terminated our participation in the association after policy year 2002. The A.M. Best insurer financial strength ratings as of December 31, 2012, are also shown for each those reinsurers.
Primary components of the 2013 property and casualty reinsurance program include:
· 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 $7 million of each loss. Losses between $7 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $37 million for 2013, compared with $37 million in 2012 and $32 million in 2011. Lower 2013 rates were essentially offset by estimates of higher levels of property coverage direct written premiums that are subject to the treaty.
· Casualty per occurrence treaty - The casualty treaty provides capacity up to $25 million. Similar to the property treaty, it provides sufficient capacity to cover the vast majority of casualty accounts we insure and also includes protection for extra-contractual liability coverage losses. We retain the first $7 million of each loss. Losses between $7 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $29 million in 2013, compared with approximately $37 million in 2012 and in 2011. Lower 2013 rates for this treaty were partially offset by estimates of higher levels of liability coverage direct written premiums that are subject to the treaty.
· Casualty excess treaty - We purchase a casualty reinsurance treaty that provides an additional $45 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $75 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 $3 million in 2013, similar to the premium we paid in 2012 and 2011.
· Property catastrophe treaty - To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, we purchased property catastrophe reinsurance with a limit up to $600 million. The treaty contains one reinstatement provision. For the 2013 treaty, ceded premiums are estimated at $60 million, up slightly from approximately $59 million in 2012, primarily due to minor changes in our share of losses described below. We retain the first $75 million of any loss, plus varying shares of losses up to $600 million:
o 61.3 percent of losses between $75 million and $100 million
o 5.0 percent of losses between $200 million and $300 million
· Beginning in 2013 we added an alternative reinsurance structure to protect against certain catastrophic events. For certain exposures in the United States, we arranged for the purchase of collateralized reinsurance funded through the issuance of collateralized risk-linked securities, known as catastrophe bonds. The catastrophe bond arrangements generally provide reinsurance coverage for specific types of losses in specific geographic locations. They are generally designed to supplement coverage provided under the North American catastrophe treaty. Effective January 2013, we have a catastrophe bond arrangement providing up to $72 million in reinsurance protection. It expires in January 2014 and provides coverage for severe convective storm losses in certain key core regions as well as supplemental coverage in the event of an earthquake occurring along the New Madrid fault line.
After reinsurance, our maximum exposure to a catastrophic event that causes $700 million in covered losses that qualified, in 2013 only, for the collateralized reinsurance described above would be $145 million compared with $219 million in 2012. The largest catastrophe loss event in our history occurred during 2011 from a May 20-27 storm system that included a tornado in Joplin, Missouri, and also significant losses from hail in the Dayton, Ohio, area. Our losses from that storm were estimated at December 31, 2012, to be $231 million before reinsurance.
Terrorism coverage at various levels has been secured in most of our reinsurance agreements. The broadest coverage for this peril is found in the property and casualty working treaties, the property per risk treaty and the casualty per occurrence treaty, which provide coverage for commercial and personal risks. Our property catastrophe treaty provides terrorism coverage for personal risks, and coverage for commercial risks with total insured values of $10 million or less. For insured values between $10 million and $25 million, there also may be coverage in the property working treaty.
A form of reinsurance is also provided through The Terrorism Risk Insurance Act of 2002 (TRIA). TRIA was originally signed into law on November 26, 2002, and extended on December 22, 2005, in a revised form, and extended again on December 26, 2007. TRIA provides a temporary federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. TRIA now is scheduled to expire December 31, 2014. Under regulations promulgated under this statute, insurers are required to offer terrorism coverage for certain lines of property casualty insurance, including property, commercial multi-peril, fire, ocean marine, inland marine, liability, aircraft and workers’ compensation. In the event of a terrorism event defined by TRIA, the federal government would reimburse terrorism claim payments subject to the insurer’s deductible. The deductible is calculated as a percentage of subject written premiums for the preceding calendar year. Our deductible in 2012 was $383 million (20 percent of 2011 subject premiums), and we estimate it is $416 million (20 percent of 2012 subject premiums) in 2013.
· Basket retention - Cincinnati Specialty Underwriters has purchased this coverage to limit our retention to $1 million in the event that the same occurrence results in both a property and a casualty loss.
· Property catastrophe treaty - As a subsidiary of Cincinnati Insurance, Cincinnati Specialty Underwriters has been added as a named insured under our corporate property catastrophe treaty, and for our collateralized reinsurance funded through the issuance of catastrophe bonds. All terms and conditions of this reinsurance coverage apply to policies underwritten by Cincinnati Specialty Underwriters.
o Significant or prolonged decline in the value of a particular security or group of securities and impairment of the asset(s)
o Significant decline in investment income due to reduced or eliminated dividend payouts from a particular security or group of securities
· Delays or performance inadequacies from ongoing development and implementation of underwriting and pricing methods or technology projects and enhancements expected to increase our pricing accuracy, underwriting profit and competitiveness
· Inability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased, financial strength of reinsurers and the potential for nonpayment or delay in payment by reinsurers
· Difficulties with technology or data security breaches, including cyber attacks, that could negatively affect our ability to conduct business and our relationships with agents, policyholders and others
· Inability to defer policy acquisition costs for any business segment if pricing and loss trends would lead management to conclude that segment could not achieve sustainable profitability
o Restrict our ability to exit or reduce writings of unprofitable coverages or lines of business
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2012, in accordance with accounting principles generally accepted in the United States of America (GAAP).
Deloitte & Touche LLP, our independent registered public accounting firm, audited the consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2012. Its report is on Page 107. Deloitte & Touche LLP met with our audit committee to discuss the results of their examination. They have the opportunity to discuss the adequacy of internal controls and the quality of financial reporting without management present.
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 1,408 independent insurance agencies with 1,758 reporting locations across 39 states. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life and disability income insurance and fixed annuities, and The Cincinnati Specialty Underwriters Insurance Company, which offers excess and surplus lines property and casualty insurance products.
We account for stock-based compensation in accordance with Accounting Standards Codification (ASC) 718, Compensation - Stock Compensation. We grant qualified and nonqualified 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. We grant service-based restricted stock units that cliff vest three years after the date of grant. We also grant performance-based restricted stock units that vest if certain market conditions are attained. In 2012, the CFC compensation committee approved a mix of incentive stock options, nonqualified stock options, service-based restricted and performance-based restricted stock units. See Note 17, Stock-Based Associate Compensation Plans, Page 135, for further details.
We sponsor a defined benefit pension plan that was modified during 2008. We froze entry into the pension plan, and only participants 40 years of age or older could elect to remain in the plan. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method. Refer to Note 13, Employee Retirement Benefits, Page 130 for more information about our defined benefit pension plan.
Certain property casualty policies are not entered into underwriting systems before the effective date. An actuarial estimate is made to determine the amount of these unprocessed written premiums. A large majority of the estimate is unearned and does not have a material impact on earned premiums.
We calculate the profit-sharing commission accrual estimate from property casualty underwriting results. These commissions are paid to agencies using a formula that takes into account agency profitability and premium volume. The commission accrual of $102 million at December 31, 2012, contributed 3.1 percentage points to the consolidated property casualty combined ratio. The profit-sharing commission accrual at December 31, 2011, was $68 million.
When we issue a traditional long-duration contract, we capitalize acquisition costs. Acquisition costs are related to the successful acquisition 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 used in establishing the liability for the contract. All acquisition costs reflect the retrospective adoption of ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which we adopted on January 1, 2012. We update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate our deferred acquisition cost for recoverability.
We carry the assets of separate account BOLIs at fair value. The liabilities on separate account BOLIs primarily are the contract holders’ claims to the related assets and are carried at an amount equal to the contract holders’ account value. At December 31, 2012, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders’ account value by approximately $77 million. If the BOLI projected fair value were to fall below the value we guaranteed, a liability would be established by a charge to the company’s earnings.
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, which approximates fair value.
Our invested asset impairment policy states that fixed maturities below their amortized cost that the company (1) intends to sell or (2) more likely than not will be required to sell before recovery of their amortized cost basis are deemed to be other-than-temporarily impaired (OTTI). The amortized cost of any such securities is reduced to fair value as the new cost basis, and a realized loss is recorded in the period in which it is recognized. When these two criteria are not met, and the company believes that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount with the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the period in which it occurred. The difference between the fair value and the net present value of the cash flows of the security, the noncredit loss, is recognized in other comprehensive income as an unrealized loss.
ASC 820 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 a pricing
vendor, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. The company obtains and reviews the pricing service’s valuation methodologies and related inputs and validates these prices by replicating a sample across each asset class using a discounted cash flow model. 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 a pricing vendor is less than 1 percent of the fair value of our total investment portfolio.
For the purpose of ASC 825 disclosure, we base fair value for long-term senior notes on market pricing of similar debt instruments that are actively trading. We base fair value for notes payable on our year-end outstanding balance because it is short term and tied to a variable interest rate. We estimate the fair value of liabilities for investment contracts and annuities using discounted cash flow calculations across a wide range of economic interest rate scenarios with a provision for our nonperformance risk. We estimate the fair value for policyholder loans on insurance contracts using a discounted cash flow model. Determination of fair value for structured settlements assumes the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December 31, 2012, to account for nonperformance risk. See Note 3, Fair Value Measurements, Page 121, for further details.
Our leasing subsidiary provides auto and equipment direct financing (leases and loans) to commercial and individual clients. We generally transfer ownership of the property to the client as the terms of the leases expire. Our lease contracts contain bargain purchase options. We account for these leases and loans as direct financing-type leases. We capitalize and amortize lease or loan origination costs over the life of the financing, using the effective interest method. These costs may include, but are not limited to finder fees, broker fees, filing fees and the cost of credit reports. We record income over the financing term using the effective interest method. Finance receivables are reviewed for impairment on a quarterly basis and considered insignificant to our consolidated financial condition, results of operations and cash flows.
· In December 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-11, Disclosures About Offsetting Assets and Liabilities. ASU 2011-11 requires entities to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. The ASU is effective for interim and annual reporting periods beginning on or after January 1, 2013, and should be applied retrospectively for all comparative periods presented. The ASU has not yet been adopted and will not have a material impact on our company’s financial position, cash flows or results of operations.
The following table illustrates the effect of adopting ASU 2010-26 in the consolidated statements of comprehensive income:
The net unrealized investment gains in our fixed-maturity portfolio are primarily the result of the current low interest rate environment that increased the fair value of our fixed-maturity portfolio. The three largest net unrealized investment gains in our common stock portfolio are from Exxon Mobil Corporation (NYSE:XOM), The Procter & Gamble Company (NYSE:PG), and Chevron Corporation (NYSE:CVX), which had a combined net gain position of $282 million. At December 31, 2012, we had $31 million fair value of hybrid securities included in fixed maturities that follow ASC 815-15-25, Accounting for Certain Hybrid Financial Instruments. The hybrid securities are carried at fair value, and the changes in fair value are included in realized investment gains and losses.
At December 31, 2012, contractual maturity dates for fixed-maturity investments were:
The following table provides investment income, realized investment gains and losses and the change in unrealized investment gains and losses and other items, by investment category:
For the years ended December 31, 2012 and 2011, there were no credit losses on fixed-maturity securities for which a portion of OTTI has been recognized in other comprehensive income.
In accordance with accounting guidance for fair value measurements and disclosures, we categorized our financial instruments, based on the priority of the observable and market-based data for the valuation technique used, 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. Our valuation techniques have not changed from those used at December 31, 2011, and ultimately management determines fair value.
We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. 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 a nationally recognized pricing vendor, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. The company obtains and reviews the pricing service’s valuation methodologies and related inputs and validates these prices by replicating a sample across each asset class using a discounted cash flow model. 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. We have generally obtained and evaluated two nonbinding quotes from brokers; our investment professionals determine our best estimate of fair value. The fair value of investments not priced by a pricing vendor is less than 1 percent of the fair value of our total investment portfolio. Reclassification of certain financial instruments may occur when input observability changes. All reclassifications are reported as transfers in or out of the Level 3 category as of the beginning of the quarter in which the reclassification occurred.
The Level 2 preferred equities technique used is the application of matrix pricing. The inputs used, similar to those used by the pricing vendor for our fixed-maturity securities, include relevant market information, trade activity of like securities, yield to maturity, corporate action notices and economic events. All of the Level 2 preferred equities are priced by a nationally recognized pricing vendor.
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is identified in the following tables by security type with a summary of changes in fair value as of December 31, 2012. Total Level 3 assets continue to be less than 1 percent of financial assets measured at fair value in the consolidated balance sheets. Assets presented in the table below were valued based primarily on broker/dealer quotes for which there is a lack of transparency as to inputs used to develop the valuations. The quantitative detail of these unobservable inputs is neither provided nor reasonably available to us.
Fair value of the long-term debt was determined under the fair value measurements and disclosure accounting rules based on market pricing of similar debt instruments that are actively trading. We determine fair value for our debt the same way that we value corporate fixed maturities in our investment portfolio. Fair value can vary with macroeconomic conditions. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt is $793 million. None of the long-term debt is encumbered by rating triggers.
The following table shows the fair value of our life policy loans, included in other invested assets, subject to fair value disclosure requirements:
Outstanding principal and interest for these life policy loans was $37 million at December 31, 2012, and December 31, 2011. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates as nonperformance risk is minimal; and (2) the loan repayment rate by which policyholders pay off their loan balances is in line with past experience.
Determination of fair value for structured settlements assumes the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December, 2012, to account for nonperformance risk.
During 2010, we experienced $304 million of favorable loss development on prior accident years including $269 million in commercial lines. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $186 million for the commercial casualty line and $39 million for the workers’ compensation line due to reduced uncertainty of these lines one year later.
We believe our exposure to asbestos and environmental claims is limited, largely because our reinsurance retention was $500,000 or below prior to 1987. We also were predominantly a personal lines company in the 1960s and 1970s. During the 1980s and early 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 included an asbestos and environmental exclusion in most policies or endorsed the exclusion to the policies. 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.
Our insurance subsidiary declared dividends to the parent company of $300 million in 2012, $180 million in 2011 and $220 million in 2010. 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 2013, the total that our insurance subsidiary, which is the parent of all other insurance subsidiaries, may declare in dividends is approximately $391 million.
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions about the appropriate level of risk retention are affected by various factors, including changes in our underwriting practices, capacity to retain risks and reinsurance market conditions. Primary components of our property and casualty reinsurance program include a property risk treaty, casualty per occurrence treaty and property catastrophe treaty.
Changes in 2012 ceded earned premiums compared with 2011 are related to ceded earned reinstatement premiums for additional reinsurance coverage as a result of the increase in catastrophe losses that occurred during 2011.
Changes in 2012 ceded loss and loss expenses compared with 2011 are related to our increase in catastrophe losses in 2011 that resulted in increased ceded incurred losses to our reinsurers.
Our consolidated statements of comprehensive income include earned life insurance premiums on ceded business:
Our consolidated statements of comprehensive income include life insurance contract holders’ benefits incurred on assumed and ceded business:
As a result of positions either taken in our 2011 federal tax return filed with the IRS or expected to be taken in the 2012 filing, we believe it is more likely than not that our tax liability will be sustained upon examination by the IRS. We therefore carry no amount for unrecognized tax benefits for the years ended 2012, 2011 and 2010.
We sponsor a defined benefit pension plan. During 2008, we changed the form of retirement benefit we offer some associates to a company match on contributions to a 401(k) plan from the defined benefit pension plan. We froze entry into the pension plan for new associates as of June 30, 2008, and only participants 40 years of age or older as of August 31, 2008, could elect to continue to participate. For participants remaining in the pension plan, we continue to contribute to fund future benefit obligations. Benefits for the defined benefit pension plan are based on years of credited service and compensation level. Contributions are based on the prescribed method defined in the Pension Protection Act. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method. During the fourth quarters of 2012 and 2011, we offered limited opportunities for distribution of vested balances to terminated participants in the qualified pension plan. The plan paid $2 million and $9 million to these terminated vested participants during 2012 and 2011, respectively. The qualified plan was amended to allow for distribution of vested balances to terminated participants on an ongoing basis.
We also sponsor a defined contribution plan (401(k) plan). Matching contributions totaled $9 million, $8 million and $8 million during the years 2012, 2011 and 2010, respectively. Associates who are not accruing benefits under the pension plan are eligible to receive the company match of up to 6 percent of cash compensation. We also pay all operating expenses for the 401(k) plan. Participants vest in the company match for the 401(k) plan after three years of eligible service.
We maintain a supplemental executive retirement plan (SERP) with obligations of $9 million at year-end 2012 and $8 million at year-end 2011, which are included in the obligation and expense amounts. The company also makes available to a select group of associates the CFC Top Hat Savings Plan, a nonqualified deferred compensation plan.
We evaluate our pension plan assumptions annually and update them as necessary. The weighted-average assumptions used to determine benefit obligations at December 31 follow:
This is a summary of the weighted-average assumptions we use to determine our net expense for the plans:
The total recognized in net periodic benefit cost and other comprehensive income was $31 million, $38 million and $9 million for the years ended December 31, 2012, 2011 and 2010, respectively. The increase in the amount recognized in other comprehensive income from 2010 is largely due to the decreases in discount rate and lump sum rate. The estimated costs to be amortized from AOCI into net periodic benefit cost over the next year for our plans are an $8 million actuarial loss and a $1 million prior service cost.
The pension plan assets are managed to maximize total return over the long term while providing sufficient liquidity and current return to satisfy the cash flow requirements of the plan. The plan’s day-to-day investment decisions are managed by our internal investment department; however, overall investment strategies are discussed with our employee benefits committee.
Investments in securities are valued based on the fair value hierarchy outlined in Note 3, Fair Value Measurements, Page 121. The following table illustrates the fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2012 and 2011. The pension plan did not have any liabilities carried at fair value or any Level 3 assets at or during the years ended December 31, 2012 and 2011. There have been no transfers between Level 1 and Level 2 for the years ended December 31, 2012 and 2011.
As of December 31, 2012, we had $19 million of unrecognized total compensation cost related to nonvested stock options and restricted stock unit awards. That cost will be recognized over a weighted-average period of 1.8 years.
Stock options are granted to associates at an exercise price that is equal to the fair value as reported on the Nasdaq Global Select Market for the grant date and are exercisable over 10-year periods. The stock options 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 a binomial option-pricing model. We make assumptions in four areas to develop the binomial option-pricing model:
· Expected volatility is based on our stock price over a historical period that approximates the expected term.
· Dividend yield is determined by dividing the annualized per share dividend by the stock price on the date of grant.
The following weighted average assumptions were used in determining fair value for option grants issued during 2012 and 2011:
The weighted-average remaining contractual life for exercisable awards as of December 31, 2012, was 3.2 years. Under all active shareholder approved plans, a total of 17.3 million shares were authorized to be granted. These include the 7 million shares available under the Cincinnati Financial Corporation 2012 Stock Compensation Plan approved by shareholders in 2012. At December 31, 2012, 9.3 million shares remained available for future issuance under the plans. During 2012, we granted 24,118 shares of common stock to our directors for 2011 board service fees. We currently issue new shares or use treasury shares for stock-based compensation award issues or exercises.
We have performance-based awards that vest on the first day of March after a three-calendar-year performance period. These awards vest according to the level of total shareholder return achieved compared to a peer group over a three-year period with payouts ranging from 0-125%. Total shareholder return is calculated by Bloomberg using annualized total return of a stock to an investor due to capital gain appreciation plus reinvestment of all dividends. We issued 53,150 shares of performance-based restricted stock units during 2012 at the target-level performance hurdle for the three-year performance period ending December 31, 2011, as we achieved a three-year total shareholder return which exceeded four of our eight peers. For the three-year performance period ended December 31, 2012, our total shareholder return exceeded all peers in our peer group. We expect payout of these shares at the maximum level to occur on March 1, 2013. Performance-based shares are issued out of treasury shares.
These performance-based awards are valued using a Monte-Carlo valuation on the date of grant, which uses a risk-neutral framework to model future stock price movements based upon the risk-free rate of return, the volatility of each peer and the correlations of each peer being modeled. Compensation cost is recognized regardless of whether the market-based performance objective has been satisfied. We make assumptions to develop the Monte-Carlo model as follows:
· Expected volatility is based on our stock price over a historical period that approximates the expected term. We have used the historical volatilities of 2.87 for 2012 grants and 2.59-2.87 years for 2011 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 were 0.40% for 2012 grants and 0.65%-1.25% for 2011 grants.
· Fee revenues for the commercial and personal insurance segments primarily represent installment fees.
· Income before income taxes for the insurance segments is defined as underwriting profit or loss.
· Income before income taxes for the investment operations segment is net investment income plus realized investment gains and losses for investments of the entire company, minus investment interest credited to contract holders of the life insurance segment.