Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building has approximately 1,508,200 total square feet of available space. The property, including land, is carried in our financial statements at $150 million as of December 31, 2011, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (less than 1 percent). This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
Cincinnati Financial Corporation also owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property. This four-story office building has approximately 124,000 square feet of available space. The property is carried in the financial statements at $8 million as of December 31, 2011, and is classified as land, building and equipment, net, for company use. Unaffiliated tenants occupy approximately 5 percent. This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
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, 2011, 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, 2011.
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, Pages 37, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 114. We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and stock dividends.
To measure our progress, we have defined a measure of value creation that we believe captures the contribution of our insurance operations, the success of our investment strategy and the importance we place on paying cash dividends to shareholders. We refer to this measure as our value creation ratio, or VCR, and it is made up of two primary components: (1) our rate of growth in book value per share plus (2) the ratio of dividends declared per share to beginning book value per share. For the period 2010 through 2014, an annual value creation ratio averaging 12 percent to 15 percent is our primary performance target. Management believes this non-GAAP measure is a useful supplement to GAAP information. With the continuation of economic and market uncertainty since 2008, we believe the long-term nature of this ratio is an appropriate way to measure our long-term progress in creating shareholder value. VCR trends and a reconciliation of the non-GAAP measure to comparable GAAP measures are shown in the tables below.
· 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 101.3 percent over the five-year period 2007 through 2011. Our combined ratio was below 100 percent in 2007, but above 100 percent for 2008 through 2011, when our average catastrophe loss ratio of 7.7 percentage points was 3.8 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 51. Our statutory combined ratio averaged 101.2 percent over the five-year period 2007 through 2011 compared with an estimated 100.8 percent for the property casualty industry, excluding the mortgage and financial guaranty segments.
o Investment income growth, on a before-tax basis, had a compound annual rate of negative 1.6 percent over the five-year period 2007 through 2011. It grew in each year except 2008 and 2009, when we experienced a dramatic reduction in dividend payouts by financial services companies held in our equity portfolio, a risk we addressed aggressively during 2008, completing that effort in early 2009.
o Over the five years ended December 31, 2011, our compound annual equity portfolio return was a negative 4.7 percent compared with a compound annual total return of 0.3 percent for the Index. Our equity portfolio underperformed the market for the five-year period primarily because of the 2008 decline in the market value of our previously large holdings in the financial services sector. For the year 2011, our compound annual equity portfolio return was 6.1 percent, compared with 2.1 percent for the Index, as the large-cap, dividend paying stocks that we prefer outpaced the broader equity market.
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 2011, the company has increased the indicated annual cash dividend rate for 51 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 85.
· Improve insurance profitability - Implementation of these initiatives is intended to improve pricing capabilities for our property casualty business and increase our ability to manage our business while also enhancing our efficiency. Improved pricing capabilities through the use of technology and analytics can lead to better profit margins. Improved internal processes with additional performance metrics can help us be more efficient and effective. These initiatives also support the ability of the agencies that represent us to grow profitably by allowing them to serve clients faster and to more efficiently manage agency expenses.
Invested assets grew 3 percent during 2011 on a fair value basis, with market gains slightly outpacing an increase in the cost basis of invested assets of approximately 1 percent. Entering 2012, the portfolio continues to be well-diversified, and we believe it is well-positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, Page 20, and results for the segment in Investment Results of Operations, Page 81.
Short-term debt rose $55 million, primarily to fund share repurchases using our relatively low-cost source of borrowing. Our ratio of debt to total capital (debt plus shareholders’ equity) increased somewhat in 2011 but remains comfortably within our target range.
Our property casualty insurance operations reported an underwriting loss in each of the last three years. The $229 million change for 2011, compared with 2010, was driven by a $254 million rise in losses from natural catastrophe events. We measure property casualty underwriting profitability primarily by the combined ratio. Our combined ratio measures the percentage of each earned premium dollar spent on claims plus all expenses related to our property casualty operations. A lower ratio indicates more favorable results and better underlying performance. Our combined ratio was over 100 percent in each of the last three years. Higher losses from natural catastrophes drove the 2011 ratio increase. Initiatives to improve our combined ratio are discussed in Item 1, Strategic Initiatives, Page 10. In 2011, 2010 and 2009, favorable development on reserves for claims that occurred in prior accident years helped offset other incurred loss and loss expenses. Reserve development is discussed further in Property Casualty Loss and Loss Expense Obligations and Reserves, beginning on Page 88. Losses from weather-related catastrophes are another important item influencing the combined ratio and are discussed along with other factors in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 57, Page 69 and Page 75, respectively.
Our view of the 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 insurance pricing throughout 2012. Second, we assume that the economy can maintain a growth track during 2012. If those assumptions prove to be inaccurate, we may not be able to achieve our performance targets even if we accomplish our strategic objectives.
Other factors that could influence our ability to achieve our target include:
· We expect the independent insurance agency system to remain strong, with continued agency consolidation. If soft insurance market conditions return in 2012, it will create additional risk for agencies.
We discuss in our Item 1A, Risk Factors, Page 26, many potential risks to our business and our ability to achieve our qualitative and quantitative objectives. These are real risks, but their probability of occurring may not be high. We also believe that our risk management programs generally could mitigate their potential effects, in the event they would occur. We continue to study emerging risks, including climate change risk and its potential financial effects on our results of operation and those we insure. These effects include deterioration in credit quality of our municipal or corporate bond portfolios and increased losses without sufficient corresponding increases in premiums. As with any risk, we seek to identify the extent of the risk exposure and possible actions to mitigate potential negative effects of risk, at an enterprise level.
We have formal risk management programs overseen by an executive officer and supported by a team of representatives from business areas. The team provides reports to our chairman, our president and chief executive officer and our board of directors, as appropriate, on risk assessments, risk metrics and risk plans. Our use of operational audits, strategic plans and departmental business plans, as well as our culture of open communications and our fundamental respect for our Code of Conduct, continue to help us manage risks on an ongoing basis.
· The rally in financial markets during 2009 and 2010 had a favorable impact on our value creation ratio, offsetting much of the unfavorable impact of the sharp decline in financial markets during 2008. Financial markets continued to display volatility during 2011, and some predict more turbulence in 2012 from effects of events such as the sovereign debt crisis in several European countries. Should financial markets decline during 2012, which could occur as part of typical market volatility patterns, the related component of our 2012 value creation ratio could also register a weak or negative result.
Our field claims representatives establish case reserves when claims are reported to the company to provide for our unpaid loss and loss expense obligation associated with 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.
Case reserves of all sizes are subject to review on a 90-day cycle, or more frequently if new information about a loss becomes available. As part of the review process, we monitor industry trends, cost trends, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional loss exposures.
· For all other claims and events, IBNR reserves are calculated as the difference between an actuarial estimate of the ultimate cost of total loss and loss expenses incurred reduced by the sum of total loss and loss expense payments and total case reserves estimated for individual claims. We discuss below the development of actuarially based estimates of the ultimate cost of total loss and loss expenses incurred.
· 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 will 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 90, for more details on our total reserve range. While the table reflects our assessment of the most likely range within which each line's actual unpaid loss and loss expenses may fall, one or more lines' actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
Our 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 120.
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 2011 in Item 7A, Application of Asset Impairment Policy, Page 104. An other-than-temporary decline in the fair value of a security is recognized in net income as a realized investment loss.
In accordance with ASC 820-10, we have categorized our financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level that is significant to the fair value measurement of the instrument. While we consider pricing data from outside services, we ultimately determine whether the data or inputs used by these outside services are observable or unobservable.
Financial assets that fall within the Level 3 hierarchy are valued based upon unobservable market inputs, normally because they are not actively traded on a public market. Pricing for each Level 3 security is based upon inputs that are market driven, including third-party reviews provided to the issuer or broker quotes. We placed in the Level 3 hierarchy securities for which we were unable to obtain the pricing methodology or we could not consider the price provided as binding. Pricing for securities classified as Level 3 could not be corroborated by similar securities priced using observable inputs.
In 2011, the net pension expense was $13 million. In 2012, we expect the net pension expense to be $18 million.
Holding all other assumptions constant, a 0.5 percentage-point decrease in the discount rate would decrease our 2012 income before income taxes by $1 million. A 0.5 percentage point decrease in the expected return on plan assets would decrease our 2012 income before income taxes by $1 million.
We establish a deferred asset for costs that vary with, and are primarily related to, issuing property casualty and life insurance policies. Underlying assumptions are updated periodically to reflect actual experience, and we evaluate our deferred acquisition cost recoverability.
For property casualty policies, deferred acquisition costs are amortized over the terms of the policies. These costs are principally agent commissions, premium taxes and certain underwriting costs, which are deferred and amortized into net income as premiums are earned. We assess recoverability of deferred acquisition costs at the segment level, consistent with the ways we acquire, service, manage and measure profitability. Deferred acquisition costs track with the change in premiums. Our property casualty insurance operations consist of three segments, commercial lines, personal lines and excess and surplus lines.
Investments held by the parent company and the investment portfolios for the insurance subsidiaries are managed and reported as the investments segment, separate from the underwriting businesses. Net investment income and net realized investment gains and losses for our investment portfolios are discussed in the Investment Results of Operations.
Earned and net written premiums for our consolidated property casualty operations grew in 2011, reflecting improving pricing, strategic initiatives for targeted growth and the effects of slowly improving economic conditions. A key measure of property casualty profitability is underwriting profit or loss. Our underwriting loss rose by $229 million, driven by a $254 million increase in natural catastrophe losses, mostly from severe weather. Underwriting results before catastrophe losses improved, evidence of benefits from various recent-year profit improvement and premium growth initiatives.
The table below highlights property casualty results of operations, with analysis and discussion in the sections that follow. Analysis and discussion by property casualty segment can be found in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 57, Page 69 and Page 75, respectively.
· Premiums - Solid growth in 2011 renewal and new business written premiums drove the increase in earned premiums and net written premiums, offsetting additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty. The rate of growth for earned and net written premiums exceeded that of 2010 as each of our property casualty segments experienced significant increases in 2011 premiums. Improving pricing during 2011 occurred in each of those segments and is further discussed in the results of operations sections below by segment. A fourth straight year of higher new business premiums reflected our premium growth initiatives from recent years that continue to favorably affect current year growth, particularly as newer agency relationships mature over time. Agents appointed during 2010 or 2011 produced an increase in standard lines new business of $31 million during 2011, compared with 2010. Improving insured exposure-level comparatives from the slow economic recovery also favorably affected premium growth, primarily in our commercial lines segment. The contributions to premiums from audits, which are significantly affected by economic trends, are further discussed in Commercial Lines Insurance Results of Operations beginning on Page 57.
The table below analyzes premium revenue components and trends. Premium trends by segment are further discussed beginning on Page 58, Page 69 and Page 75, for the respective property casualty segments.
Our statutory combined ratio was 108.9 percent in 2011 compared with 101.8 percent in 2010 and 104.4 percent in 2009. The estimated property casualty industry, excluding mortgage and financial guaranty segments, was 107.5 percent in 2011, 101.0 percent in 2010 and 99.5 percent in 2009. The contribution of catastrophe losses to our statutory combined ratio was 13.3 percentage points in 2011, 5.1 percentage points in 2010 and 5.7 percentage points in 2009, compared with an estimated 10.1, 4.6 and 3.4 percentage points, respectively, for the industry. Components of the combined ratio are discussed below, followed by additional discussion by segment.
The 2011 ratio of catastrophe losses included 0.4 percentage points from losses of $11 million for our participation in assumed reinsurance treaties that spread the risk of very high catastrophe losses among many insurers. The majority of the assumed reinsurance losses were for the first-quarter 2011 earthquake in Japan. The only assumed reinsurance treaty for which we had a material exposure has been reserved at the $7 million policy limit for the Japan earthquake event.
Catastrophe loss trends, discussed above, drove the increase in 2011 current accident year loss and loss expenses compared with 2010. Catastrophe losses added 13.4 percentage points for 2011, 5.6 points for 2010 and 5.9 points for 2009 to the respective consolidated property casualty accident year loss and loss expense ratios in the table above.
The trend for our current accident year loss and loss expense ratio before catastrophe losses over the past three years included unique items for 2011 discussed below, in addition to normal loss cost inflation and higher pricing.
In 2011, other underwriting expenses were down $9 million or 2 percent, primarily due to a first-quarter 2010 provision for matters involving prior years and related to Note 16, Commitments and Contingent Liabilities, Page 134. The combined effects of a 4 percent increase in earned premiums and a 2 percent decrease in other underwriting expenses resulted in a ratio that was 0.7 percentage points lower.
Salaries, benefits and payroll taxes for our associates account for approximately half of our property casualty other underwriting expenses. Most of our associates either provide direct service to the property casualty portion of our agencies’ business or provide support to those associates. Since the end of 2009 the total number of associates and contractors, on a consolidated basis, declined 4 percent, reflecting careful management of our non-commission expenses. The total number of field associates providing direct service to agencies rose by 4 percent, reflecting our emphasis on providing excellent service.
· Premiums - Earned premiums and net written premiums rose in 2011, primarily due to an $85 million increase in renewal written premiums that reflected the effects of slowly improving economic conditions and improved pricing. Premium growth initiatives that helped new business written premiums grow $18 million in 2011 also contributed to earned and net written premium growth. Earned and net written premiums were up in 2011 despite the partially offsetting effect of $24 million for ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty.
Our commercial lines statutory combined ratio was 104.2 percent in 2011 compared with 99.6 percent in 2010 and 101.9 percent in 2009. The estimated commercial lines combined ratios for the industry were 108.2 percent in 2011, 102.7 percent in 2010 and 103.0 percent in 2009. Industry ratios reported for 2011 and 2010 excluded the mortgage and financial guaranty segments. The contribution of catastrophe losses to our commercial lines statutory combined ratio was 10.4 percentage points in 2011, 4.1 percent points in 2010 and 2.5 percentage points in 2009, compared with an estimated 8.5, 3.5 and 1.8 percentage points, respectively, for the industry.
We began in 2009 to use a predictive modeling tool for our workers’ compensation line of business, working to better align individual insurance policy pricing to risk attributes. We believe such tools are improving our pricing precision. For example, for the year 2011 we achieved average renewal pricing increases three to four times higher for workers’ compensation rating segments indicated as lower quality in our model compared with the higher quality rating segments. During 2011, our underwriters began full use of predictive modeling tools for our other major commercial lines of business: commercial auto, general liability and commercial property coverages in our commercial package accounts. Underwriters using these tools have enhanced abilities to target profitability and to discuss pricing impacts with agency personnel.
The 4 percent increase in 2011 agency renewal written premiums in part reflected improving pricing trends compared with recent years. 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. Our commercial lines pricing transitioned from having a negative effect on renewal written premiums in the first half of 2011 to having a positive effect in the last half. During the fourth quarter of 2011, our standard commercial lines policies averaged an estimated price change that increased in a low- to mid-single-digit range, an improvement compared with a slightly positive price change during the third quarter of 2011 and a first-half 2011 negative price change in 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. Consistent with several commercial lines industry pricing surveys in recent years, our larger accounts typically experienced more pressure to lower pricing upon renewal. Our smaller accounts sometimes saw little if any premium decrease at renewal. For the last half of 2011, we estimated that 75 percent to 80 percent of our standard commercial lines policies renewed at flat or higher prices.
While our commercial lines policy retention rates have remained fairly stable in recent years, agency renewal written premium trends reflected the effects of economic slowdown or recovery in various regions. 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 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.
In 2011, our commercial lines new business premiums written by our agencies grew 6 percent, reversing the new business decline of 3 percent for 2010. For new business, our field associates are frequently in our agents’ offices helping to judge the quality of each account, emphasizing the Cincinnati value proposition, calling on sales prospects with those agents, carefully evaluating risk exposure and providing their best quotes. Some of our new business comes from accounts that are not new to the agent. We believe these seasoned accounts tend to be priced more accurately than business that may be less familiar to our agent in cases where it was recently obtained from a competing agent. As we appoint new agencies who choose to move accounts to us, we report these accounts as new business to us.
New business premium volume in recent years has been significantly influenced by new agency appointments. All agencies newly appointed since the beginning of 2010 generated commercial lines new business written premiums of $34 million during 2011, up $26 million from 2010, while all other agencies contributed the remaining $273 million, which was down 3 percent.
Many of the recently appointed agencies are in five states we entered since 2008: Texas, Colorado, Connecticut, Oregon and Wyoming. Those states accounted for 11 percent of the $307 million 2011 new business volume. On a net written premium basis, agencies in those states contributed $69 million of commercial lines volume during 2011, up $29 million from 2010. New states represent significant potential for long-term premium growth. Based on our history of appointing new agencies, we generally earn a 10 percent share of an agency’s business within 10 years of its appointment.
The table below summarizes agents’ contribution to our commercial lines new business and net written premiums for the five states we entered since 2008. Net written premiums are earned over the term covered by insurance policies and are an important leading indicator of earned premium revenue trends.
Other written premiums, primarily premiums that are ceded to reinsurers and that lower our net written premiums, had a significantly greater unfavorable effect in 2011 compared with 2010. The $40 million change was driven by additional ceded premiums for our property catastrophe reinsurance treaty, $24 million for reinstatement premiums following two large catastrophe events during 2011 and $14 million for the third and fourth event cover that was discussed in Consolidated Property Casualty Insurance Results of Operations, Page 51. For estimated premiums of policies in effect but not yet processed, 2011 had a less favorable adjustment and 2010 had a more favorable adjustment, both compared with the prior year. The adjustment for estimated premiums had an immaterial effect on earned premiums.
The trend for our commercial lines current accident year loss and loss expense ratio before catastrophe losses over the past three years included unique items for 2011 discussed below, in addition to normal loss cost inflation and higher pricing.
The 71.8 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2011 declined 2.7 percentage points compared with the 74.5 percent accident year 2010 ratio measured as of December 31, 2010. The effect of the $24 million ceded to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 0.8 percentage points. Large losses, described below, and the corresponding ratios for new losses above $250,000 caused a 1.9 percentage-point rise in the 2011 ratio. The refined line of business allocation process for loss expenses reduced the 2011 ratio by approximately 3 percentage points. 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.
For 2011, commercial casualty, our largest line of business with earned premiums representing over 30 percent of commercial lines segment earned premiums, continued to be very profitable, based on the total loss and loss expense ratio. Commercial property and specialty packages had 2011 total loss and loss expense ratios significantly higher than we desired, largely due to unusually high weather-related losses in 2011. As discussed below, we are taking actions to improve pricing and reduce loss costs to benefit future profitability trends. The executive risk portion of bond and executive risk continues to experience effects from the U.S. credit crisis of 2008, as most of our prior accident year claims related to financial institution liability developed unfavorably. Since the credit crisis, many of our financial institution policies have been non-renewed, reducing exposure for this portion of our bond and executive risk business. Profitability trends for workers’ compensation continued to improve, reflecting what we believe are the results of initiatives to improve pricing and reduce loss costs.
The 2011 current accident year loss and loss expense ratio before catastrophe losses improved by 10.4 percentage points compared with accident year 2010, largely reflecting higher earned premiums from improving economic trends and pricing that offset normal loss cost inflation. In addition, the refined line of business allocation process for loss expenses reduced the 2011 ratio by approximately 4 percentage points.
Commercial property net written premiums and earned premiums for 2011 rose, largely due to improving pricing trends.
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 non-catastrophe 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 rose 4.5 percentage points, compared with accident year 2010, primarily due to a rise in loss cost trends that might relate to the improving economy, combined with pricing that improved more slowly. Non-catastrophe weather losses also had a slight adverse effect on the ratio.
Workers’ compensation net written premiums and earned premiums rose in 2011 as higher pricing offset a $3 million reduction in new business written premiums that reflected particularly cautious risk selection. As discussed in the commercial lines insurance premiums section of Commercial Lines Insurance Results of Operations, on Page 58, economic trends cause corresponding changes in underlying insured exposures, including workers’ compensation coverage where the premium amount is heavily influenced by economically-driven measures of risk exposure such as payroll volume. Slowly improving economic factors during 2011 helped increase net written and earned premiums, including favorable effects from premiums resulting from audits.
The 2011 current accident year loss and loss expense ratio declined 9.9 percentage points compared with accident year 2010, estimated as of December 31, 2010. In addition to the favorable effect of the refined line of business allocation process for loss expenses, the loss portion of the ratio improved, reflecting initiatives begun early in 2010 as discussed below.
Favorable development on prior accident year reserves rose in 2011, primarily due to more favorable trends in loss payments as well as case reserves. The indicated calendar year trend for future loss payments has decreased slightly, but such decreases have a leveraged effect on less mature accident years. Development trends are further discussed in Commercial Lines Insurance Segment Development of Estimated Reserves by Accident Year, Page 93.
Since we pay a lower commission rate on workers’ compensation business, relative to our other commercial lines of business, this line has a higher calendar year loss and loss expense breakeven point than our other commercial business lines. The ratio was at an unprofitable level in recent years, and management continues to work to improve financial performance for this line. We believe various initiatives in recent years contributed to the improved profitability trend since 2009.
Specialty packages net written premiums and earned premiums were down in 2011, primarily due to ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty.
Net written premiums and earned premiums for surety and executive risk rose in 2011, partly from a $3 million increase in new business written premiums. In addition, premiums ceded to reinsurers had less of a downward effect on net written premiums and earned premiums in 2011. Ceded premiums were reduced due to better than expected loss experience in recent years, resulting in lower rates charged by reinsurers.
The 2011 current accident year loss and loss expense ratio before catastrophe losses improved 2.8 percentage points, compared with accident year 2010, reflecting an improved loss climate for financial institutions.
· Marketing primarily to nonprofit organizations, which accounted for approximately 64 percent of the policies and 30 percent of the premium volume for director and officer liability new business written in 2011.
· Closely monitoring our for-profit policyholders - At year-end 2011, our director and officer liability policies in force provided coverage to 15 non-financial publicly traded companies, including two Fortune 1000 companies. We also provided this coverage to approximately 500 banks, savings and loans and other financial institutions. The majority of these financial institution policyholders are smaller community banks, and we believe they have no unusual exposure to credit-market concerns, including subprime mortgages. Based on new policy data or information from the most recent policy renewal, only 10 of our bank and savings and loan policyholders have assets greater than $2 billion; only 23 have assets from $1 billion to $2 billion; and 45 have assets from $500 million to $1 billion.
· Providing limits no higher than $10 million with facultative or treaty reinsurance in place in 2012 to cover losses greater than $6 million.
Net written premiums for the commercial lines industry, excluding the mortgage and financial guaranty segments, are projected to increase approximately 4 percent in 2012 with the industry statutory combined ratio estimated at approximately 104 percent. Over the past several years, renewal and new business pricing has experienced significant competitive pressure, reinforcing the need for more pricing analytics and careful risk selection. While competition remains intense, overall commercial lines market pricing turned positive toward the end of 2011 according to several industry surveys, and average renewal pricing for our commercial lines segment also turned positive. Opinions vary, according to a variety of reports that focus on the commercial lines market, regarding the sustainability of improved pricing. According to A.M. Best, further rate firming in select commercial lines is anticipated during 2012, following pricing stabilization during 2011. Despite challenging market conditions, we believe we can manage our business and execute strategic initiatives to offset market pressures to some extent and still profitably grow our commercial lines segment.
In Item 1, Strategic Initiatives, Page 10 we discuss the initiatives we are implementing to achieve our corporate performance objectives. We discuss factors influencing future results of our property casualty insurance operations in the Executive Summary, Page 38.
Our personal lines statutory combined ratio was 124.2 percent in 2011, 107.1 percent in 2010 and 111.4 percent in 2009. By comparison, the estimated industry personal lines combined ratio was 107.4 percent in 2011, 100.4 percent in 2010 and 100.6 percent in 2009. Our concentration of business in areas hard-hit by catastrophe events contributed to recent results that differed from the overall industry, an issue we are addressing in part through geographic expansion. Since early 2008, we have worked to improve our geographic diversification by expanding our personal lines operation to several states less prone to catastrophes, including the western states of Arizona, Idaho, Montana, and Utah. We have also non-renewed approximately 2,600 homeowner policies in Florida and Alabama that we believe were the most exposed to losses from hurricane damage. The contribution of catastrophe losses to our personal lines statutory combined ratio was 22.7 percentage points in 2011, 8.1 percentage points in 2010 and 16.1 percentage points in 2009, compared with an estimated 10.5, 5.3 and 4.9 percentage points, respectively, for the industry.
The 10 percent increase in 2011 agency renewal written premiums reflected various rate changes during recent years. In October 2011 we began our third round of increases for the homeowner line of business, averaging approximately 8 percent, with some individual policy rate increases lower or higher based on attributes of risk that characterize the insured exposure. That followed rate changes averaging approximately 7 percent that were implemented beginning the fourth quarter of 2010 for states representing the majority of our personal lines business. Similar rate changes averaging approximately 6 percent were implemented beginning October 2009. Beginning in the second quarter of 2012, we are implementing rate changes for our personal auto line of business in the majority of the 29 states where we market personal lines policies. The average rate change is an increase in the low-single-digit range, with some individual policies experiencing lower or higher rates based on enhanced pricing precision enabled by predictive models. Rate changes for personal auto implemented during the fourth quarter of 2010 also represented an average rate increase in the low-single-digit range.
In 2011, our personal lines new business premiums written by our agencies grew 6 percent, following 2010 growth at a rate of 20 percent. A primary reason for the higher rate of growth during 2010 was agent response to a new version of our Diamond personal lines policy processing system deployed in early 2010.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the three-year highlights table on Page 69 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 79.2 percent accident year 2010 loss and loss expense ratio reported as of December 31, 2010, developed favorably by 3.6 percentage points to 75.6 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2011. Accident years 2010 and 2009 for the personal lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
The 76.7 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2011 rose 6.3 percentage points compared with the 70.4 percent accident year 2010 ratio measured as of December 31, 2010. Some weather-related losses not identified as part of designated catastrophe events for the property casualty industry are typically referred to as non-catastrophe weather losses. For our homeowner line of business alone, non-catastrophe weather losses from wind, hail and lightning were $22 million higher during 2011 compared with 2010, raising the 2011 loss ratio by 2.3 percentage points. The effect of the $18 million ceded to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 1.8 percentage points. The refined line of business allocation process for loss expenses added approximately 3 percentage points to the 2011 ratio. Large losses described below were a minor factor as the ratio for new losses above $250,000 rose by 0.4 percentage points.
Personal lines commission expense as a percent of earned premium decreased in 2011, primarily due to lower agency profit-sharing commissions. In 2010 higher agency profit-sharing commission drove the increase.
We prefer to write personal lines coverages within accounts that include both auto and homeowner coverages as well as coverages from the other personal business line. As a result, we believe that the personal lines segment is best measured and evaluated on a segment basis. However, we provide line-of-business data to analyze growth and profitability trends separately for each line. The accident year loss data provides current estimates of incurred loss and loss expenses and corresponding ratios over the most recent three accident years. Accident year data classifies losses according to the year in which the corresponding loss events occur, regardless of when the losses are actually reported, recorded or paid.
For 2011, 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 69, and below, we are taking actions to improve pricing and reduce loss costs that we expect to benefit future profitability trends.
Net written premiums for personal auto increased significantly in 2011, largely due to very strong new business growth during 2010 that resulted in the opportunity to renew many accounts for the first time during 2011. Rate increases also contributed to the growth.
While still at a profitable level, the total and current accident year loss and loss expense ratios for other personal increased in 2011, reflecting the results of higher catastrophes and non-catastrophe weather. Reserve development on prior accident years recognized during 2011 was similar to 2010, 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 Personal Lines Insurance Segment Development of Estimated Reserves by Accident Year, Page 95.
Our excess and surplus lines segment includes results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources. Performance highlights for the excess and surplus lines segment include:
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses, as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the three-year highlights table on Page 75 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than 20 percent of our 2011 excess and surplus lines current accident year incurred losses and loss expenses represents net paid losses, a large 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 85.0 percent accident year 2010 loss and loss expense ratio reported as of December 31, 2010, developed favorably by 7.4 percentage points to 77.6 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2011. Accident years 2010 and 2009 for this segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Excess and surplus lines commission expense as a percent of earned premiums rose in 2011, primarily due to the absence of ceding commissions formerly received from our third-party reinsurers. As discussed above, beginning in 2011 treaty reinsurance for our excess and surplus lines segment was provided by The Cincinnati Insurance Company.
The excess and surplus lines markets are expected to see slight firming in 2012, according to several industry reports. Competition is expected to remain strong, in part due to standard market insurance companies insuring businesses that previously were written by excess and surplus lines insurers. While soft market conditions for commercial lines business overall is the driver of this trend, some firming is expected primarily for property coverage due to industry catastrophe losses and for select casualty classes of business where loss costs are exceeding rates. The slowly recovering U.S. economy, another major factor in demand for insurance products, is also expected to contribute to modestly increasing premium volume during 2012 for the excess and surplus lines industry.
Earned premiums increased in 2011 largely because of growth in our term life insurance business. Earned premiums from term insurance grew $9 million, or 9 percent.
Separate account investment management fee income contributed $2 million to total revenue in 2011, compared with $1 million contribution in 2010 and less than $1 million in 2009.
The life insurance industry was challenged in 2011 by a persistently low interest rate environment. It now appears likely rates will remain low through 2013 as the Federal Reserve has indicated its intent to keep short-term rates low into 2014. Low interest rates pressure earnings by reducing investment income. They are particularly troublesome for interest-sensitive products that are already crediting interest at or near their guaranteed minimum rates and for products with a fixed rate of interest embedded into their benefit structure.
Our property casualty agencies remain the main distribution system for our life insurance segment, and we continue to emphasize securing an increasing share of the life insurance premium produced by these agencies. While other life insurers expand nontraditional distribution channels such as direct sales, we intend to market through agencies affiliated with our property casualty insurance operations or independent life-only agencies. In 2011, our property casualty agencies produced 69 percent and our life-only agencies 31 percent of our life insurance premium.
· Investment income - Pretax investment income increased 1 percent in 2011, primarily because of a higher average dividend payment rate for common stocks in our equity portfolio. Pretax investment income increased 3 percent in 2010, primarily because of additional net purchases in our fixed-maturity portfolio that offset declining bond yields. For the investment portfolio in total, additional net purchases slowed in 2011 relative to 2010 due to higher catastrophe losses that reduced net cash provided by operating activities. After-tax investment income increased 1 percent in 2011, down from 2 percent in 2010, primarily due to lower additional net purchases in our total investment portfolio.
In 2011, we continued to invest available cash flow in both fixed income and equity securities in a manner that we believe balances current income needs with longer-term invested assets growth goals.
We have a small portfolio of convertible preferred stocks and bonds that have an embedded derivative component. In 2011, we recorded $1 million in fair value realized losses compared with fair value realized gains of $10 million in 2010 and $27 million in 2009. 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. See the discussion of Derivative Financial Instruments and Hedging Activities in Item 8, Note 1 of the Consolidated Financial Statements, Page 114, for details on the accounting for convertible security embedded options.
In 2011, we recorded $57 million in write-downs for 12 securities that we deemed had experienced an other-than-temporary decline in fair value compared with $36 million for 15 securities in 2010 and $131 million for 50 securities in 2009. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 46. The OTTI charges in 2011, 2010 and 2009 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.
OTTI charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 20, are summarized below:
The general market view is that, in light of Federal Reserve commentary, interest rates are likely to remain well below historic averages for at least the next two to three years. This will continue to apply pressure on investment income.
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 46.
The parent company’s primary means of meeting liquidity requirements are dividends from our insurance subsidiary, investment income and sale proceeds from investments held at the parent company level. The parent company’s primary contractual obligations are interest and principal payments on long- and short-term debt as described under Contractual Obligations, Page 87. Other uses of parent company cash include dividends to shareholders, common stock repurchases and general operating expenses described under Other Commitments, Page 88. As of December 31, 2011, the parent company had $1.051 billion in cash and marketable securities, providing strong liquidity to fund uses of cash.
Further, financial resources of the parent company also could be made available to our insurance subsidiaries, if circumstances required. This flexibility would include our ability to access the capital markets and short-term bank borrowings.
At December 31, 2011, we had two lines of credit with commercial banks totaling $225 million, with $104 million borrowed. During the third quarter of 2011, there was a $55 million increase to the previous balance of $49 million in short-term debt by the parent company, primarily to fund share repurchases using our relatively low-cost source of borrowing. There was no change in the amount of the $49 million short-term debt during 2010 or 2009. Access to these lines of credit requires compliance with various covenants, including maintaining a minimum consolidated net worth and not exceeding a 20 percent consolidated leverage ratio, as defined by the agreement. As of December 31, 2011, we were well within compliance with all covenants under the credit agreements and believe we will remain in compliance.
We anticipate renewing our lines of credit in 2012 with terms and conditions similar to the expiring agreements. Should available terms and conditions be unacceptable to us, we could repay our short-term debt with the $1.051 billion in cash and marketable securities held by the parent company at year-end 2011, without a material adverse effect on our results of operations.
Capital resources represent our overall financial strength to support writing and growing our insurance businesses. At December 31, 2011, we had total shareholders’ equity of $5.055 billion, an increase of $23 million, or less than 1 percent, from the prior year. Our total debt was $894 million, up $55 million, from a year ago. We seek to maintain a solid financial position and provide capital flexibility by keeping our ratio of debt to total capital moderate. We target a ratio below 20 percent. At year-end 2011, the ratio was 15.0 percent compared with 14.3 percent at year-end 2010. The increase in the debt-to-total-capital ratio was due to the $55 million increase in debt during the year 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 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 approximately 56 percent of net income as dividends. Through 2011, the board had increased our cash dividend for 51 consecutive years. The board decision in August 2011 to increase the dividend demonstrated confidence in the company’s strong capital, liquidity, financial flexibility and initiatives to improve earnings performance.
Our two most significant contractual obligations are discussed in conjunction with related insurance reserves in Gross Property Casualty Loss and Loss Expense Payments and Gross Life Insurance Policyholder Obligations beginning on Pages 89 and 97, respectively. Other future contractual obligations include:
· Interest on long- and short-term debt - We expect total interest expense to be approximately $52 million in 2012. We discuss outstanding debt in Additional Sources of Liquidity, Page 86.
· Computer hardware and software - We expect to spend $36 million over the next three years for current material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discuss below the non-contractual expenses we anticipate for computer hardware and software in 2012.
· Commissions - We expect commission payments to generally track with written premiums.
At December 31, 2011, we had $438 million in cash and cash equivalents. That strong liquidity and our consistent cash flows gives us the flexibility to meet current obligations and commitments while building value by prudently investing where we see potential for both current income and long-term return.
We do not expect future pension contributions to constrain our liquidity. The fair value of plan assets is 92 percent of the accumulated benefit obligation at December 31, 2011.
Continued economic weakness also has the potential to affect our liquidity and capital resources in a number of different ways, potentially including: delinquent payments from agencies, defaults on interest payments by fixed-maturity holdings in our portfolio, dividend reductions by holdings in our equity portfolio or declines in the market value of holdings in our portfolio.
Further, parent company liquidity could be constrained by Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay. During 2012, total dividends that our insurance subsidiary can pay to our parent company without regulatory approval are approximately $375 million.
The rise in total gross reserves was primarily due to higher case and IBNR reserves for our commercial property, specialty packages and homeowner lines of business. Catastrophe and non-catastrophe weather losses accounted for most of the increase.
We carried $136 million of net loss and loss expense reserves for asbestos and environmental claims as of year-end 2011, compared with $134 million for such claims as of year-end 2010. These amounts constitute 3.5 percent and 3.5 percent of total loss and loss expense reserves as of these year-end dates.
Our estimate of future gross property casualty loss and loss expense payments of $4.280 billion is lower than loss and loss expense reserves of $4.339 billion reported on our balance sheet at December 31, 2011. The $59 million difference is due to life and health loss reserves, as discussed in Item 8, Note 4 of the Consolidated Financial Statements, Page 125.
We direct our associates and agencies to settle claims and pay losses as quickly as is practical and we made $2.241 billion of net claim payments during 2011. At year-end 2011, total net property casualty reserves of $3.905 billion reflected $2.056 billion in unpaid amounts on reported claims (case reserves), $920 million in loss expense reserves and $929 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 42.
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 45.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2011 and 2010. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
· Section D, cumulative net reserve development, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 2001, had developed favorably by $183 million over 10 years, net of reinsurance, which was reflected in income over the 10 years. The table shows favorable reserve development as a negative number. Favorable reserve development on prior accident years, which represents a negative expense, is favorable to income. The “One year later” line in the table shows the effects on income before income taxes in 2011, 2010 and 2009 of changes in estimates of the reserves for loss and loss expenses for all accident years. The effect was favorable to pretax income for those three years by $285 million, $304 million, and $188 million, respectively.
The following table shows net reserve changes at year-end 2011, 2010 and 2009 by commercial line of business and accident year:
Overall favorable development for commercial lines reserves of $234 million in 2011 illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. Favorable reserve development of $132 million for the commercial casualty line accounted for approximately 55 percent of the segment total in 2011, while favorable reserve development of $97 million for the workers’ compensation line accounted for approximately 40 percent of the segment total in 2011. Drivers of significant reserve development are discussed below.
· Commercial casualty loss emergence - As in 2010, commercial multiple peril liability coverages contributed to favorable reserve development. Actual reported losses in calendar year 2011 fell short of the amount projected at year-end 2010 by more than $40 million.
· Workers’ compensation trends and initiatives - Favorable calendar year development was $97 million. Accident year 2010 contributed $32 million in favorable development. Accident year 2009 contributed $18 million in favorable development with all other prior years accounting for the balance. The trend for payments to be made in future calendar years is down slightly, likely due to the claims initiatives that began in 2010. Initiatives to improve profitability for our workers’ compensation line of business are discussed in Commercial Lines Insurance Results of Operations, Commercial Lines of Business Analysis, Page 62.
· Surety and executive risk unfavorable development - Reserve development on prior accident years recorded during 2011 for accident year 2010 was primarily due to the refined line of business allocation process for loss expenses discussed in Commercial Lines Insurance Results of Operations, Commercial Lines of Business Analysis, Page 62. Unfavorable development recorded for accident year 2008 was mostly due to adverse loss emergence on a few large claims related to coverage provided to financial institutions.
As noted in Critical Accounting Estimates, Key Assumptions - Loss Reserving, Page 44, our models predict that actual loss and loss expense emergence will differ from projections, and we do not attempt to monitor or identify such normal variations.
Favorable development for personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. We continued to see favorable reserve development related to umbrella liability coverage in the other personal line of business. Among the factors that appeared to be causing moderating loss cost trends were a slow economic recovery, favorable court decisions, policy form restrictions, and claims department initiatives.
Excess and Surplus Lines Insurance Segment Development of Estimated Reserves by Accident Year
A single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event could present us with a liquidity risk. In an effort to control such losses, we avoid marketing property casualty insurance in specific geographic areas and monitor our exposure in certain coastal regions. An example of this is the reduction of our homeowner policies in the southeastern coastal region in recent years. This area was identified as a major contributor to our catastrophe probable maximum loss estimates and has subsequently been greatly reduced. We also continually review aggregate exposures to huge disasters and purchase reinsurance protection to cover these exposures. We use the Risk Management Solutions (RMS) and Applied Insurance Research (AIR) models to evaluate exposures to a once-in-a-100 year and a once-in-a-250 year event to help determine appropriate reinsurance coverage programs. In conjunction with these activities, we also continue to evaluate information provided by our reinsurance broker. These various sources explore and analyze credible scientific evidence, including the impact of global climate change, which may affect our exposure under insurance policies.
Currently participating on our standard market property and casualty per-risk and per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of which had A.M. Best insurer financial strength ratings of A (Excellent) or A+ (Superior) as of December 31, 2011. Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and the European markets. The largest participant in our property catastrophe program, representing approximately 50 percent of total participation, is the Lloyds of London placement that features numerous syndicates, with the R.J. Kiln group and the Catlin syndicate taking the largest participations. Other primary participants in our property catastrophe program include a Liberty Syndicate, Alterra, Argo Re and Flagstone Reinsurance Limited.
The following table shows our five largest reinsurance receivable amounts by reinsurer at year-end 2011 and 2010. The A.M. Best insurer financial strength ratings as of December 31, 2011 are also shown for each those reinsurers.
Primary components of the 2012 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 $6 million of each loss, except for our homeowner line of business, which has a separate treaty that limits our retention to $4 million per loss. Losses between $6 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $37 million for 2012, compared with $32 million in 2011 and $36 million in 2010. The higher ceded premium for 2012 compared with 2011 is largely due to higher rates and estimates of higher levels of property coverage direct written premiums that are subject to the treaty.
· Casualty excess treaties - We purchase a casualty reinsurance treaty that provides an additional $25 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $50 million of protection for workers’ compensation, extra-contractual liability coverage and clash coverage losses, which would apply when a single occurrence involves multiple policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated at approximately $2 million in 2012, similar to the premium we paid in 2011 and 2010.
We purchase a second casualty excess treaty, which provides an additional $20 million in casualty loss coverage. This treaty also provides catastrophic coverage for workers’ compensation and extra-contractual liability coverage losses. The ceded premium is estimated at approximately $1 million for 2012, similar to the premium we paid in 2011 and 2010.
· 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 2012 treaty, ceded premiums are estimated at $59 million, up from approximately $49 million in 2011 and in 2010, due to increasing the coverage limit above $500 million plus higher rates. We retain the first $75 million of any loss, up from $45 million for 2011, plus varying shares of losses up to $600 million:
o 11.3 percent of losses between $100 million and $200 million
o 5.4 percent of losses between $200 million and $300 million
o 5.0 percent of losses between $300 million and $400 million
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 2011 was $366 million (20 percent of 2010 subject premiums), and we estimate it is $383 million (20 percent of 2011 subject premiums) in 2012.
The Cincinnati Specialty Underwriters Insurance Company, which began issuing insurance policies in 2008, has separate property and casualty reinsurance treaties for 2012 through The Cincinnati Insurance Company. Primary components of the treaties include:
· Basket retention - The Cincinnati Specialty Underwriters Insurance Company 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.
The Cincinnati Insurance Company’s reinsurance program for 2012 includes participation in two assumed reinsurance treaties with Kiln Group Limited, a reinsurer that spreads the risk of very high catastrophe losses among many insurers. The larger treaty has exposure of up to nearly $3 million of assumed losses from a single event and the smaller treaty has exposure of up to nearly $2 million of assumed losses from a single event. The treaties with Kiln Group Limited were in place during 2011 at similar exposure levels. A separate assumed reinsurance treaty, with Munich Re Group, was in effect during 2011 but was not renewed for 2012. The Munich Re Group treaty had exposure of up to $7 million of assumed losses in three layers, from $1.0 billion to $1.7 billion, from a single event.
· Unusually high levels of catastrophe losses due to risk concentrations, changes in weather patterns, environmental events, terrorism incidents or other causes
· Events resulting in capital market or credit market uncertainty, followed by prolonged periods of economic instability or recession, that lead to:
o Significant rise in losses from surety and director and officer policies written for financial institutions or other insured entities
· Increased competition that could result in a significant reduction in the company’s premium volume
o Concerns that doing business with the company is too difficult
o Delays or inadequacies in the development, implementation, performance and benefits of technology projects and enhancements
o Limit our ability to set fair, adequate and reasonable rates
o Restrict our ability to execute our business model, including the way we compensate agents
· Unforeseen departure of certain executive officers or other key employees due to retirement, health or other causes that could interrupt progress toward important strategic goals or diminish the effectiveness of certain longstanding relationships with insurance agents and others
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2011, in accordance with accounting principles generally accepted in the United States of America (GAAP).
· Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2011, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment was based on the criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and was designed to provide reasonable assurance that the company maintained effective internal control over financial reporting as of December 31, 2011. The assessment led management to conclude that, as of December 31, 2011, the company’s internal control over financial reporting was effective based on those criteria.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the company as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Premiums receivable are reviewed for impairment on a quarterly basis. We currently do not have an allowance for uncollectible premiums.
We establish reserves to cover the expected cost of claims, losses and expenses related to investigating, processing and resolving claims. Although the appropriate amount of reserves is inherently uncertain, we base our decisions on past experience and current facts. Reserves are based on claims reported prior to the end of the year and estimates of unreported claims. We take into account the fact that we may recover some of our costs through salvage and subrogation reserves. We regularly review and update reserves using the most current information available. Any resulting adjustments are reflected in current calendar year insurance losses and policyholder benefits.
We base 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 $68 million as of December 31, 2011, contributed 2.2 percentage points to the property casualty combined ratio. Profit-sharing commission accruals for 2010 and 2009 were $77 million and $81 million, respectively.
For universal life long-duration contracts, we maintain a liability equal to the policyholder account value. There is no provision for adverse deviation. Some of our universal life policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance, based on expected no-lapse guarantee benefits and expected policy assessments.
When we issue a universal life long-duration contract, we capitalize acquisition costs. We then charge these capitalized costs to expenses over the term of coverage of the contract in accordance with the recognition of gross profit from the contract. When we charge deferred policy acquisition costs to expenses, we use assumptions based on our best estimates of long-term experience. We review and modify these assumptions on a regular basis.
We issue universal life contracts with guaranteed minimum returns, referred to as bank-owned life insurance contracts (BOLIs). A BOLI is designed so the bank is the policy owner and the policy beneficiary. We legally segregate and record as separate accounts the assets and liabilities for some of our BOLIs, based on the specific contract provisions. We guarantee minimum investment returns, account values and death benefits for our separate account BOLIs. Our other BOLIs are general account products.
Both reinsurance assumed and ceded premiums are deferred and recorded as earned premiums on a pro rata basis over the terms of the contract. We estimate loss amounts recoverable from our reinsurers based on the reinsurance policy terms. Historically, our claims with reinsurers have been paid. We do not have an allowance for uncollectible reinsurance.
Our portfolio investments are primarily in publicly traded fixed-maturity, equity and short-term investments. Fixed-maturity investments (taxable bonds, tax-exempt bonds and redeemable preferred stocks) and equity investments (common and non-redeemable preferred stocks) are classified as available for sale and recorded at fair value in the consolidated financial statements. The number of fixed-maturity securities with fair value below 100 percent of amortized cost can be expected to fluctuate as interest rates rise or fall. Because of our strong surplus and long-term investment horizon, our general intent is to hold fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values.
We account for derivative financial instruments as prescribed by ASC 815, Derivatives and Hedging. The hedging definitions included in ASC 815 guide our recognition of the changes in the fair value of derivative financial instruments either as realized gains or losses in the consolidated statements of income or as a component of AOCI in shareholder’s equity in the period for which they occur.
We record land at cost, and record building and equipment at cost less accumulated depreciation. Certain equipment held under capital leases also is classified as property and equipment with the related lease obligations recorded as liabilities. We capitalize and amortize costs for internally developed computer software during the application development stage. These costs generally consist of external consulting, payroll and payroll-related costs. Our depreciation is based on estimated useful lives (ranging from three years to 39½ years) using straight-line and accelerated methods. Depreciation expense was $46 million in 2011, $40 million in 2010, and $48 million in 2009. We monitor land, building and equipment and software for potential impairments. Potential impairments may include a significant decrease in the fair values of the assets, considerable cost overruns on projects, a change in legal factors or business climate or other factors that indicate that the carrying amount may not be recoverable. There were no recorded land, building and equipment impairments for 2011, 2010 or 2009.
We calculate deferred income tax liabilities and assets using tax rates in effect when temporary differences in financial statement income and taxable income are expected to reverse. We recognize deferred income taxes for numerous temporary differences between our taxable income and financial statement income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains and losses on investments and differences in the recognition of deferred acquisition costs, unearned premium and insurance reserves. We charge deferred income taxes associated with unrealized appreciation and depreciation (except the amounts related to the effect of income tax rate changes) to shareholders’ equity in AOCI. We charge deferred taxes associated with other differences to income.
· In October 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. ASU 2010-26 modifies the definitions of the type of costs incurred by insurance entities that can be capitalized in the successful acquisition of new and renewal contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. The effective date of ASU 2010-26 is for interim and annual reporting periods beginning after December 15, 2011. We anticipate that ASU 2010-26 will have an after-tax reduction on our shareholders’ equity of approximately $20 million, or about $0.12 of book value per share. We will adopt the ASU retrospectively. The ASU will not have a material impact on our company’s financial position, cash flows or results of operations on a historical or prospective basis.
· In December 2011, the FASB issued 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.
· In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures. ASU 2010-06 applies to all entities that are required to make disclosures about recurring or nonrecurring fair value measurements. ASU 2010-06 requires separate disclosures of the activity in the Level 3 category related to any purchases, sales, issuances and settlements on a gross basis. The company adopted ASU 2010-06 during 2011, and it did not have a material impact on our company’s financial position, cash flows or results of operations as it focuses on additional disclosures.
At December 31, 2011, 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:
During 2010, we other-than-temporarily impaired 15 securities. At December 31, 2010, 17 fixed-maturity investments with a total unrealized loss of $4 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity investments had fair values below 70 percent of amortized cost. Three equity investments with a total unrealized loss of $1 million had been in an unrealized loss position for 12 months or more as of December 31, 2010. Of that total, no equity investments were trading below 70 percent of cost.
When determining OTTI charges for our fixed-maturity portfolio, management places significant emphasis on whether issuers of debt are current on contractual payments and whether future contractual amounts are likely to be paid. As required by ASC 320 effective April 1, 2009, our invested asset impairment policy for fixed-maturity securities states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed-maturity security or (2) if it is more likely than not we will be required to sell the fixed maturity security before recovery of its amortized cost basis. If we intend to sell or it is more likely than not we will be required to sell, the amortized cost of any such securities is reduced to fair value as the new cost basis, and a realized loss is recorded in the period in which it is recognized. When we believe that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount to the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the period in which it occurred. The difference between the fair value and the net present value of the cash flows of the security, the non-credit loss, is recognized in other comprehensive income as an unrealized loss.
· Level 3 - Financial assets and liabilities for which values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. Level 3 inputs include the following:
· Quotes from brokers or other external sources that are not considered binding;
· Quotes from brokers or other external sources where it cannot be determined that market participants would in fact transact for the asset or liability at the quoted price;
We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. Reclassification of certain financial instruments may occur when input observability changes. As noted below in the Level 3 disclosure table, 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.
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is identified in the table below by security type with a summary of changes in fair value for the years ended December 31, 2011 and 2010. As of December 31, 2011 and 2010, total Level 3 assets were less than 1 percent of financial assets measured at fair value.
The following tables provide changes to Level 3 securities during 2011 and 2010:
For the year ended December 31, 2011, three Level 3 corporate fixed-maturity securities were purchased for $16 million and three corporate fixed-maturity securities were transferred into Level 3 for $10 million. There were also six corporate fixed-maturity securities that were transferred out of Level 3 for $28 million. As a result of these purchases and transfers, corporate fixed-maturity securities decreased $2 million. There were no other significant changes to Level 3 assets during the year ended December 31, 2011.
We use actuarial methods, models and judgment to estimate, as of a financial statement date, the property casualty loss and loss expense reserves required to pay for and settle all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date. The actuarial estimate is subject to review and adjustment by an inter-departmental committee that includes actuarial management and is familiar with relevant company and industry business, claims and underwriting trends, as well as general economic and legal trends, that could affect future loss and loss expense payments. The amount we will actually have to pay for claims can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. The reserve for loss and loss expenses in the consolidated balance sheets also includes $59 million, $63 million and $46 million for certain life and health loss reserves at December 31, 2011, 2010 and 2009, respectively.
We carried $136 million of net loss and loss expense reserves for asbestos and environmental claims at December 31, 2011, compared with $134 million for such claims at December 31, 2010. These amounts constitute 3.5 percent of total net loss and loss expense reserves as of both these year-end dates.
Additionally, since 2002, we have revised policy terms, where permitted by state regulation, to limit our exposure to mold claims prospectively and further reduce our exposure to other environmental claims generally. Finally, we have not engaged in any mergers or acquisitions through which such a liability could have been assumed. We continue to monitor our claims for evidence of material exposure to other mass tort classes such as silicosis, but we have found no such credible evidence to date.
We establish the reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, lapse rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience, adjusted for historical trends, in arriving at our assumptions for expected mortality, morbidity and withdrawal rates as well as for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
There were no premium deficiencies recorded in the consolidated statements of income, as the sum of the anticipated loss and loss adjustment expenses, policyholder dividends and unamortized deferred acquisition expenses did not exceed the related unearned premiums and anticipated investment income.
At December 31, 2011 and 2010, we had two lines of credit with commercial banks with an aggregate borrowing capacity of $225 million. Our note payable balance, which approximates fair value, was $104 million at year-end 2011 and $49 million at year-end 2010. The $150 million line of credit with a $104 million balance expires July of 2012. The $75 million line of credit expires August of 2012. We had no compensating balance requirements on short-term debt for either 2011 or 2010. The interest rate charged on our borrowings on these lines of credit ranged from 0.58 percent to 2.58 percent during 2011.
The fair value of our senior debt approximated $814 million at year-end 2011 compared with $783 million at year-end 2010. Fair value for 2011 and 2010 was determined under ASC 820 based on market pricing of these or similar debt instruments that are actively trading. Fair value can vary with macroeconomic concerns. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt remained unchanged from year-end 2010. None of the notes are encumbered by rating triggers.
Below are the expected capital lease obligations, totaling $31 million, excluding an insignificant amount of interest, that we expect to pay over the next five years:
Our insurance subsidiary declared dividends to the parent company of $180 million in 2011, $220 million in 2010 and $50 million in 2009. 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 2012, the total that our lead subsidiary may declare in dividends is approximately $375 million.
As of December 31, 2011, 4.4 million shares of common stock were available for future equity award grants.
Our consolidated statements of income include incurred consolidated property casualty insurance loss and loss expenses on assumed and ceded business:
For the year ended December 31, 2010, a reserve reduction occurred in our USAIG pool. Direct and ceded incurred loss and loss expenses were reduced by $33 million, and there was no effect on net incurred loss and loss expenses.
Cincinnati Life purchases reinsurance for protection of a portion of the risk that is written. Primary components of our life reinsurance program include individual mortality coverage and aggregate catastrophe and accidental death coverage in excess of certain deductibles. Our consolidated statements of income include earned life insurance premiums on assumed and ceded business:
The reduction in 2011 ceded contract holders’ benefits incurred compared with 2010 related to ceded death claims. The ceded benefits incurred can vary depending on the type of life insurance policy held and the year the policy was sold.
The provision for federal income taxes is based upon filing a consolidated income tax return for the company and its subsidiaries. As of December 31, 2011, we had no operating or capital loss carry forwards. 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.
Basic earnings per share are computed based on the weighted average number of shares outstanding. Diluted earnings per share are computed based on the weighted average number of common and dilutive potential common shares outstanding. We have adjusted shares and earnings per share to reflect all stock splits and stock dividends prior to December 31, 2011.
The basic and diluted earnings per share are calculated as follows:
The current sources of dilution of our common shares are certain equity-based awards as discussed in Note 17 Stock-Based Associate Compensation Plans, Page 134. The above table shows the number of anti-dilutive stock-based awards at year-end 2011, 2010 and 2009. We did not include these stock-based awards in the computation of net income per common share (diluted) because their exercise would have anti-dilutive effects.
We also sponsor a defined contribution plan (401(k) plan). Matching contributions totaled $8 million, $8 million and $7 million during the years 2011, 2010 and 2009, 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 approximately $8 million at year-end 2011 and $6 million at year-end 2010, 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 non-qualified deferred compensation plan. For SERP participants who left the defined benefit pension plan, SERP benefit accruals were frozen as of December 31, 2008. During 2009, the frozen accrued SERP benefit for those participants, collectively amounting to approximately $1 million, transferred to the Top Hat Savings Plan. Beginning in 2009, for these associates, the company began matching deferrals to the Top Hat Savings Plan up to the first 6 percent of an associate’s compensation that exceeds the compensation limit specified by the Internal Revenue Code of 1986, as amended. Participants vest after three years of eligible service.
The change in the amount recognized in other comprehensive income is largely due to the decrease in discount rate. We assume that 100 percent of participants will choose lump sum payments.
The total recognized in net periodic benefit cost and other comprehensive income was $38 million, $9 million and $25 million for the years ended December 31, 2011, 2010 and 2009, respectively. The increase in the amount recognized in other comprehensive income is largely due to the decreases in discount rate and lump sum rate from prior year end. The estimated costs to be amortized from AOCI into net periodic benefit cost over the next year for our plans are a $6 million actuarial loss and a $1 million prior service cost.
Our pension plan assets included 567,113 shares of the company’s common stock, which had a fair value of $17 million at December 31, 2011. At December 31, 2010 our pension plan held 642,113 shares of the company’s common stock, which had a fair value of $20 million. The defined benefit pension plan did not purchase any shares of our common stock during 2011 and 2010. During 2011, the pension plan sold 75,000 shares of the company’s common stock for a realized gain of $2 million. No shares of our common stock were sold during 2010. The company paid $1 million in cash dividends on our common stock to the pension plan in both 2011 and 2010.
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $6 million in 2011, 2010 and 2009, on premium volume of approximately $34 million, $36 million and $36 million for 2011, 2010 and 2009, respectively.
The company and its subsidiaries also are occasionally involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, breach of an alleged duty to search national data bases to ascertain unreported deaths of insureds under life insurance policies. The company’s insurance subsidiaries also are occasionally parties to individual actions in which extra-contractual damages, punitive damages or penalties are sought, such as claims alleging bad faith in the handling of insurance claims or claims alleging discrimination by former associates.
On a quarterly basis, we review these outstanding matters. Under current accounting guidance, we establish accruals when it is probable that a loss has been incurred and we can reasonably estimate its potential exposure. The company accounts for such probable and estimable losses, if any, through the establishment of legal expense reserves. Based on our quarterly review, we believe that our accruals for probable and estimable losses are reasonable and that the amounts accrued should not have a material effect on our consolidated financial condition or results of operations. Based on our quarterly review, for any other matter for which the risk of loss is more than remote, we are unable to reasonably estimate the potential loss or establish a reasonable range of loss.
We currently have four equity compensation plans that permit us to grant various types of equity awards. We currently grant incentive stock options, non-qualified stock options, service-based restricted stock units and performance-based restricted stock units, including some with market-based performance objectives, under our shareholder-approved plans. We also have a Holiday Stock Plan that permits annual awards of one share of common stock to each full-time associate for each full calendar year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant stock to our outside directors as a component of their annual compensation.
Stock-based compensation cost after tax was $9 million, $8 million and $7 million for the years ended December 31, 2011, 2010 and 2009, respectively. The related income tax benefit recognized was $4 million, $3 million and $3 million for the years ended December 31, 2011, 2010 and 2009, respectively. Options exercised during the years ended December 31, 2011, 2010 and 2009 had intrinsic value less than $1 million. (Intrinsic value is the market price less the exercise price.) Options vested during the year ended December 31, 2011 and 2010, had total intrinsic value of $2 million and $1 million, respectively. Options vested during the year ended 2009 had intrinsic value less than $1 million.
· Risk-free rates are the implied yield currently available on U.S. Treasury issues with a remaining term approximating the expected term.
During 2011 and 2010, we granted stock-based awards to associates and issued our common stock to eligible associates under our Holiday Stock Plan. No stock-based awards were granted to associates during 2009 except for under our Holiday Stock Plan. The following weighted average assumptions were used for option grants issued during 2011 and 2010 in determining fair value:
· Risk-free rates are equal to the yield, as of the measurement date, of the zero-coupon U.S. Treasury bill that is commensurate with the performance period. Risk free rates used range from 0.65%-1.25% for 2011 grants and 1.43%-1.50% for 2010 grants.
We operate primarily in two industries, property casualty insurance and life insurance. We regularly review our reporting segments to make decisions about allocating resources and assessing performance:
We revised our reportable segments during 2010 to establish a separate reportable segment for excess and surplus lines, allowing readers to view this business in a manner similar to the way we manage it internally when making operating decisions. This segment includes results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources.
· All four insurance segments record revenues from insurance premiums earned. Life insurance segment revenues also include separate account investment management fees.
· Our investment operations’ revenues are pretax net investment income plus realized investment gains and losses.
o For commercial lines, personal lines and excess and surplus insurance segments, we calculate underwriting income or loss by recording premiums earned and fee revenue minus loss and loss expenses and underwriting expenses incurred.
o For the life insurance segment, we calculate underwriting income or loss by recording premiums earned and separate account investment management fees, minus contract holders’ benefits and expenses incurred, plus investment interest credited to contract holders.
* Revenues including realized investment gains and losses, which are integral to our financial results over the long term, may cause this value to fluctuate substantially because we have substantial discretion in the timing of investment sales. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 81.