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, 2009, and is classified as land, building and equipment, net, for company use.
Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2009.
Although 2009 and 2008 were difficult years for our economy, our industry and our company, our long-term perspective lets us address the immediate challenges while focusing on the major decisions that best position the company for success through all market cycles. We believe that this forward-looking view has consistently benefited our shareholders, agents, policyholders and associates.
Premium growth - We believe over any five-year period our agency relationships and initiatives can lead to a property casualty written premium growth rate that exceeds the industry average. The compound annual growth rate of our net written premiums was negative 0.6 percent over the five-year period 2005 through 2009, equal to the negative 0.6 percent estimated growth rate for the property casualty insurance industry.
Combined ratio - We believe our underwriting philosophy and initiatives can generate a GAAP combined ratio over any five-year period that is consistently below 100 percent. Our GAAP combined ratio has averaged 95.6 percent over the five-year period 2005 through 2009. Our combined ratio was below 100 percent in each year during the period, except 2008 and 2009, which averaged 102.5 percent, and which averaged catastrophe losses that were 2.5 percentage points higher than the average for the 10-year period prior to 2008. Performance as measured by the combined ratio is discussed in Consolidated Property Casualty Insurance Results of Operations, Page 46. Our statutory combined ratio averaged 95.4 percent over the five-year period 2005 through 2009 compared with an estimated 98.9 percent for the property casualty industry.
Investment contribution - We believe our investment philosophy and initiatives can drive investment income growth and lead to a total return on our equity investment portfolio over a five-year period that exceeds the five-year return of the Standard & Poor’s 500 Index.
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 2009, the company has increased the indicated annual cash dividend rate for 49 consecutive years, a record we believe is matched by only 11 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 68.
The strong rally in financial markets during 2009 had a highly favorable impact on our 2009 value creation ratio, offsetting much of the unfavorable impact of the sharp decline in financial markets during 2008. That decline also was reflected in the value creation ratio. Should financial markets decline during 2010, which could occur as part of typical volatility patterns, the related component of our 2010 value creation ratio could also register a weak or negative result.
Lingering effects of soft insurance market pricing are expected to affect growth rates and earned premium levels into 2010 and perhaps later, depending on when insurance market conditions improve. These conditions continue to weaken loss ratios and hamper near-term profitability. Economic factors, including inflation, may increase our claims and settlement expenses related to medical care, litigation and construction.
The weak economy is expected to continue to affect policyholders by deflating the valuation of their business and personal insurable assets. Until the weak economy significantly strengthens, we do not expect to see significant premium growth for the property casualty industry or our commercial lines
Diversification of the investment portfolio during 2008 and early 2009 included sales of selected positions to lock in gains, reduce concentrations and increase liquidity. Proceeds of sales were reinvested in both fixed income and in equity securities with yields that we believe are likely to be more secure, but which could result in slower growth of investment income. We expect to continue making changes to the portfolio, as appropriate.
We expect initiatives that make it easier for agents to do business with us will continue to be a significant factor in agency relationships, with technology being a major driver. Policyholders will increasingly demand online services and access from agents or carriers.
We discuss in our Item 1A, Risk Factors, Page 23, 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 a senior officer and supported by a team of representatives from business areas. The team makes 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.
Our ratio of debt to total capital (debt plus shareholders’ equity) decreased during 2009 after rising in 2008. The increase during 2008 was due to the effect on shareholders’ equity from the declining value of our invested assets.
Net income increased $3 million during 2009, reflecting the after-tax net effect of three major contributing items: a $132 million increase from net realized investment gains, partially offset by a $48 million decrease from investment income and a $74 million decrease from property casualty underwriting results. Net income declined in 2008 because of a decline in realized investment gains, a first-ever decline in investment income and a lower aggregate contribution from our insurance segments. A 2008 pension plan settlement reduced 2008 net income by $17 million, or 11 cents per share. The transition from a defined benefit pension plan reduced company risk while providing a company-sponsored 401(k) match to associates.
Weighted average shares outstanding may fluctuate from period to period due to repurchases of shares under board authorizations or issuance of shares when associates exercise stock options. Weighted average shares outstanding on a diluted basis declined by less than 1 million in 2009, after declining 9 million in 2008 and 3 million in 2007.
Lower income from common stock dividends led to a 6.8 percent decline in pretax net investment income in 2009, improving on an 11.6 percent decline for 2008, which was the first decline for this measure in company history. The primary reason for the decline was dividend reductions by common and preferred holdings, including reductions during the year on positions subsequently sold or reduced.
The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 of the Consolidated Financial Statements, Page 94. In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company’s critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate.
For some lines of business that we write, a considerable and uncertain amount of time can elapse between the occurrence, reporting and payment of insured claims. The amount we will actually have to pay for such claims also can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. Gross loss and loss expense reserves were $4.096 billion at year-end 2009 compared with $4.040 billion at year-end 2008.
For weather events designated as catastrophes, we calculate IBNR reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Our claims department management coordinates the assessment of these events and prepares the related IBNR reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the storm, of policyholder exposures within the affected geographic area and of available claims intelligence. Depending on the nature of the event, available claims intelligence could include surveys of field claims associates within the affected geographic area, feedback from a catastrophe claims team sent into the area, as well as data on claims reported as of the financial statement date. We generally use the catastrophe definition provided by Property Claims Service, a division of Insurance Services Office (ISO). PCS defines a catastrophe as an event that causes countrywide damage of $25 million or more in insured property losses and affects a significant number of policyholders and insureds.
For asbestos and environmental claims, we calculate IBNR reserves by deriving an actuarially based estimate of total unpaid loss and loss expenses. We then reduce the estimate by total case reserves. We discuss the reserve analysis that applies to asbestos and environmental reserves in Asbestos and Environmental Reserves, Page 74.
Quarterly, our actuarial staff summarizes its reserve analysis by preparing an actuarial best estimate and a range of reasonable IBNR reserves intended to reflect the uncertainty of the estimate. An inter-departmental committee that includes our actuarial management team reviews the results of each quarterly reserve analysis. The committee establishes management’s best estimate of IBNR reserves, which is the amount that is included in each period’s financial statements. In addition to the information provided by actuarial staff, the committee also considers factors such as the following:
These key assumptions have not changed since 2005, when our actuarial staff began using probabilistic trend family models to estimate IBNR reserves.
Management believes that the standard error of a reserve estimate, a measure of the estimate's variability, provides the most appropriate measure of the estimate's sensitivity. The reserves we establish depend on the models we use and the related parameters we estimate in the course of conducting reserve analyses. However, the actual amount required to settle all outstanding insured claims, including IBNR claims, as of a financial statement date depends on stochastic, or random, elements as well as the systematic elements captured by our models and estimated model parameters. For the lines of business we write, process uncertainty - the inherent variability of loss and loss expense payments - typically contributes more to the imprecision of a reserve estimate than parameter uncertainty.
Consequently, a sensitivity measure that ignores process uncertainty would provide an incomplete picture of the reserve estimate's sensitivity. Since a reserve estimate's standard error accounts for both process and parameter uncertainty, it reflects the estimate's full sensitivity to a range of reasonably likely scenarios.
The application of our impairment policy resulted in other-than-temporary impairment charges that reduced our income before income taxes by $131 million in 2009, $510 million in 2008 and $16 million in 2007. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, there is little expectation that the value may be recouped within a designated recovery period. Other than-temporary impairment losses represent non-cash charges to income and are reported as realized investment losses.
Our portfolio managers monitor their assigned portfolios. If a security is trading below book value, 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. Management reviews 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
All securities valued below 100 percent of book value are reported to the asset impairment committee for evaluation. Securities valued between 95 percent and 100 percent of book value are reviewed but not monitored separately by the committee. These assets generally are at this value because of interest rate-driven factors.
When determining OTTI charges for our fixed-maturity portfolio, management places significant emphasis on whether issuers of debt are current on contractual payments and whether future contractual amounts are likely to be paid. Our fixed maturity invested asset impairment policy states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed maturity security; (2) if it is more likely than not we will be required to sell the fixed maturity security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. If we intend to sell or it is more likely than not we will be required to sell, the book value of any such securities is reduced to fair value as the new cost basis, and a realized loss is recorded in the quarter in which it is recognized. When we believe that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount to the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the quarter in which it 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.
Securities that have previously been impaired are evaluated based on their adjusted book value and written down further, if deemed appropriate. We provide detailed information about securities trading in a continuous loss position at year-end 2009 in Item 7A, Application of Asset Impairment Policy, Page 85. An other-than-temporary decline in the fair value of a security is recognized in net income as a realized investment loss.
The fair value measurement and disclosure exit price notion requires our valuation also to consider what a marketplace participant would pay to buy an asset or receive to assume a liability. Therefore, while we can
consider pricing data from outside services, we ultimately determine whether the data or inputs used by these outside services are observable or unobservable.
Financial assets and liabilities recorded on the Consolidated Balance Sheets are categorized based on the inputs to the valuation techniques as described in Item 8, Note 3, Fair Value Measurements, Page 103.
Included in the Level 2 hierarchy is a small portfolio of collateralized mortgage obligations (CMOs) that represented less than 1 percent of the fair value of our investment portfolio at December 31, 2009. We obtained the CMOs as part of the termination of our securities lending program during 2008.
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. Level 3 corporate fixed-maturity securities include certain private placements, small issues, general corporate bonds and medium-term notes. Level 3 state, municipal and political subdivisions fixed-maturity securities include various thinly traded municipal bonds. Level 3 common equities include private equity securities. Level 3 preferred equities include private and thinly traded preferred securities.
Management ultimately determined the pricing for each Level 3 security that we considered to be the best exit price valuation. As of December 31, 2009, total Level 3 assets were less than 1 percent of our investment portfolio measured at fair value. Broker quotes are obtained for thinly traded securities that subsequently fall within the Level 3 hierarchy. We obtained two non-binding quotes from brokers and, after evaluating, our investment professionals typically selected the lower quote as the fair value.
We establish a deferred asset for costs that vary with, and are primarily related to, acquiring property casualty and life insurance business. These costs are principally agent commissions, premium taxes and certain underwriting costs, which are deferred and amortized into net income as premiums are earned. Deferred acquisition costs track with the change in premiums. Underlying assumptions are updated periodically to reflect actual experience. Changes in the amounts or timing of estimated future profits could result in adjustments to the accumulated amortization of these costs.
Separate account assets are carried at fair value. Separate account liabilities primarily represent the contract holders' claims to the related assets and are carried at an amount equal to the contract holders’ account value. Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holders and, therefore, are not included in our Consolidated Statements of Income. However, each separate account contract includes a negotiated realized gain and loss sharing arrangement with the company. This share is transferred from the separate account to our general account and is recognized as revenue or expense. In the event that the asset value of contract holders’ accounts is projected below the value guaranteed by the company, a liability is established through a charge to our earnings.
For our most significant separate account, written in 1999, realized gains and losses are retained in the separate account and are deferred and amortized to the contract holder over a five-year period, subject to certain limitations. Upon termination or maturity of this separate account contract, any unamortized deferred gains and/or losses will revert to the general account. In the event this separate account holder were to exchange the contract for the policy of another carrier in 2010, the account holder would not pay a surrender charge. The surrender charge is zero in 2010 and beyond.
We measure profit or loss for our commercial lines and personal lines property casualty and life insurance segments based upon underwriting results (profit or loss), which represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also frequently evaluate results for our consolidated property casualty insurance operations, which is the total of our commercial, personal plus our excess and surplus insurance results. Underwriting results and segment pretax operating income are not substitutes for net income determined in accordance with GAAP.
The calculations of segment data are described in more detail in Item 8, Note 18 of the Consolidated Financial Statements, Page 115. The following sections review results of operations for each of the four segments. Commercial Lines Insurance Results of Operations begins on Page 49, Personal Lines Insurance Results of Operations begins on Page 57, Life Insurance Results of Operations begins on Page 62, and Investment Results of Operations begins on Page 64. We begin with an overview of our consolidated property casualty operations, which is the total of our commercial lines, personal lines plus excess and surplus lines results.
Our 2009 and 2008 combined ratios before catastrophe losses and reserve development on prior accident years were substantially higher than 2007 primarily due to lower pricing prompted by soft market conditions and also due to normal loss cost inflation. During 2008, we also experienced a higher level of larger commercial lines losses and the impact of a pension plan settlement cost. The pension plan settlement increased the 2008 combined ratio by 0.8 percentage points. We have taken actions to manage expenses, increasing spending in some areas such as technology to pursue long-term benefits and decreasing in other areas of our operation. However, lower pricing continues to put upward pressure on the underwriting expense ratio. This is consistent with industry trends as A.M. Best estimates that the industry’s 2009 statutory underwriting expense ratio increased by 1.4 percentage points compared with the year 2006 level.
Changes in written and earned premiums over the past three years reflected growing price competition partially offset by fairly stable policy retention rates of renewal business and increases in new business. New business written directly by agencies rose in both 2009 and 2008 after declining in 2007. The resurgence in new business was largely due to the contribution of new agency appointments - in both new and existing states of operation; the contribution of our excess and surplus lines business; and more competitive personal lines pricing. Other written premiums primarily include premiums ceded to our reinsurers as part of our reinsurance program.
Hurricane Ike, which reached the Gulf Coast on September 12, 2008, moved into the Midwest on September 14, causing unusually high winds in Ohio, Indiana and Kentucky. At December 31, 2009, our gross losses from Hurricane Ike were estimated at $145 million, making it the single largest catastrophe in the company’s history. Net of reinsurance, the loss was estimated at $59 million. Virtually all of the losses reported by our policyholders occurred in the Midwest.
The rise in the total underwriting expense ratio since 2007 largely was due to the rise in non-commission underwriting expenses, reflecting our continued investment in the people and systems necessary for our future growth, and also reflecting lower premiums. Commission expenses include our profit-sharing, or contingent commissions, which are primarily based on the profitability of an agency’s aggregate property casualty book of Cincinnati business. The commission ratio has declined from the 2007 level. These profit-based commissions generally fluctuate with our loss and loss expense ratio, with the expense ratio generally increasing when our loss and loss expense ratio declines. The change in our pension plan added 0.5 percentage points to the 2008 non-commission underwriting expense ratio.
The discussions of our property casualty insurance segments provide additional detail about these factors.
Premiums - Pricing in our industry continues to be very competitive, and the poor economy is driving exposures lower. Our commercial lines net written premium decline for 2009 of 5.6 percent compared favorably with the estimated decline of 7.9 percent for the overall commercial lines industry, and our 2008 decline of 4.2 percent was slightly worse than the decline of 3.9 percent estimated for the industry. We believe our pace for new and renewal business in recent years is consistent with our agents’ practice of selecting and retaining accounts with manageable risk characteristics that support the lower prevailing prices. We also believe our favorable comparison to the industry for 2009 reflects the advantages we achieve through our field focus, which provides us with quality intelligence on local market conditions. Our earned premiums declined in 2009 and 2008, following the pattern of our written premiums, after rising slightly in 2007.
As commercial lines markets have grown more competitive over the past several years, we have focused on leveraging our local relationships as well as the efforts of our agents and the teams that work with them. In this environment, we have been careful to maintain appropriate pricing discipline for both new and renewal business as we emphasize the importance of assessing account quality to our agencies and underwriters. We continue to make case-by-case decisions not to write or renew certain business. We continue to use rate credits to retain renewals of quality business and earn new business, but do so selectively in order to avoid commercial accounts that we believe have insufficient profit margins. Our experience remains that the larger the account, the higher the credits needed to write or retain the account, with variations by geographic region and class of business.
Over the past three years, we continued to focus on seeking and maintaining adequate premium per risk exposure as well as pursuing non-pricing means of enhancing longer-term profitability. Non-pricing means have included deliberate reviews of each risk, terms and conditions and limits of insurance. We continue to adhere to our underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions. In addition, we continue to leverage our strong local presence. Our field marketing representatives meet with local agencies to reaffirm agreements on the extent of the frontline renewal underwriting that agents will perform. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. To assist underwriters, field claims representatives prepare full reports on their first-hand observations of risk quality.
while other agencies appointed during 2008 and 2009 contributed $23 million of our new commercial lines business. During 2009 we wrote fewer policies with annual premiums above $100,000, reflecting significant competition for larger accounts as many carriers continued to protect their renewal portfolio of business during the soft pricing environment. Some of our 2009 new business came from accounts that were not new to the agent. We believe these seasoned accounts tend to be priced more accurately than business that is less familiar to our agent because 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.
The trend for our commercial lines current accident year loss and loss expense ratio before catastrophe losses over the past three years reflected normal loss cost inflation as well as softer pricing that began in 2005 and continued through 2009, as discussed above.
Catastrophe losses were volatile over the three-year period as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 46. Catastrophe losses added 3.0, 4.6 and 1.1 percentage points to the commercial lines accident year loss and loss expense ratios in the table above.
Commercial lines reserve development for prior accident years continued to net to a favorable amount in 2009, although it was less than in 2008, as discussed in Commercial Lines Insurance Segment Reserves, Page 75. Accident years 2008 and 2007 for the commercial lines segment have developed favorably, as indicated in the table above.
Trends for commercial lines loss and loss expenses and the related ratios are further analyzed in Commercial Lines of Business Analysis, Pages 52 through 57.
The 2009 decline of $16 million or 2.5 percent in the loss and loss expenses from new losses and case reserve increases greater than $250,000, net of reinsurance, was more than offset by a larger decline in commercial lines earned premiums, causing an increase in the corresponding ratio. Our analysis indicated no unexpected concentration of these losses and reserve increases by geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of loss experience for larger policies is greater than that of smaller policies, and we continue to monitor that in addition to general inflationary trends in loss costs. In 2007, our retention for our property and casualty working treaties was $4 million.
We intend to continue marketing our products to a broad range of business classes, pricing our products appropriately and taking a package approach. We intend to maintain our underwriting selectivity and carefully manage our rate levels as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions about rates, the use of three-year commercial policies and other policy conditions on a case-by-case basis, even in lines and classes of business that are under competitive pressure. Nonetheless, we expect commercial lines profitability to remain under pressure in 2010, in part due to small average pricing declines on policies renewed during 2009 for which premiums will be earned during 2010.
Approximately 95 percent of our commercial lines premiums relate to accounts with coverages from more than one of our business lines. As a result, we believe that the commercial lines segment is best measured and evaluated on a segment basis. However, we provide line-of-business data to summarize 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 2009, the only commercial line of business that exhibited significant adverse profitability trends was workers’ compensation. Most of the profit deterioration in worker’s compensation was a result of prior accident year reserve development. As discussed below, actions we are taking to improve pricing and reduce loss costs are expected to benefit future profitability trends.
Commercial casualty is our largest business line. The decline in commercial casualty premiums reflected the intensifying competition in the casualty market. In addition, premiums for this business line reflect economic trends, including changes in underlying exposures, particularly for general liability coverages where the premium amount is heavily influenced by economically-driven measures of risk exposure such as sales volume.
The 2009 current accident year loss and loss expense ratio before catastrophe losses deteriorated slightly, reflecting lower pricing per exposure and normal loss cost inflation.
The calendar year loss and loss expense ratio improved compared with 2008, primarily due to lower catastrophe losses. The 2008 ratio was also adversely affected by 3.4 percentage points for new losses and case reserve increases greater than $250,000. Development on prior period reserves was relatively stable for all periods shown.
The decline in commercial auto premiums over the three-year period reflected the downward pressure exerted by the market on the pricing of commercial accounts. Commercial auto is one of the business lines that we renew and price annually, so market trends may be reflected here more quickly than in other lines. Commercial auto also experiences pricing pressure because it often represents the largest portion of insurance costs for many commercial policyholders.
Since we pay a lower commission rate on workers’ compensation business, this line has a higher calendar year loss and loss expense breakeven point than our other commercial business lines. Nonetheless, the ratio was at an unprofitable level in each of the last three years, and management continues to work to improve financial performance for this line. During 2009, we began using a predictive modeling tool to improve risk selection and pricing capabilities. Predictive modeling increases pricing precision so that our agents can better compete for the most desirable workers’ compensation business. We also added to our staff of loss control field representatives, premium audit field representatives and field claims representatives specializing in workers’ compensation risks. In early 2010, we implemented direct reporting of workers’ compensation claims, allowing us to quickly obtain detailed information to promptly assign the appropriate level of claims handling expertise for each case. Obtaining more information sooner for specific claims allows for medical care appropriate to the nature of each injury, benefiting injured workers, employers and agents while ultimately lowering overall loss costs.
Surety and executive risk premiums declined in 2009 as we non-renewed many policies in an effort to improve the quality of the financial institution portion of this book of business. Prior to the credit crisis in 2008, this line of business had been growing in response to our marketing of these products.
Limiting the number of for-profit policies. At year-end 2009, our in-force director and officer liability policies provided coverage to 14 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.
Writing on a claims-made basis, which normally restricts coverage to losses reported during the policy term.
Combined ratio - The combined ratio improved slightly in 2009, reflecting in part improved pricing, following substantial deterioration in 2008. The level of catastrophe losses remained high in 2009, and the current accident year loss and loss expense ratio remained fairly steady, once refinements made to the IBNR reserve allocation in 2008, noted below, are taken into account. In 2008, the current accident
year loss and loss expense ratio before catastrophe losses also rose substantially, in part due to approximately $20 million, or 2.9 percentage points, from refinements made to the allocation of IBNR reserves by accident year.
Our personal lines policy retention and new business levels have remained at higher levels following introduction in recent years of a limited program of policy credits for personal auto and homeowner pricing in most of the states in which we operate. The program provided credits for eligible new and renewal policyholders identified as above-average quality risks. Additional pricing and credit changes were implemented in early 2009, further improving pricing for the best accounts, which should help us retain and attract even more of our agents’ preferred business.
Our personal lines new business written by our agencies rose significantly in 2009 as the number of agency locations writing our personal lines rose by 133, or 14.4 percent, following an increase of 136 agency locations in 2008. Since early 2008, we have worked to improve our geographic diversification by expanding our personal lines operation to several states less prone to catastrophes. There are seven states where we began writing business or significantly expanded our personal lines product offerings and automation capabilities beginning in 2008, and they accounted for $13 million of our 2009 increase in our personal lines new business written premiums. Those seven states are Arizona, Idaho, Maryland, Montana, North Carolina, South Carolina, and Utah.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Catastrophe losses were unusually high during 2009 and 2008, and also are inherently volatile, as discussed above and in Consolidated Property Casualty Insurance Results of Operations, Page 46. Development on loss and loss expense reserves for prior accident years continued to trend favorably in 2009 as discussed in Personal Lines Insurance Segment Reserves, Page 77.
The increase in the current accident year loss and loss expense ratio before catastrophe losses since 2007 reflects the pricing factors discussed above, normal loss cost inflation and higher non-catastrophe weather-related losses. During 2009, one unusually large fire loss for our homeowner line of business contributed $5 million to personal lines segment losses. In addition, refinements made to the allocation of IBNR reserves by accident year increased the 2008 ratio.
The effect on the loss and loss expense ratio from new losses and case reserve increases greater than $250,000, net of reinsurance, was higher in 2009 than it was in 2008. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory.
Personal lines commission expense as a percent of earned premium for 2009 was essentially flat compared with 2008. The decrease in the commission expenses ratio in 2008 reflected a lower level of our profit-sharing, or contingent commissions, which are primarily based on the profitability of an agency’s aggregate property casualty book of Cincinnati business.
catastrophe loss level of 2009 may return nearer to the historical average, with the long-term future catastrophe loss ratio improving due to our gradual geographic diversification into states less prone to catastrophe losses.
Net written premiums for personal auto increased slightly in 2009 as strong new business growth offset pricing decreases taken in early 2009 and business lost due to normal attrition. We continue to monitor and modify selected rates and credits to address our competitive position.
The calendar year loss and loss expense ratio rose slightly over the three-year period. In recent years, we have seen generally higher costs for liability claims, including severe injuries, and we have sought rate increases for liability coverages that partially offset price decreases for physical damage coverages.
Price reductions, in part reflecting our trend toward a higher quality book of business, combined with normal loss cost inflation as the primary drivers in the rise in the accident year loss and loss expense ratio before catastrophe losses since 2007. The 2008 accident year loss and loss expense ratio also reflected refinements made to our IBNR reserve allocation by accident year that contributed approximately 4 percentage points.
The calendar year loss and loss expense ratio over the past three years fluctuated with catastrophe losses, non-catastrophe weather-related losses and other large losses. Catastrophe losses have been above our expected range in recent years, averaging 34.5 percent of homeowner earned premium from 2008 to 2009, compared with the most recent 10-year average of 21.9 percent.
The current accident year loss and loss expense ratio before catastrophe losses remained high in 2009, in part due to the same non-catastrophe weather related losses and other large losses that affected the calendar year result. Non-catastrophe weather-related losses contributed about 14.0 percentage points to the 2009 ratio and about 5 percentage points to the 2008 ratio. In addition, the refinements made to our IBNR reserve allocation by accident year and a lower estimate of salvage and subrogation reserves raised the 2008 ratio by about 2 percentage points.
Separate account investment management fee income contributed less than $1 million to total revenue in 2009, compared with a $2 million contribution in 2008 and $4 million in 2007. These fees declined primarily because of a net realized capital loss sharing agreement between the separate account and the general account.
Operating expenses incurred, net of deferred acquisition costs, accounted for 23.6 percent of 2009 total benefits and expenses compared with 24.3 percent in 2008 and 28.1 percent in 2007. Operating expenses increased principally because of the level of commission expense associated with new term life insurance and fixed annuity policies, partially offset by deferred acquisition costs related to these products.
Current statutory laws and regulations require life insurers to hold redundant reserves, particularly for preferred risk underwriting classes. While these redundant reserves have no direct effect on GAAP results, they depress statutory earnings and require a large commitment of capital. Redundant reserves are a significant challenge, not just for our life insurance operations, but for all writers of term insurance and universal life insurance with secondary guarantees.
Investment income - Pretax investment income declined 6.8 percent in 2009, primarily because of prior year dividend cuts in our common stock portfolio. Pretax investment income declined 11.6 percent in 2008, primarily because of dividend reductions by common and preferred holdings, including reductions during the year on positions subsequently sold or reduced. After-tax investment income declined 11.3 percent in 2009 compared with 10.9 percent in 2008. This after-tax decline has been primarily driven by the above-mentioned dividend reductions.
Realized investment gains and losses - We reported realized investment gains in all three years, largely due to investment sales that were discretionary in timing and amount. Those sales were somewhat offset in 2009 and 2008, respectively, by $131 million and $510 million of other-than-temporary impairment charges for the write-down of 50 securities in 2009 and 126 securities in 2008.
Interest income rose again in 2009 as we increased our allocation of investments to fixed maturity securities. At year-end 2009, the fixed maturities fair value was 104.5 percent of book value compared with 96.2 percent at year-end 2008.
Investment gains or losses are recognized upon the sales of investments or as otherwise required under GAAP. The timing of realized gains or losses from sales can have a material effect on results in any quarter.
However, such gains or losses usually have little, if any, effect on total shareholders’ equity because most equity and fixed maturity investments are carried at fair value, with the unrealized gain or loss included as a component of other comprehensive income.
Net realized investment gains and losses totaling $440 million for the year ended December 31, 2009, reflected:
$162 million in realized losses from the sales of various equity securities, including $52 million from the sale of General Electric Co. (NYSE: GE). These realized losses partially offset the $624 million in realized gains from equity sales.
$7 million in other net losses, including $6 million from a write-off of an other invested asset.
In 2008, most of the gain was due to sales of holdings of common and preferred stocks of financial services issuers, to reduce our historical weighting in financial sector securities. The majority of these holdings were sold following reductions or elimination of their cash dividends to shareholders. Because of our low cost basis, we were able to record gains on many of these sales despite the decline in overall stock market values during 2008. Realized gains were lower in 2007, although we chose to take gains from partial sales of selected holdings and to sell other holdings because of general credit concerns that began in the subprime mortgage market and spread to other areas in the homebuilding and related industries over the course of 2007.
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 other-than-temporary impairment 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 42.
Revenues for our Other businesses increased during 2009, primarily due to earned premiums from our excess and surplus lines business. Other also includes other income of our standard market insurance subsidiary, as well as non-investment operations of the parent company and its subsidiary, CFC Investment Company, and former subsidiary CinFin Capital Management Company. Upon commencing our excess and surplus lines operations in 2008, we also included results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources.
Losses before income taxes for Other were largely driven by interest expense from debt of the parent company plus losses and loss expenses and underwriting expenses from our excess and surplus lines operation.
The change in our effective tax rate was driven by changes in pretax income from underwriting results, investment income from dividends and the amount of realized investment gains and losses. Higher tax-exempt interest and changes in our dividends received deduction in the current year compared with prior years also contributed with the change in the effective tax rates from 2007 to 2009.
Historically, we have pursued a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. See Tax-Exempt Fixed Maturities, Page 19 for further discussion on municipal bond purchases in our fixed-maturity investment portfolio. For our insurance subsidiaries, approximately 85 percent of income from tax-advantaged fixed-maturity investments is exempt from federal tax. Our non-insurance companies own an immaterial amount of tax-advantaged fixed-maturity investments. For our insurance subsidiaries, the dividend received deduction, after the dividend proration of the 1986 Tax Reform Act, exempts approximately 60 percent of dividends from qualified equities from federal tax. For our non-insurance subsidiaries, the dividend received deduction exempts 70 percent of dividends from qualified equities. Details about our effective tax rate are found on Note 11, Income Taxes, Page 108.
Liquidity and capital resources represent the overall financial strength of our company and our ability to generate cash flows to meet the short- and long-term cash requirements of business obligations and growth needs. We seek to maintain prudent levels of liquidity and financial strength for the protection of our policyholders, creditors and shareholders. We manage liquidity at two levels. The first is the liquidity of the parent company. The second is the liquidity of our insurance subsidiary. The management of liquidity at both levels is essential because each has different funding needs and sources, and each is subject to certain regulatory guidelines and requirements.
This table below shows a summary, by the direct method, of the major sources and uses of liquidity by the parent company. Dividends received in 2009 and 2008 from our insurance subsidiary were much lower than in the several years prior to that, in order to maintain strong statutory surplus and financial strength ratings. We expect sources of liquidity to increase in 2010 and beyond, as we anticipate investment income growth and improved profitability for our property casualty operations. A dividend of $50 million was received from our insurance subsidiary in January 2010. The majority of expenditures for the parent company have been consistent during the last three years, and we expect future expenditures to remain fairly stable.
Dividends to shareholders - Over the past 10 years, the company has paid an average of 39.9 percent of net income as dividends. The ability of the company to continue paying cash dividends is subject to factors the board of directors may deem relevant.
Consistent with our approach for the second half of 2008, in 2009 we chose to preserve capital rather than repurchase shares. During the first half of 2008, we repurchased 3.8 million shares. In the past, repurchases have occurred when we believed that stock prices on the open market were favorable for such repurchases. Our corporate Code of Conduct restricts repurchases during certain time periods. The details of the repurchase authorizations and activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 30. Between February 1999 and year-end 2009, we have repurchased 28.7 million shares at a total cost to the company of $1.105 billion. We do not adjust the number of shares repurchased and average price per repurchased share for stock dividends.
Our insurance subsidiaries’ primary contractual obligations are property casualty loss and loss expenses and life policyholder obligations as well as certain ongoing operating expenses as shown under Contractual Obligations, Page 71. Other uses of insurance subsidiary cash include payments of dividends to the parent company and other operating expenses as discussed under Other Commitments, Page 71.
Over the past three years, cash receipts from property casualty and life insurance premiums, along with investment income, have been more than sufficient to pay claims, operating expenses and dividends to the parent company. We discuss the factors that affected insurance operations in Commercial Lines and Personal Lines Insurance Results of Operations, Page 48 and Page 57.
Investing is a primary source of liquidity for both the parent company and our insurance subsidiary operations. For both, cash in excess of operating requirements is invested in fixed-maturity and equity securities. Equity securities provide the potential for future increases in dividend income and for appreciation. In Item 1, Investments Segment, Page 18, we discuss our investment strategy, portfolio allocation and quality.
One way we seek to maintain a solid financial position and provide capital flexibility is by keeping our ratio of debt to total capital moderate. We target a ratio below 20 percent. At year-end 2009, the ratio was 15.0 percent compared with 16.7 percent at year-end 2008. The decrease in the debt-to-total-capital ratio was due entirely to the increase in shareholders’ equity at year-end 2009. Based on our present capital requirements, we do not believe we will need to increase debt levels during 2010. As a result, we believe that changes in our debt-to-capital ratio will again be a function of changes in shareholders’ equity.
We provide details of our three long-term notes in Item 8, Note 8 of the Consolidated Financial Statements, Page 106. None of the notes are encumbered by rating triggers:
The company’s senior debt is rated investment grade by independent ratings firms. On August 2, 2009, Fitch Ratings lowered our senior debt rating from A- to BBB+. Three other rating agencies made no changes
to our debt ratings in 2009. Our debt ratings from the other rating agencies are: a from A.M. Best, A3 from Moody’s Investors Service and BBB+ from Standard & Poor’s Ratings Services. The ratings are described in Item 1, Financial Strength, Page 3.
The second line of credit is an unsecured $150 million revolving line of credit administered by The Huntington National Bank. It was established in 2007 and will mature in 2012. CFC Investment Company, a subsidiary of Cincinnati Financial Corporation, also is a borrower under this line of credit. At year-end 2009, there was $49 million outstanding on this line of credit. The Huntington National Bank, a subsidiary of Huntington Bancshares Inc. (NASDAQ:HBAN), is the lead participant with a $75 million share. U.S. Bancorp (NYSE:USB), Bank of America (NYSE:BAC) and Northern Trust Corporation (NASDAQ:NTRS) also participate, each providing $25 million of capacity.
A long-term perspective governs all of our major decisions, with the goal of benefiting our policyholders, agents, shareholders and associates over time. While our insurance results remained weak for 2009, even after a strong second half of the year, our improved capital position from year-end 2008 provided adequate cushion. We have taken the necessary steps to protect our capital and are confident in our strategies to return our insurance operations to growth and profitability.
Our consistent cash flows and prudent cash balances continue to create strong liquidity. As of December 31, 2009, we had $557 million in cash and cash equivalents. That strong liquidity and our consistent cash flows gives us the flexibility to meet current obligations while building value by prudently investing where we see potential for both current income and long-term return.
In any year, we consider the most likely source of pressure on liquidity would be an unusually high level of catastrophe losses within a short period of time. This could create additional obligations for our insurance operations by increasing the severity or frequency of claims. To address the risk of unusual insurance loss obligations including catastrophe events, we maintain property casualty reinsurance contracts with highly rated reinsurers, as discussed under 2010 Reinsurance Programs, Page 79. We also monitor the financial condition of our reinsurers because an insolvency could place in jeopardy a portion of our $675 million in outstanding reinsurance recoverables as of December 31, 2009.
Continued economic weakness also has the potential to affect our liquidity and capital resources in a number of different ways, 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.
As of December 31, 2009, we believe our most significant other commitments are:
Qualified pension plan - In 2010, we currently estimate a voluntary cash contribution of $25 million to our qualified pension plan, a $12 million net pension expense and a $7 million expense for company 401(k) contributions. Going forward, potential savings due to lower funding requirements for the pension plan are expected to be offset by the company 401(k) contributions. In 2008, we chose to transition away from a defined benefit plan to reduce the company’s future market risk while offering associates an up-to-date, more flexible benefits program. We discuss the change to the pension plan, future contributions and plan assets in Item 8, Note 13 to the Consolidated Financial Statements, Page 109.
As of December 31, 2009, we estimate our future contractual obligations as follows:
Interest on long- and short-term debt - We expect total interest expense to be approximately $52 million in 2010. We discuss outstanding debt in Additional Sources of Liquidity, Page 69.
due to life and health loss reserves, as discussed in Item 8, Note 5 of the Consolidated Financial Statements, Page 105.
We direct our associates and agencies to settle claims and pay losses as quickly as is practical and we made $1.923 billion of net claim payments during 2009. At year-end 2009, net property casualty reserves reflected $2.026 billion in unpaid amounts on reported claims (case reserves), $792 million in loss expense reserves and $843 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 38.
The historical pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The effective duration of our consolidated fixed-maturity portfolio was 5.3 years at year-end 2009. By contrast, the duration of our loss and loss expense reserves was approximately three years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow from operations is sufficient to meet these obligations. In addition, investment holdings could be liquidated, if necessary, to meet higher than anticipated loss and loss expenses.
The company established a reasonably likely range for net loss and loss expense reserves of $3.459 billion to $3.774 billion at year-end 2009, with the company carrying net reserves of $3.661 billion. The likely range was $3.256 billion to $3.592 billion at year-end 2008, with the company carrying net reserves of $3.498 billion. Our loss and loss expense reserves are not discounted for the time-value of money, but we have reduced the reserves by an estimate of the amount of salvage and subrogation payments we expect to recover. We provide a reconciliation of the property casualty reserves with the loss and loss expense reserve as shown on the balance sheet in Item 8, Note 5 of the Consolidated Financial Statements, Page 105.
We reconcile the beginning and ending balances of our reserves for loss and loss expenses at December 31, 2009, 2008 and 2007, in Item 8, Note 5 of the Consolidated Financial Statements, Page 105. The reconciliation of our year-end 2008 reserve balance to net incurred losses one year later recognizes approximately $188 million of favorable reserve development.
Section A shows our total property casualty loss and loss expense reserves recorded at the balance sheet date for each of the indicated calendar years on a gross and net basis. Those reserves represent
Section C shows the re-estimated amount of the previously reported reserves based on experience as of the end of each succeeding year. The estimate is increased or decreased as we learn more about the development of the related claims.
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, 1999, had developed favorably by $164 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 reconciliation shows the effects on income before income taxes in 2009, 2008 and 2007 of changes in estimates of the reserves for loss and loss expenses for all accident years. The effect was favorable to pre-tax income for those three years by $188 million, $323 million, and $244 million, respectively. Our annual review has led us to add to income in each of the past 21 years due to favorable development of reserves on prior accident years.
In evaluating the development of our estimated reserves for loss and loss expenses for the past 10 years, note that each amount includes the effects of all changes in amounts for prior periods. For example, payments or reserve adjustments related to losses settled in 2009 but incurred in 2002 are included in the cumulative deficiency or redundancy amount for 2002 and each subsequent year. In addition, this table presents calendar year data, not accident or policy year development data, which readers may be more accustomed to analyzing. Conditions and trends that affected development of reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future reserve development based on this data.
We carried $118 million of net loss and loss expense reserves for asbestos and environmental claims as of year-end 2009, compared with $114 million for such claims as of year-end 2008. These amounts constitute 3.2 percent and 3.3 percent of total loss and loss expense reserves as of these year-end dates.
Reserving data for asbestos and environmental claims has characteristics that limit the usefulness of the methods and models used to analyze loss and loss expense reserves for other claims. Specifically, asbestos and environmental loss and loss expenses for different accident years do not emerge independently of one another as loss development and Bornhuetter-Ferguson methods assume. In addition, asbestos and environmental loss and loss expense data available to date does not reflect a well-defined tail, greatly complicating the identification of an appropriate probabilistic trend family model.
The following table shows net reserve changes at year-end 2009, 2008 and 2007 by commercial line of business and accident year:
Refinements to umbrella liability reserving - As discussed on page 79 of our 2008 Annual Report on 10-K, our actuaries introduced a second reserving model at the end of 2008 to improve the accuracy of estimates of commercial umbrella liability loss reserves, which are a component of our commercial casualty reserves. Further work on these models led to a change in the weighting accorded to each model’s estimate for deriving actuarial best estimates in 2009. If this change had been in place at the time year-end 2008 reserves were established, commercial casualty reserves at year-end 2008 would have been approximately $19 million lower. Accordingly, 2009 favorable reserve development would have been reduced by a like amount.
Flat paid loss trends - Two of our commercial casualty coverages exhibited flat paid loss trends in 2009, which differed from our expectations. Trends in paid losses on a calendar-year basis for medical malpractice and non-discounted premises/operations coverages were essentially flat in 2009, while year-end 2008 reserve estimates reflected upward trends of over 8 percent for these coverages. Had our actuaries reflected these flat trends in paid losses in their reserve estimates a year ago, commercial casualty reserves at year-end 2008 would have been reduced by $22 million, and favorable reserve development in 2009 would have been similarly lower.
Moderation in trend selections - Various commercial casualty coverages that we write have reflected moderating loss cost trends over periods of one or more years. A number of factors seem to have played a role, including sluggish economic activity, favorable court decisions, policy form restrictions, medical malpractice tort reform and claims department initiatives. Accordingly, it is not wholly clear whether these moderating loss cost trends represent short-term or longer-term changes, and our
actuaries have responded cautiously to these changes, electing to recognize improvements in trends used for estimating reserves in a progressive, incremental fashion. If the resulting, revised trends had been used to estimate year-end 2008 reserves, those reserves and 2009 favorable reserve development would have been $31 million lower.
Unusual deviations from predictions of reserving methods and models - Similar to 2008, commercial multi-peril liability coverages made a major contribution to favorable reserve development again in 2009, because both paid loss and reported loss emergence deviated favorably from projections. Projected to rise more than $5 million in 2009, calendar year paid losses on these coverages, excluding asbestos and environmental claims, fell by $22 million instead. Reported losses for accident years 2005 and 2008 also developed more favorably than expected, while reported loss development related to other accident years aligned closely with expectations. If our actuaries had been able to take this information into account when estimating year-end 2008 reserves, their estimates would have been $59 million lower, as would 2009 favorable reserve development.
Workers’ compensation reserve strengthening - Additions to workers’ compensation IBNR reserves on accident years prior to 2009 lowered commercial lines favorable reserve development by $48 million. A reserving model adjustment necessitated by increasingly large deviations between expected and actual paid loss emergence prompted the additions to IBNR reserves. To account for the increasingly large deviations, our actuaries partially shifted the attribution of recent accident years’ paid loss growth from exposure growth to loss cost inflation in their workers’ compensation reserving models. This adjustment produced a significantly higher estimate of loss cost inflation, which raised reserve estimates for all active accident years, not just the recent accident years for which paid loss growth had been previously misinterpreted. The reserving models resulting from this adjustment would have increased the year-end 2008 reserve estimate for workers’ compensation by approximately $61 million had they been available at the time the estimate was derived. In such an event, 2009 favorable reserve development would have increased by a comparable amount.
For the business lines in the personal lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were down from year-end 2008 due to favorable reserve development and the decline in premiums and exposures for this segment, as we discussed in Personal Lines Insurance Results of Operations, Page 57.
The following table shows net reserve changes at year-end 2009, 2008 and 2007 by personal line of business and accident year:
Favorable development for personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. Several atypical factors discussed in Commercial Lines Insurance Segment Reserves, Page 75, that contributed to commercial lines segment reserve development in 2009 also contributed to personal lines favorable reserve development.
Our estimates of life, annuity and disability policyholder obligations reflect future estimated cash payments to be made to policyholders for future policy benefits, policyholders’ account balances and separate account liabilities. These estimates include death and disability claims, policy surrenders, policy maturities, annuity payments, minimum guarantees on separate account products, commissions and premium taxes offset by expected future deposits and premiums on in-force contracts.
Our estimates of gross life, annuity and disability obligations do not reflect net recoveries from reinsurance agreements. Ceded life reinsurance receivables were $213 million at year-end 2009. As discussed in
Gross life policy reserves were $1.783 billion at year-end 2009, compared with $1.551 billion at year-end 2008. We establish reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal 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. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
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, monitor our exposure in certain coastal regions, review aggregate exposures to huge disasters and purchase reinsurance. 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.
of each loss. Losses between $6 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $38 million in 2010, compared with $38 million in 2009 and $43 million in 2008.
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 $1 million for 2010, similar to the premium we paid in 2009.
After reinsurance, our maximum exposure to a catastrophic event that caused $500 million in covered losses would be $104 million compared with $118 million in 2009. The largest catastrophe loss in our history was Hurricane Ike in September 2008, which was estimated to be $145 million before reinsurance at December 31, 2009. The treaty contains one reinstatement provision.
Terrorism coverage at various levels has been secured in most of our reinsurance agreements. The broadest coverage for this peril is found in the property and casualty working treaties, which provide coverage for commercial and personal risks. Our property catastrophe treaty provides coverage for personal risks, and coverage for commercial risks with total insured values of $10 million or less. For insured values between $10 million and $25 million, there also may be coverage in the property working treaty.
Reinsurance protection for the company’s surety business is covered under separate treaties with many of the same reinsurers that write the property casualty working treaties.
The Cincinnati Specialty Underwriters Insurance Company, which began issuing insurance policies in 2008, has separate property and casualty reinsurance treaties for 2010 through Swiss Reinsurance America Corporation. Primary components of the treaties include:
Property per risk treaty - The property treaty provides limits up to $5 million, which is adequate capacity for the risk profile we insure. We retain the first $1 million of any policy loss. Losses between $1 million and $5 million are reinsured at 100 percent.
Casualty treaties - The casualty treaties are written on a quota share basis and provide limits up to $5 million, which is adequate capacity for the risk profile we insure. The maximum exposure for any one casualty loss is $1 million.
This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. Some of those risks and uncertainties are discussed in Item 1A, Risk Factors, Page 23. Although we often review or update our forward-looking statements when events warrant, we caution our readers that we undertake no obligation to do so.
Recession or other economic conditions resulting in lower demand for insurance products or increased payment delinquencies
Events, such as the credit crisis, followed by prolonged periods of economic instability or recession, that lead to:
Prolonged low interest rate environment or other factors that limit the company’s ability to generate growth in investment income or interest rate fluctuations that result in declining values of fixed-maturity investments, including declines in accounts in which we hold bank-owned life insurance contract assets
Place the insurance industry under greater regulatory scrutiny or result in new statutes, rules and regulations
Events, such as an epidemic, natural catastrophe or terrorism, that could hamper our ability to assemble our workforce at our headquarters location
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2009, in accordance with accounting principles generally accepted in the United States of America (GAAP).
Deloitte & Touche LLP, our independent registered public accounting firm, audited the consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2009. Its report is on Page 89. Deloitte’s auditors met with our audit committee to discuss the results of their examination. They have the opportunity to discuss the adequacy of internal controls and the quality of financial reporting without management present.
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 independent registered public accounting firm has issued an audit report on our internal control over financial reporting as of December 31, 2009. This report appears on Page 89.
Cincinnati Financial Corporation operates through our insurance group and two complementary subsidiary companies:
The Cincinnati Insurance Company leads our standard market property casualty insurance group that also includes two subsidiaries: The Cincinnati Casualty Company and The Cincinnati Indemnity Company. This group markets a broad range of standard market business, homeowner and auto policies. The group provides quality customer service to our select group of 1,180 independent insurance agencies with 1,463 reporting locations across 37 states. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life and disability income insurance and annuities, and The Cincinnati Specialty Underwriters Insurance Company, which began offering excess and surplus lines insurance products in 2008.
Our consolidated financial statements include the accounts of the parent company and our wholly owned subsidiaries. We present our statements in accordance with accounting principles generally accepted in the United States of America (GAAP). In consolidating our accounts, we have eliminated intercompany balances and transactions.
Property casualty written premiums are deferred and recorded as earned premiums on a pro rata basis over the terms of the policies. We record as unearned premiums the portion of written premiums that applies to unexpired policy terms. The expenses associated with issuing insurance policies - primarily commissions, premium taxes and underwriting costs - are deferred and amortized over the terms of the policies. Our standard market insurance operations consist of two segments, commercial lines and personal lines. We assess recoverability of deferred acquisition costs at the segment level, consistent with the ways we acquire, service and manage insurance and measure profitability. We also have deferred acquisition costs in our surplus lines operation, which is reported in Other. We analyze our acquisition cost assumptions periodically to reflect actual experience; we evaluate our deferred acquisition cost for recoverability; and we regularly conduct reviews for potential premium deficiencies.
deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency. We did not record a premium deficiency for the three years ended 2009, 2008 and 2007.
We establish reserves to cover the expected cost of claims, or losses, and our expenses related to investigating, processing and resolving claims. Although determining 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. We regularly review and update reserves using the most current information available. Any resulting adjustments are reflected in current year insurance losses and policyholder benefits.
The consolidated property casualty companies actively write property casualty insurance through independent agencies in 37 states. Our 10 largest states generated 68.1 percent and 68.7 percent of total earned premiums in 2009 and 2008. Ohio, our largest state, accounted for 21.0 percent and 20.9 percent of total earned premiums in 2009 and 2008. Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each accounted for between 4 percent and 9 percent of total earned premiums in 2009. Our largest single agency relationship accounted for approximately 1.2 percent of the company's total earned premiums in 2009. Our largest reinsurer, Swiss Reinsurance Company, accounted for 21.5 percent of total ceded earned premiums.
We issue life contracts with guaranteed minimum returns, referred to as bank-owned life insurance contracts (BOLIs). 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.
We carry the assets of separate account BOLIs at fair value. The liabilities on separate account BOLIs primarily are the contract holders’ claims to the related assets and are carried at an amount equal to the contract holders’ account value. At December 31, 2009, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders’ account value by approximately $7 million. If the BOLI projected fair value were to fall below the value we guaranteed, a liability would be established by a charge to the company’s earnings.
statements. The number of fixed-maturity securities trading below 100 percent of book value can be expected to fluctuate as interest rates rise or fall. Because of our strong surplus and long-term investment horizon, our general intent is to hold fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values.
On April 1, 2009, we adopted Accounting Standards Codification (ASC) 320, Recognition and Presentation of Other-Than-Temporary Impairments (OTTI). Our invested asset impairment policy states that fixed maturities the company (1) intends to sell or (2) are more likely than not will be required to sell before recovery of their amortized cost basis are deemed to be other-than-temporarily impaired. The book value of any such securities is reduced to fair value as the new cost basis, and a realized loss is recorded in the period in which it is recognized. When these two criteria are not met, and the company believes that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount 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. With the adoption of this ASC in the second quarter of 2009, we recognized a cumulative effect adjustment of $106 million, net of tax, to reclassify the non-credit component of previously recognized impairments by increasing retained earnings and reducing accumulated other comprehensive income.
We include the non-credit portion of fixed maturities and all other unrealized gains and losses on investments, net of taxes, in shareholders’ equity as accumulated other comprehensive income. Realized gains and losses on investments are recognized in net income based on the trade date accounting method.
We adopted the provisions of Fair Value Measurements on January 1, 2008. Fair Value Measurements defines fair value as the exit price or the amount that would be (1) received to sell an asset or (2) paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. When determining an exit price we must, whenever possible, rely upon observable market data. We primarily base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on prices from FT Interactive Data, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. When a price is not available from these sources, as in the case of securities that are not publicly traded, we determine the fair value using various inputs including quotes from independent brokers. The fair value of investments not priced by FT Interactive Data is less than 1 percent of the fair value of our total investment portfolio.
Our leasing subsidiary provides auto and equipment direct financing (leases and loans) to commercial and individual clients. We generally transfer ownership of the property to the client as the terms of the leases expire. Our lease contracts contain bargain purchase options. We record income over the financing term using the effective interest method.
We record building and equipment at cost less accumulated depreciation. Certain equipment held under capital leases also is classified as property and equipment with the related lease obligations recorded as liabilities. Our depreciation is based on estimated useful lives (ranging from three years to 39½ years) using straight-line and accelerated methods. Depreciation expense was $48 million in 2009, $35 million in 2008, and $38 million in 2007. We monitor land, building and equipment for potential impairments. Potential impairments may include a significant decrease in the fair values of the assets, considerable cost overruns on projects or a change in legal factors or business climate, or other factors that indicate that the carrying amount may not be recoverable. There were no recorded land, building and equipment impairments for 2009, 2008 or 2007.
There are no amounts in our ASC 740 liability that would change the effective tax rate if recognized. Although no penalties currently are accrued, if incurred, they would be recognized as a component of income tax expense. Accrued interest expense is recognized as other interest expense in the consolidated statements of income.
In December 2008, the FASB issued ASC 715-20-65-2, Employers’ Disclosures about Postretirement Benefit Plan Assets. ASC 715-20-65-2 is an amendment of ASC 715-20, Employers’ Disclosures about Pensions and Other Postretirement Benefits, an amendment of ASC 715-10, 715-30, and 715-60. ASC 715-20-65-2 provides guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. The effective date of this ASC is the company’s fiscal year ending after December 15, 2009. We adopted this standard; however, it did not have an impact on our company’s financial position, cash flows or results of operations as it focuses on additional disclosures.
In April 2009, the FASB issued ASC 820-10-65-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. ASC 820-10-65-4 is an amendment of ASC 820-10, Fair Value Measurements. ASC 820-10-65-4 applies to all assets and liabilities and provides guidance on measuring fair value when the volume and level of activity has significantly decreased and guidance on identifying transactions that are not orderly. ASC 820-10-65-4 requires interim and annual disclosures of the inputs and valuation techniques used to measure fair value and a discussion of changes in valuation techniques and related inputs, if any, that occurred during the period. We have adopted this ASC, which is effective for interim and annual reporting periods ending after June 15, 2009. It did not have a material impact on our company’s financial position, cash flows or results of operations.
In June 2009, the FASB issued ASC 105, The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles-a replacement of FASB Statement No. 162. ASC 105 establishes a single source of authoritative, nongovernmental U.S. GAAP, except for rules and interpretive releases of the SEC. We have adopted this ASC, which is effective for interim and annual reporting periods ending after September 15, 2009. It did not have an impact on our company’s financial position, cash flows or results of operations as it does not change authoritative guidance.
In September 2009, the FASB issued ASU 2009-12, Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent). ASU 2009-12 provides guidance on estimating fair value of alternative investments when using the net asset value per share provided by the investment entity. We have adopted this ASU, which is effective for interim and annual periods ending after December 15, 2009, with early adoption permitted. It did 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 provides guidance on additional disclosures on any significant transfers in and out of Level 1 and Level 2 and a description of the transfer. ASU 2010-06 also requires separate disclosures of the activity in the Level 3 category related to any purchases, sales, issuances and settlements on a gross basis. The effective date of the new disclosures relating to the existing disclosures regarding Level 1 and Level 2 categories is for interim and annual periods ending after December 15, 2009. We have adopted the portion of ASU 2010-06 related to significant transfers in and out of Level 1 and Level 2. The effective date of the disclosures regarding purchases, sales, issuances and settlements to the Level 3 category is for interim and annual periods ending after December 15, 2010. The portion of ASU 2010-06 that has been adopted 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, 2009, contractual maturity dates for fixed-maturity and short-term investments were:
At December 31, 2009, investments with book value of $85 million and fair value of $89 million were on deposit with various states in compliance with regulatory requirements.
At year-end 2009, Procter & Gamble was our largest stock holding of the publicly traded common stock portfolio at 5.8 percent. At year-end 2008 and 2007 our largest stock holding made up 14.5 percent and 28.1 percent of the publicly traded common stock portfolio, respectively. We also diversified our investment portfolio as a result of the fourth-quarter 2009 Pfizer acquisition of Wyeth (NYSE:WYE). In addition to receiving approximately $146 million in cash for our Wyeth shares, we sold approximately 2.4 million shares of Pfizer subsequent to the merger. As a result of these transactions, our stock portfolio exposure to the healthcare sector reduced to 18.0 percent at December 31, 2009, from 24.6 percent at September 30, 2009.
This table reviews unrealized losses and fair values by investment category and by the duration of the securities’ continuous unrealized loss position:
During 2007, we impaired 20 securities. At December 31, 2007, 184 fixed-maturity investments with a total unrealized loss of $20 million had been in an unrealized position for 12 months or more. Three of these securities were trading below 70 percent of book value with a total unrealized loss of $6 million. There were no equities trading below book value for 12 months or more.
When determining OTTI charges for our equity portfolio, our invested asset impairment policy considers qualitative and quantitative factors, including facts and circumstances specific to individual securities, asset classes, the financial condition of the issuer, changes in dividend payment, the length of time fair
value had been less than book value, the severity of the decline in fair value below book value, the volatility of the security and our ability and intent to hold each position until its forecasted recovery.
Level 1 - Financial assets and liabilities for which inputs are observable and are obtained from reliable quoted prices for identical assets or liabilities in actively traded markets. This is the most reliable fair value measurement and includes, for example, active exchange-traded equity securities.
Quotes from brokers or other external sources where it can not be determined that market participants would in fact transact for the asset or liability at the quoted price;
The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis for the periods ended December 31, 2009, and December 31, 2008. We do not have any material liabilities carried at fair value. There were also no significant transfers between Level 1 or Level 2.
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is summarized in the tables below by security type with a summary of changes in fair value for the year ended December 31, 2009 and 2008. As of December 31, 2009, total Level 3 assets were less than 1 percent of financial assets measured at fair value compared with 1.6 percent at December 31, 2008.
Because of changes in estimates of insured events in prior years, we decreased the provision for loss and loss expenses by $188 million, $323 million and $244 million in calendar years 2009, 2008 and 2007. These decreases are partly due to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for amounts less than expected. The reserve for loss and loss expenses in the consolidated balance sheets also includes $46 million for both 2009 and 2008, and $42 million at December 31, 2007, for certain life and health losses.
Reserves for deferred annuities and other investment contracts were $736 million and $569 million for December 31, 2009, and December 31, 2008, respectively. Fair value for these deferred annuities and investment contracts was $737 million and $460 million for December 31, 2009, and December 31, 2008, respectively. Fair values of liabilities associated with certain investment contracts are calculated based upon internally developed models because active, observable markets do not exist for those items. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers as of December 31, 2009, to account for non-performance risk; (2) the rate of interest credited to policyholders is the portfolio net earned interest rate less a spread for expenses and profit; and (3) additional lapses occur when the credited interest rate is exceeded by an assumed competitor credited rate, which is a function of the risk-free rate of the economic scenario being modeled. The fair value of life policy loans outstanding principal and interest approximated $44 million, compared with book value of $40 million reported in the consolidated balance sheets as of December 31, 2009.
Our insurance subsidiary declared dividends to the parent company of $50 million in 2009, $160 million in 2008 and $420 million in 2007. State regulatory requirements restrict the dividends insurance subsidiaries can pay. Generally, the most our insurance subsidiaries 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 2010, the total dividends that our lead insurance subsidiary may pay to our parent company without regulatory approval is approximately $365 million.
In May 2008, the IRS concluded the examination phase of its audit of our 2005 and 2006 tax years and presented us with adjustments primarily related to the valuation of our loss reserves. In October 2008, we reached agreement with the IRS settling all issues related to the 2005 and 2006 tax years. As a result of the IRS agreement for tax years 2005 and 2006, management refined certain assumptions used to calculate the unrecognized tax benefits associated with loss reserves, resulting in a revised measurement of the unrecognized tax benefits as of December 31, 2008.
In addition to our IRS filings, we file income tax returns in various state jurisdictions. Material amounts of income tax are paid to Ohio, Illinois and Florida. In December 2009, the State of Illinois began an income tax audit of amended returns for tax years 2002 through 2006 as well as an audit of the return filed for tax year 2007. Although we have not yet been presented with the final examination reports for any of these years, we do not expect any material changes as a result of the Illinois audits. With the exception of Illinois, no other state audits are currently under way nor are we aware of any audits pending. Excluding years under examination by Illinois, tax years 2006 and forward remain open for state examination.
We sponsor a defined benefit pension plan and a defined contribution plan (401(k) savings plan). During 2008, we changed the form of retirement benefit we offer some associates to a company match on contributions to the 401(k) plan from the defined benefit pension plan. We froze entry into the pension plan for new associates during 2008. Only participants 40 years of age or older could elect to continue to participate. For participants remaining in the pension plan, we continue to contribute to fund future benefit obligations. Benefits for the defined benefit pension plan are based on years of credited service and compensation level. Contributions are based on the prescribed method defined in the Pension Protection Act. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method.
We also maintain a supplemental executive retirement plan (SERP) with liabilities of approximately $5 million at year-end 2009 and $6 million at year-end 2008. The SERP is included in the obligation and expense amounts in the tables below. The company also makes available to a select group of associates the Cincinnati Financial Corporation Top Hat Savings Plan, a non-qualified deferred compensation plan.
For any participant who left the pension plan, benefit accruals were frozen during 2008. We transferred $60 million of the pension plan’s accumulated benefit obligation during 2008 to an intermediary spin-off plan to facilitate the partial curtailment and settlement for these participants. For SERP participants who chose to leave the defined benefit pension plan, benefit accruals were frozen in the SERP as of December 31, 2008. During 2009, the frozen accrued 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 has begun 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.
Pursuant to ASC 715-30 we recognized expense of $3 million during 2008 in the consolidated statement of income associated with the partial termination of the qualified pension plan. In addition, we recognized $27 million in the consolidated statement of income during 2008 for a settlement loss associated with the payout to the participants who left the pension plan of the obligation held in their behalf. Included in the charge is the contribution of $24 million to complete funding of benefits that were distributed in 2008 to participants leaving the pension plan.
The weighted-average assumptions used to determine benefit obligations for our qualified plan and SERP at December 31 follows:
We evaluate our pension plan assumptions annually and update them as necessary. The discount rate assumptions for our benefit obligation track with high grade corporate bond yields and yearly adjustments reflect any changes to those bond yields. Compensation increase assumptions reflect historical calendar year compensation increases.
The total recognized in net periodic benefit cost and other comprehensive income was $25 million, $62 million and $9 million for the periods ended December 31, 2009, 2008 and 2007, respectively. The estimated costs to be amortized from accumulated other comprehensive income into net periodic benefit cost over the next year for our plans are a $2 million actuarial loss and a $1 million prior service cost.
Investments in securities traded on a national securities exchange are valued at the last reported sales price on the last business day of the year. Investments in securities that are traded in active markets are based on quoted market prices at December 31, 2009 and 2008. Investments in securities that are not
Refer to Note 3, Fair Value Measurements, Page 103 for valuation techniques and categorization of financial instruments within the pension plan assets. The methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement.
Our pension plan assets included 642,113 shares of the company’s common stock, which had a fair value of $17 million and $19 million at December 31, 2009 and 2008, respectively. The defined benefit pension plan did not purchase or sell any shares of our common stock during 2009 and 2008. The company paid $1 million in cash dividends on our common stock to the pension plan in both 2009 and 2008.
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, improper reimbursement of medical providers paid under workers’ compensation insurance policies, erroneous coding of municipal tax locations and excessive premium charges for uninsured motorist coverage. 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.
On a quarterly basis, we review the outstanding lawsuits seeking such recourse. Based on our year-end review, we believe we have valid defenses to each. As a result, we believe the ultimate liability, if any, with respect to these lawsuits, after consideration of provisions made for estimated losses, is immaterial to our consolidated financial position.
Nonetheless, given the potential for large awards in certain of these actions and the inherent unpredictability of litigation, an adverse outcome could have a material adverse effect on the company’s consolidated results of operations or cash flows.
We currently have four equity compensation plans that together 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 under our shareholder-approved plans. We also have a Holiday Stock Bonus Plan that permits annual awards of one share of common stock to each full-time associate for each 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.
We use the modified-prospective-transition method under which we recognize our pretax and after-tax share-based compensation costs, which are summarized below:
Stock options are granted to associates at an exercise price that is equal to the fair value as reported on the NASDAQ Global Select Market for the grant date and are exercisable over 10-year periods. The stock options generally vest ratably over a three-year period. In determining the share-based compensation amounts, we estimate the fair value of each option granted on the date of grant using the binomial option-pricing model. We make assumptions in four areas to develop the binomial option-pricing model:
Cash received from the exercise of options was less than $1 million, $4 million and $19 million for the years ended December 31, 2009, 2008 and 2007, respectively. We did not realize a tax benefit on options exercised for the years ended December 31, 2009 and 2008. We realized a $2 million tax benefit on options exercised for the year ended December 31, 2007.
As of December 31, 2009, management assumed that performance targets used for restricted stock unit awards granted during November 2008 would be met, and we recognized related compensation cost.
This table includes unaudited quarterly financial information for the years ended December 31, 2009 and 2008: