Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building has 1,508,200 total square feet of available space. The property, including land, is carried in our financial statements at $141 million as of December 31, 2013, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies 6,750 square feet (less than 1 percent). This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
The Cincinnati Insurance Company owns the CFC Winton Center 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, 2013, and is classified as land, building and equipment, net, for company use. This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
* Realized investment gains and losses are integral to our financial results over the long term, but our substantial discretion in the timing of investment sales may cause this value to fluctuate substantially. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations.
We begin with an executive summary of our results of operations, followed by an overview of our strategy, an outlook for future performance and details on critical accounting estimates. In several instances, we refer to estimated industry data so that we can provide information on our performance within the context of the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory accounting basis. When we provide our results on a comparable statutory accounting basis, we label it as such; all other company data is presented in accordance with accounting principles generally accepted in the United States of America (GAAP).
Through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on net written premium volume for the first nine months of 2013, among approximately 2,000 U.S. stock and mutual insurer groups. We market our insurance products through a select group of independent insurance agencies in 39 states as discussed in Item 1, Our Business and Our Strategy.
For the period 2013 through 2017, we are targeting an annual value creation ratio averaging 10 percent to 13 percent. We exceeded that target for 2013, and for the five-year period that ended in 2013. For the period 2009 through 2012, our annual value creation ratio averaged 12.4 percent, within the 12 percent to 15 percent five-year target range established in early 2009, soon after the U.S. credit crisis. For several years following the credit crisis, interest rates generally declined and credit spreads tightened, increasing the contribution
The next two tables show the primary components of our value creation ratio, first on a percentage basis and then on a per-outstanding-share basis. Analysis of the components aids understanding of our financial performance. Our financial results are further analyzed in the Corporate Financial Highlights section below.
** Dividend declared to shareholders divided by beginning of year book value as originally reported
Combined ratio - We believe our underwriting philosophy and initiatives can drive performance to achieve our underwriting profitability target of a GAAP combined ratio over any five-year period that consistently averages within the range of 95 percent to 100 percent. Our GAAP combined ratio averaged 101.1 percent over the five-year period 2009 through 2013. Our combined ratio improved to below 100 percent in 2012 and 2013, after rising above 100 percent for 2009 through 2011, when our average catastrophe loss ratio of 8.0 percentage points was 4.1 points higher than the average for the 10-year period prior to 2009. Performance as measured by the combined ratio is discussed in Consolidated Property Casualty Insurance Results of Operations. Our statutory combined ratio averaged 100.6 percent over the five-year period 2009 through 2013 compared with an estimated 101.4 percent for the property casualty industry. The industry’s ratio again excludes its mortgage and financial guaranty lines of business.
Investment income growth, on a pretax basis, had a compound annual growth rate of 0.7 percent over the three-year period 2011 through 2013. It has grown every year since 2009, except for 2013 with its slight decrease of less than 1 percent.
Over the five years ended December 31, 2013, our equity portfolio compound annual total return was 14.9 percent compared with a compound annual total return of 17.9 percent for the Index. By design, our equity portfolio is comprised of larger capitalization, high-quality dividend-growing stocks. Therefore we would generally expect its return to lag during the type of extended, lower-quality rally that has occurred since early 2009. For the year 2013, our annual equity portfolio total return was 31.7 percent, compared with 32.4 percent for the Index.
Invested assets grew 8 percent during 2013 on a fair value basis, with market gains that added to the 5 percent increase in the cost basis of invested assets. Entering 2014, we believe the portfolio continues to be well diversified and is well positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, and results for the segment in Investment Results of Operations. Total assets rose 7 percent, primarily due to the increase in invested assets. Shareholders’ equity and book value per share each rose 11 percent, for reasons discussed in the preceding Executive Summary.
The amount of our debt obligations did not change in 2013. Our ratio of debt to total capital (debt plus shareholders’ equity) decreased by 1.3 percentage points in 2013 and remains comfortably within our target range.
catastrophe losses, and net realized investment gains that were $26 million higher. Net income increased $257 million in 2012, compared with 2011, reflecting the after-tax net effect of those same two major contributing items: a $270 million improvement in property casualty underwriting results, including $44 million from lower catastrophe losses, and a $17 million decline in net realized investment gains.
As discussed in Investment Results of Operations, sales of securities that had appreciated in value led to realized investment gains in all three years. Realized and unrealized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and for securities with embedded derivatives without actual realization of those gains and losses.
Dividend income rose 6 percent in 2013 to nearly offset a decline in interest income and a slight increase in investment expenses, resulting in a net decrease in pretax investment income of $2 million, or less than 1 percent. In addition to a larger common stock portfolio generating more dividend income in both 2013 and 2012, both years also benefited from higher average dividend payment rates. Our investment operation’s performance is discussed further in Investment Results of Operations.
Our property casualty insurance operations generated underwriting profits for both 2013 and 2012, following underwriting losses for each of the preceding four years. The $96 million improvement for 2013, compared with 2012, included a $162 million decrease in losses from natural catastrophe events. The $415 million improvement in underwriting results for 2012, compared with 2011, was largely a result of a $315 million increase in earned premiums and a $68 million decrease in losses from natural catastrophe events.
We measure property casualty underwriting profitability primarily by the combined ratio. Our combined ratio measures the percentage of each earned premium dollar spent on claims plus all expenses related to our property casualty operations, all on a pretax basis. A lower ratio indicates more favorable results and better underlying performance. A ratio below 100 percent represents an underwriting profit. Initiatives to improve our combined ratio are discussed in Item 1, Strategic Initiatives. In 2013, 2012 and 2011, favorable development on reserves for claims that occurred in prior accident years helped offset other incurred losses and loss expenses. Reserve development is discussed further in Property Casualty Loss and Loss Expense Obligations and Reserves. Losses from weather-related catastrophes are another important item influencing the combined ratio and are discussed along with other factors in Results of Operations for our property casualty business and related segments.
Our life insurance segment reported a modest profit in 2013, reversing a small loss in 2012. We discuss results for the segment in Life Insurance Results of Operations. Most of this segment’s investment income is included in our investments segment results. In addition to investment income, realized investment gains from the life insurance investment portfolio are also included in our investments segment results.
Management has worked to identify a strategy that can lead to long-term success, with concurrence by the board of directors. Our strategy is intended to position us to compete successfully in the markets we have targeted while appropriately managing risk. We discuss our long-term, proven strategy in Item 1, Our Business and Our Strategy. We believe successful implementation of initiatives that support our strategy will help us better serve our agent customers and reduce volatility in our financial results while we also grow earnings and book value over the long-term, successfully navigating challenging economic, market or industry pricing cycles.
Improve insurance profitability - Implementation of these initiatives is intended to enhance underwriting expertise and knowledge, thereby increasing our ability to manage our business while also gaining efficiency. Better profit margins can arise from additional information and more focused action on underperforming product lines, plus pricing capabilities we are expanding through the use of technology and analytics. Improved internal processes with additional performance metrics can help us be more efficient and effective. These initiatives also support the ability of the independent agencies that represent us to grow profitably by allowing them to serve clients faster and to more efficiently manage agency expenses.
We expect the independent insurance agency system to remain strong, with continued agency consolidation. If soft insurance market conditions return in 2014, it will create additional risk for agencies.
The rally in financial markets during recent years had a favorable impact on our value creation ratio, offsetting the unfavorable impact of the sharp decline in financial markets during 2008. Financial markets continued to display volatility during 2013, and some predict more turbulence in 2014 from effects such as changes in government policy, growth challenges for emerging country economies or other geopolitical events that could also affect the U.S. economy and markets. Should financial markets decline during 2014, which could occur as part of typical market volatility patterns, the related book value component of our 2014 value creation ratio could also register a weak or negative result.
A return of soft insurance market pricing could significantly affect growth rates and earned premium levels into 2014 and for some time into the future, depending on insurance market conditions. After several years of market
We establish loss and loss expense reserves for our property casualty insurance business as balance sheet liabilities. These reserves account for unpaid loss and loss expenses as of a financial statement date. Unpaid loss and loss expenses are the estimated amounts necessary to pay for and settle all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date.
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 $4.241 billion at year-end 2013 compared with $4.169 billion at year-end 2012.
For events designated as natural catastrophes, we calculate bulk reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Once case reserves are established for a catastrophe event, we reduce the bulk reserves. Our claims department management coordinates the assessment of these events and prepares the related bulk reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the affected geographic area and of available claims intelligence. Depending on the nature of the event, available claims intelligence could include surveys of field claims associates within the affected geographic area, feedback from a catastrophe claims team sent into the area, as well as data on claims reported as of the financial statement date. To determine whether an event is designated as a catastrophe, we generally use the catastrophe definition provided by Property Claims Service (PCS), a division of Insurance Services Office (ISO). PCS defines a catastrophe as an event that causes countrywide damage of $25 million or more in insured property losses and affects a significant number of policyholders and insureds.
trends and exposure levels. Consequently, our actuarial staff monitors a number of trends and measures to gain key business insights necessary for exercising appropriate judgment when estimating the parameters mentioned, such as:
Our actuarial staff makes a number of key assumptions when using their methods and models to derive IBNR reserve estimates. Appropriate reliance on these key assumptions essentially entails determinations of the likelihood that statistically significant patterns in historical data may extend into the future. The four most significant of the key assumptions used by our actuarial staff and approved by management are:
Calendar year inflation. For long-tail and mid-tail business lines, calendar year inflation trends for future paid losses and paid defense and cost containment expenses do not vary significantly from a stable, long-term average. Our actuaries base reserve estimates derived from probabilistic trend family models on this assumption.
The application of our impairment policy resulted in other-than-temporary impairment (OTTI) charges that reduced our income before income taxes by $2 million in 2013, $33 million in 2012 and $57 million in 2011. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, the value is not expected to be recouped within a designated recovery period. OTTI losses represent noncash charges to income and are reported as realized investment losses.
For each of our equity securities in an unrealized loss position at December 31, 2013, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is other-than-temporarily impaired. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong statutory capital and surplus, liquidity and cash flow,
Financial assets and liabilities recorded in the Consolidated Balance Sheets are categorized based on the inputs to the valuation techniques as described in Item 8, Note 3 of the Consolidated Financial Statements.
We measure profit or loss for our commercial lines, personal lines and excess and surplus 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, and excess and surplus lines insurance results. Underwriting results and segment pretax operating income are not substitutes for net income determined in accordance with GAAP.
Earned and net written premiums for our consolidated property casualty operations grew in 2013, reflecting higher pricing and strategic initiatives for targeted growth. A key measure of property casualty profitability is underwriting profit or loss. Our 2013 underwriting profit of $233 million represents a $96 million improvement over 2012. The improvement included a $162 million decrease in natural catastrophe losses, mostly from severe weather. Improved 2013 underwriting results included better current accident year loss experience before catastrophes, reflecting higher pricing in addition to the effects of our initiatives to improve pricing precision and loss experience related to claims and loss control practices. Prior accident year loss experience before catastrophes during 2013 was favorable but less so than in 2012. The less favorable experience was primarily due to re-estimates of losses and loss expenses incurred but not reported (IBNR).
Premiums - Strong growth in renewal and new business written premiums drove double-digit increases in earned premiums and net written premiums for both 2013 and 2012. Premium volumes rose at a healthy rate in each of our property casualty segments. Higher and more precise pricing continues to benefit operating results and is further discussed by segment in the results of operations sections below. A sixth straight year of higher new business premiums reflected our premium growth initiatives from recent years that continue to favorably affect current year growth, particularly as newer agency relationships mature over time. Agents appointed during 2012 or 2013 produced an increase in standard lines new business of $31 million during 2013, compared with 2012. A higher level of insured exposures, reflecting improvement in some areas of the economy, also favorably affected
Our statutory combined ratio was 92.7 percent in 2013 compared with 95.4 percent in 2012 and 108.9 percent in 2011. The estimated statutory combined ratio for the property casualty industry, with the industry’s ratio excluding its mortgage and financial guaranty lines of business, was 97.6 percent in 2013, 102.2 percent in 2012 and 106.7 percent in 2011. The contribution of catastrophe losses to our statutory combined ratio was 4.6 percentage points in 2013, 10.0 percentage points in 2012 and 13.3 percentage points in 2011, compared with an industry estimate of 3.2, 7.5 and 9.4 percentage points, respectively. Components of the combined ratio are discussed below, followed by additional discussion by segment.
Catastrophe loss trends, discussed above, explain much of the movement in current accident year loss and loss expense ratios for years 2011 through 2013. Catastrophe losses added 5.4 percentage points for 2013, 11.1 points for 2012 and 13.4 points for 2011 to the respective consolidated property casualty current accident year loss and loss expense ratios in the table above.
The 60.6 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2013 improved 4.0 percentage points compared with the 64.6 percent accident year 2012 ratio measured as of December 31, 2012. Large losses described below and the corresponding ratios for new losses above $250,000 improved the 2013 ratio by 0.2 percentage points. We believe the remaining 3.8 percentage points of the improvement was largely due to initiatives to improve pricing precision and loss experience related to claims and loss control practices, somewhat offset by normal loss cost inflation.
In 2013, total large losses incurred increased by $52 million or 8 percent, net of reinsurance. The corresponding ratio decreased 0.6 percentage points, as earned premium growth was higher than the rate of growth in total large losses. Large loss trends are further analyzed in the segment discussion and analysis that follows discussion of consolidated property casualty results. Our analysis of large losses incurred indicated no unexpected concentration of these losses and reserve increases by geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
Combined ratio - The 2013 combined ratio remained at a healthy sub-95 percent level, up less than 1 percentage point from 2012. The ratio for catastrophe losses and loss expenses was 4.5 percentage points lower than in 2012 and the ratio for current accident year losses and loss expenses before catastrophe losses improved by 3.1 points, reflecting benefits from higher pricing and from recent-year initiatives to improve pricing precision and loss experience related to claims and loss control practices. Development on prior accident years’ loss and loss expenses before catastrophes during 2013 was 8.6 percentage points less favorable than in 2012, including 8.1 points from re-estimates of IBNR losses and loss expenses.
Initiatives to improve commercial lines underwriting profitability complement our business practices that continue to leverage the local presence of our field staff. Field marketing representatives meet with local agencies to assess each risk, determine limits of insurance and establish appropriate terms and conditions. They continue to underwrite new business while field loss control, machinery and equipment and claims representatives continue to conduct on-site inspections. Field claims representatives also assist underwriters by preparing full reports on their first-hand observations of risk quality.
Our commercial lines statutory combined ratio was 91.8 percent in 2013 compared with 92.1 percent in 2012 and 104.2 percent in 2011. The estimated commercial lines combined ratios for the industry were 98.3 percent in 2013, 104.4 percent in 2012 and 106.8 percent in 2011. The industry’s ratios exclude its mortgage and financial guaranty lines of business. The contribution of catastrophe losses to our commercial lines statutory combined ratio was 3.7 percentage points in 2013, 8.2 percentage points in 2012 and 10.4 percentage points in 2011, compared with an industry estimate of 2.5, 7.4 and 7.4 percentage points, respectively.
Premiums resulting from audits of actual sales or payrolls that confirmed or adjusted initial premium estimates significantly affected premium trends in recent years. On an earned premium basis for our commercial lines segment, audits contributed negative $3 million to the $253 million earned premiums increase in 2013, $35 million of the $186 million earned premiums increase in 2012 and $46 million of the $43 million earned premiums increase in 2011. On a net written premium basis, audits contributed $12 million of the $301 million net written premiums increase in 2013, $30 million of the $241 million net written premiums increase in 2012 and $34 million of the $63 million net written premiums increase in 2011.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, explain much of the movement in current accident year loss and loss expense ratios for accident years 2011 through 2013. Catastrophe losses added 4.3 percentage points for 2013, 8.9 points for 2012 and 10.3 points for 2011 to the respective commercial lines current accident year loss and loss expense ratios in the table above.
The 59.8 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2013 improved 3.1 percentage points compared with the 62.9 percent accident year 2012 ratio measured as of December 31, 2012. Large losses, described below, and the corresponding ratios for new losses above $250,000 contributed a 0.3 percentage-point increase to the 2013 ratio. We believe the overall ratio reduction was largely due to higher pricing and initiatives to improve pricing precision and loss experience related to claims and loss control practices, somewhat offset by normal loss cost inflation.
The 2013 ratio for other underwriting expenses decreased by 0.5 percentage points, as earned premiums grew faster than expenses. This ratio had also decreased slightly in 2012 as higher earned premiums offset an increase in expenses.
For 2013, commercial casualty, our largest line of business representing over 30 percent of earned premiums for our commercial lines segment, continued to be very profitable, based on the total loss and loss expense ratio. Specialty packages, representing approximately 5 percent of earned premiums for our commercial lines segment, was the only commercial line of business with 2013 total loss and loss expense ratios significantly higher than we desired. As discussed below, we are taking actions to improve pricing and reduce loss costs to benefit future profitability trends.
The 2012 total loss and loss expense ratio improved by 10.2 percentage points, reflecting lower current accident year losses and loss expenses and favorable development on prior accident year reserves.
Commercial property net written premiums and earned premiums rose significantly in both 2013 and 2012, reflecting higher pricing and premium growth initiatives. New business written premiums increased nearly 15 percent in 2013 and nearly 25 percent in 2012.
The 2013 total loss and loss expense ratio improved, primarily due to a lower ratio for current accident year losses and loss expenses. We believe that reflected better pricing precision and other initiatives to improve profitability. In 2011, we began full use of predictive modeling tools for commercial auto policies to improve our pricing precision.
Since we pay a lower commission rate on workers’ compensation business, relative to our other commercial lines of business, this line has a higher calendar year loss and loss expense ratio breakeven point than our other commercial business lines. We believe various initiatives in recent years contributed to improved profitability. During 2009, we began using a predictive modeling tool to improve risk selection and pricing precision. In 2010, we added to our staff of loss control field representatives, premium audit field representatives and field claims representatives specializing in workers’ compensation risks. We also implemented direct reporting of workers’ compensation claims, allowing us to quickly obtain detailed information from policyholders to promptly assign the appropriate level of claims handling expertise to each case. Obtaining more information sooner for specific claims allows for medical care appropriate to the nature of each injury, benefiting injured workers, employers and agents while ultimately lowering overall loss costs. In addition, our medical provider bill review process continues to provide significant savings compared with initial charges by providers.
Net written premiums and earned premiums for management liability and surety - formerly referred to as surety and executive risk - rose in 2013 and 2012, largely due to higher pricing for management liability policies. New business written premiums were less than the prior year for both 2013 and 2012.
The 2013 total loss and loss expense ratio was in line with 2012. An improved ratio for current accident year losses and loss expenses was offset by an increase in unfavorable development on prior accident year reserves. Prior accident year reserve development has been volatile for this line of business in recent years, reflecting varying loss experience for director and officer liability related to financial institutions we insured during the U.S. credit crisis of 2008.
The 2012 total loss and loss expense ratio improved 36.4 percentage points due to a 32.6 point decrease from unfavorable development on prior accident year reserves, returning to a level close to 2010. Year 2011 included a large amount of unfavorable development on prior accident year reserves, including four claims from accident year 2008, two for director and officer liability and two for fidelity bonding due to fraud or lending practices at financial institutions.
Marketing primarily to nonprofit organizations, accounting for approximately 80 percent of the policies and 47 percent of the premium volume in force for 2013 director and officer liability business.
Providing limits no higher than $10 million with facultative or treaty reinsurance in place in 2014 to cover losses greater than $8 million.
selection. While competition remains intense, industrywide commercial lines market pricing turned positive toward the end of 2011 and continued to firm in 2012 and 2013, according to several industry surveys. Average renewal pricing for our commercial lines segment generally followed a similar trend. Opinions continue to vary, according to a variety of reports that focus on the commercial lines market, regarding the sustainability of improved pricing. According to A.M. Best, commercial lines pricing is anticipated to continue to improve during 2014 for select markets but the pace of rate increases is generally expected to be slower than for rate increases in 2013. Despite challenging market conditions, we believe we can manage our business and execute strategic initiatives to offset market pressures to some extent and still profitably grow our commercial lines segment.
In Item 1, Strategic Initiatives, we discuss the initiatives we are implementing to achieve our corporate performance objectives. We discuss factors influencing future results of our property casualty insurance operations in the Executive Summary.
Combined ratio - The 2013 combined ratio improved 8.5 percentage points compared with 2012, largely due to natural catastrophe losses that were 8.2 percentage points lower, plus better pricing and a decrease in other weather-related losses. Such losses, typically referred to as noncatastrophe weather losses, were not identified as part of designated catastrophe events for the property casualty industry.
22.7 percentage points in 2011, compared with an industry estimate of 3.9, 7.4 and 10.4 percentage points, respectively.
The 11 percent increase in agency renewal written premiums for both 2013 and 2012 largely reflected various rate changes during recent years. In October 2013, we began our fifth round of increases for the homeowner line of business, averaging approximately 10 percent, with some individual policy rate increases lower or higher based on attributes of risk that characterize the insured exposure. That last round of rate changes followed rate changes over successive years averaging approximately 7 percent annually that were implemented beginning the fourth quarter of 2009 for states representing the majority of our personal lines business.
Beginning in the first half of 2013, we implemented rate changes for our personal auto line of business in the majority of the 30 states where we market personal lines policies. The average rate change is an increase in the low-single-digit range, with some individual policies experiencing lower or higher rate changes based on enhanced pricing precision enabled by predictive models. Rate changes for personal auto implemented beginning late 2011 and also late 2010 each represented an annual average rate increase in the low-single-digit range.
The 61.9 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2013 improved 6.3 percentage points compared with the 68.2 percent accident year 2012 ratio measured as of December 31, 2012. Noncatastrophe weather losses for our homeowner line of business alone were approximately $16 million lower during 2013 compared with 2012, reducing the 2013 ratio for personal lines by approximately 2 percentage points, compared with 2012. Lower new large losses incurred, described below, reduced the 2013 ratio by 2.1 percentage points. We believe the remaining improvement of approximately 2 percentage points was largely due to higher pricing and initiatives to improve pricing precision, somewhat offset by normal loss cost inflation.
Personal lines commission expense as a percent of earned premiums was at similar levels for both 2013 and 2012. In 2012, higher agency profit-sharing commission drove a 2.1 percentage-point increase over 2011.
Other underwriting expenses as a percent of earned premiums were also at similar levels for both 2013 and 2012. The total personal lines underwriting expense ratio for 2013 was essentially unchanged from 2012.
Beginning in March of 2014, commission rates for selected personal lines insurance products will be modified, resulting in an estimated reduction in our personal lines total underwriting expense ratio, on a full-year basis, of approximately 2 percentage points.
For 2013, our personal auto line of business had a total loss and loss expense ratio significantly higher than desired. As discussed in the overview section of Personal Lines Insurance Results of Operations, and below, we are taking actions to improve pricing and reduce loss costs that we expect to benefit future profitability trends. A similar approach was used to improve the total loss and loss expense ratio for our homeowner line of business to a satisfactory result for 2013.
noncatastrophe component. Large losses above $250,000 per claim were $15 million or 37 percent higher in 2013, compared with 2012, contributing to the rise in the total loss and loss expense ratio.
As discussed in Personal Lines Insurance Premiums, we continue to implement rate changes and improve our pricing precision to improve our total loss and loss expense ratio for our personal auto line of business.
The total loss and loss expense ratio for both 2013 and 2012 experienced a steady reduction for catastrophe losses and losses before catastrophes. The 2013 catastrophe loss ratio of 16.6 percentage points was near the 17.4 percent 10-year average for the years 1998 through 2007. For the five-year period 2008 through 2012, the homeowner catastrophe loss ratio averaged 34.5 percent, approximately double that 10-year average. For the past several years, pricing for our homeowner line of business has assumed a catastrophe loss ratio averaging approximately 26 percentage points.
We continue efforts to improve pricing precision through predictive analytics, which we believe will help to achieve long-term profitability. Rate increases in recent years, discussed in Personal Lines Insurance Premiums, should help lower loss ratios as the rate increases are earned. Those rate changes were implemented beginning in October of 2013, 2012, 2011, 2010 and 2009 and averaged approximately 10 percent, 9 percent, 8 percent, 7 percent and 6 percent, respectively. In 2013, we began increasing our use of higher loss deductibles and actual cash value claims settlement for insured damage to older roofs. In addition, in 2013 we increased the number of property inspections conducted when homeowner policies renewed, and plan to further increase that number in 2014. Inspections provide more opportunities for underwriting or pricing actions on a case-by-case basis. We also continue our gradual expansion into states less prone to catastrophe losses, which we believe will reduce variability in the long-term future catastrophe loss ratio. In recent years, we nonrenewed approximately 2,300 policies in Florida and Alabama that we believe were the most exposed to losses from hurricane damage, and we intend to nonrenew additional Florida policies in 2014 and 2015. Together these actions represent important steps we are taking to further improve homeowner results.
Our excess and surplus lines segment includes results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources Inc. The year 2013 represented our sixth full year of operations for our excess and surplus lines segment. Performance highlights for the excess and surplus lines segment include:
Premiums - Earned premiums continued to rise in 2013, a result of strong growth in net written premiums, similar to recent years. Growth of net written premiums in 2013 was driven by higher renewal written premiums that included high-single-digit average renewal price increases. New business written premiums for 2013 rose compared with 2012, reflecting growth initiatives and higher pricing.
The $21 million increase in 2013 renewal premiums reflected the opportunity to renew many policies for the first time as well as higher renewal pricing. Average renewal pricing rose in the high-single-digit range during 2013, similar to 2012. December 2013 was the 40th consecutive month of positive average price changes for this segment of our property casualty business. We measure average changes in excess and surplus lines renewal pricing as the rate of change in renewal premium for the new policy period compared with the premium for the expiring policy period, assuming no change in the level of insured exposures or policy coverage between those periods for respective policies.
New business written premiums for the year 2013 rose 11 percent, compared with 2012, reflecting higher pricing and the addition of four excess and surplus lines field marketing representatives since April 2013, an increase of 40 percent compared with the field staffing level at year-end 2012.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses, as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in our excess and surplus lines segment three-year highlights table are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than 20 percent of our 2013 excess and surplus lines current accident year incurred losses and loss expenses represents net paid amounts, a large majority represents reserves for our estimate of unpaid losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 74.9 percent accident year 2012 loss and loss expense ratio reported as of December 31, 2012, developed favorably by 9.0 percentage points to 65.9 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2013. Accident years 2012 and 2011 for this segment have both developed favorably, as indicated by the progression over time of the ratios in the table.
Excess and surplus lines reserve development on prior accident years continued to net a favorable amount in 2013 as $13 million was recognized, compared with $5 million in 2012. Nearly two-thirds of the 2013 favorable development was for accident year 2012, and related primarily to lower than anticipated loss emergence on known claims.
Other underwriting expenses declined in 2013 and 2012 as a percent of earned premiums primarily due to earned premiums outpacing expenses.
Our strategy of providing superior service is expected to continue to grow our excess and surplus lines segment and to achieve profitability despite challenging market conditions. We intend to keep carefully selecting and pricing risks, providing prompt delivery of insurance quotes and policies and giving outstanding claims and loss control service from local field representatives who also handle the standard lines business for their assigned agencies. These local representatives are supported by headquarters underwriters and claims managers who specialize in excess and surplus lines.
Profitability - The life insurance segment frequently reports only a small profit or loss because most of its investment income is included in investment segment results. We include only investment income credited to contract holders (interest assumed in life insurance policy reserve calculations) in life insurance segment results. The segment reported a $9 million profit in 2013, following a $3 million loss in both 2012 and 2011, and has averaged a $2 million profit over the past five years.
Over the past several years, we have worked to maintain a portfolio of simple yet competitive products primarily under the LifeHorizons banner. Our product development efforts emphasize death benefit protection and guarantees. Distribution expansion within our property casualty insurance agencies remains a high priority. Our 28 life field marketing representatives work in partnership with our 130 property casualty field marketing representatives. Approximately 69 percent of our term and other life insurance product premiums were generated through our property casualty insurance agency relationships.
Contract holders’ benefits incurred, related to traditional life and interest-sensitive products, accounted for 77.3 percent of 2013 total benefits and expenses compared with 70.1 percent in 2012 and 75.3 percent in 2011. Total contract holders’ benefits increased as the increase in life policy reserves and the increase in net death claims were higher in 2013 compared with 2012. Net death claims increased over 2012, but were less than we projected and remained within our range of pricing expectations.
We seek to maintain a competitive advantage with respect to benefits paid and reserve increases by consistently achieving better than average claims experience due to skilled underwriting. Commissions paid by the life insurance operation are on par with industry averages.
Issues that could challenge our growth include a still tepid U.S. economic recovery, adverse regulatory developments associated with UL products with secondary guarantees and continued turmoil in group benefits associated with the Affordable Care Act. While we do not market health products, many of our independent agencies do, and the more time they have to spend servicing their health care customers, the less time they have to market our life products. Finally, should foreign and emerging markets struggle, we could see renewed interest in U.S. treasuries, which could put a damper on the recent trend of rising interest rates.
In our core term insurance product line, more companies are now competing on price, and there is a potential for a softening market. Issues related to captive reinsurers and progress on principles-based reserves also could disrupt market prices in the near future. Principles-based reserves, once effective, would likely lead to rate reductions for term life insurance. While the new reserve law's ultimate passage is still not certain, industry consensus is that the beginning of 2016 would be the earliest implementation date.
Our property casualty agencies remain the main distribution system for our life insurance segment, and we continue to emphasize securing an increasing share of the life insurance premium produced by these agencies. While other life insurers expand nontraditional distribution channels such as direct sales, we intend to market through agencies affiliated with our property casualty insurance operations or independent life-only agencies. We believe there is ample room for growth in further penetration of our existing property casualty distribution.
Investment income - Pretax investment income decreased less than 1 percent in 2013 as higher dividend income nearly offset lower interest income and an increase in investment expenses. Dividend income reflected rising dividend rates and net purchases of equity securities from available funds. Interest income declined, largely due to the continuing investment yield effects of the low interest rate environment. Average yields in the investment income table below are based on the average invested asset and cash amounts indicated in the table, using fixed-maturity securities valued at amortized cost and all other securities at fair value. Pretax investment income increased 1 percent in 2012, driven by higher dividend income.
Realized investment gains and losses - We reported realized investment gains in all three years, largely due to investment sales that were discretionary in timing and amount. Those gains were somewhat offset by OTTI charges.
The table below shows total return based on calculation assumptions that simplify cash flow timing that is commonly used in total return measures. This simplified calculation uses data shown in our consolidated financial statements or notes to those statements. Added to invested asset amounts from our consolidated balance sheets are 50 percent of annual amounts pertaining to invested asset categories included in net cash used in investing activities from our consolidated statements of cash flows. The cash flow amounts are reduced by realized gains on investments, with the net result reduced by 50 percent to represent estimated new cash invested during each respective year. All new cash is assumed to be invested at the midpoint of the year.
Interest income declined 2 percent in 2013 as the average fixed-maturity pretax yield declined by approximately 27 basis points, offsetting a larger fixed-maturity portfolio that rose 5 percent on an amortized cost basis. Interest income declined in 2012 for similar reasons.
The $42 million net realized investment gains and losses in 2012 were primarily due to $37 million in net realized gains from equity security sales and $35 million in gains from fixed-maturity security sales and calls, partially offset by $33 million of OTTI charges for 13 securities.
OTTI charges from the investment portfolio by the asset classes we described in Item 1, Investments Segment, are summarized below:
Revenues in 2013 for our Other operations remained at the same level as 2012, while expenses rose $1 million. Other includes noninvestment operations of the parent company and its subsidiary, CFC Investment Company. Losses before income taxes for Other were largely driven by interest expense from debt of the parent company.
Our insurance subsidiary’s primary sources of cash inflows are collection of premiums, investment income, maturity of fixed-income securities and sale proceeds from investments. Property casualty insurance premiums generally are received before losses are paid under the policies purchased with those premiums. Our insurance subsidiary’s cash outflows are primarily property casualty loss and loss expenses, commissions, salaries, taxes, operating expenses and investment purchases. Over the past three years, premium receipts and investment income have been more than sufficient to pay claims and operating expenses. Excess cash flows were partially used to pay dividends to the parent company. We are not aware of any known trends that would materially change historical cash flow results over the next 12 months, other than fluctuations in catastrophe claims and other large losses either individually or in aggregate.
The table below shows a summary of operating cash flow for property casualty insurance (direct method). Historically, annual variation in operating cash flow has tended to be largely related to changes in levels of catastrophe losses.
Financial resources of the parent company also could be made available to our insurance subsidiaries, if circumstances required. This flexibility would include our ability to access the capital markets and short-term bank borrowings.
Our debt totaled $894 million at year-end 2013, consisting of $790 million of noncallable long-term debt and $104 million in borrowings on our short-term line of credit. We generally have minimized our reliance on debt financing although we may use the line to fund short-term cash needs.
We provide details of our three long-term notes in Item 8, Note 8 of the Consolidated Financial Statements. None of the notes are encumbered by rating triggers. The total principal amount of our long-term debt at December 31, 2013, was $793 million and included:
$391 million aggregate principal amount of 6.92% senior debentures due 2028.
$374 million aggregate principal amount of 6.125% senior debentures due 2034.
The credit agreement provides alternative interest charges based on the type of borrowing and our debt rating. The interest rate charged is adjusted LIBOR plus an applicable margin.
Common stock repurchase - Generally, our board believes that share repurchases can help fulfill our commitment to enhancing shareholder value. Consequently, the board has authorized the repurchase of outstanding shares, giving management discretion to purchase shares at reasonable prices in light of circumstances at the time of purchase.
Our approach since mid-2008 has been to preserve capital and repurchase a minimal amount of shares. Those repurchases were intended to partially offset the issuance of shares through equity compensation plans, primarily due to vesting of service-based restricted stock units of equity awards granted in the past. Our corporate Code of Conduct restricts repurchases during certain time periods. The details of the repurchase authorizations and activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Interest on long-term debt - We expect total interest expense to be $52 million in 2014. We discuss outstanding debt in Additional Sources of Liquidity.
Computer hardware and software - We expect to spend $26 million over the next three years for current material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discuss below the noncontractual expenses we anticipate for computer hardware and software in 2014.
Other operating expenses - Many of our operating expenses are not contractual obligations but reflect the ongoing expenses of our business. In addition to contractual obligations for hardware and software discussed above, we anticipate capitalizing approximately $5 million in spending for key technology initiatives in 2014. Capitalized development costs related to key technology initiatives totaled $4 million in both 2013 and 2012. These activities are conducted at our discretion, and we have no material contractual obligations for activities planned as part of these projects.
At December 31, 2013, we had $433 million in cash and cash equivalents. That strong liquidity and our consistent cash flows give us the flexibility to meet current obligations and commitments while building value by prudently investing where we see potential for both current income and long-term return. They also provide adequate financial cushion when short-term operating results do not meet our objectives.
Parent-company liquidity could be constrained by Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay. During 2014, our insurance subsidiary can declare $433 million in dividends to our parent company without regulatory approval. We do not expect future pension contributions to constrain our liquidity. The fair value of plan assets is 109 percent of the accumulated benefit obligation at December 31, 2013. Continued economic weakness also has the potential to affect our liquidity and capital resources in a number of different ways, potentially including: delinquent payments from agencies, defaults on interest payments by fixed-maturity holdings in our portfolio, dividend reductions by holdings in our equity portfolio or declines in the market value of holdings in our portfolio.
The increase in total gross reserves was due to a $101 million increase in IBNR reserves, including $45 million for our commercial casualty line of business and $49 million for our workers’ compensation line of business. Total gross
Due to these considerations, our actuarial staff reviewed additional reserving methods and elected to use a weighted average of a paid survival ratio method and report year method to estimate reserves for IBNR asbestos and environmental claims. The result is a decrease of approximately 2.6 percent in the indicated net reserve as derived from the 2003 survival ratio analysis alone. Our exposure to such claims is limited; we believe moving to weighted average of both methods produces a sufficient level of reserves.
We direct our associates and agencies to settle claims and pay losses as quickly as is practical, and we made $2.172 billion of net claim payments during 2013. At year-end 2013, total net property casualty reserves of $3.942 billion reflected $2.032 billion in unpaid amounts on reported claims (case reserves), $884 million in loss expense reserves and $1.026 billion 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.
The historical pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The effective duration of our consolidated property casualty fixed-maturity portfolio was 4.5 years at year-end 2013. By contrast, the duration of our loss and loss expense reserves was approximately 4.32 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow from operations is sufficient to meet these obligations. In addition, investment holdings could be sold, if necessary, to meet higher than anticipated loss and loss expenses.
The company established a reasonably likely range for net loss and loss expense reserves of $3.727 billion to $4.078 billion at year-end 2013, with the company carrying net reserves of $3.942 billion. The likely range was $3.598 billion to $3.918 billion at year-end 2012, with the company carrying net reserves of $3.813 billion. Our loss and loss expense reserves are not discounted for the time-value of money, but we have reduced the reserves by an estimate of the amount of salvage and subrogation payments we expect to recover.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2013 and 2012. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
Management’s best estimate of total loss and loss expense reserves as of year-end 2013 was consistent with the corresponding actuarial best estimate. Management’s best estimate of total loss and loss expense reserves as of year-end 2012 also was consistent with the corresponding actuarial best estimate.
Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year
The following table shows net reserve changes at year-end 2013, 2012 and 2011 by property casualty segment and accident year:
Favorable reserve development of $70 million for the commercial casualty line accounted for approximately 75 percent of the commercial lines insurance segment total in 2013, while favorable reserve development of $14 million for the workers’ compensation line accounted for approximately 15 percent of the segment total in 2013. Our commercial property line of business experienced $22 million of favorable reserve development on prior accident years recorded during 2013, including $14 million for catastrophe losses. Drivers of significant reserve development for various lines of business are discussed below.
Moderation in commercial casualty trend selections - We saw moderating loss cost trends continue in several commercial casualty coverages. A number of factors seem to have played a role, including a slow economic recovery, favorable court decisions, policy form restrictions and claims department initiatives. Accordingly, it is not entirely clear whether these moderating loss cost trends will persist, and our actuaries have responded cautiously to these changes, electing to recognize improvements in trends used for estimating reserves in a progressive, incremental fashion.
For the excess and surplus lines insurance segment, the table showing reserves by segment and lines of business in Property Casualty Loss and Loss Expense Obligations and Reserves, shows the components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were up $31 million from year-end 2012 primarily due to the increase in premiums and exposures for this segment, as we discussed in Excess and Surplus Lines Insurance Results of Operations. Favorable development during 2013 of $13 million for excess and surplus lines insurance segment reserves, shown in the table above, illustrates the potential for revisions inherent in estimating reserves. During 2011, we began to rely more heavily on development patterns from our own excess and surplus lines business, contributing to the modest decrease in reserves, especially for the defense and cost containment portion of loss expense reserves.
The modeled losses according to RMS in the table are based on its RiskLink version 13.0 catastrophe model and use a near-term storm catalog methodology. The near-term storm catalog theory is a more conservative approach and places a higher weighting on the increased hurricane activity of the past several years, thus producing higher probable maximum loss projections than a longer-term view. The modeled losses according to AIR in the table are based on its AIR Clasic/2 version 15 catastrophe model and use a long-term methodology. The AIR storm catalog includes decades of documented weather events used in simulations for probable maximum loss projections.
Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover for losses covered under any reinsurance agreement depends on the financial viability of the reinsurer.
Currently participating on our standard market property and casualty per-risk and per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of which had A.M. Best insurer financial strength ratings of A+ (Superior) or better as of December 31, 2013. Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and the European markets. The largest participant in our property catastrophe program, representing approximately 47 percent of total participation, is the Lloyds of London placement that features numerous syndicates, with R.J. Kiln & Company Limited and the Catlin Syndicate taking the largest participations. Other primary participants in our property catastrophe program include Liberty Syndicates, Axis Specialty, Amlin Re and Markel Ltd.
Primary components of the 2014 property and casualty reinsurance program include:
Property excess treaty - For 2014, we again purchased a property reinsurance treaty that provides an additional $10 million in protection for property losses. This treaty, along with the property per risk treaty, provides a total of $35 million of protection. The ceded premium is estimated at approximately $4 million for 2014, compared with an initial estimate of $5 million for 2013.
Individual risks with insured values in excess of $35 million, as identified in the policy, are handled through a different reinsurance mechanism. We typically reinsure property coverage for individual risks with insured values between $35 million and $65 million under an automatic facultative agreement. For risks with property values exceeding $65 million, we negotiate the purchase of facultative coverage on an individual certificate basis. For casualty coverage on individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis. For risks with property or casualty limits that are between $35 million and $37 million, we sometimes forego facultative reinsurance and retain an additional $2 million of loss exposure.
A form of reinsurance is also provided through The Terrorism Risk Insurance Act of 2002 (TRIA). TRIA was originally signed into law on November 26, 2002, and extended on December 22, 2005, in a revised form, and extended again on December 26, 2007. TRIA provides a temporary federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. TRIA now is scheduled to expire December 31, 2014. Under regulations promulgated under this statute, insurers are required to offer terrorism coverage for certain lines of property casualty insurance, including property, commercial multi-peril, fire, ocean marine, inland marine, liability, aircraft and workers’ compensation. In the event of a terrorism event defined by TRIA, the federal government would reimburse terrorism claim payments subject to the insurer’s deductible. The deductible is calculated as a percentage of subject written premiums for the preceding calendar year. Our deductible in 2013 was $416 million (20 percent of 2012 subject premiums), and we estimate it is $459 million (20 percent of 2013 subject premiums) for 2014.
The Cincinnati Specialty Underwriters Insurance Company has separate property and casualty reinsurance treaties for 2014 through its parent, The Cincinnati Insurance Company. Primary components of the treaties include:
Casualty treaties - The casualty treaty is written on an excess of loss basis and provide limits up to $6 million, which is adequate capacity for the risk profile we insure. A second treaty layer of $5 million excess of $6 million is written to provide coverage for extra contractual obligations or clash exposures. The maximum retention for any one casualty loss is $1 million by Cincinnati Specialty Underwriters. Losses between $1 million and $11 million are reinsured at 100 percent by Cincinnati Insurance.
Property catastrophe treaty - As a subsidiary of Cincinnati Insurance, Cincinnati Specialty Underwriters has been added as a named insured under our corporate property catastrophe treaty, and for our collateralized reinsurance funded through the issuance of catastrophe bonds. All terms and conditions of this reinsurance coverage apply to policies underwritten by Cincinnati Specialty Underwriters.
Cincinnati Life, our life insurance subsidiary, purchases reinsurance under separate treaties with many of the same reinsurers that write the property casualty working treaties. For our core term life insurance line of business, we retain no more than a $500,000 exposure on a single policy, ceding the balance using excess over retention mortality coverage and retaining the policy reserve. Because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of our capital. Our corporate retention is $1 million on a single life. For term life insurance business written prior to 2005, we retain 10 percent to 25 percent of each term policy, not to exceed $500,000, ceding the balance of mortality risk and policy reserve.
business among many reinsurers. The exposure to loss is usually triggered as a result of very high catastrophe losses. The First Surplus treaty has exposure for us of up to nearly $2 million of assumed losses from a single event and the Second Surplus treaty has exposure for us of up to nearly $3 million of assumed losses from a single event. The treaties with Kiln Group Limited were in place during 2013 at similar exposure levels.
Increased frequency and/or severity of claims or development of claims that are unforseen at the time of policy issuance
Difficulties with technology or data security breaches, including cyber attacks, that could negatively affect our ability to conduct business and our relationships with agents, policyholders and others
Delays or performance inadequacies from ongoing development and implementation of underwriting and pricing methods or technology projects and enhancements expected to increase our pricing accuracy, underwriting profit and competitiveness
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, 2013. Deloitte & Touche LLP met with our audit committee to discuss the results of its examination. They have the opportunity to discuss the adequacy of internal controls and the quality of financial reporting without management present.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the “Company”) as of December 31, 2013 and 2012, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2013. Our audits also included the financial statement schedules listed in the Index at Item 15(c). We also have audited the Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedules and an opinion on the Company’s internal control over financial reporting based on our audits.
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 1,450 independent insurance agencies with 1,823 reporting locations across 39 states. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life and disability income insurance and fixed annuities, and The Cincinnati Specialty Underwriters Insurance Company, which offers excess and surplus lines property casualty insurance products.
Universal life contracts are long-duration contracts for which contractual provisions are not fixed, unlike whole life insurance. Universal life contracts allow policyholders to vary the amount of premium, within limits, without our consent. However, we may vary the mortality, expense charges and the interest crediting rate, within limits, used to accumulate policy values. We do not record universal life premiums as revenue. Instead we recognize as revenue the mortality charges, administration charges and surrender charges when received. Some of our universal life contracts assess administration charges in the early years of the contract that are compensation for services we will provide in the later years of the contract. These administration charges are deferred and are recognized over the period when we provide those future services.
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, 2013, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders’ account value by approximately $8 million. If the BOLI projected fair value were to fall below the value we guaranteed, a liability would be established with a corresponding charge to the company’s earnings.
Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holder, and we do not include them in the consolidated statements of income. Revenues and expenses
We reduce risk and uncertainty by buying property casualty and life reinsurance. Reinsurance contracts do not relieve us from our duty to policyholders, but rather help protect our financial strength to perform that duty. All of these ceded reinsurance contracts transfer the economic risk of loss. We assume risk in a limited way as a reinsurer for other insurance companies, reinsurers and involuntary state pools.
For the purpose of ASC 825 disclosure, we base fair value for long-term senior notes on market pricing of similar debt instruments that are actively trading. We base fair value for notes payable on our year-end outstanding balance because it is short term and tied to a variable interest rate. We estimate the fair value of liabilities for investment contracts and annuities using discounted cash flow calculations across a wide range of economic interest rate scenarios with a provision for our nonperformance risk. We estimate the fair value for policyholder loans on insurance contracts using a discounted cash flow model. Determination of fair value for structured settlements assumes the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December 31, 2013, to account for nonperformance risk. See Note 3, Fair Value Measurements for further details.
We calculate deferred income tax liabilities and assets using tax rates in effect when temporary differences in financial statement income and taxable income are expected to reverse. We recognize deferred income taxes for
There were no subsequent events requiring adjustment to the financial statements or disclosure.
In February 2013, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. ASU 2013-02 requires entities to present in either a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line items affected by the reclassification. The company adopted this ASU during the first quarter of 2013, and it did not have a material impact on our company’s financial position, cash flows or results of operations. See Note 9, Shareholders’ Equity and Dividend Restrictions, for further details.
$18 million and $31 million of fair value of hybrid securities included in fixed maturities that follow ASC 815-15-25, Accounting for Certain Hybrid Financial Instruments, at December 31, 2013 and 2012, respectively. The hybrid securities are carried at fair value, and the changes in fair value are included in realized investment gains and losses.
For the years ended December 31, 2013, 2012 and 2011, there were no credit losses on fixed-maturity securities for which a portion of OTTI has been recognized in other comprehensive income.
The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3). When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used. Our valuation techniques have not changed from those used at December 31, 2012, and ultimately management determines fair value. Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:
We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. We primarily base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on prices from a nationally recognized pricing vendor, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. The company obtains and reviews the pricing service’s valuation methodologies and related inputs and validates these prices by replicating a sample across each asset class using a discounted cash flow model. When a price is not available from these sources, as in the case of securities that are not publicly traded, we determine the fair value using various inputs including quotes from independent brokers. In these circumstances, we have generally obtained and evaluated two nonbinding quotes from brokers; our investment professionals determine our best estimate of fair value. The fair value of investments not priced by a pricing vendor is less than 1 percent of the fair value of our total investment portfolio. Reclassification of certain financial instruments may occur when input observability changes. All reclassifications are reported as transfers as of the beginning of the quarter in which the reclassification occurred.
The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2013 and 2012. We do not have any material liabilities carried at fair value. There were no transfers between Level 1 and Level 2 for the years ended December 31, 2013 and 2012.
The following tables provide the change in Level 3 assets during 2013 and 2012:
The following table shows fair values of our note payable and long-term debt subject to fair value disclosure requirements:
Fair value of the note payable was determined based upon the outstanding balance at December 31, 2013, because it is short term and tied to a variable interest rate. The note payable was classified as Level 2 as a market does not exist.
Outstanding principal and interest for these life policy loans were $36 million and $37 million at December 31, 2013, and December 31, 2012, respectively. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates as nonperformance risk is minimal; and (2) the loan repayment rate by which policyholders pay off their loan balances is in line with past experience.
The following table shows fair value of our deferred annuities and structured settlements, included in life policy and investment contract reserves, subject to fair value disclosure requirements:
Recorded reserves for the deferred annuities and structured settlements were $1.051 billion and $1.043 billion at December 31, 2013, and December 31, 2012, respectively.
Fair values for deferred annuities 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 at December 31, 2013, to account for nonperformance 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.
$70 million, $61 million and $59 million for certain life and health loss reserves at December 31, 2013, 2012 and 2011, respectively.
During 2013, we experienced $147 million of favorable development on prior accident years including $95 million of favorable development in commercial lines. Favorable development in 2013 was $249 million less than in 2012, largely due to the change in prior accident years before catastrophes. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $70 million for the commercial casualty line, $22 million for the commercial property line, $14 million for the workers’ compensation line and $19 million for the homeowner line due to reduced uncertainty of these lines one year later.
During 2011, we experienced $285 million of favorable development on prior accident years including $234 million of favorable development in commercial lines. Overall favorable development for commercial lines reserves
illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $132 million for the commercial casualty line and $97 million for the workers’ compensation line due to reduced uncertainty of these lines one year later.
We have one line of credit with multiple commercial banks with a borrowing capacity of $225 million, with an additional $50 million accordion feature. The 2012 credit agreement is a $225 million unsecured revolving credit facility with a term of five years expiring May 31, 2017. We had no compensating balance requirements on short-term debt for either 2013 or 2012. At December 31, 2013 and 2012, $104 million was drawn on the line of credit.The interest rate charged on our borrowings on this credit agreement ranged from 1.3 percent to 1.35 percent during 2013 and ranged from 0.7 percent to 2.58 percent during 2012.
Below are the expected capital lease obligations, totaling $45 million, excluding an insignificant amount of interest, that we expect to pay over the next six years:
Our insurance subsidiary declared dividends to the parent company of $375 million in 2013, $300 million in 2012 and $180 million in 2011. State regulatory requirements restrict the dividends insurance subsidiaries can pay. Dividends must be paid within 30 days of declaration. Generally, the most our insurance subsidiary can pay without prior regulatory approval is the greater of 10 percent of statutory capital and 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 2014, the total that our insurance subsidiary, which is the parent of all other insurance subsidiaries, may declare in dividends is approximately $433 million.
Declared cash dividends per share were $1.655, $1.62 and $1.605 for the years ended December 31, 2013, 2012 and 2011, respectively.
The change in AOCI includes changes in unrealized gains and losses on investments, pension obligations, life deferred acquisition costs, life policy reserves and other as follows:
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions about the appropriate level of risk
Our life insurance company purchases reinsurance for protection of a portion of the risk that is written. Primary components of our life reinsurance program include individual mortality coverage and aggregate catastrophe and accidental death coverage in excess of certain deductibles.
Our consolidated statements of income include earned life insurance premiums on ceded business:
As a result of positions either taken in our 2011 and 2012 federal tax return filed with the IRS or expected to be taken in the 2013 filing, we believe it is more likely than not that our tax liability will be sustained upon examination by the IRS. We therefore carry no amount for unrecognized tax benefits for the years ended 2013, 2012 and 2011.
On September 13, 2013, the Internal Revenue Service released final tangible property regulations under Sections 162(a) and 263(a) of the Internal Revenue Code of 1986 (Code), regarding the deduction and capitalization of expenditures related to tangible property. The final regulations replace temporary regulations that were issued in December 2011. Also released were proposed regulations under Section 168 of the Code regarding dispositions of tangible property. These regulations generally apply to taxable years beginning on or after January 1, 2014. Although the final regulations will affect all taxpayers that acquire, produce, or improve tangible property, we do not expect them to have a material impact on our consolidated financial statements.
In addition to our IRS filings, we file income tax returns with immaterial amounts in various state jurisdictions.
The current sources of dilution of our common shares are certain equity-based awards as discussed in Note 17 Stock-Based Associate Compensation Plans. The above table includes the number of anti-dilutive stock-based awards at year-end 2013, 2012 and 2011. We did not include these stock-based awards in the computation of net income per common share (diluted) because their exercise would have anti-dilutive effects.
We sponsor a qualified defined benefit pension plan. During 2008, we changed the form of retirement benefit we offer some associates to a company match on contributions to a 401(k) plan from the defined benefit pension plan. We froze entry into the pension plan for new associates as of June 30, 2008, and only participants 40 years of age or older as of August 31, 2008, could elect to continue to participate. For participants remaining in the pension plan, we continue to contribute to fund future benefit obligations. Benefits for the defined benefit pension plan are based on years of credited service and compensation level. Contributions are based on the prescribed method defined in the Pension Protection Act. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method. During the fourth quarters of 2012 and 2011, we offered limited opportunities for distribution of vested balances to
terminated participants in the qualified pension plan. The qualified plan was amended to allow for distribution of vested balances to terminated participants on an ongoing basis.
year-end 2013 and 2012, which are included in the obligation and expense amounts. The company also makes available to a select group of associates the CFC Top Hat Savings Plan, a nonqualified deferred compensation plan.
Excluding cash, during 2013 we held approximately 80 percent of our pension portfolio in domestic common equity investments, which reflect the long-term time horizon of pension obligations. The remainder of the portfolio consists of 12 percent in states, municipalities and taxable political subdivisions fixed-maturity investments and 8 percent in domestic corporate fixed-maturity investments. Our common equity portfolio consists of 22 percent in the financial sector, 22 percent in the information technology sector, 12 percent in the healthcare sector and 12 percent in the industrial sector during 2013. No additional sectors accounted for 10 percent or more of our common equity portfolio balance at year-end 2013. We had $19 million of cash on hand at December 31, 2013, to cover
Investments in securities are valued based on the fair value hierarchy outlined in Note 3, Fair Value Measurements. The pension plan did not have any liabilities carried at fair value during the years ended December 31, 2013 and 2012. There have been no transfers between Level 1 and Level 2 for the years ended December 31, 2013 and 2012. The following table shows the fair value hierarchy for those assets measured at fair value on a recurring basis
Our pension plan assets included 467,113 and 567,113 shares of the company’s common stock at December 31, 2013 and 2012, which had a fair value of $24 million and $22 million at December 31, 2013 and 2012, respectively. The defined benefit pension plan did not purchase any shares of our common stock during 2013 and 2012. During 2013, the pension plan sold 100,000 shares of the company’s common stock for a realized gain of $5 million. No shares of our common stock were sold during 2012. The company paid $1 million in cash dividends on our common stock to the pension plan in both 2013 and 2012.
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $6 million in 2013, $5 million in 2012 and $6 million 2011, on premium volume of approximately
$35 million, $35 million and $34 million for 2013, 2012 and 2011, respectively.
Four equity compensation plans currently permit us to grant various types of equity awards. We currently grant incentive stock options, nonqualified stock options, service-based restricted stock units and performance-based restricted stock units to associates, including some with market-based performance objectives under our shareholder-approved plans. We also have a Holiday Stock Plan that permits annual awards of one share of common stock to each full-time associate for each full calendar year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant stock to our outside directors as a component of their annual compensation. We used a combination of new shares and treasury shares for share-based compensation award issues or exercises during 2013.
December 31, 2013, 2012 and 2011, respectively. The related income tax benefit recognized was $6 million,
As of December 31, 2013, we had $20 million of unrecognized total compensation cost related to nonvested stock options and restricted stock unit awards. That cost will be recognized over a weighted-average period of 1.7 years.
The following weighted average assumptions were used in determining fair value for option grants issued during 2013 and 2012:
Cash received from the exercise of options was $25 million, $10 million and $1 million for the years ended December 31, 2013, 2012 and 2011. We acquired 577,745 and 311,524 shares totaling $28 million and $12 million, respectively, from associates in consideration for option exercises during 2013 and 2012.
The weighted-average remaining contractual life for exercisable awards as of December 31, 2013, was 3.2 years. Under all active shareholder approved plans, a total of 17.3 million shares were authorized to be granted. At December 31, 2013, 7.7 million shares remained available for future issuance under the plans. During 2013, we granted 21,363 shares of common stock to our directors for 2012 board service fees.
Service-based restricted stock units granted to associates are valued at fair value of the shares on the date of grant less the present value of the dividends that holders of restricted stock units will not receive on the shares underlying the restricted stock units during the vesting period. Service-based restricted stock units cliff vest three years after the date of grant. Service-based restricted stock units vested during the year had an intrinsic value of $15 million, less than $1 million and $13 million for the years ended December, 31, 2013, 2012 and 2011, respectively.
We have performance-based awards that vest on the first day of March after a three-calendar-year performance period. These awards vest according to the level of three-year total shareholder return achieved compared to a peer group over a three-year performance period with payouts ranging from 0 - 125 percent for awards granted prior to 2013. For awards granted in 2013, the payout range on these performance awards are 0 - 200 percent. Three-year total shareholder return is calculated by Bloomberg using annualized total return of a stock to an investor due to capital gain appreciation plus reinvestment of all dividends. We issued 61,146 shares of performance-based restricted stock units during 2013 at the maximum-level performance hurdle for the three-year performance period ending December 31, 2012, as we achieved a three-year total shareholder return which exceeded all of our seven peers. For the three-year performance period ended December 31, 2013, our total shareholder return exceeded all peers in our peer group. We expect payout of these shares at the maximum level to occur on March 1, 2014.
Expected volatility is based on our stock price over a historical period that approximates the expected term. We have used the historical volatilities of 2.87 percent for both the 2013 and 2012 grants.
Dividend yield has been modeled assuming that the holder of the award is not entitled to receive dividends that are paid during the performance period. Dividend yields of 3.63 percent for 2013 grants and 4.51 percent for 2012 grants were used.
Risk-free rates are equal to the yield, as of the measurement date, of the zero-coupon U.S. Treasury bill that is commensurate with the performance measurement period. Risk-free rates used were 0.40 percent for both 2013 and 2012 grants.
This is a summary of restricted stock unit and performance-based share information, assuming a target payout for performance-based shares, for the year 2013:
We operate primarily in two industries, property casualty insurance and life insurance. We regularly review our reporting segments to make decisions about allocating resources and assessing performance.
Fee revenues for the commercial and personal insurance segments primarily represent installment fees.
Income before income taxes for the insurance segments is defined as underwriting profit or loss.