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 $11 million as of December 31, 2010, and is classified as land, building and equipment, net, for company use.
Realized investment gains and losses are integral to our financial results over the long term, but our substantial discretion in the timing of investment sales may cause this value to fluctuate substantially. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 75.
The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial condition. Our Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Pages 34 and 35, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 105. We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and stock dividends.
Investment income growth, on a before-tax basis, declined at a compound annual rate of 0.3 percent over the five-year period 2006 through 2010. It grew in each year except 2008 and 2009, when we experienced a dramatic reduction in dividend payouts by financial services companies held in our equity portfolio, a risk we addressed aggressively during 2008, completing that effort in early 2009.
We will incur the cost of continued investment in our business, including technology, recent entry in new states and process initiatives to create long-term value. In addition, we will not see the full advantage of many of these investments for several years.
We have formal risk management programs overseen by a senior officer and supported by a team of representatives from business areas. The team provides reports to our chairman, our president and chief executive officer and our board of directors, as appropriate, on risk assessments, risk metrics and risk plans. Our use of operational audits, strategic plans and departmental business plans, as well as our culture of open communications and our fundamental respect for our Code of Conduct, continue to help us manage risks on an ongoing basis.
Below we review highlights of our financial results for the past three years. Detailed discussion of these topics appears in Results of Operations, Page 48, and Liquidity and Capital Resources, Page 78.
The value creation ratio discussed in the Executive Summary, Page 36, was 11.1 percent in 2010, 19.7 percent in 2009 and negative 23.5 percent in 2008. The book value per share growth component of the value creation ratio was 5.7 percent during 2010 and 13.6 percent during 2009, largely reflecting improved valuation of our investment portfolio in addition to earnings. In 2008, a decline in unrealized gains on our investment portfolio was the most significant factor in the 27.9 percent decline in book value. Net income declined 13 percent in 2010 after growing 1 percent in 2009, reflecting lower realized investment gains. In 2008, net income was down 47 percent. Cash dividends declared per share rose approximately 1 percent in 2010, 1 percent in 2009 and 10 percent in 2008.
Our ratio of debt to total capital (debt plus shareholders’ equity) decreased in both 2010 and 2009 and is comfortably within our target range.
Weighted average shares outstanding may fluctuate from period to period due to repurchases of shares under board authorizations or issuance of shares through equity compensation plans. Weighted average shares outstanding on a diluted basis increased by less than 1 million in 2010, after declining by less than 1 million in 2009 and by 9 million in 2008.
As discussed in Investment Results of Operations, Page 75, security sales led to realized investment gains in all three years, although 2008 gains were tempered by $510 million in other-than-temporary impairment (OTTI) charges. Realized 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.
Higher interest income drove 3 percent growth in 2010 pretax investment income. Lower income from common stock dividends led to a 7 percent decline in 2009 pretax net investment income, improving on a 12 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 sold or reduced.
Our actuarial staff applies significant judgment in selecting models and estimating model parameters when preparing reserve analyses. In addition, unpaid loss and loss expenses are inherently uncertain as to timing and amount. Uncertainties relating to model appropriateness, parameter estimates and actual loss and loss expense amounts are referred to as model, parameter and process uncertainty, respectively. Our management and actuarial staff address these uncertainties in the reserving process in a variety of ways.
Our actuarial staff uses diagnostics provided by stochastic reserving software to evaluate the appropriateness of the models and methods listed above. The software’s diagnostics have indicated that the appropriateness of these models and methods for estimating IBNR reserves for our lines of business tends to depend on a line's tail. Tail refers to the time interval between a typical claim's occurrence and its settlement. For our long-tail lines such as workers’ compensation and commercial casualty, models from the probabilistic trend family tend to provide superior fits and to validate well compared with models underlying the loss development and Bornhuetter-Ferguson methods. The loss development and Bornhuetter-Ferguson methods, particularly the reported loss variations, tend to produce the more appropriate IBNR reserve estimates for our short-tail lines such as homeowner and commercial property. For our mid-tail lines such as personal and commercial auto liability, all models and methods provide useful insights.
Our actuarial staff also devotes significant time and effort to the estimation of model and method parameters. The loss development and Bornhuetter-Ferguson methods require the estimation of numerous loss development factors. The Bornhuetter-Ferguson methods also involve the estimation of numerous ultimate loss ratios by accident year. Models from the probabilistic trend family require the estimation of development trends, calendar year inflation 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.
These trends and measures also support the estimation of ultimate accident year loss ratios needed for applying the Bornhuetter-Ferguson methods and for assessing the reasonability of all IBNR reserve estimates computed. Our actuarial staff reviews these trends and measures quarterly, updating parameters derived from them as necessary.
Exposure levels. Historical earned premiums, when adjusted to reflect common levels of product pricing and loss cost inflation, can serve as a proxy for historical exposures. Our actuaries require this assumption to estimate expected loss ratios and expected allocated loss expense ratios used by the Bornhuetter-Ferguson reserving methods. They also use this assumption to establish exposure levels for recent accident years, characterized by “green” or immature data, when working with probabilistic trend family models.
business cannot be computed by simply adding the standard errors and reserve ranges of the component lines of business, since such an approach would ignore the effects of product diversification. See Range of Reasonable Reserves, Page 83, for more details on our total reserve range. While the table reflects our assessment of the most likely range within which each line's actual unpaid loss and loss expenses may fall, one or more lines' actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
If actual unpaid loss and loss expenses fall within these ranges, our cash flow and fixed maturity investments should provide sufficient liquidity to make the subsequent payments. To date, our cash flow has covered our loss and loss expense payments, and we have never had to sell investments to make these payments. If this were to become necessary, however, our fixed maturity investments should provide us with ample liquidity. At year-end 2010, consolidated fixed maturity investments exceeded total insurance reserves (including life policy reserves) by $2.149 billion.
Our fixed-maturity and equity investment portfolios are our largest assets. The company’s asset impairment committee continually monitors the holdings in these portfolios and all other assets for signs of other-than-temporary or permanent impairment. The committee monitors significant decreases in the fair value of invested assets, an accumulation of costs in excess of the amount originally expected to acquire or construct an asset, uncollectability of all receivable assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure to pay interest or dividends, signs indicating that the carrying amount may not be recoverable, or changes in legal factors or in the business climate.
Our investment 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
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.
Securities considered to have a temporary decline would be expected to recover their book value, which may be at maturity. Under the same accounting treatment as fair value gains, temporary declines (changes in the fair value of these securities) are reflected in shareholders’ equity on our balance sheet in accumulated other comprehensive income (AOCI), net of tax, and have no impact on net income.
Financial assets and liabilities recorded on the Consolidated Balance Sheets are categorized based on the inputs to the valuation techniques as described in Item 8, Note 3, Fair Value Measurements, Page 114.
Over 99 percent of the $11.424 billion of securities in our investment portfolio measured at fair value are classified as Level 1 or Level 2. Financial assets that fall within Level 1 and Level 2 are priced according to observable data from identical or similar securities that have traded in the marketplace. Also within Level 2 are securities that are valued by outside services or brokers where we have evaluated the pricing methodology and determined that the inputs are observable.
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 preferred equities include private and thinly traded preferred securities.
Pricing for each Level 3 security is based upon inputs that are market driven, including third-party reviews provided to the issuer or broker quotes. However, we placed in the Level 3 hierarchy securities for which we were unable to obtain the pricing methodology or we could not consider the price provided as binding. Pricing for securities classified as Level 3 could not be corroborated by similar securities priced using observable inputs.
Management ultimately determined the pricing for each Level 3 security that we considered to be the best exit price valuation. As of December 31, 2010, 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 have generally obtained two non-binding quotes from brokers and, after evaluating, our investment professionals typically selected the lower quote as the fair value.
We have a defined benefit pension plan that was modified during 2008; refer to Item 8, Note 13 of the Consolidated Financial Statements, Page 121, for additional information. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates, expected return on plan assets and compensation increase rates, which are updated annually. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions.
Holding all other assumptions constant, a 0.5 percentage-point decrease in the discount rate would decrease our 2011 income before income taxes by $1 million. A 0.5 percentage point decrease in the expected return on plan assets would decrease our 2011 income before income taxes by $1 million.
The fair value of the plan assets was $30 million less than the accumulated benefit obligation at year-end 2010 and $42 million less at year-end 2009. The fair value of the plan assets was $62 million less than the projected plan benefit obligation at year-end 2010 and $77 million less at year-end 2009. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. On February 1, 2011, we contributed $35 million to our qualified plan.
We issue life contracts referred to as bank-owned life insurance policies (BOLI). Based on the specific contract provisions, the assets and liabilities for some BOLIs are legally segregated and recorded as assets and liabilities of the separate accounts. Other BOLIs are included in the general account. For separate account BOLIs, minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders.
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 2011, the account holder would not pay a surrender charge. The surrender charge is zero for 2011 and beyond.
Our consolidated property casualty operations grew earned premiums slightly in 2010 and lowered its underwriting loss, reversing the lower revenue and deteriorating profitability trends of 2008 and 2009. While soft market conditions persisted for commercial lines, our largest operating segment, several profit improvement and premium growth initiatives began to be evident in results for 2010.
Combined ratio - The 2010 combined ratio improved 2.8 percentage points to 101.7 percent, lowering the 2009 underwriting loss by more than half. The 1.4 percentage point increase in the ratio for current accident year losses and loss expenses was offset by a larger benefit from net favorable reserve development on prior accident years and lower catastrophe losses. Components of the combined ratio are discussed below, followed by additional discussion by segment.
Catastrophe loss trends, discussed above, explain some of the accident year loss and loss expenses trend for years 2008 through 2010. Catastrophe losses added 5.6 for 2010, 5.9 for 2009 and 6.8 percentage points for 2008 to the respective consolidated property casualty accident year loss and loss expense ratios in the table above.
Reserve development on prior accident years continued to net to a favorable amount in 2010, as $304 million was recognized, similar to $323 million in 2008. During 2009, the $188 million of net favorable development recognized was lower, due primarily to unfavorable development of $48 million for our workers’ compensation line of business, as discussed in Commercial Lines Insurance Segment Reserves, Page 85.
Premiums - Pricing in the commercial lines marketplace again reflected very strong competition, driving modest declines for both renewal and new business premiums. Our commercial lines net written premium decrease for 2010 of 1 percent compared favorably with the estimated decline of 2 percent for the overall commercial lines industry, similar to the 2009 comparison when our decline of 6 percent was slightly better than the decrease estimated for the commercial lines segment of the industry at 8 percent. 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 in recent years reflects our premium growth initiatives and the advantages we achieve through our field focus, which provides us with quality intelligence on local market conditions. Our earned premiums declined in 2010 and 2009, following the pattern of our written premiums.
Combined ratio - For our commercial lines segment, the 2010 combined ratio improved 2.2 percentage points to 99.4 percent, and the segment generated a small underwriting profit. Modest increases in the ratios for catastrophes and current accident year losses and loss expenses were offset by a larger benefit from net favorable reserve development on prior accident years. That larger benefit was accounted for almost entirely by our workers’ compensation and commercial casualty lines of business. We continue to focus on sound underwriting fundamentals and obtaining adequate premiums for risks insured by each individual policy. Predictive analytics for better pricing precision have been used for our workers’ compensation line of business since the second half of 2009. We plan to deploy in 2011 similar tools for our commercial auto, general liability and commercial property lines.
Due to the highly competitive commercial lines markets of several years, we have focused on leveraging our local relationships to benefit from the efforts of our agents and the teams that work with them. We seek to maintain appropriate pricing discipline for both new and renewal business as management emphasizes the importance of assessing account quality to our agencies and underwriters, for careful decisions on a case-by-case basis whether to write or renew a policy. Rate credits may be used to retain renewals of quality business and to earn new business, but we do so selectively in order to avoid commercial accounts that we believe have insufficient profit margins. In recent years we experienced that typically the larger the account, the higher the credits needed to write or retain it, with variations by geographic region and class of business.
In 2010, we estimated that policyholders with a contractor-related ISO general liability code accounted for approximately 33 percent of our general liability premiums, which are included in the commercial casualty line of business, and that policyholders with a contractor-related National Council on Compensation Insurance Inc. (NCCI) workers’ compensation code accounted for approximately 44 percent of our workers’ compensation premiums. The market seeking to insure contractors has been more adversely affected by the economic slowdown than some other markets.
while earned premiums from audits decreased $40 million and $26 million. Compared with late 2009 and early 2010, premiums from audits by the end of 2010 represented only a slight drag, or unfavorable effect, on total commercial lines written and earned premiums, and we expect the effect to become favorable at some point in 2011.
For new business, our field associates are frequently in our agents’ offices helping to judge the quality of each account, emphasizing the Cincinnati value proposition, calling on sales prospects with those agents, carefully evaluating risk exposure and providing their best quotes. Some of our new business comes from accounts that are not new to the agent. We believe these seasoned accounts tend to be priced more accurately than business that 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.
New business premium volume in recent years has been significantly influenced by new agency appointments. All agencies newly appointed since the beginning of 2009 generated commercial lines new business written premiums of $40 million during 2010, up $26 million from 2009, while all other agencies contributed the remaining $249 million, which was down 12 percent.
Many of the recently appointed agencies are in Texas, which we entered in late 2008, or Colorado, which we entered in 2009. Those two states accounted for over 9 percent of the $289 million 2010 new business volume. On a net written premium basis, agencies in Texas and Colorado contributed $40 million of commercial lines volume during 2010, up $28 million from 2009. The size of the Texas insurance market, relative to most other states, represents significant potential for long-term premium growth.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the three-year highlights table above on Page 54 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid losses, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 75.5 percent accident year 2009 loss and loss expense ratio reported as of December 31, 2009, developed favorably by 8.0 percentage points to 67.5 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2010. Accident years 2009 and 2008 for the commercial lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
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 2010, as discussed above in Commercial Lines Insurance Premiums. In addition, previously discussed refinements made to the allocation of IBNR reserves by accident year increased the 2008 ratio.
In 2010, total large losses incurred decreased by $115 million or 19 percent, helping to lower the corresponding ratio by 4.9 percentage points. The majority of the decrease was for claims related to general liability coverages, largely included in our commercial casualty line of business. The 2009 decline of $16 million or 3 percent for total large losses incurred was more than offset by a larger decline in commercial lines earned premiums, causing an increase in the 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 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. In 2009, we raised the casualty treaty retention to $6 million from $5 million and raised the property treaty retention to $5 million from $4 million.
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 2010, based on the total loss and loss expense ratio, commercial casualty, our largest line of business, continued to be highly profitable. Workers’ compensation and specialty packages had 2010 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.
Commercial casualty is our largest line of business and has in recent years maintained a very satisfactory total loss and loss expense ratio. The rate of decline in commercial casualty premiums slowed in 2010, despite ongoing pressure from market competition. Economic trends showed modest improvement during the year, causing corresponding changes in underlying insured 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 2010 current accident year loss and loss expense ratio before catastrophe losses deteriorated by 3.9 percentage points compared with accident year 2009, reflecting lower pricing per exposure and normal loss cost inflation.
The 2010 current accident year loss and loss expense ratio before catastrophe losses also was higher, compared with accident year 2009, due to higher large losses for fires and non-catastrophe weather, in addition to lower pricing per exposure and normal loss cost inflation. In 2011 we plan to improve pricing precision for commercial property as we begin using predictive modeling tools. In addition, we have increased our loss control staff and are studying methods for improving the effectiveness of conducting property inspections for both new and renewal business.
The 2010 accident year loss and loss expense ratio was up slightly compared with accident year 2009, as a lower level of large losses partially offset lower pricing per exposure and higher physical damage losses.
Workers’ compensation net written premiums for 2010 were down $13 million, largely due to an $8 million or 17 percent decrease in new business written premiums. Premiums resulting from audits of initially recorded premiums, based on policyholder payroll levels, also lowered net written premiums, reflecting the slow economy of recent years. Net written premiums declined sharply in 2009, primarily due to economically-related lower insured exposures and more selective underwriting resulting in the non-renewal of a number of policies in our worst pricing tiers.
The workers’ compensation business line includes our longest tail exposures, making initial estimates of accident year loss and loss expenses incurred more uncertain. Due to the lengthy payout period of workers’ compensation claims, small shifts in medical cost inflation and payout periods could have a significant effect on our potential future liability compared with our current projections.
The calendar year total loss and loss expense ratio improved during 2010 primarily due to $39 million of favorable development on prior accident year reserves. Most of the favorable reserve development was for accident year 2009; approximately half of the favorable development was for losses and the other half was for loss adjustment expenses related to reserves for our claims staff to settle outstanding claims. In 2009, we recognized $48 million in unfavorable reserve development on accident years 2005 and prior as discussed below.
estimated for many prior accident years, resulting in $48 million of net unfavorable development on prior accident year reserves.
The calendar year and accident year loss and loss expense ratios reflected a high level of catastrophe losses for each year in the three-year period. Losses for 2010 also reflected a higher level of large losses for fires and non-catastrophe weather, increasing both the calendar year and accident year ratios for 2010. In addition, pricing reductions and normal loss cost inflation continued to put upward pressure on the ratios. Our adverse loss experience has been primarily driven by our Religious Institutions Program as our other specialty programs have generally performed adequately. We are working to improve this program, including enhanced pricing precision through predictive models and greater attention as management of the program shifts to our Target Markets department. Improved pricing precision and additional loss control actions will be used later for the other programs in our Specialty Packages line of business as well.
Surety and executive risk premiums declined in both 2010 and 2009, primarily due to our non-renewal of many policies as we improved the quality of the financial institution portion of this book of business.
Director and officer liability coverage accounted for 59.8 percent of surety and executive risk net written premiums in 2010 compared with 60.5 percent in 2009 and 63.0 percent in 2008. We have actively managed the potentially high risk of writing director and officer liability by:
Providing limits no higher than $10 million with facultative or treaty reinsurance in place in 2011 to cover losses greater than $6 million.
We intend to continue marketing our products to a broad range of business classes with a package approach, while improving our pricing precision. We intend to maintain our underwriting selectivity and carefully manage our rate levels as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions about rates, the use of three-year commercial policies and other policy conditions on a case-by-case basis, even in lines and classes of business that are under competitive pressure. Nonetheless, we expect commercial lines profitability to remain under pressure in 2011, in part due to small average pricing declines on policies renewed during 2010 for which premiums will be earned during 2011.
In Item 1, Strategic Initiatives, Page 9, we discuss the initiatives we are implementing to achieve our corporate performance objectives. We discuss factors influencing future results of our property casualty insurance operations in the Executive Summary, Page 36.
Combined ratio - The combined ratio improved 4.1 percentage points in 2010, mostly due to lower weather-related catastrophe losses and partly due to improved pricing. The improvement was partially offset by a higher underwriting expense ratio and a lower benefit from net favorable reserve development on prior accident years. The 2010 level of catastrophe losses, with an 8.1 percent ratio, returned to near longer-term historical averages, just 0.4 percentage points below the 10-year average of 8.5 percent. The ratio for catastrophe losses in 2009, at 16.1 percent, was approximately twice the 10-year historical average but was only 1.6 percentage points higher than 2008. The current accident year loss and loss expense ratio, before catastrophe losses, improved slightly during 2010 and reflected better underwriting and pricing. For 2009, it trended up slightly, once refinements made to the IBNR reserve allocation in 2008 were taken into account. The 2008 ratio included approximately $20 million, or 2.9 percentage points, from refinements made to the allocation of IBNR reserves by accident year.
Our personal lines statutory combined ratio was 107.1 percent in 2010, 111.4 percent in 2009 and 111.6 percent in 2008. By comparison, the estimated industry personal lines combined ratio was 99.5 percent in 2010, 100.6 percent in 2009 and 103.6 percent in 2008. Our concentration of business in areas hard-hit by catastrophe events contributed to recent results that differed from the overall industry, an issue we are addressing in part through geographic expansion as noted below. The contribution of catastrophe losses to our personal lines statutory combined ratio was 8.1 percentage points in 2010, 16.1 percent points in 2009 and 14.5 percentage points in 2008, compared with an estimated 5.5, 4.9 and 7.5 percentage points, respectively, for the industry.
The 7 percent increase in 2010 agency renewal written premiums reflected various rate changes that were implemented beginning in October 2009. Increases for the homeowner line of business averaging approximately 5 percent, with some individual policy rate increases in the double-digit range, should improve loss ratios as the increases are earned. Similar rate changes, with a slightly higher average rate increase, were implemented in the fourth quarter of 2010 for states representing the majority of our personal lines business. Rate changes for our personal auto line of business implemented during the fourth quarter of 2010 represented an average rate increase in the low-single-digit range. The 2010 personal auto rate changes reflected enhanced pricing precision enabled by the recent deployment of predictive models. Predictive modeling tools also influenced policy pricing and various rate changes during 2008 through 2010 for our homeowner line of business.
In 2010, our personal lines new business premiums written by our agencies grew 20 percent. We believe the main drivers for the growth were more attractive pricing, plus ease of use and efficiency gained by agencies from the new version of our Diamond personal lines policy processing system deployed in early 2010. New business also rose strongly 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. Seven states where we began writing business or significantly expanded our personal lines product offerings and automation capabilities, beginning in 2008, accounted for $13 million of the 2009 increase in our personal lines new business written premiums. Those seven states are Arizona, Idaho, Maryland, Montana, North Carolina, South Carolina, and Utah.
For the three-year period, other written premiums, primarily premiums that are ceded to reinsurers and that lower our net written premiums, remained relatively stable. Additional premiums ceded to reinsurers to reinstate our catastrophe reinsurance treaty contributed $9 million to other written premiums in 2008.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 49, explain some of the movement in accident year loss and loss expense ratios among the years 2008 through 2010. Catastrophe losses added 8.8 percentage points for 2010, 15.4 points for 2009 and 14.4 points for 2008 to the respective personal lines accident year loss and loss expense ratios in the table above. 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 49.
The trend for our personal lines current accident year loss and loss expense ratio before catastrophe losses over the past three years reflected normal loss cost inflation, better risk selection and improved pricing, as discussed above in Personal Lines Insurance Premiums. Higher non-catastrophe weather-related losses also affected trends, particularly for 2008 and 2009, and large losses described below also were a factor. In addition, previously discussed refinements made to the allocation of IBNR reserves by accident year increased the 2008 ratio.
Personal lines reserve development on prior accident years continued to net to a favorable amount in 2010, as $34 million was recognized, somewhat lower than $40 million in 2009 and $50 million in 2008. Most of the personal lines reserve development on prior accident years for years 2008 through 2010 occurred in our other personal line of business, primarily for personal umbrella liability coverage. Development by line of business and other trends for personal lines loss and loss expenses and the related ratios are further analyzed in Personal Lines of Business Analysis, beginning on Page 67, and in Personal Lines Insurance Segment Reserves, Page 87.
In 2010, total large losses incurred decreased by $12 million or 13 percent, helping to lower the corresponding ratio by 2.1 percentage points. The majority of the decrease was for claims related to our personal auto line of business. In 2009 the total large losses incurred ratio was higher than it was in 2008, primarily due to more homeowner fire losses. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
Other underwriting expenses grew $17 million or 22 percent, primarily due to a first-quarter 2010 provision for matters involving prior years and related to Note 16, Commitments and Contingent Liabilities, Page 125. They declined in 2009 primarily due to lower depreciation expense on previously capitalized software expenditures. An unusual expense of $3 million due to a pension charge was included in the 2008 ratio.
We prefer to write personal lines coverages within accounts that include both auto and homeowner coverages as well as coverages from the other personal business line. As a result, we believe that the personal lines segment is best measured and evaluated on a segment basis. However, we provide line-of-business data to 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 2010, the homeowner line of business had a total loss and loss expense ratio significantly higher than desired. As discussed below, we are taking actions to improve pricing and reduce loss costs that we expect to benefit future profitability trends.
Net written premiums for personal auto increased significantly in 2010, in part due to strong new business growth.
The 2010 current accident year loss and loss expense ratio before catastrophe losses deteriorated slightly compared with accident year 2009, primarily due to earned pricing changes.
Net written premiums for homeowner increased significantly in 2010, in part due to strong new business growth. Premiums ceded for reinsurance, which reduce premium revenue, were $18 million in 2010, $22 million in 2009, and $26 million in 2008, including a 2008 reinstatement premium of $8 million. The pricing changes of the past several years have had a positive effect on policyholder retention and new business activity. We continue to monitor and modify selected rates and credits to address our competitive position and to achieve long-term profitability. Implementation of predictive modeling has provided additional pricing points to target profitability. Various rate changes were implemented in both late October 2010 and 2009, including rate increases that respond in part to weather-related loss trends as well as other trends in loss costs. The 2009 increases for the homeowner line of business averaged approximately 6 percent in affected states and 5 percent overall, although some individual policies experienced renewal increases in the double-digit range. The average effect of the 2010 rate changes were approximately the same as 2009 and should lower loss ratios as the rate increases are earned. We also continue our gradual geographic diversification into states less prone to catastrophe losses, which we believe will reduce variability in the long-term future catastrophe loss ratio. These actions are important steps we are taking to improve homeowner results.
The calendar year total loss and loss expense ratio over the past three years fluctuated with catastrophe losses, non-catastrophe weather-related losses and other large losses. A $5 million increase in 2010 large losses, compared with 2009, contributed 1.7 percentage points to the homeowner loss ratio. The 2010 catastrophe loss effect of 17.9 percentage points returned to a level near historical averages. In 2008 and 2009, our catastrophe loss ratio averaged 34.5 percent, compared with a 10-year average through 2007 of 17.4 percent.
The calendar year and accident year loss and loss expense ratio for other personal continued to improve in 2010 and has been at a very profitable level the past two years. Reserve development on prior accident years can fluctuate significantly for this business line because personal umbrella liability coverage is a major component of other personal losses.
Premiums - Higher earned premiums in 2010 reflected very strong net written premium growth during 2009, the second full year of operations for our excess and surplus lines segment. Net written premiums grew in 2010 primarily due to more initial opportunities to renew accounts that were written for the first time as new business during the previous year. The 2010 volume of those initial opportunities to renew nearly doubled the volume of 2009 because new business written premiums in 2009 approximately doubled new business premiums written in 2008. New business written premiums grew modestly in 2010, at a much slower rate than in 2009, partly due to increased competition in the excess and surplus lines market, including standard market companies writing policies for risks that were formerly insurable only in the excess and surplus lines market.
The $19 million increase in renewal premiums in 2010 was primarily a result of the opportunity to renew more policies that represented new business in 2009, when new business written premiums grew by $18 million. Renewal pricing changes also accounted for some of the increase, as our excess and surplus lines policies averaged estimated price increases that were flat to slightly up in the second half of 2010. 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 premium growth in 2009 was largely a result of introducing new coverages, and also increased understanding by agencies representing The Cincinnati Insurance Companies of competitive advantages described in Excess and Surplus Lines Property Casualty Insurance Segment, Page 16. For most
of 2008, only general liability coverages were available. In late 2008, property and professional liability coverages were first offered, followed by excess liability in late 2009.
Other written premiums are primarily premiums that are ceded to reinsurers and that lower our net written premiums. Changes in ceded premium volume tend to follow a pattern similar to changes in the total of renewal and new business written premiums.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the three-year highlights table above on Page 70 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than 20 percent of our 2010 excess and surplus lines current accident year incurred losses and loss expenses represents net paid losses, a large majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 75.6 percent accident year 2009 loss and loss expense ratio reported as of December 31, 2009, developed favorably by 2.1 percentage points to 73.5 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2010. Accident years 2009 and 2008 for the excess and surplus lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Catastrophe losses partially explain some of the accident year loss and loss expenses trend for years 2008 through 2010. Catastrophe losses added 1.2 percentage points for 2010, 0.2 for 2009 and 0.4 percentage points for 2008 to the respective excess and surplus lines accident year loss and loss expense ratios in the table above.
The 2010 increase of 8.4 percentage points in the current accident year loss and loss expense ratio before catastrophe losses was driven by higher large losses. New losses of $250,000 or more per claim totaled $12 million in 2010, compared with less than $1 million in 2009, and accounted for 23.5 percentage points of the ratio. No unexpected concentration of these losses was indicated from our analysis by risk category, geographic region, policy inception, agency or field marketing territory.
We believe the adequacy of loss and loss expenses reserves for our excess and surplus lines business is strong. We establish case reserves in a manner consistent with standard lines coverages, despite the more restrictive terms and conditions for excess and surplus lines policies.
The general trends of 2010 for the excess and surplus lines markets are expected to continue in 2011, according to several industry reports. Competition is expected to remain strong, in part due to standard market insurance companies insuring businesses that previously were written by excess and surplus lines insurers. Soft market conditions for commercial lines business overall is the driver of this trend, and industry observers generally expect little change in the foreseeable future. The slowly recovering U.S. economy, another major factor in demand for insurance products, is also expected to contribute to modestly declining or relatively flat premium volume during 2011 for the excess and surplus lines industry.
Our strategy of providing superior service is expected to continue to grow our excess and surplus lines segment and achieve profitability despite challenging market conditions. We intend to continue carefully selecting and pricing risks, providing prompt delivery of insurance quotes and policies and 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.
Revenues - Driven by higher term life insurance premiums, earned premiums have grown at a double-digit rate the past two years. Gross in-force policy face amounts increased to $74.124 billion at year-end 2010 from $69.815 billion at year-end 2009 and $65.888 billion at year-end 2008.
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 $7 million profit in 2010.
Contract holders’ benefits incurred, related to traditional life and interest-sensitive products, accounted for 73.6 percent of 2010 total benefits and expenses compared with 76.4 percent in 2009 and 75.7 percent in 2008. Total contract holders’ benefits rose due to net death claims that increased but remained within our range of pricing expectations.
Operating expenses incurred, net of deferred acquisition costs, accounted for 26.4 percent of 2010 total benefits and expenses compared with 23.6 percent in 2009 and 24.3 percent in 2008. Unlocking of actuarial assumptions for our universal life contracts was the primary reason for increased operating expenses in 2010. Expenses in 2010 were also up from increased commissions due to growth in term life insurance and fixed annuities.
During the past several years, we have invested in imaging and workflow technology and have significantly improved application processing. We have achieved process efficiencies while improving our service. These efficiencies have played a significant role in cost containment and in our ability to increase total premiums and policy count over the past 10 years with minimal headcount additions.
We expect annuity sales to moderate somewhat in 2011 as we introduce a new product with a lower guaranteed rate of interest. Such a product affords us more protection during prolonged periods of low interest rates. New annuity suitability regulations also are a headwind on annuity sales due to the added burden on the agent and the resulting increased acquisition costs.
Investment income - Pretax investment income increased 3 percent in 2010, primarily because of additional net purchases in our fixed-maturity portfolio that offset declining yields. Pretax investment income declined 7 percent in 2009, primarily because of prior year dividend cuts in our common stock portfolio. After-tax investment income increased 2 percent in 2010 compared with a decrease of 11 percent in 2009. The steeper decline in 2009 after-tax investment income, compared with the pretax basis, was primarily due to a change in mix of investment income as dividends have tax-advantages relative to interest on corporate bonds.
Interest income rose 5 percent in 2010 primarily due to investing our typical allocation of net cash flow from operations in fixed-maturity securities. It increased significantly in 2009 as we increased our allocation of investments to fixed-maturity securities.
Dividend income declined 1 percent in 2010 after declining 51 percent in 2009. In early 2009, we reduced the size of our preferred stock portfolio, which generally provides higher yields, in response to the market conditions related to the banking crisis. During 2008, we reduced the size of our common stock portfolio by more than 50 percent in response to actual or anticipated dividend reductions as well as for the implementation of a risk management program.
In 2010, we continued to invest available cash flow in both fixed income and equity securities in a manner that we believe balances current income needs with longer-term invested assets growth goals.
Net realized investment gains and losses are made up of realized investment gains and losses on the sale of securities, changes in the valuation of embedded derivatives within certain convertible securities and OTTI charges. These three areas are discussed below.
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 given period. 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. At year-end 2010, the fixed maturities fair value was 106.3 percent of book value compared with 104.5 percent at year-end 2009.
$174 million in realized gains from equity sales, including $128 million from the sale of Verisk Analytics Inc. (NYSE: VRSK).
$10 million in gains from changes in fair value of securities with embedded derivatives.
The $13 million in net gains from fixed-maturity sales included a $1 million gain in short-term investments due to the final receipt from the Reserve Primary Fund that exceeded the impaired basis. The net gains also included $12 million in losses due to sales of all of the remaining holdings of collateralized mortgage obligations, which occurred during the first quarter of 2010.
The $440 million net realized investment gain in 2009, was primarily due to $624 million from sales of various equity holdings, including Pfizer Inc. (NYSE: PFE), Exxon Mobil Corporation (NYSE: XOM), The Procter & Gamble Company (NYSE: PG), Fifth Third Bancorp (NASDAQ: FITB), and Piedmont Natural Gas Company Inc. (NYSE: PNY). Realized losses of $162 million from the sale of several equity securities partially offset realized investment gains.
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.
We have a small portfolio of convertible preferred stocks and bonds, which have an embedded derivative component. In 2010 we recorded $10 million in fair value realized gains compared with $27 million in 2009 and a $38 million fair value decline for 2008. These changes in fair value were due to the application of ASC 815-15-25, which allows us to account for the entire hybrid financial instrument at fair value, with changes recognized in realized investment gains and losses. The changes in fair values are recognized in net income in the period they occur. See the discussion of Derivative Financial Instruments and Hedging Activities in Item 8, Note 1 of the Consolidated Financial Statements, Page 105, for details on the accounting for convertible security embedded options.
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 21 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 120.
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 to meet the short- and long-term cash requirements of business obligations and growth needs. 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.
The parent company’s primary means of meeting liquidity requirements are dividends from our insurance subsidiary, investment income and sale proceeds from investments held at the parent company level. The parent company’s primary contractual obligations are interest and principal payments on long- and short-term debt as described under Contractual Obligations, Page 81. Other uses of parent company cash include dividends to shareholders, common stock repurchases and general operating expenses described under Other Commitments, Page 81. As of December 31, 2010, the parent company had $1.042 billion in cash and marketable securities, providing strong liquidity to fund uses of cash.
The table below shows a summary, by the direct method, of the major sources and uses of liquidity by the parent company. Dividends received in 2010 from our insurance subsidiary returned to a level near the average of recent years. No dividends were received from our insurance subsidiary in 2009, in order to maintain strong statutory surplus and financial strength ratings. We expect sources of liquidity to increase in 2011 and beyond, primarily from improved profitability from our property casualty operations, funding a potentially larger dividend to the parent company. 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. Share repurchases are discretionary, depending on cash availability and capital management decisions.
Income from our investments is the most important investment contribution to cash flow. While we have never sold investments to make claim payments, the sale of investments could provide an additional source of liquidity at either the parent company or insurance subsidiary level, if required, although we follow a buy-and-hold investment philosophy, seeking to compound cash flows over the long-term. In addition to possible sales of investments, proceeds of call or maturities of fixed maturities also can provide liquidity. During the next five years, $2.804 billion, or 35.4 percent, of our fixed-maturity portfolio will mature. At year-end 2010, total unrealized gains in the investment portfolio, before deferred income taxes, were $1.250 billion. Further,
financial resources of the parent company also could be made available to our insurance subsidiaries, if circumstances required. This flexibility would include our ability to access the capital markets and short-term bank borrowings.
We had $790 million of long-term debt and $49 million in borrowings on our short-term lines of credit at year-end 2010. We generally have minimized our reliance on debt financing although we may use lines of credit 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, Page 118. None of the notes are encumbered by rating triggers:
The company’s senior debt is rated investment grade by independent rating firms. On July 19, 2010, Standard & Poor’s lowered counterparty credit rating for our senior debt from BBB+ to BBB. Three other rating agencies made no changes to our debt ratings in 2010. Our debt ratings from the other rating agencies are: a from A.M. Best, BBB+ from Fitch Ratings and A3 from Moody’s Investors Service.
Our $75 million unsecured line of credit with PNC Bank, N.A. was established more than five years ago and was renewed effective August 30, 2010, for a one-year term to expire on August 28, 2011. CFC Investment Company also is a borrower under this line of credit. PNC Bank is a subsidiary of The PNC Financial Services Group Inc. (NYSE:PNC).
Consistent with our approach since mid-2008, we chose to preserve capital and repurchased a minimal amount of shares. Recent repurchases have been 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. 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 31.
As of December 31, 2010, 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 2011. We discuss outstanding debt in Additional Sources of Liquidity, Page 79.
Property casualty profit-sharing commissions - Profit-sharing, or contingent, commissions are paid to agencies using a formula that takes into account agency profitability and other factors. We estimate 2011 contingent commission payments of approximately $77 million. We discuss commission expense trends in Commercial Lines and Personal Lines Insurance Results of Operations, Page 54 and Page 64, respectively.
Qualified pension plan - In 2011, we made a voluntary cash contribution of $35 million to our qualified pension plan. We currently estimate a $13 million net pension expense and a $8 million expense for company 401(k) contributions. Going forward, we anticipate a lower cash pension contribution.
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 $8 million in spending for key technology initiatives in 2011. Capitalized development costs related to key technology initiatives totaled $7 million in 2010, $28 million in 2009 and $38 million in 2008. These activities are conducted at our discretion, and we have no material contractual obligations for activities planned as part of these projects.
In any year, we consider the most likely source of pressure on liquidity would be an unusually high level of catastrophe loss payments within a short period of time. There could also be additional obligations for our insurance operations due to increasing severity or frequency of non-catastrophe 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 2011 Reinsurance Programs, Page 90. We also monitor the financial condition of our reinsurers because an insolvency could place in jeopardy a portion of our $572 million in outstanding reinsurance recoverables as of December 31, 2010.
Our estimate of future gross property casualty loss and loss expense payments of $4.137 billion is lower than loss and loss expense reserves of $4.200 billion as of year-end 2010. The $63 million difference is due to life and health loss reserves, as discussed in Item 8, Note 5 of the Consolidated Financial Statements, Page 117.
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 5.0 years at year-end 2010. By contrast, the duration of our loss and loss expense reserves was approximately three and one-half 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 ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2010 and 2009. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
Section B shows the cumulative net amount paid with respect to the previously recorded reserve as of the end of each succeeding year. For example, as of December 31, 2010, we had paid $1.797 billion of loss and loss expenses in calendar years 2001 through 2010 for losses that occurred in accident years 2000 and prior. An estimated $237 million of losses remained unpaid as of year-end 2010 (net re-estimated reserves of $2.034 billion from Section C less cumulative net paid loss and loss expenses of $1.797 billion).
We carried $134 million of net loss and loss expense reserves for asbestos and environmental claims as of year-end 2010, compared with $118 million for such claims as of year-end 2009. These amounts constitute 3.5 percent and 3.2 percent of total loss and loss expense reserves as of these year-end dates.
Due to these considerations, our actuarial staff elected to use a paid survival ratio method to estimate reserves for incurred but not yet reported asbestos and environmental claims. Although highly uncertain, reserve estimates obtained via this method have developed in a reasonably stable fashion since 2004. Since our exposure to such claims is limited, we believe the paid survival ratio method is sufficient. Reserves for asbestos and environmental claims increased in 2010 as a result of changes in the identification of asbestos and environmental losses and is not related to new or additional asbestos and environmental exposures.
For the business lines in the commercial lines insurance segment, the following table shows the components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves for the segment in total grew less than 1 percent from year-end 2009.
The following table shows net reserve changes at year-end 2010, 2009 and 2008 by commercial line of business and accident year:
Overall favorable development for commercial lines reserves of $269 million in 2010 illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. Favorable reserve development of $186 million for the commercial casualty line accounted for approximately 70 percent of the segment total in 2010, while favorable reserve development of $39 million for the workers’ compensation line accounted for approximately 15 percent of the segment total in 2010. Drivers of significant reserve development are discussed below.
Commercial casualty loss emergence - As in 2009, commercial multiple peril liability coverages contributed to favorable reserve development because both paid loss and reported loss emergence deviated favorably from projections. Actual paid losses in calendar year 2010 fell short of the amount projected at year-end 2009 by more than $20 million. Reported losses for accident years 2007 through 2009 also developed more favorably than expected, while reported loss development related to other accident years aligned more closely with expectations.
Workers’ compensation trends and initiatives - Favorable calendar year development was $39 million. Accident year 2009 contributed $54 million in favorable development while accident years 2003 and prior developed adversely by $11 million. Higher than anticipated trend continues to plague the older accident years causing us to raise our paid loss trend estimate for the second year in a row. However, projections of ultimate loss for accident years 2004-2008 held steady. The improvement in accident year 2009 is likely an early manifestation of several claims initiatives begun in the first part of 2010, as discussed in Commercial Lines Insurance Results of Operations, Commercial Lines of Business Analysis, Page 58.
For the business lines in the personal lines insurance segment, the following table shows the components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves for the segment in total were fairly stable, up approximately 1 percent from year-end 2009.
The following table shows net reserve changes at year-end 2010, 2009 and 2008 by personal line of business and accident year:
For the excess and surplus lines insurance segment, the following table shows the components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were up from year-end 2009 primarily due to the increase in premiums and exposures for this segment, as we discussed in Excess and Surplus Lines Insurance Results of Operations, Page 70. Favorable development during 2010 of $1 million for excess and surplus lines insurance segment reserves illustrates the potential for revisions inherent in estimating reserves. Factors affecting the modest favorable reserve development included the lack of a sufficiently long experience period on which to base reserve estimates.
Our estimates of gross life, annuity and disability obligations do not reflect net recoveries from reinsurance agreements. Ceded life reinsurance receivables were $228 million at year-end 2010. As discussed in 2011 Reinsurance Programs, Page 90, we purchase reinsurance to mitigate our life insurance risk exposure. At year-end 2010, ceded death benefits represented approximately 47.2 percent of our total policy face amounts in force.
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions about the appropriate level of risk retention are affected by various factors, including changes in our underwriting practices, capacity to retain risks and reinsurance market conditions. 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.
Primary components of the 2011 property and casualty reinsurance program include:
After reinsurance, our maximum exposure to a catastrophic event that caused $500 million in covered losses would be $88 million compared with $104 million in 2010. The largest catastrophe loss in our history was Hurricane Ike in September 2008, which was estimated to be $142 million before reinsurance at December 31, 2010. The treaty contains one reinstatement provision.
Individual risks with insured values in excess of $25 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 $25 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 which are between $25 million and $27 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 2010 was $369 million (20 percent of 2009 subject premiums), and we estimate it is $366 million (20 percent of 2010 subject premiums) in 2011.
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 The Cincinnati Specialty Underwriters Insurance Company. Losses between $1 million and $11 million are reinsured at 100 percent by The Cincinnati Insurance Company.
Basket retention - The Cincinnati Specialty Underwriters Insurance Company has purchased this coverage to limit our retention to $1 million in the event that the same occurrence results in both a property and a casualty loss.
Property catastrophe treaty - As a subsidiary of The Cincinnati Insurance Company, The Cincinnati Specialty Underwriters Insurance Company has been added as a named insured under our corporate property catastrophe treaty. All terms and conditions of this treaty apply to policies underwritten by The Cincinnati Specialty Underwriters Insurance Company.
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 24. 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.
Significant rise in losses from surety and director and officer policies written for financial institutions
Difficulties with technology or data security breaches that could negatively affect our ability to conduct business and our relationships with agents, policyholders and others
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, 2010. Its report is on Page 100. 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 that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP and that receipts and expenditures of the company are being made only in accordance with authorizations of management and the directors of the company; and
The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2010, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment was based on the criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and was designed to provide reasonable assurance that the company maintained effective internal control over financial reporting as of December 31, 2010. The assessment led management to conclude that, as of December 31, 2010, the company’s internal control over financial reporting was effective based on those criteria.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the company) as of December 31, 2010 and 2009, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. 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, 2010, based on criteria established in the Internal Control - Integrated Framework 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 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.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) 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.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the company as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
As discussed in Note 1 to the consolidated financial statements, the company changed its method of accounting for the recognition and presentation of other-than-temporary impairments in 2009.
Our consolidated financial statements include the accounts of the parent and its subsidiaries, each of which are wholly owned, and are presented in conformity with accounting principles generally accepted in the United States of America (GAAP). All significant intercompany balances and transactions have been eliminated in consolidation.
In the first quarter of 2010, we changed our presentation of earned premiums in our consolidated statements of income. We have summarized property casualty and life earned premiums to a single caption, “Earned premiums.” See Note 10, Reinsurance, Page 119, for further detail on property casualty and life earned premiums.
In the second quarter of 2010, we changed our presentation of long-term debt in our consolidated balance sheets. We have summarized the long-term debt to a single caption, “Long-term debt.” See Note 8, Senior Debt, Page 118, for further detail on interest rates, year of issue and maturity of our long-term debt.
In the fourth quarter of 2010, we revised our reportable segments to establish a separate reportable segment for excess and surplus lines. This segment includes results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources. Historically, the excess and surplus lines results were reflected in Other. We began offering excess and surplus lines insurance products in 2008. Separating excess and surplus lines into a reportable segment allows readers to view this business in a manner similar to how it is managed internally when making operating decisions. Prior period data included in this annual report has been recasted to represent this new segment.
We sponsor a defined benefit pension plan that was modified during 2008. We froze entry into the pension plan, and only participants 40 years of age or older could elect to remain in the plan. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method. Refer to Note 13, Employee Retirement Benefits, Page 121 for more information regarding our defined benefit pension plan.
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. 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 analyze our acquisition cost assumptions periodically to reflect actual experience and we test for potential premium deficiencies.
Certain property casualty policies are not booked before the effective date. An actuarial estimate is made to determine the amount of unbooked written premiums. The majority of the estimate is unearned and does not have a material impact on earned premium.
The consolidated property casualty companies actively write property casualty insurance through independent agencies in 39 states. Our 10 largest states generated 67.1 percent and 68.1 percent of total earned premiums in 2010 and 2009. Ohio, our largest state, accounted for 20.5 percent and 21.0 percent of total earned premiums in 2010 and 2009. Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each accounted for between 4 percent and 9 percent of total earned premiums in 2010. Our largest single agency relationship accounted for approximately 1.2 percent of the company's total earned premiums in 2010.
Certain workers’ compensation policies include the possibility of a policyholder earning a return of a portion of its premium in the form of a policyholder dividend. The dividend generally is calculated by determining the profitability of a policy year along with the associated premium. We reserve for all probable future policyholder dividend payments. We incur policyholder dividends as underwriting, acquisition and insurance expenses.
Whole life insurance and disability income insurance are examples. Some traditional long-duration contracts have premium payment periods shorter than the period over which coverage is provided. For these contracts, the excess of premium over the amount required to pay expenses and benefits is recognized over the term of the coverage rather than over the premium payment period. Ten-pay whole life insurance is an example.
We establish a liability for traditional long-duration contracts as we receive premiums. The amount of this liability is the present value of future expenses and benefits less the present value of future net premiums. Net premium is the portion of gross premium required to provide for all expenses and benefits. We estimate future expenses and benefits and net premium using assumptions for expected expenses, mortality, morbidity, withdrawal rates and investment income. We include a provision for deviation, meaning we allow for some uncertainty in making our assumptions. We establish our assumptions when the contract is issued and we generally maintain those assumptions for the life of the contract. 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 assumption for expected expenses. We base our assumption for expected investment income on our own experience, adjusted for current economic conditions.
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, 2010, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders’ account value by approximately $15 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.
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 related to separate accounts consist of contractual fees and mortality, surrender and expense risk charges. Also, each separate account BOLI includes a negotiated capital gain and loss sharing arrangement with the company. A percentage of each separate account’s realized capital gain and loss representing contract fees and assessments accrues to us and is transferred from the separate account to our general account and is recognized as revenue or expense.
On April 1, 2009, we adopted a subsection of 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 subsection of ASC 320 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 (AOCI).
Included within our other invested assets are $40 million of life policy loans, $28 million of venture capital fund investments and $5 million of investments in real estate. Life policy loans are carried at the receivable value, which approximates fair value. We use the equity method of accounting for venture capital fund investments. The venture capital funds provide their financial statements to us and generally report investments on their balance sheets at fair value. Investment in real estate consists of one office building that is carried at cost less accumulated depreciation.
We account for our investment portfolio at fair value and apply fair value measurements as defined by ASC 820, Fair Value Measurements and Disclosures, to financial instruments. Fair value is applicable to ASC 320, Investments-Debt and Equity Securities, ASC 815, Derivatives and Hedging, and ASC 825, Financial Instruments.
We account for derivative financial instruments as defined by ASC 815, Derivatives and Hedging. The hedging definitions included in ASC 815 guide our recognition of the changes in the fair value of derivative financial instruments as realized gains or losses in the consolidated statements of income or as a component of AOCI in shareholder’s equity in the period for which they occur.
We calculate deferred income tax liabilities and assets using tax rates in effect for the time when temporary differences in financial statement income and taxable income are expected to reverse. We recognize deferred income taxes for numerous temporary differences between our taxable income and financial statement income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains and losses on investments and differences in the recognition of deferred acquisition costs and insurance reserves. We charge deferred income taxes associated with unrealized appreciation and depreciation (except the amounts related to the effect of income tax rate changes) to shareholders’ equity in AOCI. We charge deferred taxes associated with other differences to income.
See Note 11, Income Taxes, Page 120, for further detail on our uncertain tax positions. Although no Internal Revenue Service (IRS) penalties currently are accrued, if incurred, they would be recognized as a component of income tax expense. Accrued IRS interest expense is recognized as other operating expense in the consolidated statements of income.
In October 2010, the FASB issued ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. ASU 2010-26 modifies the definitions of the type of costs incurred by insurance entities that can be capitalized in the successful acquisition of new and renewal insurance contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. The effective date of ASU 2010-26 is for interim and annual reporting periods beginning after December 15, 2011. The ASU has not yet been adopted, and we are currently evaluating the impact this ASU will have on our company’s financial position, cash flows or results of operations.
In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU 2010-20 will improve transparency in financial reporting for companies that hold financing receivables, which include loans, lease receivables and other long-term receivables. The additional disclosures required by ASU 2010-20 are effective for interim and annual reporting periods ending on or after December 15, 2010. The ASU did not have a material impact on our company’s financial position, cash flows or results of operations.
The unrealized investment gains at December 31, 2010, were largely due to a net gain position in our fixed income portfolio of $495 million and a net gain position in our common stock portfolio of $729 million. The two primary contributors to the net gain position were The Procter & Gamble Company (NYSE:PG) and Exxon Mobil Corporation (NYSE:XOM) common stocks, which had a combined net gain position of $237 million. At December 31, 2010, we had $69 million fair value of hybrid securities included in fixed maturities that follow ASC 815-15-25, Accounting for Certain Hybrid Financial Instruments. The hybrid securities are carried at fair value, and the changes in fair value are included in realized investment gains and losses.
During 2010, we impaired 15 securities. At December 31, 2010, 17 fixed-maturity investments with a total unrealized loss of $4 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed maturity investments were trading below 70 percent of book value. Three equity investments with a total unrealized loss of $1 million had been in an unrealized loss position for 12 months or more as of December 31, 2010. Of that total, no equity investments were trading below 70 percent of book value.
During 2009, we impaired 50 securities. At December 31, 2009, 121 fixed-maturity investments with a total unrealized loss of $25 million had been in an unrealized loss position for 12 months or more. Of that total, eight fixed maturity investments were trading below 70 percent of book value with a total unrealized loss of $2 million. Ten equity investments with a total unrealized loss of $26 million had been in an unrealized loss position for 12 months or more as of December 31, 2009. Of that total, no equity investments were trading below 70 percent of book value.
When determining OTTI charges for our fixed-maturity portfolio, management places significant emphasis on whether issuers of debt are current on contractual payments and whether future contractual amounts are likely to be paid. As required by ASC 320 effective April 1, 2009, our invested asset impairment policy for fixed-maturity securities states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed maturity security; (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 period in which it is recognized. When we believe that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount to the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the period in which it occurred. The difference between the fair value and the net present value of the cash flows of the security, the non-credit loss, is recognized in other comprehensive income as an unrealized loss.
With the adoption of ASC 320 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 AOCI. ASC 320 does not allow retrospective application of the new OTTI model. Our consolidated statements of income for the year ended December 31, 2010 and 2009, are not measured on the same basis as December 31, 2008, and, accordingly, these amounts are not comparable.
For each of our equity securities in an unrealized loss position at December 31, 2010, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong surplus, liquidity and cash flow, provides us the ability to hold these investments through what we believe to be slightly longer recovery periods occasioned by the recession and historic levels of market volatility. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition
Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is identified in the table below by security type with a summary of changes in fair value for the year ended December 31, 2010 and 2009. As of December 31, 2010 and 2009, total Level 3 assets were less than 1 percent of financial assets measured at fair value. At December 31, 2010, total fair value of assets priced with broker quotes and other non-observable market inputs for the fair value measurements and disclosures was $31 million.
The following tables explain changes to Level 3 securities during 2010 and 2009:
The expenses associated with issuing insurance policies - primarily commissions, premium taxes and underwriting costs - are deferred and amortized over the terms of the policies. We update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate our deferred acquisition costs for recoverability. The table below shows the deferred policy acquisition costs and asset reconciliation, including the amortized deferred policy acquisition costs.
We use actuarial methods, models and judgment to estimate, as of a financial statement date, the property casualty loss and loss expense reserves required to pay for and settle all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date. The actuarial estimate is subject to review and adjustment by an inter-departmental committee that includes actuarial management and is familiar with relevant company and industry business, claims and underwriting trends, as well as general economic and legal trends, that could affect future loss and loss expense payments. The amount we will actually have to pay for claims can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate.
Reserves for deferred annuities and other investment contracts were $930 million and $736 million at December 31, 2010, and December 31, 2009, respectively. Fair value for these deferred annuities and investment contracts was $933 million and $737 million at December 31, 2010, and December 31, 2009, 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, 2010, to account for non-performance risk; (2) the rate of interest credited to
The fair value of our senior debt approximated $783 million at year-end 2010 compared with $740 million at year-end 2009. Fair value for 2010 and 2009 was determined under ASC 820 based on market pricing of these or similar debt instruments that are actively trading. Fair value can vary with macroeconomic concerns. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt remained unchanged from year-end 2009. None of the notes are encumbered by rating triggers.
As of December 31, 2010, 6 million shares of common stock were available for future equity award grants.
For the year ended December 31, 2010, a reserve reduction occurred in our USAIG pool. Therefore, direct and ceded incurred loss and loss expenses were reduced by $33 million, so there was no effect on net incurred loss and loss expenses.
Our consolidated statements of income include earned life insurance premiums on assumed and ceded business:
As a result of positions taken in our federal tax returns filed with the IRS, we believe it is more likely than not that tax positions for which we previously carried a liability for unrecognized tax benefits will be sustained upon examination by the IRS.
In December 2010, we reached agreement with the IRS settling all issues related to the 2007 and 2008 tax years. As a result of this IRS agreement, there is no liability for unrecognized tax benefits as of December 31, 2010. Tax year 2009 has not been audited by the IRS and remains open for examination.
Basic earnings per share are computed based on the weighted average number of shares outstanding. Diluted earnings per share are computed based on the weighted average number of common and dilutive potential common shares outstanding. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2010.
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. In addition, we froze entry into the pension plan for new associates as of June 30, 2008. Only participants 40 years of age or older as of August 31, 2008, could elect to continue to participate. For participants who left the pension plan, benefit accruals were frozen as of August 31, 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 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 evaluate our pension plan assumptions annually and update them as necessary. The discount rate assumptions for our benefit obligation generally track with high grade corporate bond yields and yearly adjustments reflect any changes to those bond yields. We believe the expected return on plan assets is
representative of the expected long-term rate of return on these assets. Our compensation increase assumptions reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases.
The total recognized in net periodic benefit cost and other comprehensive income was $9 million, $25 million and $62 million for the years ended December 31, 2010, 2009 and 2008, respectively. The estimated costs to be amortized from AOCI into net periodic benefit cost over the next year for our plans are a $3 million actuarial loss and a $1 million prior service cost.
On February 1, 2011, we contributed $35 million to our qualified plan. We also expect to pay $2 million to the SERP during 2011. We expect to make the following benefit payments for our qualified plan and SERP, reflecting expected future service:
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $6 million, $6 million and $6 million on premium volume of approximately $36 million, $36 million and $38 million for 2010, 2009 and 2008, respectively.
The company and its subsidiaries also are occasionally involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, 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. From time to time, the company also becomes aware of incidents that could result in liability, with or without litigation or regulatory action, for example, data processing errors by third-party vendors servicing certain of our employee benefit plans.
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, including some with market-based performance objectives, under our shareholder-approved plans. We also have a Holiday Stock Plan that permits annual awards of one share of common stock to each full-time associate for each full calendar year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant stock to our outside directors as a component of their annual compensation.
Stock 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
Risk-free rates are the implied yield currently available on U.S. Treasury issues with a remaining term approximating the expected term.
The weighted-average remaining contractual life for exercisable awards as of December 31, 2010, was 3.5 years. A total of 16.9 million shares are authorized to be granted under the shareholder-approved plans. At December 31, 2010, 6.0 million shares were available for future issuance under the plans. During 2009, our shareholders approved the Directors’ Stock Plan of 2009, which authorizes 300,000 shares to be granted to our directors. During 2010 we granted 31,310 shares of common stock to our directors for 2009 board service fees. We currently issue new shares or use treasury shares for stock-based compensation award issues or exercises.
If certain performance conditions are attained, performance-based restricted stock units vest on the first day of March after a three-calendar-year performance period. Quarterly, management reviews and determines the likelihood that the company will achieve the conditions for the outstanding groups of performance restricted stock units and recognizes related compensation costs in accordance with ASC 718, Compensation, Stock Compensation.
Correlation coefficients are based upon the price data used to calculate the historical volatilities. The correlation coefficients are used to model the way in which each entity tends to move in relation to each other.
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 yield range from 5.41%-5.94% for 2010 grants and 5.87% for 2008 grants.
We report as Other the non-investment operations of the parent company and its non-insurer subsidiary, CFC Investment Company. Also included in 2009 and 2008 results for this segment are the operations of a former subsidiary, CinFin Capital Management.
Fee revenues for the commercial and personal insurance segments primarily represent installment fees. Previously the fee revenues were reflected in Other. Prior period data included in this annual report has been adjusted to reflect this new presentation.
For the life insurance segment, we calculate underwriting income or loss by recording premiums earned and separate account investment management fees, minus contract holders’ benefits and expenses incurred, plus investment interest credited to contract holders.
This table includes unaudited quarterly financial information for the years ended December 31, 2010 and 2009: