Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building has 1,508,200 square feet of total space. The property, including land, is carried in our financial statements at $137 million as of December 31, 2014, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies 6,750 square feet (less than 1 percent). This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
The Cincinnati Insurance Company owns the CFC Winton Center used for business continuity, with approximately 48,000 square feet of total space, located approximately six miles from our headquarters. The property, including land, is carried on our financial statements at $10 million as of December 31, 2014, and is classified as land, building and equipment, net, for company use. This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
* Realized investment gains and losses are integral to our financial results over the long term, but our substantial discretion in the timing of investment sales may cause this value to fluctuate substantially. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results.
Our value creation ratio, defined above, is our primary performance target. VCR trends are shown in the table below.
subsequent five-year period, as indicated by a significant negative effect in 2013, management believes the company will continue to produce strong underwriting results.
The 2014 value creation ratio included operating results as its primary contributor, with higher valuation for our equity securities investment portfolio also contributing significantly. A higher valuation for our fixed-maturity securities investment portfolio also contributed, reversing the unfavorable 2013 effect that reflected lower valuation. The 2014 contribution from operating results was 1.3 percentage points lower than in 2013, while the contribution from realized gains plus the change in unrealized gains from our investment portfolios was 0.9 points lower. The 2013 VCR also benefited from other items that affected book value per share, primarily a contribution from updated valuations and related assumptions for our employee benefit pension plan, while the 2014 effect was minimal. The 2012 value creation ratio had contribution amounts fairly similar to 2014.
Premium growth - We believe over any five-year period our agency relationships and initiatives can lead to a property casualty written premium growth rate that exceeds the industry average. The compound annual growth rate of our net written premiums was 7.3 percent over the five-year period 2010 through 2014, approximately double the 3.4 percent estimated growth rate for the property casualty insurance industry. The industry’s growth rate excludes its mortgage and financial guaranty lines of business. Our long-term target for profitable premium growth, established in late 2011 for our property casualty and life insurance segments in aggregate, is to reach $5 billion of annual direct written premiums by the end of 2015. In 2014, our direct written premiums totaled $4.577 billion.
Investment income growth, on a pretax basis, had a compound annual growth rate of 1.8 percent over the five-year period 2010 through 2014. It has grown every year since 2009, except for 2013 with its slight decrease of less than 1 percent.
The board of directors is committed to rewarding shareholders directly through cash dividends and share repurchase authorizations. The board also has periodically declared stock dividends and splits. Through 2014, the company has increased the indicated annual cash dividend rate for 54 consecutive years, a record we believe is matched by only nine other publicly traded companies. The board regularly evaluates relevant factors in dividend-related decisions, and the 2014 increase reflects confidence in our strong capital, liquidity and financial flexibility, as well as progress through our initiatives to improve earnings performance while growing insurance premium revenues. We discuss our financial position in more detail in Liquidity and Capital Resources.
Total investments grew 6 percent during 2014 on a fair value basis, with market gains that added to the 4 percent increase in the cost basis. Entering 2015, we believe the portfolio continues to be well diversified and is well positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, and results for the segment in Investments Results. Total assets rose 6 percent, primarily due to the increase in total investments. Shareholders’ equity and book value per share each rose 8 percent, for reasons discussed in the preceding Executive Summary.
Net income in 2014 rose $8 million or 2 percent compared with 2013, due primarily to the after-tax effects of net realized investment gains that were $31 million higher and investment income that rose by $18 million. Property casualty underwriting results for 2014, on an after-tax basis, were $31 million lower than in 2013, including $21 million from higher natural catastrophe losses and $34 million from higher noncatastrophe weather losses described below in Consolidated Property Casualty Insurance Results.
Net income increased $96 million in 2013, compared with 2012, reflecting the after-tax net effect of two major contributing items: a $62 million improvement in property casualty underwriting results, including $105 million from lower catastrophe losses, and a $26 million increase in net realized investment gains.
We discuss these strategic initiatives, along with related metrics to assess progress, in Item 1, Our Business and Our Strategy, Strategic Initiatives. Detailed discussion of related financial results appears below in Financial Results and Liquidity and Capital Resources.
Our view of the shareholder value we can create over the next five years relies largely on three assumptions - each highly dependent on the external environment. First, we anticipate our average commercial and personal insurance prices will increase in excess of our loss cost trends. Second, we assume that the economy can maintain a growth track during 2015. Third, we assume that valuations of our marketable securities will vary within a typical range, based on historical trends. If those assumptions prove to be inaccurate, we may not be able to achieve our performance targets even if we accomplish our strategic objectives.
We expect the independent insurance agency system to remain strong, with continued agency consolidation. If soft insurance market conditions return in 2015, it will create additional risk for agencies.
We expect initiatives that make it easier for agents to do business with us to continue to be a significant factor in agency relationships. Technology is a major driver, with policyholders increasingly demanding online services and access from agents or carriers.
The slowly recovering economy continued to help increase the value of business and personal insurable assets owned by policyholders in 2014. If the economy falters, we may experience low or no premium growth for the property casualty industry. Property casualty written premium growth also may lag as some of our growth initiatives require more time to reach their full contribution.
We will incur costs for continued investment in our business, including technology, geographic expansion and process initiatives to create long-term value. In addition, we will not see the full advantage of some of these investments for several years.
For some lines of business that we write, a considerable and uncertain amount of time can elapse between the occurrence, reporting and payment of insured claims. The amount we will actually have to pay for such claims also can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. Gross loss and loss expense reserves were $4.438 billion at year-end 2014 compared with $4.241 billion at year-end 2013.
For asbestos and environmental claims, we calculate IBNR reserves by deriving an actuarially-based estimate of total unpaid loss and loss expenses. We then reduce the estimate by total case reserves. We discuss the reserve analysis that applies to asbestos and environmental reserves in Liquidity and Capital Resources, Asbestos and Environmental Reserves.
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, such as:
Quarterly, our actuarial staff summarizes their reserve analysis by preparing an actuarial best estimate and a range of reasonable IBNR reserves intended to reflect the uncertainty of the estimate. An inter-departmental committee that includes our actuarial management team reviews the results of each quarterly reserve analysis. The committee establishes management’s best estimate of IBNR reserves, which is the amount that is included in each period’s financial statements. In addition to the information provided by actuarial staff, the committee also considers factors such as:
Emergence of loss and defense and cost containment expenses, also referred to as DCCE, on an accident year basis. Historical paid loss, reported loss and paid DCCE data for the business lines we analyze contain patterns that reflect how unpaid losses, unreported losses and unpaid DCCE as of a financial statement date will emerge in the future on an accident year basis. Unless our actuarial staff or management identifies reasons or factors that invalidate the extension of historical patterns into the future, these patterns can be used to make projections necessary for estimating IBNR reserves. Our actuaries significantly rely on this assumption in the application of all methods and models mentioned above.
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 DCCE ratios used by the Bornhuetter-Ferguson reserving methods. They may 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.
The application of our impairment policy resulted in other-than-temporary impairment (OTTI) charges that reduced our income before income taxes by $24 million in 2014, $2 million in 2013 and $33 million in 2012. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, the value is not expected to be recouped within a designated recovery period. OTTI losses represent noncash charges to income and are reported as realized investment losses.
Management ultimately determined the pricing for each Level 3 security that we considered to be the best exit price valuation. As of December 31, 2014, 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 and evaluated two nonbinding quotes from brokers; our investment professionals determine our best estimate of 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, 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.
Key assumptions used in developing the 2014 net pension expense for our qualified plan were a 5.15 percent discount rate, a 7.25 percent expected return on plan assets and rates of compensation increases ranging from 2.75 percent to 3.25 percent.
In 2014, the net pension expense was $13 million. In 2015, we expect the net pension expense to be approximately $14 million.
For property casualty insurance policies, deferred acquisition costs are amortized over the terms of the policies. These costs are principally agent commissions, premium taxes and certain underwriting costs related to successful contract acquisition, which are deferred and amortized into net income as premiums are earned. We assess recoverability of deferred acquisition costs at the segment level, consistent with the ways we acquire, service, manage and measure profitability. Deferred acquisition costs track with the change in premiums. Our property casualty insurance operations consist of three segments, commercial lines insurance, personal lines insurance and excess and surplus lines insurance.
The table below highlights property casualty results, with analysis and discussion in the sections that follow.
Premiums - Strong growth in renewal written premiums drove increases in earned premiums and net written premiums for both 2014 and 2013, rising in each of our property casualty segments. Higher and more precise pricing continues to benefit operating results and is further discussed by segment in the results sections below. New business written premiums in 2014 were down $40 million, compared with the record-high amount we reported in 2013. The year 2013 also represented the sixth straight year of higher new business premiums, reflecting our premium growth initiatives from recent years. Those initiatives also favorably affect growth in subsequent years, particularly as newer agency relationships mature over time. Agents appointed during 2014 or
2013 produced an increase in standard lines new business of $20 million during 2014, compared with 2013. A higher level of insured exposures, reflecting improvement in some areas of the economy, also favorably affected growth in net written premiums, primarily in our commercial lines insurance segment. The contributions to commercial lines premiums from audits, which are significantly affected by economic trends, are further discussed in Commercial Lines Insurance Results.
Other written premiums - primarily premiums ceded to our reinsurers as part of our reinsurance program - in total reduced 2014 net written premiums by $11 million more than in 2013. A decrease in ceded premiums contributed $22 million to net written premium growth for 2014, compared with 2013. Other written premiums also included a less favorable adjustment for 2014, compared with 2013, for estimated direct written premiums of policies in effect but not yet processed in our commercial lines insurance segment. This written premium adjustment has an immaterial effect on earned premiums.
Catastrophe loss trends are an important factor in assessing trends for overall underwriting results. Our 10-year historical annual average contribution of catastrophe losses to the combined ratio was 6.0 percentage points at December 31, 2014. Our five-year average was 7.4 percentage points.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the consolidated property casualty insurance results three-year highlights table are for the respective current accident years, with reserve development on prior accident years shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid amounts, 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 66.0 percent accident year 2013 loss and loss expense ratio reported as of December 31, 2013, developed favorably by 1.6 percentage points to 64.4 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2014. Accident years 2013 and 2012 have both developed favorably, as indicated by the progression over time for the ratios in the table.
The 61.7 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2014 rose 1.1 percentage points compared with the 60.6 percent accident year 2013 ratio measured as of December 31, 2013. Noncatastrophe weather losses and higher commercial casualty IBNR, noted above, largely accounted for the increase and offset favorable effects from initiatives to improve pricing precision and loss experience related to claims and loss control practices.
In 2014, total large losses incurred decreased by $25 million or 11 percent, net of reinsurance. The corresponding ratio decreased 1.1 percentage points. Large loss trends are further analyzed in the segment discussion and analysis that follows discussion of consolidated property casualty results. Our analysis of large losses incurred indicated no unexpected concentration of these losses and reserve increases by geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
Consolidated property casualty commission expenses rose $39 million or 6 percent in 2014, with profit-sharing commissions for agencies rising by $10 million. Commission expenses as a percent of earned premiums resulted in a ratio that was 0.6 percentage points lower than in 2013, primarily due to lower commission rates for selected personal lines insurance products, beginning in March of 2014. The 2014 ratio for other underwriting expenses was 0.7 percentage-points lower than 2013, reflecting a 9 percent increase in earned premiums that was higher than the
Salaries, benefits and payroll taxes for our associates account for approximately half of our property casualty other underwriting expenses. Most of our associates either provide direct service to the property casualty portion of our agencies’ businesses or provide support to those associates. Since the end of 2009, the total number of associates, on a consolidated basis, rose by 3 percent, reflecting careful management of our noncommission expenses during a period of significant premium growth. The total number of field associates providing direct service to agencies rose by 12 percent, reflecting our emphasis on providing excellent service in addition to territory expansion.
Discussions below of our property casualty insurance segments provide additional detail about our results.
Premiums - Earned premiums and net written premiums each rose again in 2014, primarily due to a $207 million increase in renewal written premiums, which continued to reflect improved pricing. New business written premiums in 2014 were down $31 million, or 8 percent, compared with the record-high amount we reported in 2013.
Combined ratio - The 2014 combined ratio rose 2.1 percentage points compared with 2013, largely reflecting a 0.6 percentage-point increase in the ratio for natural catastrophe losses and a 1.0 point increase for noncatastrophe weather losses. Those unfavorable weather effects somewhat offset benefits from higher pricing and from recent-year initiatives to improve pricing precision and loss experience related to claims and loss control practices. Development on prior accident years’ loss and loss expense reserves before catastrophes during 2014 was 1.5 percentage points less favorable than in 2013, including 0.7 points from re-estimates of IBNR reserves for losses and loss expenses.
Our largest commercial line of business, commercial casualty, experienced an increase in its 2014 total loss and loss expense ratio. While that line was still profitable in 2014, its higher ratio had the effect of increasing our 2014 commercial lines insurance segment total loss and loss expense ratio by 4.2 percentage points, compared with 2013. As a percentage of its $938 million in 2014 earned premiums, our commercial casualty line of business experienced ratio increases of 1.6 points for paid losses and loss expenses for accident years three or more years ago in aggregate and 6.2 points for estimates of IBNR losses and loss expenses for all accident years in aggregate.
As discussed in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, stable historical paid loss patterns are a key assumption used to make projections necessary for estimating IBNR reserves. During 2014, paid losses for commercial casualty, especially related to a few umbrella liability claims, emerged at levels higher than we expected, particularly for accident years 2005 and 2007. Considering that new data, we estimated commercial casualty IBNR reserves for subsequent accident years at levels more likely to be adequate, compared with estimates at the end of 2013.
We continue to refine our use of predictive analytics tools to improve pricing precision as we further segment commercial lines policies, emphasizing identification and retention of policies we believe have relatively stronger price adequacy. These tools better align individual insurance policy pricing to risk attributes, providing our underwriters with enhanced abilities to target profitability and to discuss pricing impacts with agency personnel. We also continue to leverage our local relationships with agents through the efforts of our teams that work closely with them. We believe our field focus is unique and has several advantages, including providing us with quality intelligence on local market conditions. We seek to maintain appropriate pricing discipline for both new and renewal business as management emphasizes the importance of our agencies and underwriters assessing account quality to make careful decisions on a case-by-case basis whether to write or renew a policy. Rate credits may be used to retain renewals of quality business and to earn new business, but we do so selectively in order to avoid commercial accounts that we believe have insufficient profit margins.
Our 8 percent increase in 2014 agency renewal written premiums largely reflected higher pricing and improving economic conditions. We measure average changes in commercial lines renewal pricing as the rate of change in renewal premium for the new policy period compared with the premium for the expiring policy period, assuming no change in the level of insured exposures or policy coverage between those periods for respective policies. In 2014, our standard commercial lines policies averaged an estimated pricing change that increased near the high end of the low-single-digit range, compared with a mid-single-digit range in both 2013 and 2012. The average pricing change for policies renewed during 2011 was slightly positive, near the low end of the low-single-digit range. For policies renewed during both 2010 and 2009, the typical pricing change was a decline, on average, in the low-single-digit range. Our average commercial lines pricing change includes the flat pricing effect of certain coverages within package policies written for a three-year term that were in force but did not expire during the period being measured. Therefore, the average commercial lines pricing change we report reflects a blend of policies that did not expire and other policies that did expire during the measurement period.
In recent years prior to 2011, our agency renewal written premium trends included an unfavorable effect from the economic downturn and slow recovery in various regions. Each year since then, the effect was favorable. Changes in the economy affect insured exposures that directly relate to premium amounts for any given policy. For commercial accounts, we usually calculate initial estimates for general liability premiums based on estimated sales or payroll volume, while we calculate workers’ compensation premiums based on estimated payroll volume. A change in sales or payroll volume generally indicates a change in demand for a business’s goods or services, as well as a change in its exposure to risk. Policyholders who experience sales or payroll volume changes due to economic factors may also have other exposures requiring insurance, such as commercial auto or commercial property. Premium levels for these other types of coverages generally are not linked directly to sales or payroll volumes.
In 2014, our commercial lines new business premiums written by our agencies decreased 8 percent or $31 million, compared with 2013. Commercial lines new business premiums written rose 11 percent in 2013 to a record-high amount of $391 million. In 2014, our workers' compensation line of business decreased by $18 million, reflecting strong competition in the marketplace and accounting for much of the $31 million commercial lines decrease. For new business, our field associates are frequently in our agents’ offices to: help judge the quality of each account; emphasize the Cincinnati value proposition; call on sales prospects with those agents; carefully evaluate risk exposure; and provide 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 new to us and the agency. 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 appointed since the beginning of 2013 produced commercial lines new business written premiums of $24 million during 2014, up $17 million from what they produced during 2013, while all other agencies contributed the remaining $336 million, down $48 million from the $384 million they produced in 2013.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the commercial lines insurance segment three-year highlights table are for the respective current accident years, with reserve development on prior accident years shown separately. Since less than half of our commercial lines insurance segment current accident year incurred losses and loss expenses represents net paid amounts, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously
In 2014, total large losses incurred decreased by $5 million or 3 percent, net of reinsurance. The corresponding ratio decreased 0.8 percentage points. The 2014 decreases on both a dollar and ratio basis were largely due to lower amounts for our workers' compensation line of business and were somewhat offset by higher large losses for our commercial casualty and commercial property lines of business. In 2013, the total large losses incurred ratio was higher than it was in 2012, primarily due to higher large losses for commercial property. 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.
The 2014 total loss and loss expense ratio rose 12.1 percentage points, primarily due to the absence of a benefit from favorable development on prior accident year reserves. As discussed above in the overview section of Commercial Lines Insurance Results, our commercial casualty line experienced a 1.6 point increase in its paid loss and loss expense ratio for cumulative accident years three or more years old, resulting in a significant increase in estimates for IBNR losses and loss expenses for all prior accident years in total. This line of business experienced favorable reserve development in 2013 at a satisfactory level, though less than in 2012. Moderation in loss cost trends, particularly for umbrella liability coverage included in many commercial package accounts, had a larger than usual effect in 2012. Development trends are further discussed in Liquidity and Capital Resources, Property Casualty Insurance Development of Estimated Reserves by Accident Year.
Commercial property net written premiums and earned premiums rose significantly in both 2014 and 2013, largely due to higher pricing, rising insured exposures and migrating certain polices formerly in our other commercial lines category. That ongoing migration pertains to property coverages in CinciPakTM, a newer program designed to replace many of our former specialty products. Premium growth initiatives had a significant effect in 2013, as new business written premiums increased nearly 15 percent.
Workers’ compensation net written premiums decreased in 2014, while earned premiums rose slightly. Both increased in 2013. Average renewal pricing rose in both 2014 and 2013, but an $18 million decrease in new business written premiums in 2014 offset the effect of price increases, netting to the decrease in net written premiums. New business written premiums contributed nearly half of the increase in 2013 net written premiums.
The total loss and loss expense ratio for other commercial lines improved in 2014, compared with 2013. The 2014 improvement was primarily due to more benefit from favorable development on prior accident year reserves. That ratio rose modestly in 2013, compared with 2012, when less benefit from favorable development on prior accident year reserves more than offset lower catastrophe losses. Development on prior accident year reserves was unfavorable in 2013, largely due to experience with our management liability policies. Prior accident year reserve development has been volatile for this business in recent years, reflecting varying loss experience for director and officer liability related to financial institutions we insured during the U.S. credit crisis of 2008. We described how we manage the potentially high risk of writing director and officer liability in Item 1, Commercial Lines Insurance Segment.
We intend to keep marketing our products to a broad range of business classes with a package approach, while also continuing to improve our pricing precision. We intend to maintain our underwriting selectivity and carefully manage our rate levels as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions about rates, the use of three-year commercial policies and other policy conditions on a case-by-case basis, even in lines and classes of business that are under competitive pressure. We believe that our initiatives to improve pricing precision and lower loss costs will continue to benefit commercial lines profitability during 2015, and that recent-year premium growth initiatives will continue to increase commercial lines premiums.
Combined ratio - The 2014 combined ratio rose 2.4 percentage points compared with 2013, largely due to a 1.4 percentage-point increase in noncatastrophe weather losses that were not identified as part of designated catastrophe event for the property casualty industry. That unfavorable weather effect somewhat offset benefits from a 2.1 percentage-point improvement in the underwriting expense ratio, primarily from lower commission rates for selected personal lines insurance products. Development on prior accident years’ loss and loss expense reserves before catastrophes during 2014 was 2.9 percentage points less favorable than in 2013, primarily due to increased estimates of reserves for personal umbrella liability coverage.
In recent years, we have increased our use of pricing precision and implemented numerous rate increases to improve our personal lines insurance segment results. To improve results, we also made more use of higher minimum loss deductibles and nonrenewed more policies in selected areas more prone to natural catastrophes. We have worked to improve our geographic diversification by expanding our personal lines operation to several states less prone to catastrophes.
Our personal lines statutory combined ratio was 99.1 percent in 2014, up from 96.3 percent in 2013 but improved from 104.0 percent in 2012. By comparison, the estimated industry personal lines combined ratio was 98.4 percent in 2014, 97.5 percent in 2013 and 101.3 percent in 2012. Our concentration of business in areas affected by catastrophe events contributed to recent-year results that differed from the overall industry, an issue
Personal lines insurance is a strategic component of our overall relationship with most of our agencies and is an important component of our agencies’ relationships with their clients. We believe agents recommend our personal insurance products for their clients who seek to balance quality and price and who are attracted by our superior claims service and the benefits of our package approach. We also believe our efforts to continue improving pricing precision are helping us attract and retain more of our agencies’ preferred business, while also obtaining higher rates for more thinly-priced business. Our progress toward improved geographic diversification is reflected in part through premium growth trends. Personal lines earned premiums in our four highest volume states increased in aggregate by 4 percent in 2014, while premiums for the remaining states that include our newer areas of operation increased 13 percent in aggregate.
Personal lines new business written premiums were down in 2014, compared with 2013. The downward trend began in the second half of 2013 and was expected due to our higher premium rates and underwriting actions such as expanded use of actual cash value loss settlement for older roofs. For the majority of states where we market personal lines policies, those underwriting actions were effective beginning April 1, 2013.
Other written premiums primarily consist of premiums that are ceded to reinsurers and that lower our net written premiums. Other written premiums contributed to 2014 net written premium growth by $4 million more than in 2013.
Personal lines reserve development on prior accident years continued to net to a favorable amount in 2014, as $12 million was recognized. That total provided $27 million less benefit than the 2013 total of $39 million. Our other personal line of business was primarily responsible for the 2014 decrease, as reserve development from its personal umbrella liability coverage can fluctuate significantly over time. Our personal lines net favorable reserve development on prior accident years recognized during 2014 primarily occurred in our homeowner line of business. Favorable development recognized during 2013 and 2012 was mostly from our homeowner and other personal lines of business. 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, and in Liquidity and Capital Resources, Property Casualty Insurance Development of Estimated Reserves by Accident Year.
In 2014, personal lines total large losses incurred decreased by $18 million or 46 percent, compared with 2013, net of reinsurance. The corresponding ratio decreased 2.1 percentage points. The 2014 decreases on both a dollar and ratio basis were primarily due to lower amounts for our personal auto line of business. In 2013, total large losses increased compared with 2012, primarily due to higher amounts for our other personal line of business. 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.
For 2014, our personal auto line of business had a total loss and loss expense ratio significantly higher than desired. As discussed in the overview section of Personal Lines Insurance Results, and below, we are taking actions to improve pricing and reduce loss costs that we expect to benefit future profitability trends. A similar approach was used to improve the total loss and loss expense ratio for our homeowner line of business to a satisfactory result in 2014 and 2013.
The 2014 total loss and loss expense ratio rose 2.0 percentage points, largely due to a 1.4 point increase for IBNR reserves that contributed to a total increase of 1.7 points in the ratio for the current accident year before catastrophe losses. The 2013 total loss and loss expense ratio increase was primarily due to a reduction in the ratio for favorable reserve development on prior accident years. That reduction related to both case and IBNR reserves. For accident year 2013, a lower catastrophe loss and loss expenses ratio offset a modest increase in the noncatastrophe component. Larger losses, above $250,000 per claim, were $15 million or 37 percent higher in 2013, compared with 2012, contributing to the rise in the total loss and loss expense ratio.
As discussed in Personal Lines Insurance Premiums, we continue to implement rate changes and improve our pricing precision to improve our total loss and loss expense ratio for our personal auto line of business. Rate increases that apply pricing precision features for our personal auto line of business became effective beginning the second-quarter 2014 for the majority of states where we market personal lines products and continue to be implemented. On average, the rate increase percentage was in the low-single-digit range, with approximately half of those states experiencing a mid-single-digit increase. Similar rate increases are planned for the year 2015.
Net written premiums for homeowner rose in both 2014 and 2013, primarily due to higher renewal premiums that largely reflected higher pricing.
The total loss and loss expense ratio for 2014 increased 5.5 percentage points compared with 2013, including 2.8 percentage points from weather-related losses not identified as part of designated catastrophe events for the property casualty industry, also known as noncatastrophe weather losses. The 2013 ratio improvement was largely due to lower catastrophe losses and losses before catastrophes. The 2014 catastrophe loss ratio of 16.1 percentage points was near the 17.4 percent 10-year average for the years 1998 through 2007. For the six-year period 2008 through 2013, the homeowner catastrophe loss ratio averaged 31.5 percent, almost double the average of the previous 10 years. Our pricing models are adjusted annually to account for expected losses from catastrophe perils that relate to causes of insured losses from weather or earthquake catastrophe events.
Other personal premiums grew in both 2014 and 2013. Premium trends for this line of business have generally been similar to the growth pattern of our personal auto and homeowner lines before the effects of reinsurance. Most of our other personal coverages are written in conjunction with homeowner or auto policies. In addition to umbrella liability coverage, our other personal lines policies provide property-oriented coverages such as dwelling fire and inland marine.
A.M. Best projections for 2015 indicate personal lines written premiums for the U.S. property casualty industry may grow approximately 3 percent, with an industry statutory combined ratio estimated at approximately 99 percent. We believe our growth rate will likely be higher than the industry projection for 2015, driven by our rate increases, stable policy retention rate, accelerated pace of new agency appointments in recent years and increased focus on the high net worth personal lines market. Our high net worth initiative, along with various other actions to improve performance in our personal lines insurance segment, is discussed in greater detail in Item 1, Our Business and Our Strategy, Strategic Initiatives, and Personal Lines Insurance Results. Our personal lines pricing trends need to exceed loss trends to improve personal lines profitability, thereby helping to achieve our corporate financial targets. We discuss our overall outlook for our property casualty insurance operations in the Executive Summary.
Premiums - Earned premiums continued to rise in 2014, a result of strong growth in net written premiums, similar to recent years. Growth of net written premiums in 2014 was driven by higher renewal written premiums that included average renewal price increases in a mid-single-digit range. New business written premiums for 2014 again rose, compared with the prior year, largely reflecting strong agency relationships and premium growth initiatives.
New business written premiums for the year 2014 rose 21 percent, compared with 2013, reflecting higher pricing and an increase in submissions from agencies requesting an insurance policy quote. High-quality service provided by excess and surplus lines field marketing representatives and headquarters underwriters enhances the benefits of our strong agency relationships, also helping increase our 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. The majority of the total incurred losses and loss expenses shown in our excess and surplus lines insurance segment three-year highlights table are for the respective current accident years, with reserve development on prior accident years shown separately. Since less than 20 percent of our 2014 excess and surplus lines current accident year incurred losses and loss expenses represents net paid amounts, a large majority represents reserves for our estimate of unpaid losses and loss expenses. These reserves develop over time, and we update our estimates of previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 67.8 percent accident year 2013 loss and loss expense ratio reported as of December 31, 2013, developed favorably by 8.1 percentage points to 59.7 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2014. Accident years 2013 and 2012 for this segment have both developed favorably, as indicated by the progression over time of the ratios in the table.
The 68.1 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2014 rose a modest 1.0 percentage point compared with the 67.1 percent accident year 2013 ratio measured as of December 31, 2013.
We believe the loss and loss expense reserves for our excess and surplus lines business are adequate. We establish case reserves in a manner consistent with standard lines coverages, despite the more restrictive terms and conditions for excess and surplus lines policies. After the first two years of our excess and surplus lines operation, reserves for estimated unpaid losses and loss expenses were $18 million as of December 31, 2009, for losses that occurred in 2008 and 2009. As of December 31, 2014, our estimate for the remaining unpaid losses that occurred in those years was less than $1 million. The inherent uncertainty in estimating reserves is discussed in Liquidity and Capital Resources, Property Casualty Insurance Loss and Loss Expense Reserves. Development trends are further analyzed in Property Casualty Insurance Development of Estimated Reserves by Accident Year.
Over the past several years, we have worked to maintain a portfolio of simple yet competitive products primarily under the LifeHorizons banner. Our product development efforts emphasize death benefit protection and guarantees. Distribution expansion within our property casualty insurance agencies remains a high priority. Our 30 life field marketing representatives work in partnership with our 133 property casualty field marketing representatives. Approximately 69 percent of our term and other life insurance product premiums were generated through our property casualty insurance agency relationships.
Life insurance segment profitability depends largely on premium levels, the adequacy of product pricing, underwriting skill and operating efficiencies. This segment's results include only investment interest credited to contract holders (interest assumed in life insurance policy reserve calculations). The remaining investment income is reported in the investments segment results. The life investment portfolio is managed to earn target spreads between earned investment rates on general account assets and rates credited to policyholders. We consider the value of assets under management and investment income for the life investment portfolio as key performance indicators for the life insurance segment.
We view the life insurance industry as stable and remain optimistic moving into 2015 despite the persistently low interest rate environment. The U.S. economy continued to gradually improve with unemployment dropping and Gross Domestic Product marginally improving during the year. We are also encouraged by recent guidance from the Federal Reserve that reiterates its plan to gradually increase the targeted short term interest rate starting in the latter half of 2015.
Total investment return declined 0.6 percentage points in 2014, compared with 2013. The return contribution from the combination of 2014 investment income and net investment gains, both realized and the change in unrealized, essentially matched 2013. The base component of the return calculation, annual average invested assets, was up 8 percent.
Interest income rose $4 million or 1 percent in 2014. The average fixed-maturity pretax yield declined by approximately 14 basis points but was offset by a larger fixed-maturity portfolio that rose 3 percent on an amortized cost basis. Interest income declined in 2013 when that yield declined by approximately 25 basis points while the portfolio rose 5 percent on an amortized cost basis.
In 2012, the $42 million net realized investment gains and losses were primarily due to $37 million in net realized gains from equity security sales and $35 million in gains from fixed-maturity security sales and calls, partially offset by $33 million of OTTI charges for 13 securities.
OTTI charges from the investment portfolio by industry are summarized as follows:
Historically, we have pursued a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. See Item 1, Our Segments,Tax-Exempt Fixed Maturities, for further discussion on municipal bond purchases in our fixed-maturity investment portfolio. For our property casualty insurance subsidiaries, approximately 85 percent of interest from tax-advantaged fixed-maturity investments and approximately 60 percent of dividends from qualified equities are exempt from federal tax after applying proration from the 1986 Tax Reform Act. Our noninsurance companies own an immaterial amount of tax-advantaged fixed-maturity investments. For our noninsurance companies, the dividend received deduction exempts 70 percent of dividends from qualified equities. Our life insurance company does not own tax-advantaged, fixed maturity investments or equities subject to the dividend received deduction. Our effective tax rate reconciliation is found in Item 8, Note 11 of the Consolidated Financial Statements.
Dividends received from the subsidiary in 2014 were $50 million more than 2013, supported by strong property casualty insurance subsidiary net cash flow from operating activities. We expect 2015 parent company sources of cash flows to be similar to 2014. 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.
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 generally have minimized our reliance on debt financing although we may use the line to fund short-term cash needs.
We provide details of our three long-term notes in Item 8, Note 8 of the Consolidated Financial Statements. None of the notes are encumbered by rating triggers. The total principal amount of our long-term debt at December 31, 2014, was $793 million and included:
The company’s senior debt is rated investment grade by independent rating firms. None of the four rating agencies made changes to our debt ratings in 2014. Our debt ratings at February 25, 2015, were: a- from A.M. Best, BBB+ from Fitch Ratings, A3 from Moody’s Investors Service and BBB from Standard & Poor’s Ratings Services.
the syndication agent with a $65 million share. U.S. Bancorp (NYSE:USB), BB&T Corp (NYSE:BBT) and Huntington Bancshares, Inc. (Nasdaq:HBAN) each provide $25 million of capacity, and Northern Trust Corporation (Nasdaq:NTRS), provides $20 million of capacity.
Capital resources consisting of shareholders’ equity and total debt represent our overall financial strength to support current obligations and growth in our insurance businesses. At December 31, 2014, we had total capital of $7.413 billion. Shareholders’ equity was $6.573 billion, an increase of $503 million, or 8 percent, from the prior year. Our total debt was $840 million, down $54 million from a year ago. We seek to maintain a solid financial position and provide capital flexibility by keeping our ratio of debt to total capital moderate. We target a ratio below 20 percent. At year-end 2014, the ratio was 11.3 percent compared with 12.8 percent at year-end 2013.
At the discretion of the board of directors, the company can return capital directly to shareholders as discussed below.
Dividends to shareholders -The ability of our company to continue paying cash dividends is subject to factors the board of directors deem relevant. While the board and management believe there is merit to sustaining the company’s long record of dividend increases, our first priority is the company’s financial strength. Over the past 10 years, the company has paid an average of 60 percent of net income as dividends. Through 2014, the board had increased our cash dividend for 54 consecutive years. The board decision in January 2015 to increase the dividend demonstrated confidence in the company’s strong capital, liquidity, financial flexibility and initiatives to grow earnings.
As of December 31, 2014, we estimate our future contractual obligations as follows:
Interest on long-term debt - We expect total interest expense to be $52 million in 2015. We discuss outstanding debt in Additional Sources of Liquidity.
At December 31, 2014, we believe our most significant other commitments are:
A long-term perspective governs our liquidity and capital resources decisions, with the goal of benefitting our policyholders, agents, shareholders and associates over time. Our 2014 insurance results were within our longer-term combined ratio objective of averaging within the range of 95 percent to 100 percent over five-year periods, resulting in strong underwriting profits.
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, such as what occurred in the second quarter of 2011. We responded with a reduced insurance subsidiary dividend to our parent company in 2011. There could be additional obligations for our insurance operations due to increasing severity or frequency of noncatastrophe claims. To address the risk of unusually large insurance loss obligations including catastrophe events, we maintain property
Parent-company liquidity could be constrained by Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay. During 2015, our insurance subsidiary can declare $447 million in dividends to our parent company without regulatory approval. We do not expect future pension contributions to constrain our liquidity. The fair value of plan assets is 101 percent of the accumulated benefit obligation at December 31, 2014. Continued economic weakness also has the potential to affect our liquidity and capital resources in a number of different ways, including delinquent payments from agencies, defaults on interest payments by fixed-maturity holdings in our portfolio, dividend reductions by holdings in our equity portfolio or declines in the market value of holdings in our portfolio.
We carried $81 million of net loss and loss expense reserves for asbestos and environmental claims and $51 million of reserves for mold claims at year-end 2014, compared with $77 million and $51 million, respectively, for such claims at year-end 2013. The asbestos and environmental claims amounts for each respective year constituted 2.0 percent and 1.9 percent of total net loss and loss expense reserves at these year-end dates.
The historical pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The effective duration of our consolidated property casualty fixed-maturity portfolio was 4.4 years at year-end 2014. By contrast, the duration of our loss and loss expense reserves was approximately 4.24 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 2014 and 2013. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
Management’s best estimate of total loss and loss expense reserves as of year-end 2014 was consistent with the corresponding actuarial best estimate. Management’s best estimate of total loss and loss expense reserves as of year-end 2013 also was consistent with the corresponding actuarial best estimate.
We reconcile the beginning and ending balances of our reserves for loss and loss expenses at December 31, 2014, 2013 and 2012, in Item 8, Note 4 of the Consolidated Financial Statements. The reconciliation of our year-end 2013 reserve balance to net incurred losses one year later recognized $98 million of favorable reserve development.
Section A shows our total property casualty loss and loss expense reserves recorded at the balance sheet date for each of the indicated calendar years on a gross and net basis. Those reserves represent the estimated amount of unpaid loss and loss expenses for claims arising in the indicated calendar year and all prior accident years at the balance sheet date, including losses that were incurred but not yet reported to the company.
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, 2014, we had paid $2.355 billion of loss and loss expenses in calendar years 2005 through 2014 for losses that occurred in accident years 2004 and prior. An estimated $330 million of losses remained unpaid as of year-end 2014 (net re-estimated reserves of $2.685 billion from Section C less cumulative net paid loss and loss expenses of $2.355 billion).
Commercial auto loss emergence - Commercial auto continued to develop unfavorably during calendar year 2014. This line of business has been troublesome for the industry as a whole in recent years. As part of the U.S. economic recession of a few years ago, slowing business activity influenced our estimates of reserves for ultimate losses and loss expenses during that period. As the economy slowly recovered, we believe we were slow to recognize some of the higher loss cost effects in current accident year reserve estimates for at least part of that period. As claims that occurred during that period have become more mature, paid and reported loss cost trends resulted in us increasing our reserve estimates. Initiatives to improve profitability of our commercial auto line of business are discussed in Commercial Lines Insurance Results, Commercial Lines of Business Analysis.
Favorable development of personal lines insurance segment reserves illustrates the potential for revisions inherent in estimating reserves. In 2014, we experienced unfavorable reserve development related to umbrella liability coverage in the other personal line of business. That followed several years of favorable reserve development.
Our estimates of gross life, annuity and disability obligations do not reflect net recoveries from reinsurance agreements. Ceded life reinsurance receivables were $250 million at year-end 2014. As discussed in 2015 Reinsurance Programs, we purchase reinsurance to mitigate our life insurance risk exposure. At year-end 2014, ceded death benefits represented approximately 42.8 percent of our total gross policy face amounts in force.
These estimated cash outflows are undiscounted with respect to interest. As a result, the sum of the cash outflows for all years of $4.776 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy and investment contract reserves and separate accounts for future policy benefits and claims of $3.194 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $22 million of separate accounts liabilities.
We have made significant assumptions to determine the estimated undiscounted cash flows of these policies and contracts that include mortality, morbidity, timing of claims, future lapse rates and interest crediting rates. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results.
Gross life policy reserves were $2.497 billion at year-end 2014, compared with $2.390 billion at year-end 2013. The increase was primarily due to reserves for traditional life insurance contracts. We establish reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
To help determine appropriate reinsurance coverage for hurricane, earthquake and tornado/hail exposures, we use the RMS and AIR models to estimate the probable maximum loss from a single event or multiple events occurring in a one-year period. The models are proprietary in nature, and the vendors that provide them periodically update the models, sometimes resulting in significant changes to their estimate of probable maximum loss. As of the end of 2014, both models indicated that a hurricane event represents our largest amount of exposure to losses. The table below summarizes estimated probabilities and the corresponding probable maximum loss from a single hurricane event occurring in a one-year period, and indicates the effect of such losses on consolidated shareholders’ equity at December 31, 2014. Net losses are net of reinsurance and income taxes, and assume our 2015 reinsurance programs apply.
Currently participating on our standard market property and casualty per-risk and per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of which had A.M. Best insurer financial strength ratings of A+ (Superior) or better as of December 31, 2014. Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and the European markets. The largest participant in our property catastrophe program, representing approximately 47 percent of total participation, is the Lloyds of London placement that features numerous syndicates, with R.J. Kiln & Company Limited and the Catlin Syndicate taking the largest participations. Other primary participants in our property catastrophe program include Liberty Syndicates, Axis Specialty, Amlin Re and Markel Ltd.
The following table shows our five largest property casualty reinsurance receivable amounts by reinsurer at year-end 2014 and 2013. USAIG is a joint underwriting association of individual insurance companies that collectively functions as a worldwide aviation insurance market. We terminated our participation in the association after policy year 2002. The A.M. Best insurer financial strength ratings as of the end of the two most recent years are also shown for each those reinsurers that are rated by Best.
Property per risk treaty - The primary purpose of the property treaty is to provide capacity up to $25 million, adequate for the majority of the risks we write. It also includes protection for extra-contractual liability coverage losses. We retain the first $10 million of each loss. Losses between $10 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $19 million for 2015, compared with $28 million for 2014 and $38 million for 2013. Lower 2015 rates and a $2 million increase in our retention per loss offset the effect of estimates of increased direct written premiums that are subject to the treaty.
Property excess treaty - For 2015, we again purchased a property reinsurance treaty that provides an additional $10 million in protection for property losses. Effective February 1, 2015, we purchased an additional $15 million of coverage. These treaties, along with the property per risk treaty, provides a total of $50 million of protection. The ceded premium is estimated at approximately $6 million for 2015, compared with $4 million for both 2014 and 2013, when the coverage amount was $10 million.
Casualty per occurrence treaty - The casualty treaty provides capacity up to $25 million. Similar to the property treaty, it provides sufficient capacity to cover the vast majority of casualty accounts we insure and also includes protection for extra-contractual liability coverage losses. We retain the first $10 million of each loss. Losses between $10 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $13 million for 2015, compared with $23 million for 2014 and $30 million for 2013. Lower 2015 rates and a $2 million increase in our retention per loss offset the effect of estimates of increased direct written premiums that are subject to the treaty.
Casualty excess treaty - We purchase a casualty reinsurance treaty that provides an additional $45 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $70 million of protection for workers’ compensation, extra-contractual liability coverage and clash coverage losses, which would apply when a single occurrence involves multiple policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated at approximately $3 million for 2015, similar to the premium for both 2014 and 2013.
After reinsurance, and before any applicable benefit from our catastrophe bond, our maximum exposure to a catastrophic event that causes $600 million in covered losses in 2015 would be $125 million compared with $115 million for 2014. The largest catastrophe loss event in our history occurred during 2011 from a May 20-27 storm system that included a tornado in Joplin, Missouri, and also significant losses from hail in the Dayton, Ohio, area. Our losses from that storm were estimated at December 31, 2014, to be $225 million before reinsurance.
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, and January 12, 2015. TRIA provides a temporary federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. 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 2014 was $459 million (20 percent of 2013 subject premiums), and we estimate it is $494 million (20 percent of 2014 subject premiums) for 2015.
Property per risk treaty - The property treaty provides limits up to $5 million, which is adequate capacity for the risk profile we insure. It also includes protection for extra-contractual liability coverage losses. Cincinnati Specialty Underwriters retains the first $500,000 of any policy loss. Losses between $500,000 and $5 million are reinsured at 100 percent by Cincinnati Insurance.
The Cincinnati Insurance Company’s reinsurance program for 2015 includes participation in two assumed reinsurance treaties with R.J. Kiln & Company Limited, a reinsurer that spreads its losses to its property book of business among many reinsurers. The exposure to loss is usually triggered as a result of very high catastrophe losses. The First Surplus treaty has exposure for us of up to nearly $2 million of assumed losses from a single event and the Second Surplus treaty also has exposure for us of up to nearly $2 million of assumed losses from a single event. The treaties with Kiln Group Limited were in place during 2014 at slightly higher exposure levels.
Significant rise in losses from surety and director and officer policies written for financial institutions or other insured entities
Unforeseen departure of certain executive officers or other key employees due to retirement, health or other causes that could interrupt progress toward important strategic goals or diminish the effectiveness of certain longstanding relationships with insurance agents and others
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2014, in accordance with accounting principles generally accepted in the United States of America (GAAP).
Deloitte & Touche LLP, our independent registered public accounting firm, audited the consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2014. Deloitte & Touche LLP met with our audit committee to discuss the results of its examination. They have the opportunity to discuss the adequacy of internal controls and the quality of financial reporting without management present.
Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. 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, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedules and an opinion on the Company’s internal control over financial reporting based on our audits.
The consolidated property casualty companies actively write property casualty insurance through independent agencies in 39 states. Our 10 largest states generated 62.8 percent and 63.8 percent of total earned premiums in 2014 and 2013, respectively. Ohio, our largest state, accounted for 17.7 percent and 18.5 percent of total earned
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. Expenses associated with successfully acquiring insurance policies - commissions, premium taxes and underwriting costs - are deferred and amortized over the terms of the policies. All acquisition costs are in accordance with ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. We assess recoverability of deferred acquisition costs at the segment level, consistent with the way we acquire, service and manage insurance policies and measure profitability. We analyze our acquisition cost assumptions to reflect actual experience, and we evaluate potential premium deficiencies.
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 capitalize acquisition costs for traditional long-duration contracts. We charge these capitalized costs associated with successfully acquiring traditional long-duration contract insurance policies over the premium-paying period of the policies. We use the same assumptions used in establishing the liability for the contract. All acquisition costs reflect the retrospective adoption of Accounting Standards Update (ASU) 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. We update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate our deferred acquisition cost for recoverability.
We reduce risk and uncertainty by buying property casualty and life reinsurance. Reinsurance contracts do not relieve us from our obligation to policyholders, but rather help protect our financial strength to perform that duty. All of these ceded reinsurance contracts transfer the economic risk of loss. We continue to assume risk with limited exposure as a reinsurer for other insurance companies, reinsurers and involuntary state pools.
Our portfolio investments are primarily in publicly traded fixed-maturity, equity and short-term investments. Fixed-maturity investments (taxable bonds, tax-exempt bonds, redeemable preferred equities and commercial mortgage backed securities) and equity investments (common and nonredeemable preferred equities) are classified as available for sale and recorded at fair value in the consolidated financial statements. The number of fixed-maturity securities with fair value below 100 percent of amortized cost can be expected to fluctuate as interest rates rise or fall. Because of our strong surplus and long-term investment horizon, our general intent is to hold fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values.
Our invested asset impairment policy states that fixed maturities below their amortized cost that the company (1) intends to sell or (2) more likely than not will be required to sell before recovery of their amortized cost basis are deemed to be other-than-temporarily impaired (OTTI). The amortized cost of any such securities is reduced to fair value as the new cost basis, and a realized loss is recorded in the period in which it is recognized. When these two criteria are not met, and the company believes that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount with the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the period in which it occurred. The difference between the fair value and the net present value of the cash flows of the security, the noncredit loss, is recognized in other comprehensive income as an unrealized loss. We had no fixed-maturity securities with a noncredit loss for the years ended 2014 and 2013.
We include the noncredit portion of fixed-maturity OTTI charges and all other unrealized gains and losses on investments, net of taxes, in shareholders’ equity as accumulated other comprehensive income (AOCI). Realized gains and losses on investments are recognized in net income based on the trade date accounting method.
ASC 820 defines fair value as the exit price or the amount that would be (1) received to sell an asset or (2) paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. When determining an exit price, we rely upon observable market data whenever possible. We primarily base fair value for
For the purpose of ASC 825 disclosure, we base fair value for long-term senior notes on market pricing of similar debt instruments that are actively trading. We base fair value for notes payable on our year-end outstanding balance because it is short term and tied to a variable interest rate. We estimate the fair value of liabilities for investment contracts and annuities using discounted cash flow calculations across a wide range of economic interest rate scenarios with a provision for our nonperformance risk. We estimate the fair value for policyholder loans on insurance contracts using a discounted cash flow model. Determination of fair value for structured settlements assumes the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December 31, 2014, to account for nonperformance risk. See Note 3, Fair Value Measurements, for further details.
We record land at cost, and record building and equipment at cost less accumulated depreciation. Equipment held under capital leases also is classified as property and equipment with the related lease obligations recorded as liabilities. We capitalize and amortize costs for internally developed computer software during the application development stage. These costs generally consist of external consulting, payroll and payroll-related costs. Our depreciation is based on estimated useful lives (ranging from three years to 39.5 years) using straight-line and accelerated methods. Depreciation expense was $37 million for each year in 2014, 2013 and 2012. We monitor land, building and equipment and software assets for potential impairments. Potential impairments may include a significant decrease in the fair values of the assets, considerable cost overruns on projects, a change in legal factors or business climate or other factors that indicate that the carrying amount may not be recoverable or useful. There were no recorded land, building and equipment impairments for 2014, 2013 or 2012.
In February 2015, the FASB Issued ASU 2015-02, Consolidation (Topic 810) - Amendments to the Consolidation Analysis. ASU 2015-02 makes amendments to the current consolidation guidance, focusing mainly on the investment management industry; however entities across all industries will be impacted. The effective date of ASU 2015-02 is for interim and annual reporting periods beginning after December 15, 2015. The ASU has not yet been adopted; however, there is not expected to be a material impact on our company’s consolidated financial position, cash flows or results of operations.
The following table provides investment income, realized investment gains and losses and the change in unrealized investment gains and losses, by investment category:
For the years ended December 31, 2014, 2013 and 2012, there were no credit losses on fixed-maturity securities for which a portion of OTTI has been recognized in other comprehensive income.
During 2012, we other-than-temporarily impaired 13 securities. At December 31, 2012, four fixed-maturity investments with a total unrealized loss of $1 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity investments had fair values below 70 percent of amortized cost. There were no equity security investments in an unrealized loss position for 12 months or more as of December 31, 2012.
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is identified in the following tables by security type with a summary of changes in fair value for the years ended December 31, 2014 and 2013. Total Level 3 assets continue to be less than 1 percent of financial assets measured at fair value in the consolidated balance sheets. Assets presented in the table below were valued based primarily on broker/dealer quotes for which there is a lack of transparency as to inputs used to develop the valuations. Transfers into Level 3 included situations where a fair value quote was not provided by the company's nationally recognized pricing vendor and as a result the price was stale or had been replaced with a broker quote where the inputs had not been corroborated to be market observable resulting in the security being classified as Level 3. Transfers out of Level 3 included situations where a broker quote was used in the prior period and a fair value quote became available from the company's pricing vendor in the current period. A quote utilizing the new pricing source was not available as of the prior period, and any gains or losses related to the change in valuation source for individual securities were not significant.
The following table provides the change in Level 3 assets during 2014 and 2013:
With the exception of the Level 3 rollforward table, additional disclosure for the Level 3 category is not material.
Fair values for deferred annuities were calculated based upon internally developed models because active, observable markets do not exist for those items. To determine the fair value, we made the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December 31, 2014 and 2013, to account for nonperformance risk; (2) the rate of interest credited to policyholders is the portfolio net earned interest rate less a spread for expenses and profit; and (3) additional lapses occur when the credited interest rate is exceeded by an assumed competitor credited rate, which is a function of the risk-free rate of the economic scenario being modeled.
Determination of fair value for structured settlements assumes the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December 31, 2014 and 2013, to account for nonperformance risk.
$47 million, $70 million and $61 million for certain accident, life and health loss reserves at December 31, 2014, 2013 and 2012, respectively.
During 2014, we experienced $98 million of favorable development on prior accident years including $57 million of favorable development in commercial lines, $12 million of favorable development in personal lines and $29 million of favorable development in excess and surplus lines. Favorable development in 2014 was $49 million less than in 2013, largely due to the change in prior accident years before catastrophes. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $51 million for the workers’ compensation line, $34 million for the commercial property line and $14 million for the homeowner line, due to reduced uncertainty of prior accident year loss and loss adjustment expense for these lines. Our commercial casualty line experienced $5 million of adverse development due to an increase in its paid loss and loss expenses for cumulative accident years three or more years old, resulting in an increase recognized in estimates for IBNR losses and loss expenses for all prior accident years in total compared to 2013 and 2012. Our commercial auto line developed unfavorably by $39 million during 2014 due to higher loss cost effects in recent accident years, resulting in an increase of our reserve estimate for claims that have not yet been settled.
of favorable development in commercial lines, $39 million of favorable development in personal lines and $13 million of favorable development in excess and surplus lines. Favorable development in 2013 was $249 million less than in 2012, largely due to the change in prior accident years before catastrophes. Overall favorable
During 2012, we experienced $396 million of favorable development on prior accident years including $292 million of favorable development in commercial lines, $99 million of favorable development in personal lines and $5 million of favorable development in excess and surplus lines. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $177 million for the commercial casualty line, $74 million for the workers’ compensation line and $52 million for the homeowner line, due to reduced uncertainty of prior accident year loss and loss adjustment expense for these lines.
We carried $81 million of net loss and loss expense reserves for asbestos and environmental claims and
$51 million of reserves for mold claims at December 31, 2014, compared with $77 million and $51 million, respectively, at December 31, 2013. The asbestos and environmental claims amounts for each respective year constituted 2.0 percent and 1.9 percent of total net loss and loss expense reserves at these year-end dates.
Expenses associated with successfully acquiring 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 the costs for recoverability. All acquisition costs reflect ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which we retrospectively adopted on January 1, 2012.
The table below shows the deferred policy acquisition costs and asset reconciliation:
Our insurance subsidiary declared dividends to the parent company of $400 million in 2014, $375 million in 2013 and $300 million in 2012. State regulatory requirements restrict the dividends insurance subsidiaries can pay. Dividends must be paid within 30 days of declaration. Generally, the most our insurance subsidiary can pay without prior regulatory approval is the greater of 10 percent of statutory capital and surplus or 100 percent of statutory net income for the prior calendar year. Dividends exceeding these limitations may be paid only with approval of the insurance department of the domiciliary state. During 2015, the total that our insurance subsidiary, which is the parent of all other insurance subsidiaries, may declare in dividends is approximately $447 million.
Income taxes paid in our consolidated statements of cash flows are shown net of refunds received of less than
In addition to our IRS filings, we file income tax returns with immaterial amounts in various state jurisdictions. The statute of limitations for state income tax purposes has closed for tax years 2009 and earlier.
We also sponsor a defined contribution plan (401(k) plan). Matching company contributions totaled $11 million,
We maintain a supplemental executive retirement plan (SERP) with a benefit obligation of $13 million at
year-end 2014 and $9 million at year-end 2013, which is included in the projected benefit obligation. The company also makes available to a select group of associates the CFC Top Hat Savings Plan, a nonqualified deferred compensation plan, which had a fair value of $18 million and $14 million at December 31, 2014 and 2013, respectively.
To determine the discount rate for each plan, a theoretical settlement portfolio of high quality rated corporate bonds was chosen to provide payments approximately matching the plan’s projected benefit payments. A single interest rate for each plan was determined resulting in a discounted value of the plan's benefit payments that equates to the market value of the selected bonds. The discount rate is reflective of current market interest rate conditions and our plan's liability characteristics. Based on this analysis, we decreased the rate from the prior year by 0.90 percentage points for the qualified pension plan and by 0.75 percentage points for the SERP. Compensation increase assumptions reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases. The mortality assumption was updated in 2014 to the RP-2014 Employee Mortality Tables and RP-2014 Annuitant Mortality Tables for males and females projected generationally with Scale MP-2014. The updated mortality table did not have a significant impact on our financial statements as our qualified plan assumes benefits will be paid in the form of lump sums.
The decreases in discount rate and lump sum rate resulted in an increase in actuarial loss and projected benefit obligation from 2013 and an increase in unfunded status.
The total recognized in net periodic benefit cost and other comprehensive income was a net cost of $31 million, net benefit of $63 million, and a net cost of $31 million for the years ended December 31, 2014, 2013 and 2012, respectively. The change in the amount recognized in other comprehensive income from 2013 is largely due to decreases in discount and lump sum rates, partially offset with greater than anticipated return on plan assets. The estimated costs to be amortized from AOCI into net periodic benefit cost over the next year for our plans are
$5 million in actuarial loss and $1 million in prior service cost.
The pension plan assets are managed to maximize total return over the long term while providing sufficient liquidity and current return to satisfy the cash flow requirements of the plan. The plan’s day-to-day investment decisions are managed by our internal investment department; however, overall investment strategies are discussed with our employee benefits committee. Our investment strategy, currently driven by the low interest rate environment, is to weight our portfolio towards large cap, high quality, dividend growing equities that we have historically favored. As our plan matures and interest rates normalize, we expect a greater allocation to fixed income securities to better align asset and liability market risks. Our fixed-maturity bond portfolio is investment grade. The plan does not engage in derivative transactions.
Excluding cash, during 2014 we held approximately 81 percent of our pension portfolio in domestic common equity investments, which reflect the long-term time horizon of pension obligations. The remainder of the portfolio consisted of 12 percent in states, municipalities and taxable political subdivisions fixed-maturity investments and 7 percent in domestic corporate fixed-maturity investments. Our common equity portfolio consisted of 23 percent in the financial sector, 19 percent in the information technology sector, 14 percent in the healthcare sector and 12 percent in the industrial sector at year-end 2014. No additional sectors accounted for 10 percent or more of our common equity portfolio balance at year-end 2014. We had $11 million of cash on hand at December 31, 2014, to cover retirements.
Investments in securities are valued based on the fair value hierarchy outlined in Note 3, Fair Value Measurements. The pension plan did not have any liabilities carried at fair value during the years ended December 31, 2014 and 2013. There have been no transfers between Level 1 and Level 2 for the years ended December 31, 2014 and 2013. The following table shows the fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2014 and 2013. Excluded from the table below is cash on hand of $11 million and $19 million at December 31, 2014 and 2013.
Insurance companies’ statutory financial statements are presented on the basis of accounting practices prescribed or permitted by applicable state insurance departments of domicile. Insurance companies use statutory accounting practices (SAP) as recognized by various states. We have adopted the National Association of Insurance Commissioners’ (NAIC) Accounting Practices and Procedures manual, version effective January 1, 2001, and updates through the current year as a component of prescribed or permitted practices by laws of the state of domicile. The primary differences between SAP and GAAP include the valuation of unrealized investment gains and losses, expensing of policy acquisition costs, actuarial assumptions for life insurance reserves and deferred income taxes based on differences in statutory and taxable income.
$7 million in 2014, $6 million in 2013 and $5 million 2012, on premium volume of $41 million, $35 million and
Four equity compensation plans currently permit us to grant various types of equity awards. We currently grant incentive stock options, nonqualified stock options, service-based restricted stock units and performance-based restricted stock units to associates, including some with market-based performance objectives under our shareholder-approved plans. We also have a Holiday Stock Plan that permits annual awards of one share of common stock to each full-time associate for each full calendar year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant stock to our outside directors as a component of their annual compensation. We used treasury shares for share-based compensation award issues or exercises during 2014.
The following weighted average assumptions were used in determining fair value for option grants issued during 2014 and 2013:
We have performance-based awards that vest on the first day of March after a three-calendar-year performance period. These awards vest according to the level of three-year total shareholder return achieved compared with a peer group over a three-year performance period with payouts ranging from 0 - 200 percent for awards granted in 2013 and 2014. For awards granted in 2012, the payout range on these performance awards is 0 - 125 percent. Three-year total shareholder return is calculated by Bloomberg, using annualized total return of a stock to an investor due to capital gain appreciation plus reinvestment of all dividends. We issued 59,615 shares of performance-based restricted stock units during 2014 at the maximum-level performance hurdle for the three-year performance period ended December 31, 2013, as we achieved a three-year total shareholder return that exceeded all seven of the companies in our 2011 peer group. For the three-year performance period ended December 31, 2014, our total shareholder return exceeded six of 10 peers in our 2012 peer group. We expect payout of these shares at the target level to occur in March of 2015. Performance-based awards vested during the year had an intrinsic value of $3 million, $3 million and $2 million for the years ended December 31, 2014, 2013 and 2012, respectively.
This is a summary of service-based and performance-based share information, assuming a target payout for performance-based shares, for the year 2014:
We operate primarily in two industries, property casualty insurance and life insurance. We regularly review our reporting segments to make decisions about allocating resources and assessing performance. Our reporting segments are: