* Realized investment gains and losses are integral to our financial results over the long term, but our substantial discretion in the timing of investment sales may cause this value to fluctuate substantially. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 81.
We begin with an executive summary of our results of operations and outlook, as well as details on critical accounting policies and estimates. Periodically, we refer to estimated industry data so that we can give information on our performance within the context of the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory accounting basis. When we provide our results on a comparable statutory accounting basis, we label it as such; all other company data is presented in accordance with accounting principles generally accepted in the United States of America (GAAP).
Through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on 2010 written premium volume for approximately 2,000 U.S. stock and mutual insurer groups. We market our insurance products through a select group of independent insurance agencies in 39 states as discussed in Item 1, Our Business and Our Strategy, Page 3.
Although recent years have been difficult for our economy, our industry and our company, our long-term perspective lets us address the immediate challenges while focusing on the major decisions that best position the company for success through all market cycles. We believe that this forward-looking view has consistently benefited our shareholders, agents, policyholders and associates.
In 2011, our value creation ratio of 6.0 percent was well below our target annual average of 12 percent to 15 percent for the period 2010 through 2014. The three-year average at year-end 2011 was within the target range. In 2010, it was slightly below our target and the ratio exceeded our target in 2009, as discussed in Corporate Financial Highlights below.
· 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. Our long-term target for profitable premium growth, 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 2011, our direct written premiums totaled $3.534 billion. The compound annual growth rate of our net written premiums was negative 0.5 percent over the five-year period 2007 through 2011, slightly lower than the negative 0.4 percent estimated growth rate for the property casualty insurance industry, excluding the mortgage and financial guaranty segments.
· Drive premium growth - Implementation of these initiatives is intended to further penetrate each market we serve through our independent agency network. Strategies aimed at specific market opportunities, along with service enhancements, can help our agents grow and increase our share of their business. Diversified growth also may reduce variability of losses from weather-related catastrophes.
We discuss these strategic initiatives, along with related metrics to assess progress, in Item 1, Strategic Initiatives, Page 10. Below is a review of highlights of our financial results for the past three years. Detailed discussion of these topics appears in Results of Operations, Page 50, and Liquidity and Capital Resources, Page 85.
The value creation ratio discussed in the Executive Summary, Page 38, was 6.0 percent in 2011, 11.1 percent in 2010 and 19.7 percent in 2009. The book value per share growth component of the value creation ratio was 0.8 percent during 2011 and 5.7 percent during 2010. The 2011 ratio was depressed primarily due to unusually high catastrophe losses that lowered the ratio by 3.3 percentage points compared with 2010, and also drove a 56 percent decline in net income. Higher valuations for our investment portfolio benefited the value creation ratio in addition to earnings. Realized capital gains plus the net change in unrealized capital gains contributed 3.8, 5.2 and 14.5 percentage points for the years 2011, 2010 and 2009, respectively. Net income declined 13 percent in 2010 after growing 1 percent in 2009, reflecting lower realized investment gains. Cash dividends declared per share rose approximately 1 percent during each of the years during 2009 through 2011.
Net income in 2011 declined $211 million or 56 percent compared with 2010, due primarily to the after-tax effects of property casualty underwriting results that were $149 million lower, including $165 million from higher natural catastrophe losses, and net realized investment gains that were $58 million lower. Net income decreased $55 million in 2010, reflecting the after-tax net effect of three major contributing items: a $114 million decline in net realized investment gains, partially offset by a $53 million improvement from property casualty underwriting results plus $9 million of growth in investment income.
As discussed in Investment Results of Operations, Page 81, security sales led to realized investment gains in all three years. Realized and unrealized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and for securities with embedded derivatives without actual realization of those gains and losses.
Higher dividend income was largely responsible for 1 percent growth in 2011 pretax investment income, while higher interest income drove 3 percent growth in 2010. The primary reason for the 2011 increase in dividend income was a higher average dividend payment rates for common stocks in our equity portfolio.
Property casualty net written premiums grew 5 percent in 2011 and earned premiums grew 4 percent, largely due to higher pricing and improving insured exposure-level comparatives from the slowly improving economy. Trends and related factors discussed in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 57, Page 69 and Page 75, respectively.
For the year 2012, we believe our value creation ratio may be below our long-term target for several reasons.
· Lingering effects of soft insurance market pricing in recent years could significantly affect growth rates and earned premium levels into 2012 and for some time into the future, depending on insurance market conditions. After several years of market conditions that weakened loss ratios and hampered near-term profitability, conditions affecting property casualty markets largely began to improve in the second half of 2011. In the future, economic factors, including inflation, may increase our claims and settlement expenses related to medical care, litigation and construction.
· The slowly recovering economy helped increase the value of business and personal insurable assets owned by policyholders in 2011. 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.
The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 of the Consolidated Financial Statements, Page 114 In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company’s critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate.
· For weather events designated as catastrophes, we calculate IBNR reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Once case reserves are established for a weather event, we reduce the IBNR reserves. Our claims department management coordinates the assessment of these events and prepares the related IBNR reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the affected geographic area and of available claims intelligence. Depending on the nature of the event, available claims intelligence could include surveys of field claims associates within the affected geographic area, feedback from a catastrophe claims team sent into the area, as well as data on claims reported as of the financial statement date. To determine whether an event is designated as a catastrophe, we generally use the catastrophe definition provided by Property Claims Service (PCS), a division of Insurance Services Office (ISO). PCS defines a catastrophe as an event that causes countrywide damage of $25 million or more in insured property losses and affects a significant number of policyholders and insureds.
· For asbestos and environmental claims, we calculate IBNR reserves by deriving an actuarially based estimate of total unpaid loss and loss expenses. We then reduce the estimate by total case reserves. We discuss the reserve analysis that applies to asbestos and environmental reserves in Asbestos and Environmental Reserves, Page 89.
· For loss expenses that pertain primarily to salaries and other costs related to our claims department associates, also referred to as adjusting and other expense or AOE for statutory accounting purposes, we calculate reserves based on an analysis of the relationship between paid losses and paid AOE.
Our actuarial staff bases its IBNR reserve estimates for these losses primarily on the indications of methods and models that analyze accident year data. Accident year is the year in which an insured claim, loss, or loss expense occurred. The specific methods and models that our actuaries have used for the past several years are:
If actual unpaid loss and loss expenses fall within these ranges, our cash flow and fixed-maturity investments should provide sufficient liquidity to make the subsequent payments. To date, our cash flow has covered our loss and loss expense payments, and we have never had to sell investments to make these payments. If this were to become necessary, however, our fixed-maturity investments should provide us with ample liquidity. At year-end 2011, consolidated fixed-maturity investments exceeded total insurance reserves (including life policy reserves) by $2.226 billion.
Our fixed-maturity and equity investment portfolios are our largest assets. The company’s asset impairment committee continually monitors the holdings in these portfolios and all other assets for signs of other-than-temporary or permanent impairment. The committee monitors decreases in the fair value of invested assets; an accumulation of costs in excess of the amount originally expected to acquire or construct an asset; uncollectability of all receivable assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure to pay interest or dividends; signs indicating that the carrying amount may not be recoverable; and changes in legal factors or in the business climate.
The application of our impairment policy resulted in other-than-temporary impairment (OTTI) charges that reduced our income before income taxes by $57 million in 2011, $36 million in 2010 and $131 million in 2009. 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 non-cash charges to income and are reported as realized investment losses.
All securities valued below 100 percent of cost or amortized cost are reported to the asset impairment committee for evaluation. Securities valued between 95 percent and 100 percent of cost or amortized cost are reviewed but not monitored separately by the committee. When evaluating for OTTI, the committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost. Because of the company's financial strength and other factors discussed below, management may not impair certain securities even when they are fair valued below cost or amortized cost.
When determining OTTI charges for our fixed-maturity portfolio, management places significant emphasis on whether issuers of debt are current on contractual payments and whether future contractual amounts are likely to be paid. Our fixed-maturity invested asset impairment policy states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed-maturity security; (2) if it is more likely than not we will be required to sell the fixed-maturity security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. If we intend to sell or it is more likely than not we will be required to sell, the amortized cost of any such securities is reduced to fair value as the new amortized cost basis, and a realized loss is recorded in the quarter in which it is recognized. When we believe that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount to the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the quarter in which it occurred. The difference between the fair value and the net present value of the cash flows of the security, the non-credit loss, is recognized in other comprehensive income as an unrealized loss.
Financial assets and liabilities recorded on the Consolidated Balance Sheets are categorized based on the inputs to the valuation techniques as described in Item 8, Note 3, Fair Value Measurements, Page 123.
Over 99 percent of the $11.735 billion of securities in our investment portfolio, measured at fair value, are classified as Level 1 or Level 2. Financial assets that fall within Level 1 and Level 2 are priced according to observable data from identical or similar securities that have traded in the marketplace. Also within Level 2 are securities that are valued by outside services or brokers where we have evaluated the pricing methodology and determined that the inputs are observable.
Management ultimately determined the pricing for each Level 3 security that we considered to be the best exit price valuation. As of December 31, 2011, total Level 3 assets were less than 1 percent of our investment portfolio measured at fair value. Broker quotes are obtained for thinly traded securities that subsequently fall within the Level 3 hierarchy. We have generally obtained two non-binding quotes from brokers and, after evaluating, our investment professionals typically selected the lower quote as the fair value.
Key assumptions used in developing the 2011 benefit obligation for our qualified plan were a 5.10 percent discount rate and rates of compensation increases ranging from 3.50 percent to 5.50 percent. To determine the discount rate, a hypothetical diversified portfolio of actual domestic Aa rated bonds was chosen to provide payments approximately matching the plan’s expected benefit payments. A single interest rate was determined based on the anticipated yield of the constructed portfolio.
The fair value of the plan assets was $20 million less than the accumulated benefit obligation at year-end 2011 and $30 million less at year-end 2010. The fair value of the plan assets was $65 million less than the projected plan benefit obligation at year-end 2011 and $62 million less at year-end 2010. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. On February 1, 2011, we contributed $35 million to our qualified plan. We expect to contribute $14 million to our qualified plan during 2012.
For life insurance policies, acquisition costs are amortized into income either over the premium-paying period of the policies or the life of the policy, depending on the policy type. These costs are principally agent commissions and certain underwriting costs. We analyze our acquisition cost assumptions periodically to reflect actual experience; we evaluate our deferred acquisition cost for recoverability; and we regularly conduct reviews for potential premium deficiencies or loss recognition. Changes in the amounts or timing of estimated future profits could result in adjustments to the accumulated amortization of these costs.
We establish an accrual for property casualty profit-sharing commissions. We base the profit-sharing commission accrual estimate on property casualty underwriting results. Profit-sharing commissions are paid to agencies using a formula that takes into account agency profitability over one-year and three-year periods, premium volume and other factors, including allocations of various expenses. Due to the complexity of the calculation and the variety of allocation factors that can affect profit-sharing commissions for an individual agency, the amount accrued can differ from the actual profit-sharing commissions paid. The profit-sharing commission accrual of $68 million in 2011 contributed 2.3 percentage points to the property casualty combined ratio. If profit-sharing commissions paid were to vary from that amount by 5 percent, it would affect 2012 net income by $2 million (after tax), or 1 cent per share, and the combined ratio by approximately 0.1 percentage points.
Information about recent accounting pronouncements is provided in Item 8, Note 1 of the Consolidated Financial Statements, Page 114. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
We report as Other the non-investment operations of the parent company and its non-insurer subsidiary, CFC Investment Company.
We measure profit or loss for our commercial lines, personal lines and excess and surplus property casualty and life insurance segments based upon underwriting results (profit or loss), which represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also frequently evaluate results for our consolidated property casualty insurance operations, which is the total of our commercial, personal, and excess and surplus insurance results. Underwriting results and segment pretax operating income are not substitutes for net income determined in accordance with GAAP.
The calculations of segment data are described in more detail in Item 8, Note 18 of the Consolidated Financial Statements, Page 136. The following sections review results of operations for each of the five segments. Commercial Lines Insurance Results of Operations begins on Page 57, Personal Lines Insurance Results of Operations begins on Page 69, Excess and Surplus Lines Insurance Results of Operations begins on Page 75, Life Insurance Results of Operations begins on Page 79, and Investment Results of Operations begins on Page 81. We begin with an overview of our consolidated property casualty operations.
· Combined ratio - The 2011 combined ratio rose 7.5 percentage points compared with 2010, primarily due to an 8.2 percentage-point increase in the ratio for catastrophe losses. The ratio effect of additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty contributed 1.4 percentage points to the 7.5 point rise in the 2011 ratio.
Catastrophe losses trends are an important factor in assessing trends for overall underwriting results. Incurred losses from a May 20-27, 2011, storm system that included Joplin, Missouri represent the single largest catastrophe event in our company’s history. The gross amount for that event is estimated at $239 million, including significant losses from hail in the Dayton, Ohio, area. The total gross amount of our losses incurred for all catastrophe events during the year 2011 is estimated at $658 million. Our 10-year historical annual average contribution of catastrophe losses to the combined ratio was 5.4 percentage points as of December 31, 2011.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the three-year highlights table on Page 51 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid losses, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 79.2 percent accident year 2010 loss and loss expense ratio reported as of December 31, 2010, developed favorably by 6.0 percentage points to 73.2 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2011. Accident years 2010 and 2009 have both developed favorably, as indicated by the progression over time for the ratios in the table.
The 73.0 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2011 declined 0.6 percentage points compared with the 73.6 percent accident year 2010 ratio measured as of December 31, 2010. The effect of the $42 million ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 1.0 percentage point. Large losses described below and the corresponding ratios for new losses above $250,000 caused a 1.5 percentage-point increase in the 2011 ratio. A refinement to our line of business allocation process for loss expenses reduced the 2011 accident year loss and loss expenses before catastrophes ratio by approximately 1.5 percentage points. We believe the remainder of the reduction is largely due to initiatives to improve pricing precision and loss experience related to claims and loss control practices, somewhat offset by normal loss cost inflation. The refined allocation had no effect on earnings or consolidated property casualty ratios reported on a calendar year basis. The allocation refinement pertained to the portion of loss expenses referred to as AOE, and is discussed in Item 8, Note 18 of the Consolidated Financial Statements, Page 136. Discussion of AOE reserves is included in Critical Accounting Estimates, How Reserves Are Established, Page 42.
Reserve development on prior accident years continued to net to a favorable amount in 2011, as $285 million was recognized, 6 percent less than $304 million in 2010. Approximately 80 percent of our reserve development on prior accident years recognized during 2011 occurred in our commercial casualty and workers’ compensation lines of business. Development recognized during 2009 and 2010 was primarily from our commercial casualty line of business. Development by line of business is further analyzed in Commercial Lines Insurance Segment Development of Estimated Reserves by Accident Year, Page 93, and in Personal Lines Insurance Segment Development of Estimated Reserves by Accident Year, Page 95.
In 2011, total large losses incurred rose by $87 million or 15 percent, net of reinsurance, helping to raise the corresponding ratio by 2.3 percentage points. Large loss trends are further analyzed in the segment discussion below. 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.
· Combined ratio - The 2011 combined ratio was 5.3 percentage points higher than in 2010, primarily due to a 6.3 percentage-point rise in the ratio for catastrophe losses. The ratio effect of additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty essentially offset the favorable effect of a refined line of business allocation process for loss expenses.
The combined ratio before catastrophe losses and prior years reserve development improved in 2011, in part benefiting from recent-year initiatives to improve pricing precision and loss experience related to claims and loss control practices. Initiatives to improve commercial lines underwriting profitability complement our business practices that continue to leverage the local presence of our field staff, who meet with local agencies to assess each risk, determine limits of insurance and establish appropriate terms and conditions. Our field marketing representatives continue to underwrite new business while loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. Field claims representatives also assist underwriters by preparing full reports on their first-hand observations of risk quality.
Due to the highly competitive commercial lines markets during the past several years, we have focused on increasing our use of predictive analytics tools to improve pricing precision while also leveraging 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.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the three-year highlights table on Page 57 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid losses, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 79.2 percent accident year 2010 loss and loss expense ratio reported as of December 31, 2010, developed favorably by 6.9 percentage points to 72.3 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2011. Accident years 2010 and 2009 for the commercial lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 51, explain much of the movement in current accident year loss and loss expense ratios among years 2009 through 2011. Catastrophe losses added 10.3 percentage points for 2011, 4.7 points for 2010 and 3.0 points for 2009 to the respective commercial lines accident year loss and loss expense ratios in the table above.
Commercial lines reserve development on prior accident years continued to net to a favorable amount in 2011, as $234 million was recognized, somewhat lower than $269 million in 2010. More than 95 percent of our commercial lines reserve development on prior accident years recognized during 2011 occurred in our commercial casualty and workers’ compensation lines of business, with a slight majority occurring in the commercial casualty. Development recognized during 2009 and 2010 was mostly from our commercial casualty line of business. Development by line of business and other trends for commercial lines loss and loss expenses and the related ratios are further analyzed in Commercial Lines of Business Analysis, beginning on Page 62, and in Commercial Lines Insurance Segment Development of Estimated Reserves by Accident Year, Page 93.
In 2011, total large losses incurred increased by $71 million or 15 percent, net of reinsurance, helping to raise the corresponding ratio by 2.8 percentage points. The majority of the increase was for higher incurred losses for fires and commercial auto claims. In 2010 the total large losses incurred ratio was lower than it was in 2009, primarily due to lower incurred losses for general liability coverages largely included in our commercial casualty line of business. 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.
Commercial lines commission expenses as a percent of earned premium increased slightly during 2011, in part due to higher agency profit-sharing commissions. Although the commercial lines segment had an underwriting loss in 2011, compared with a small underwriting profit in 2010, the agencies that earned profit-sharing commissions for their commercial lines business did so at a higher aggregate amount in 2011.
Commercial casualty is our largest line of business and has in recent years maintained a very satisfactory total loss and loss expense ratio. Premium growth trends for 2011 reversed compared with 2010, largely reflecting the slowly improving economy in addition to higher pricing. As discussed in the commercial lines insurance premiums section of Commercial Lines Insurance Results of Operations, on Page 58, economic trends cause corresponding changes in underlying insured exposures, including general liability coverage where the premium amount is heavily influenced by economically-driven measures of risk exposure such as sales volume. Slowly improving economic factors during 2011 helped increase commercial casualty net written and earned premiums, including favorable effects for premiums from audits. Also during 2011, our underwriters began full use of predictive modeling tools for general liability coverages in our commercial package accounts, and we believe such tools are improving our pricing precision.
The 2011 total loss and loss expense ratio improved, primarily due to the lower current accident year losses and loss expenses and higher earned premiums. Favorable development on prior accident year reserves continued in 2011 at a significant level, reflecting favorable loss emergence trends and a further moderation in loss cost trends, particularly for umbrella liability coverage included in many commercial package accounts. Development trends are further discussed in Commercial Lines Insurance Segment Development of Estimated Reserves by Accident Year, Page 93.
The 2011 current accident year loss and loss expense ratio before catastrophe losses also rose, compared with accident year 2010, largely due to higher large losses from fires and increased losses from non-catastrophe weather. In 2011, we began full use of predictive modeling tools for property coverages in our commercial package accounts to improve our pricing precision. We also increased our loss control staff, including more specialization in the areas of conducting property inspections for both new and renewal business. We believe these initiatives will improve profitability over time.
Net written premiums and earned premiums for commercial auto were up in 2011, partly from improving pricing trends. Commercial auto is one of the business lines that we renew and price annually, so market trends may be reflected for this line of business sooner than for some other commercial lines. Higher new business written premiums from agencies accounted for $7 million of the $20 million increase in net written premiums.
The 2011 total loss and loss expense ratio was 27.8 percentage points lower, reflecting both higher favorable development on prior accident year reserves and lower current accident year losses and loss expenses. The refined line of business allocation process for loss expenses reduced the 2011 total loss and loss expense ratio by 11.5 percentage points and also had the effect of decreasing the ratio for current accident year before catastrophe losses.
During 2009, we began using a predictive modeling tool to improve risk selection and pricing adequacy. Predictive modeling increases precision and thereby facilitates adequate pricing so that our agents can better compete for the most desirable workers’ compensation business. In 2010, we also added to our staff of loss control field representatives, premium audit field representatives and field claims representatives specializing in workers’ compensation risks. In early 2010, we implemented direct reporting of workers’ compensation claims, allowing us to quickly obtain detailed information to promptly assign the appropriate level of claims handling expertise to each case. Obtaining more information sooner for specific claims allows for medical care appropriate to the nature of each injury, benefiting injured workers, employers and agents while ultimately lowering overall loss costs.
The 2011 total loss and loss expense ratio rose 51.2 percentage points primarily due to a 39.3 point increase in catastrophe losses. It also rose from other weather-related losses that were not identified as part of designated catastrophe events for the property casualty industry, typically referred to as non-catastrophe weather losses. The effect of the $10 million in premiums ceded to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 8.4 percentage points.
The 2011 current accident year loss and loss expense ratio before catastrophe losses also increased, compared with accident year 2010, largely due to non-catastrophe weather and the effects of reinstatement premiums. In 2011 we began full use of predictive modeling tools for auto, general liability and property coverages for some commercial package accounts included in specialty packages. We believe these pricing analytics tools will improve our pricing precision and our loss ratios over time. By late 2012 we expect to be using predictive modeling tools to improve our pricing precision for certain additional business policies included in our specialty packages line of business. We also increased our loss control staff, including more specialization in the areas of conducting property inspections for both new and renewal business. We believe these initiatives will improve profitability over time.
The 2011 total loss and loss expense ratio rose 26.8 percentage points due to a 29.6 point increase from unfavorable development on prior accident year reserves. Included in the unfavorable development was $13 million or 13.1 percentage points for the refined line of business allocation process for loss expenses. The refined allocation had a negligible effect on the ratio for the current accident year before catastrophe losses. Most of the remainder of unfavorable development on prior accident year reserves was for four claims from accident year 2008, two for director and officer liability and two for fidelity bonding due to fraud or lending practices at financial institutions.
Machinery and equipment premiums continued to rise over the three year period, reflecting our superior service, including experienced local specialists who support agencies in writing this line of business. The total and accident year loss and loss expense ratios remain at profitable levels, although they can fluctuate substantially due to the relatively small size of this business line.
We intend to continue marketing our products to a broad range of business classes with a package approach, while improving our pricing precision. We intend to maintain our underwriting selectivity and carefully manage our rate levels as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions about rates, the use of three-year commercial policies and other policy conditions on a case-by-case basis, even in lines and classes of business that are under competitive pressure. We believe our initiatives to improve pricing precision and lower loss costs will continue to benefit commercial lines profitability during 2012, and that recent-year premium growth initiatives will continue to increase commercial lines premiums.
· Premiums - Earned premiums and net written premiums increased in 2011, primarily due to higher renewal written premiums that reflected improved pricing. Growth in earned and net written premiums occurred despite the partially offsetting effect of $18 million for ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty.
Personal lines insurance is a strategic component of our overall relationship with most of our agencies and an important component of our agencies’ relationships with their clients. We believe agents recommend Cincinnati personal insurance products for their value-oriented 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 began using predictive modeling tools for our largest personal lines of business in 2009 and 2010 to increase our pricing sophistication. We 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. For example, for the year 2011 our average renewal pricing increases were approximately 50 percent higher for homeowner insurance rating segments indicated as lower quality in our model compared with the higher quality rating segments.
Other written premiums, primarily premiums that are ceded to reinsurers and that lower our net written premiums, nearly doubled in 2011 compared with 2010 and 2009. The change was driven by additional ceded premiums for our property catastrophe reinsurance treaty, including $18 million for reinstatement premiums following two large catastrophe events during 2011 and $12 million for the third and fourth event cover that was discussed in Consolidated Property Casualty Insurance Results of Operations, Page 51.
Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 51, explain much of the movement in current accident year loss and loss expense ratios among the years 2009 through 2011. Catastrophe losses added 23.6 percentage points for 2011, 8.8 points for 2010 and 15.4 points for 2009 to the respective personal lines accident year loss and loss expense ratios in the table above. Catastrophe losses were unusually high during 2011 and 2009, and also are inherently volatile, as discussed above and in Consolidated Property Casualty Insurance Results of Operations, Page 51.
The trend for our personal lines current accident year loss and loss expense ratio before catastrophe losses over the past three years reflected unique unfavorable items for 2011 discussed below in addition to normal loss cost inflation and higher pricing. For 2011 the unfavorable effects offset the favorable effects of better risk selection and improved pricing discussed above in Personal Lines Insurance Premiums.
Personal lines reserve development on prior accident years continued to net to a favorable amount in 2011, as $42 million was recognized, somewhat higher than $34 million in 2010 and $40 million in 2009. Approximately 90 percent of our personal lines reserve development on prior accident years recognized during 2011 occurred in our homeowner line of business and our other personal line of business, in nearly equal amounts for each line. Development recognized during 2009 and 2010 was mostly from our other personal line of business, primarily for personal umbrella liability coverage. Development by line of business and other trends for personal lines loss and loss expenses and the related ratios are further analyzed in Personal Lines of Business Analysis, beginning on Page 72, and in Personal Lines Insurance Segment Development of Estimated Reserves by Accident Year, Page 95.
In 2011, total large losses incurred increased by $15 million or 19 percent, net of reinsurance,contributing to the corresponding ratio increase of 1.3 percentage points. The majority of the increase was for claims related to our personal auto line of business. In 2010 the total large losses incurred ratio was lower than it was in 2009, primarily due to lower personal auto losses. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
The total loss and loss expense ratio rose 8.9 percentage points, in part due to a 1.8 point increase from catastrophe losses plus a 2.4 point increase from losses above $250,000. The refined line of business allocation process for loss expenses added another 8.5 percentage points to the 2011 total loss and loss expense ratio and also contributed to the increase in the ratio for the current accident year before catastrophe losses.
Net written premiums for homeowner grew $13 million in 2011, reflecting higher renewal premiums that were partially offset by higher ceded premiums for reinsurance. Premiums ceded for reinsurance, which reduce premium revenue, were $40 million in 2011, $18 million in 2010, and $22 million in 2009. The total ceded premiums for 2011 included $16 million to reinstate coverage layers of our property catastrophe reinsurance treaty and $9 million for the third and fourth event cover.
The total loss and loss expense ratio over the past three years largely fluctuated with catastrophe losses, non-catastrophe weather-related losses and other large losses. For the four-year period 2008 through 2011, the homeowner catastrophe loss ratio averaged 34.7 percent, approximately double the 17.4 percent 10-year average for the years 1998 through 2007. The 36.8 percentage-point increase in the ratio for 2011 included an increase of 33.7 points for catastrophe losses. Non-catastrophe weather losses from wind, hail and lightning were $22 million higher during 2011, raising the 2011 loss ratio by 6.0 percentage points compared with 2010. A $4 million increase in 2011 large losses, compared with 2010, increased the homeowner loss ratio by 1.1 percentage points. The effect of the $16 million ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 6.4 percentage points.
Favorable development on prior accident year reserves rose in 2011, primarily due to case reserve development on accident years 2009 and 2010. Development trends for are further discussed in Personal Lines Insurance Segment Development of Estimated Reserves by Accident Year, Page 95.
Other personal premiums increased in 2011 and 2010, generally tracking with the growth in our personal auto and homeowner lines before the effects of reinsurance. Most of our other personal coverages are endorsed to 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 projects industrywide personal lines written premiums may grow approximately 3 percent in 2012, with an industry statutory combined ratio estimated at approximately 102 percent. Due to rate increases implemented in late 2011 and a stable policy retention rate, plus the effect of an accelerated pace for recent-year new agency appointments, we believe our growth rate will likely be higher than the industry projection for 2012. In Item 1, Strategic Initiatives, Page 10, and Personal Lines Results of Operations, Pages 69 through 73, we discuss various actions we are taking to address the unsatisfactory performance of our personal lines segment, in particular the homeowner line of business. We also describe steps to enhance our response to the changing marketplace. 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, Page 38.
· Combined ratio - The combined ratio improved in 2011, primarily due to earned premium growth outpacing somewhat higher total loss and loss expenses. The total loss and loss expense ratio decrease was driven by lower ratios for current accident year loss and loss expenses plus higher levels of net favorable reserve development on prior accident years.
The $20 million increase in renewal premiums in 2011 reflected the opportunity to renew many policies for the first time as well as higher renewal pricing. Renewal pricing changes during 2011 ranged from a low-single-digit range earlier in the year to a mid-single-digit range later in the year, improving over the flat- to-slightly-up range for the second half of 2010. We measure average changes in excess and surplus lines renewal pricing as the rate of change in renewal premium for the new policy period compared with the premium for the expiring policy period, assuming no change in the level of insured exposures or policy coverage between those periods for respective policies.
New business written premiums for the year 2011 were steady compared with 2010, a result of careful underwriting in a market that was highly competitive, as evidenced by standard market companies writing policies for risks formerly insurable only in the excess and surplus lines market. We observed many cases where competing carriers offered policy terms and conditions that were less restrictive than those we observed in the past for similar risks, without a corresponding premium for the broadened insurance coverage. Therefore, we declined to write many of those new business and also some renewal business opportunities.
Other written premiums are primarily premiums that are ceded to reinsurers and that lower our net written premiums. Ceded premium volume was less in 2011 than in 2010, despite higher written premiums subject to reinsurance, because of more favorable reinsurance pricing. Beginning in 2011, treaty reinsurance for our excess and surplus lines segment was provided by The Cincinnati Insurance Company except for our corporate property catastrophe treaty, where The Cincinnati Specialty Underwriters Insurance Company is a named insured under the treaty. In previous years, all reinsurance for our excess and surplus lines segment was provided by third-party reinsurers. Reinsurance arrangements are further discussed in 2012 Reinsurance Programs, Page 98.
Catastrophe losses for all segments were higher in 2011 compared with 2010, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 51. For the excess and surplus lines segment, catastrophe losses rose somewhat, but the resulting higher ratio for the catastrophe loss component of the loss and loss expense ratio was offset by other factors. Catastrophe losses added 2.1 percentage points for 2011, 1.2 for 2010 and 0.2 percentage points for 2009 to the respective excess and surplus lines accident year loss and loss expense ratios in the table above.
The 2011 decrease of 12.8 percentage points in the current accident year loss and loss expense ratio before catastrophe losses was due in part to trends for large losses incurred relative to earned premium trends, as shown in the table below. New losses of $250,000 or more per claim totaled $13 million in 2011, compared with $12 million in 2010. Relative to significant growth in earned premiums, the modest rise in new large losses reduced the ratio by 5.1 percentage points. Higher pricing, as discussed in Excess and Surplus Lines Insurance Premiums above, also helped reduce the current accident year loss and loss expense ratio before catastrophe losses for 2011 compared with 2010.
Excess and surplus lines reserve development on prior accident years continued to net to a favorable amount in 2011 as $9 million was recognized, resulting in a loss and loss expenses ratio significantly lower than in 2010 and 2009. The 2011 favorable development was primarily due to more reliance on claims experience emergence patterns from our excess and surplus lines business for IBNR loss and loss expense estimates, with relatively less reliance on historical claims experience emergence patterns from similar lines of business for our standard commercial lines business.
We believe the loss and loss expenses 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. Our first excess and surplus lines policies were written in 2008. After two years of 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, 2011, an estimated $9 million remained unpaid for loss events that occurred in 2008 and 2009. The inherent uncertainty in estimating reserves is discussed in Property Casualty Insurance Loss and Loss Expense Reserves, Page 42. Development trends are further analyzed in Excess and Surplus Lines Insurance Segment Development of Estimated Reserves by Accident Year Reserves, Page 96.
In 2011, total large losses incurred increased by $2 million or 13 percent, net of reinsurance, a rate much lower than earned premium growth at 43 percent, helping to lower the corresponding ratio by 13.5 percentage points, compared with 2010. In 2010 the total large losses incurred ratio rose as the rate of growth in losses significantly outpaced earned premium growth. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
Other underwriting expenses declined in 2011 as a percent of earned premiums primarily due to lower technology related costs and earned premiums rising faster than expenses. The ratio for other underwriting expenses declined in 2010 primarily due to the reduction of various start-up costs that occurred during 2008 and 2009, the first two years of our excess and surplus lines operation. The primary category of expense reduction was development costs for our rating and policy administration system.
Industry reports suggest that opportunities for managing profitability and growth exist through greater use of technology. Technology and data are also being used by excess and surplus lines insurance companies to identify new exposures in emerging businesses that need insurance protection or other value-added services.
· Revenues - Earned premiums rose 4 percent for the year 2011. The largest life insurance product line, term life insurance, continued to grow earned premiums at a strong rate, up 9 percent in 2011. Gross in-force policy face amounts rose to $77.691 billion at year-end 2011 from $74.124 billion at year-end 2010 and $69.815 billion at year-end 2009.
· Profitability - The life insurance segment frequently reports only a small profit or loss because most of its investment income is included in investment segment results. We include only investment income credited to contract holders (interest assumed in life insurance policy reserve calculations) in life insurance segment results. The segment reported a $3 million loss in 2011 and has averaged a $2 million profit over the past six years.
Although we exclude most of our life insurance company investment income from investment segment results, we recognize that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life products. On a basis that includes investment income and realized gains or losses from life insurance-related invested assets, the life insurance company reported a net profit of $20 million in 2011, compared with a net profit of $39 million in 2010 and a net profit of $22 million in 2009. The life insurance company portfolio had after-tax net realized investment losses of $12 million in 2011, which included $20 million in OTTI charges, compared with after-tax net realized investment gains of $2 million in 2010. Net realized investment losses were $13 million in 2009, including $15 million in OTTI charges. Realized investment gains and losses are discussed under Investment Results of Operations, Page 81.
· Contract holders’ benefits incurred, related to traditional life and interest-sensitive products, accounted for 75.3 percent of 2011 total benefits and expenses compared with 73.6 percent in 2010 and 76.4 percent in 2009. Total contract holders’ benefits rose due to net death claims that increased but remained within our range of pricing expectations.
· Operating expenses incurred, net of deferred acquisition costs, accounted for 24.7 percent of 2011 total benefits and expenses compared with 26.4 percent in 2010 and 23.6 percent in 2009. Expenses in 2011 were up slightly, primarily due to increased health care expenses for company associates.
Because of this low rate environment, we expect broad but incremental price increases in the life industry in 2012 as companies seek to maintain profit targets in a competitive pricing environment. Such activity is expected to decrease marketplace stability. In addition, turbulence generated from recent introduction of term universal life products could magnify instability in the term market. It now appears likely that pending regulation will clarify existing reserving rules and will effectively discourage term universal life sales. We view this development as a positive since we continue to market term products with simple, more traditional designs.
We retain a positive outlook despite all of these obstacles because of our unique distribution system and emphasis on service. We see the historically low ownership of life insurance as a great opportunity and believe that independent agents are the perfect messengers to communicate the value and stability that our products offer.
Operational improvements in technology continue to make it easier for our agents to do business with us. Major milestones completed in 2011 include the introduction of a suite of electronic applications and the outsourcing of the policy administration of non-core business. Planned projects in 2012 include an upgraded commissions system and additional straight-through-processing efforts, highlighted by an electronic enrollment system for our worksite line of business. Worksite products are a natural cross-sell opportunity for commercial lines agencies and were collectively one of our fastest growing lines in 2011.
As planned, annuity sales moderated in 2011. Given the interest rate issues discussed above, we do not expect to aggressively market our annuity products in 2012. We feel that our asset liability management program allows us to manage the risk to in-force business, and we intend to try to keep the impact of new money to a manageable level.
· Dividend income rose 5 percent in 2011 after declining 1 percent in 2010. Increases in dividend payment rates for many of the holdings in our common stock portfolio during 2011 drove the increase in dividend income.
Net realized investment gains and losses totaling $128 million for the year ended December 31, 2011, reflected:
The $185 million net realized investment gains and losses in 2010 were primarily due to a $128 million gain from the sale of Verisk Analytics Inc. (NYSE: VRSK).
In 2009, most of the $440 million net realized investment gains and losses were due to $624 million in gains from sales of common stock holdings, primarily from five issuers that included the energy, healthcare and financial sectors. Realized losses of $162 million from the sale of several equity securities partially offset realized investment gains.
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2012, we expect to continue to allocate a portion of cash available for investment to equity securities, taking into consideration corporate liquidity and income requirements, as well as insurance department regulations and rating agency comments. We discuss our portfolio strategies in Item 1, Investments Segment, Page 20.
We had $10 million of federal income tax expense in 2011 compared with $124 million in 2010 and $150 million in 2009. Our corporate effective tax rate for 2011 was 5.7 percent compared with 24.8 percent in 2010 and 25.7 percent in 2009.
Historically, we have pursued a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. See Item 1, Tax-Exempt Fixed Maturities, Page 21 for further discussion on municipal bond purchases in our fixed-maturity investment portfolio. For our insurance subsidiaries, approximately 85 percent of income from tax-advantaged fixed-maturity investments is exempt from federal tax. Our non-insurance companies own an immaterial amount of tax-advantaged fixed-maturity investments. For our insurance subsidiaries, the dividend received deduction, after the dividend proration of the 1986 Tax Reform Act, exempts approximately 60 percent of dividends from qualified equities from federal tax. For our non-insurance subsidiaries, the dividend received deduction exempts 70 percent of dividends from qualified equities. Details about our effective tax rate are found on Note 11, Income Taxes, Page 29.
Investment income is a primary source of liquidity for both the parent company and our insurance subsidiary operations. For both, cash in excess of operating requirements and dividends is invested in fixed-maturity and equity securities. Equity securities provide the potential for future increases in dividend income and for capital appreciation. In Item 1, Investments Segment, Page 20, we discuss our investment strategy, portfolio allocation and quality.
Cash generated from investment income is the most important investment contribution to cash flow. While we have never sold investments to make claim payments, the sale of investments could provide an additional source of liquidity at either the parent company or insurance subsidiary level, if required. However, we follow a buy-and-hold investment philosophy, seeking to compound cash flows over the long-term. In addition to possible sales of investments, proceeds of call or maturities of fixed maturities also can provide liquidity. During the next five years, $3.324 billion, or 37.9 percent, of our fixed-maturity portfolio will mature. At year-end 2011, total unrealized gains in the investment portfolio, before deferred income taxes, were $1.489 billion. Liquidity sourced from our investment portfolio is not materially at risk from European-based securities, as our total exposure to such securities at the end of 2011 was $424 million on a fair value basis, or 3.6 percent of our total invested assets. We own no European sovereign debt. Our European-based securities are summarized by country in Item 7A, Qualitative and Quantitative Disclosures About Market Risk, Page 102.
Our debt totaled $894 million at year-end 2011, consisting of $790 million of long-term debt and $104 million in borrowings on our short-term lines of credit. We generally have minimized our reliance on debt financing although we may use lines of credit to fund short-term cash needs.
The company’s senior debt is rated investment grade by independent rating firms. On December 23, 2011, A.M. Best lowered its debt rating for our senior debt from a to a-. Three other rating agencies made no changes to our debt ratings in 2011. Our debt ratings from the other rating agencies are: BBB+ from Fitch Ratings, A3 from Moody’s Investors Service and BBB from Standard & Poor’s Ratings Services.
Our $150 million unsecured revolving line of credit is administered by The Huntington National Bank. It was established in 2007 and will mature in July, 2012. CFC Investment Company also is a borrower under this line of credit. At year-end 2011, there was $104 million borrowed on this line of credit. The Huntington National Bank, a subsidiary of Huntington Bancshares Inc. (Nasdaq:HBAN), is the lead participant with a $75 million share. U.S. Bancorp (NYSE:USB), Bank of America Corporation (NYSE:BAC) and Northern Trust Corporation (Nasdaq:NTRS) also participate, each providing $25 million of capacity.
This line of credit includes a swing line sub-facility for same-day borrowing in the amount of $35 million. The credit agreement provides alternative interest charges based on the type of borrowing and our debt rating. The interest rate charged is adjusted LIBOR plus the applicable margin. Based on our debt ratings at year-end 2011, interest for Eurodollar rate advances is adjusted LIBOR plus 33 basis points, and for floating rate advances is adjusted LIBOR. Utilization and commitment fees based on Cincinnati Financial Corporation’s year-end 2011 debt ratings are 5 basis points and 8 basis points, respectively.
At the discretion of the board of directors, the company can return cash directly to shareholders:
· Common stock repurchase - Generally, our board believes that share repurchases can help fulfill our commitment to enhancing shareholder value. Consequently, the board has authorized the repurchase of outstanding shares, giving management discretion to purchase shares at reasonable prices in light of circumstances at the time of purchase.
Our approach since mid-2008 was to preserve capital and repurchase a minimal amount of shares. Those repurchases were intended to partially offset the issuance of shares through equity compensation plans, primarily due to vesting of service-based restricted stock units of equity awards granted in the past. In August 2011, repurchases occurred because we believed our stock price was attractive, compared with book value, for such repurchases. Our corporate Code of Conduct restricts repurchases during certain time periods. The details of the repurchase authorizations and activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 34.
As of December 31, 2011, we estimate our future contractual obligations as follows:
· Property casualty profit-sharing commissions - Profit-sharing commissions are paid to agencies using a formula that takes into account agency profitability and premium volume. We estimate 2012 profit-sharing commission payments of approximately $68 million.
· Qualified pension plan - In 2012, we plan to make a voluntary cash contribution of $14 million to our qualified pension plan. We currently estimate an $18 million net pension expense and an $8 million expense for company 401(k) contributions in 2012.
· Other operating expenses - Many of our operating expenses are not contractual obligations but reflect the ongoing expenses of our business. In addition to contractual obligations for hardware and software discussed above, we anticipate capitalizing approximately $4 million in spending for key technology initiatives in 2012. Capitalized development costs related to key technology initiatives totaled $5 million in 2011, $7 million in 2010 and $28 million in 2009. These activities are conducted at our discretion, and we have no material contractual obligations for activities planned as part of these projects.
A long-term perspective governs our liquidity and capital resources decisions, with the goal of benefiting our policyholders, agents, shareholders and associates over time. While our insurance results for 2011 and 2010 did not meet our combined ratio objective of being consistently below 100 percent, our improved capital position since year-end 2009 provided adequate financial cushion. We have taken the necessary steps to protect our capital and are confident in our strategies to return our insurance operations to growth and profitability.
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, which is what occurred in the second quarter of 2011. We responded with a reduced dividend to our parent company in 2011, compared with 2010. There could also be additional obligations for our insurance operations due to increasing severity or frequency of non-catastrophe claims. To address the risk of unusual insurance loss obligations including catastrophe events, we maintain property casualty reinsurance contracts with highly rated reinsurers, as discussed under 2012 Reinsurance Programs, Page 98. We also monitor the financial condition of our reinsurers because insolvency could place in jeopardy a portion of our $622 million in outstanding reinsurance receivables at December 31, 2011.
We do not use any special-purpose financing vehicles or have any undisclosed off-balance-sheet arrangements (as that term is defined in applicable SEC rules) that are reasonably likely to have a current or future material effect on the company’s financial condition, results of operation, liquidity, capital expenditures or capital resources. Similarly, the company holds no fair-value contracts for which a lack of marketplace quotations would necessitate the use of fair-value techniques.
Due to these considerations, our actuarial staff elected to use a paid survival ratio method to estimate reserves for incurred but not yet reported asbestos and environmental claims. Although highly uncertain, reserve estimates obtained via this method have developed in a reasonably stable fashion since 2004. Since our exposure to such claims is limited, we believe the paid survival ratio method is sufficient.
Our estimates of gross property casualty loss and loss expense payments do not include reinsurance receivables or ceded losses. As discussed in 2012 Reinsurance Programs, Page 98, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance unpaid receivables of $375 million at year-end 2011 are an offset to our gross property casualty loss and loss expense obligations. Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claim severity or frequency due to a catastrophic event. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover losses under our reinsurance agreements depends on the financial viability of the reinsurers.
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 4.3 years at year-end 2011. By contrast, the duration of our loss and loss expense reserves was approximately 4.25 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow from operations is sufficient to meet these obligations. In addition, investment holdings could be sold, if necessary, to meet higher than anticipated loss and loss expenses.
The company established a reasonably likely range for net loss and loss expense reserves of $3.677 billion to $4.056 billion at year-end 2011, with the company carrying net reserves of $3.905 billion. The likely range was $3.571 billion to $3.952 billion at year-end 2010, with the company carrying net reserves of $3.811 billion. Our loss and loss expense reserves are not discounted for the time-value of money, but we have reduced the reserves by an estimate of the amount of salvage and subrogation payments we expect to recover. We provide a reconciliation of the property casualty reserves with the loss and loss expense reserve as shown on the balance sheet in Item 8, Note 4 of the Consolidated Financial Statements, Page 125.
Management’s best estimate of total loss and loss expense reserves as of year-end 2011 was consistent with the corresponding actuarial best estimate. Management’s best estimate of total loss and loss expense reserves as of year-end 2010 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, 2011, 2010 and 2009, in Item 8, Note 4 of the Consolidated Financial Statements, Page 125. The reconciliation of our year-end 2010 reserve balance to net incurred losses one year later recognizes approximately $285 million of favorable reserve development.
· 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, 2011, we had paid $1.910 billion of loss and loss expenses in calendar years 2002 through 2011 for losses that occurred in accident years 2001 and prior. An estimated $259 million of losses remained unpaid as of year-end 2011 (net re-estimated reserves of $2.169 billion from Section C less cumulative net paid loss and loss expenses of $1.910 billion).
· Section C shows the re-estimated amount of the previously reported reserves based on experience as of the end of each succeeding year. The estimate is increased or decreased as we learn more about the development of the related claims.
In evaluating the development of our estimated reserves for loss and loss expenses for the past 10 years, note that each amount includes the effects of all changes in amounts for prior periods. For example, payments or reserve adjustments related to losses settled in 2011 but incurred in 2005 are included in the cumulative deficiency or redundancy amount for 2005 and each subsequent year. In addition, this table presents calendar year data, not accident or policy year development data, which readers may be more accustomed to analyzing. Conditions and trends that affected development of reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future reserve development based on this data.
Commercial Lines Insurance Segment Development of Estimated Reserves by Accident Year
· Moderation in commercial casualty trend selections - We saw moderating loss cost trends continue in several commercial casualty coverages, most notably for umbrella liability coverage. A number of factors seem to have played a role, including a slow economic recovery, favorable court decisions, policy form restrictions, and claims department initiatives. Accordingly, it is not entirely clear whether these moderating loss cost trends will persist, and our actuaries have responded cautiously to these changes, electing to recognize improvements in trends used for estimating reserves in a progressive, incremental fashion.
· Commercial auto loss emergence - Similar to commercial casualty, commercial auto liability contributed to favorable development because both paid and reported loss emergence during calendar year 2011 was substantially less than expected. As of December 31, 2010 we expected reported loss emergence in the next 12 calendar months to be approximately $21 million; actual emergence was $17 million. Paid loss emergence was approximately 16 percent lower than expected at the prior year-end.
Personal Lines Insurance Segment Development of Estimated Reserves by Accident Year
The following table shows net reserve changes at year-end 2011, 2010 and 2009 by personal line of business and accident year:
For our homeowner line of business, the favorable reserve development on prior accident years recorded during 2011 for accident years 2010 and 2009 was primarily due to a reduction in case reserves for losses.
For the excess and surplus lines insurance segment, the table showing reserves by segment and lines of business in Property Casualty Loss and Loss Expense Obligations and Reserves, Page 88, shows the components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were up $25 million from year-end 2010 primarily due to the increase in premiums and exposures for this segment, as we discussed in Excess and Surplus Lines Insurance Results of Operations, Page 75. Favorable development during 2011 of $9 million for excess and surplus lines insurance segment reserves shown in the table below illustrates the potential for revisions inherent in estimating reserves. During 2011 we began to rely more heavily on development patterns from our own excess and surplus lines business, contributing to the modest decrease in reserves, especially for the defense and cost containment portion of loss expense reserves.
The following table shows net reserve changes at year-end 2011, 2010 and 2009 by accident year:
These estimated cash outflows are undiscounted with respect to interest. As a result, the sum of the cash outflows for all years of $4.164 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy reserves and separate accounts for future policy benefits and claims of $2.835 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $7 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, 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 $2.214 billion at year-end 2011, compared with $2.034 billion at year-end 2010. The increase was primarily due to reserves for deferred annuities. 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 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 2011, both models indicated 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 as of December 31, 2011. Net losses are net of reinsurance and income taxes.
The modeled losses according to RMS in the table are based on their RiskLink version 11.0 catastrophe model and utilize a near-term storm catalog methodology. The near-term storm catalog theory is a more conservative approach and places a higher weighting on the increased hurricane activity of the past several years, thus producing higher probable maximum loss projections than a longer-term view. The modeled losses according to AIR in the table are based on their AIR Clasic/2 version 13 catastrophe model and utilize a long-term methodology. The AIR storm catalog includes decades of documented weather events used in simulations for probable maximum loss projections.
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions about the appropriate level of risk retention are affected by various factors, including changes in our underwriting practices, capacity to retain risks and reinsurance market conditions. In evaluating our 2012 reinsurance program, we considered alternative reinsurance structures including catastrophe bonds and aggregate excess of loss coverage. After careful review of these options, we determined that the traditional reinsurance program we have historically utilized was the most financially prudent approach.
· 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 $6 million of each loss. Losses between $6 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $37 million in 2012, similar to approximately $37 million paid in 2011 and in 2010. Lower 2012 rates for this treaty were partially offset by estimates of higher levels of liability coverage direct written premiums that are subject to the treaty.
o 51.7 percent of losses between $75 million and $100 million
o 5.0 percent of losses between $400 million and $600 million
After reinsurance, our maximum exposure to a catastrophic event that caused $500 million in covered losses would be $115 million compared with $88 million in 2011 and $104 million in 2010. 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, 2011, to be $235 million before reinsurance.
· 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. The Cincinnati Specialty Underwriters Insurance Company retains the first $1 million of any policy loss. Losses between $1 million and $5 million are reinsured at 100 percent by The Cincinnati Insurance Company.
· Property catastrophe treaty - As a subsidiary of The Cincinnati Insurance Company, The Cincinnati Specialty Underwriters Insurance Company has been added as a named insured under our corporate property catastrophe treaty. All terms and conditions of this treaty apply to policies underwritten by The Cincinnati Specialty Underwriters Insurance Company.
This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. Some of those risks and uncertainties are discussed in Item 1A, Risk Factors, Page 26.
· Prolonged low interest rate environment or other factors that limit the company’s ability to generate growth in investment income or interest rate fluctuations that result in declining values of fixed-maturity investments, including declines in accounts in which we hold bank-owned life insurance contract assets
· Delays in adoption and implementation of underwriting and pricing methods that could increase our pricing accuracy, underwriting profit and competitiveness
· Inability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased, financial strength of reinsurers and the potential for non-payment or delay in payment by reinsurers
· Events or conditions that could weaken or harm the company’s relationships with its independent agencies and hamper opportunities to add new agencies, resulting in limitations on the company’s opportunities for growth, such as:
o Perceptions that the company’s level of service, particularly claims service, is no longer a distinguishing characteristic in the marketplace
o Impose new obligations on us that increase our expenses or change the assumptions underlying our critical accounting estimates
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, 2011. Its report is on Page 109. Deloitte & Touche LLP met with our audit committee to discuss the results of their examination. They have the opportunity to discuss the adequacy of internal controls and the quality of financial reporting without management present.
· Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP and that receipts and expenditures of the company are being made only in accordance with authorizations of management and the directors of the company; and
The company’s independent registered public accounting firm has issued an audit report on our internal control over financial reporting as of December 31, 2011. This report appears on Page 109.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the company) as of December 31, 2011 and 2010, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. 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, 2011, based on criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedules and an opinion on the company’s internal control over financial reporting based on our audits.
Accompanying notes are an integral part of these consolidated financial statements.
The Cincinnati Insurance Company leads our standard market property casualty insurance group that also includes two subsidiaries: The Cincinnati Casualty Company and The Cincinnati Indemnity Company. This group markets a broad range of standard market business, homeowner and auto policies. The group provides quality customer service to our select group of 1,312 independent insurance agencies with 1,648 reporting locations across 39 states. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life and disability income insurance and annuities, and The Cincinnati Specialty Underwriters Insurance Company, which began offering excess and surplus lines property and casualty insurance products in 2008.
We account for stock-based compensation in accordance with Accounting Standards Codification (ASC) 718, Compensation - Stock Compensation. We grant qualified and non-qualified stock-based compensation under authorized plans. The stock options vest ratably over three years following the date of grant and are exercisable over 10-year periods. We grant service-based restricted stock units that cliff vest three years after the date of grant. We also grant performance-based restricted stock units that vest if certain performance conditions are attained. In 2011, the CFC compensation committee approved a mix of incentive stock options, non-qualified stock options, service-based restricted and performance-based restricted stock units. See Note 17, Stock-Based Associate Compensation Plans, Page 134, for further details.
We sponsor a defined benefit pension plan that was modified during 2008. We froze entry into the pension plan, and only participants 40 years of age or older could elect to remain in the plan. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method. Refer to Note 13, Employee Retirement Benefits, Page 130 for more information regarding our defined benefit pension plan.
A segment premium deficiency is recorded when the sum of expected loss and loss adjustment expenses, expected policyholder dividends and unamortized deferred acquisition expenses exceeds the total of unearned premiums and anticipated investment income. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency. We did not record a premium deficiency for the three years ended 2011, 2010 and 2009.
Certain property casualty policies are not booked before the effective date. An actuarial estimate is made to determine the amount of unbooked written premiums. A large majority of the estimate is unearned and does not have a material impact on earned premiums.
The consolidated property casualty companies actively write property casualty insurance through independent agencies in 39 states. Our 10 largest states generated 66.5 percent and 67.1 percent of total earned premiums in 2011 and 2010,respectively. Ohio, our largest state, accounted for 19.5 percent and 20.5 percent of total earned premiums in 2011 and 2010, respectively. Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each accounted for between 4 percent and 8 percent of total earned premiums in 2011. Our largest single agency relationship accounted for approximately 1.2 percent of our total property casualty earned premiums in 2011. No aggregate agency relationship locations under a single ownership structure accounted for more than 2.1 percent of our total property casualty earned premiums in 2011.
When we issue a traditional long-duration contract, we capitalize acquisition costs. Acquisition costs are costs that vary with, and are primarily related to, the production of new business. We then charge these deferred policy acquisition costs to expenses over the premium-paying period of the contract, and we use the same assumptions used in establishing the liability for the contract. We update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate our deferred acquisition cost for recoverability.
We carry the assets of separate account BOLIs at fair value. The liabilities on separate account BOLIs primarily are the contract holders’ claims to the related assets and are carried at an amount equal to the contract holders’ account value. At December 31, 2011, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders’ account value by approximately $42 million. If the BOLI projected fair value were to fall below the value we guaranteed, a liability would be established by a charge to the company’s earnings.
Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holder, and we do not include them in the Consolidated Statements of Income. Revenues and expenses related to separate accounts consist of contractual fees and mortality, surrender and expense risk charges. Also, each separate account BOLI includes a negotiated capital gain and loss sharing arrangement between the company and the bank. A percentage of each separate account’s realized capital gain and loss representing contract fees and assessments accrues to us and is transferred from the separate account to our general account and is recognized as revenue or expense.
We reduce risk and uncertainty by buying property casualty and life reinsurance. Reinsurance contracts do not relieve us from our duty to policyholders, but rather help protect our financial strength to perform that duty. All of our reinsurance contracts transfer the economic risk of loss.
We also serve in a limited way as a reinsurer for other insurance companies, reinsurers and involuntary state pools. We record our transactions for such assumed reinsurance based on reports provided to us by the ceding reinsurer.
On April 1, 2009, we adopted a subsection of ASC 320, Recognition and Presentation of Other-Than-Temporary Impairments (OTTI). Our invested asset impairment policy states that fixed maturities the company (1) intends to sell or (2) more likely than not will be required to sell before recovery of their amortized cost basis are deemed to be other-than-temporarily impaired. The 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 non-credit loss, is recognized in other comprehensive income as an unrealized loss. With the adoption of this subsection of ASC 320 in the second quarter of 2009, we recognized a cumulative effect adjustment of $106 million, net of tax, to reclassify the non-credit component of previously recognized impairments by increasing retained earnings and reducing accumulated other comprehensive income (AOCI).
Included within our other invested assets are $37 million of life policy loans and $29 million of venture capital fund investments. Life policy loans are carried at the receivable value, which approximates fair value. The venture capital funds provide their financial statements to us and generally report investments on their balance sheets at fair value. We use the equity method of accounting for venture capital fund investments.
We include the non-credit portion of fixed-maturity OTTI charges and all other unrealized gains and losses on investments, net of taxes, in shareholders’ equity as AOCI. Realized gains and losses on investments are recognized in net income based on the trade date accounting method.
For the purpose of ASC 825 disclosure, we estimate the fair value of liabilities for investment contracts and annuities. These estimates are developed using discounted cash flow calculations across a wide range of economic interest rate scenarios with a provision for our own credit risk. We base fair value for long-term senior notes on the quoted market prices for such notes. We base fair value for notes payable on our year-end outstanding balance. We also estimate the fair value for assets arising from policyholder loans on insurance contracts using a discounted cash flow model.
We capitalize and amortize lease or loan origination costs over the life of the financing, using the effective interest method. These costs may include, but are not limited to: finder fees, broker fees, filing fees and the cost of credit reports.
See Note 11, Income Taxes, Page 129, for further detail on our uncertain tax positions. Although no Internal Revenue Service (IRS) penalties currently are accrued, if incurred, they would be recognized as a component of income tax expense. Accrued IRS interest expense is recognized as other operating expense in the consolidated statements of income.
· In May 2011, the FASB issued ASU 2011-04, Fair Value Measurements, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (IFRS). The ASU converges fair value measurement and disclosures among U.S. GAAP and IFRS. ASU 2011-04 changes certain fair value measurement principles and expands disclosure requirements, particularly for Level 3 inputs. The ASU is effective for interim and annual periods beginning after December 15, 2011, and should be applied prospectively. The ASU has not yet been adopted and will not have a material impact on our company’s financial position, cash flows or results of operations.
· In December 2011, the FASB issued ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income. ASU 2011-05 requires entities to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single, continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-12 defers the changes in ASU 2011-05 that relate to the presentation of reclassification adjustments. The deferral of those changes allows the FASB time to redeliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income for all periods presented. We will continue to report reclassifications out of accumulated other comprehensive income consistent with the presentation requirements in effect before ASU 2011-05. ASU 2011-12 is effective for the same time period as ASU 2011-05, which is for interim and annual reporting periods beginning after December 15, 2011. The ASU has not yet been adopted and will not have a material impact on our company’s financial position, cash flows or results of operations.
· In April 2010, the FASB issued ASU 2010-15, How Investments Held through Separate Accounts Affect an Insurer’s Consolidation Analysis of Those Investments. ASU 2010-15 applies to all insurance entities that have separate accounts that meet the definition and requirements set forth in the Accounting Standards Codification Manual. ASU 2010-15 clarifies that an insurance entity should not consider any separate account interests held for the benefit of contract holders in an investment to be the insurer’s interests. The insurance entity should not combine those interests with its general account interest in the same investment when assessing the investment for consolidation. The insurance entity may combine those interests when the separate account interests are held for the benefit of a related-party policyholder as defined in the Variable Interest Subsections of the Consolidation topic in the Codification Manual. The company adopted ASU 2010-15 during 2011, and it did not have a material impact on our company’s financial position, cash flows or results of operations.
The net unrealized investment gains in our fixed-maturity portfolio are primarily the result of the current low interest rate environment that increased their fair value. The net unrealized investment gains in our common stock portfolio are primarily from two holdings, The Procter & Gamble Company (NYSE:PG) and Exxon Mobil Corporation (NYSE:XOM), which had a combined net gain position of $213 million. At December 31, 2011, we had $59 million fair value of hybrid securities included in fixed maturities that follow ASC 815-15-25, Accounting for Certain Hybrid Financial Instruments. The hybrid securities are carried at fair value, and the changes in fair value are included in realized investment gains and losses. For the years ended December 31, 2011 and 2010, there were no other-than-temporary impairments included within AOCI.
At December 31, 2011, fixed-maturity investments with amortized cost of $86 million and fair value of $93 million were on deposit with various states in compliance with regulatory requirements.
For the years ended December 31, 2011 and 2010, there were no credit losses on fixed-maturity securities for which a portion of OTTI has been recognized in other comprehensive income.
With the adoption of ASC 320 in the second quarter of 2009, we recognized a cumulative effect adjustment of $106 million, net of tax, to reclassify the non-credit component of previously recognized impairments by increasing retained earnings and reducing AOCI.
In accordance with fair value measurements and disclosures, we categorized our financial instruments, based on the priority of the observable and market-based data for the valuation technique used, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3). When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used. Our valuation techniques have not changed since December 31, 2010, and ultimately management determines fair value.
· Quotes from brokers or other external sources where the inputs are not deemed observable.
During 2011, we experienced $285 million of favorable loss development on prior accident years comprised mostly of $234 million in commercial lines. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $132 million for the commercial casualty line and favorable development of $97 million for the workers’ compensation line due to reduced uncertainty of these lines one year later.
During 2010, we experienced $304 million of favorable loss development on prior accident years comprised mostly of $269 million in commercial lines. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $186 million for the commercial casualty line and favorable reserve development of $39 million for the workers’ compensation line due to reduced uncertainty of these lines one year later.
During 2009, we experienced $188 million of favorable loss development on prior accident years comprised of $147 million in commercial lines. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $154 million for the commercial casualty line and recognized adverse reserve development for the workers’ compensation line of $48 million.
We believe our exposure to asbestos and environmental claims is limited, largely because our reinsurance retention was $500,000 or below prior to 1987. We also were predominantly a personal lines company in the 1960s and 1970s. During the 1980s and early 1990s, commercial lines grew as a percentage of our overall business and our exposure to asbestos and environmental claims grew accordingly. Over that period, we included an asbestos and environmental exclusion in most policies or endorsed the exclusion to the policies.
Reserves for deferred annuities and other investment contracts were $1.025 billion and $930 million at December 31, 2011 and December 31, 2010, respectively. Fair value for these deferred annuities and investment contracts was $1.002 billion and $933 million at December 31, 2011, and December 31, 2010, respectively. Fair values of liabilities associated with certain investment contracts are calculated based upon internally developed models because active, observable markets do not exist for those items. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers as of December 31, 2011, to account for non-performance risk; (2) the rate of interest credited to policyholders is the portfolio net earned interest rate less a spread for expenses and profit; and (3) additional lapses occur when the credited interest rate is exceeded by an assumed competitor credited rate, which is a function of the risk-free rate of the economic scenario being modeled. The fair value of life policy loans outstanding principal and interest approximated $43 million, compared with book value of $37 million reported in the consolidated balance sheets at December 31, 2011. The fair value of life policy loans outstanding principal and interest approximated $46 million, compared with book value of $40 million reported in the consolidated balance sheets as of December 31, 2010.
Declared cash dividends per share were $1.605, $1.59 and $1.57 for the years ended December 31, 2011, 2010 and 2009, respectively.
Changes in 2011 ceded earned premiums compared with prior periods are related to earned reinstatement premiums for additional reinsurance coverage as a result of the increase in catastrophe losses that occurred during 2011.
Changes in 2011 ceded loss and loss expenses compared with prior periods are related to our increase in catastrophe losses that resulted in increased ceded incurred losses to our reinsurers in 2011.
As a result of positions either taken in our federal tax returns filed with the IRS or expected to be taken in the 2011 filing, we believe it is more likely than not that tax positions for which we previously carried a liability for unrecognized tax benefits will be sustained upon examination by the IRS.
In December 2010, we reached agreement with the IRS settling all issues related to the 2007 and 2008 tax years. In November, 2011, the IRS began its audit of tax years 2009 and 2010.
We sponsor a defined benefit pension plan. During 2008, we changed the form of retirement benefit we offer some associates to a company match on contributions to a 401(k) plan from the defined benefit pension plan. We froze entry into the pension plan for new associates as of June 30, 2008, and only participants 40 years of age or older as of August 31, 2008, could elect to continue to participate. For participants who left the pension plan, benefit accruals were frozen as of August 31, 2008. For participants remaining in the pension plan, we continue to contribute to fund future benefit obligations. Benefits for the defined benefit pension plan are based on years of credited service and compensation level. Contributions are based on the prescribed method defined in the Pension Protection Act. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method. During the fourth quarter of 2011, the qualified pension plan was amended to allow for distribution of vested balances to terminated participants. The plan paid $9 million to these terminated vested participants during 2011.
The discount rate was decreased by 0.25 percentage points for the qualified pension plan and 0.55 percentage points for the SERP due to market interest rate conditions at the beginning of 2011. The discount rate assumptions for our benefit obligation generally track with high grade corporate bond yields chosen in our hypothetical portfolio, and yearly adjustments reflect any changes to those bond yields. We believe the expected return on plan assets is representative of the expected long-term rate of return on these assets. We reduced the return on plan assets from 8.00 percent to 7.50 percent, which is consistent with current expectations of interest rates and based partially on the fact that the plan’s common stock holdings pay dividends. We believe this rate is representative of the expected long-term rate of return on these plan assets. Our compensation increase assumptions reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases.
Excluding cash, during 2011 we allocated approximately 70 percent of our pension portfolio to highly observable domestic common equity investments, which reflect the long-term time horizon of pension obligations. The remainder of the portfolio is allocated 16 percent to states, municipalities and taxable political subdivisions fixed-maturity investments, 12 percent to domestic corporate fixed-maturity investments and 2 percent to preferred equities. Our common equity portfolio allocated 20 percent to the information technology sector, 19 percent to the financial sector and 13 percent to the healthcare sector during 2011. All remaining sectors account for 10 percent or less of the portfolio at year end 2011. We had $2 million of cash on hand at December 31, 2011, with carrying value approximating fair value. We have purchased more fixed maturities over the past several years to increase the duration of the fixed-maturity portfolio, diversify the types of credit risk and to better match our liability risks, which is consistent with our investment strategy. Our fixed-maturity bond portfolio is investment grade. The plan does not engage in derivative transactions. We do not expect to change the current allocation of pension investments for 2012.
Investments in securities are valued based on the fair value hierarchy outlined in Note 3, Fair Value Measurements, Page 123. The following table illustrates the fair value hierarchy for those assets measured at fair value on a recurring basis at December 31, 2011 and 2010. The pension plan did not have any liabilities carried at fair value or any Level 3 assets at or during the years ended December 31, 2011 and 2010. There have been no transfers between Level 1 and Level 2 for the period ended December 31, 2011 and 2010.
Insurance companies use statutory accounting practices (SAP) as prescribed by regulatory authorities. 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.
As of December 31, 2011, we had $15 million of unrecognized total compensation cost related to non-vested stock options and restricted stock unit awards. That cost will be recognized over a weighted-average period of 1.9 years.
Cash received from the exercise of options was $1 million for the year ended December 31, 2011, and less than $1 million for the years ended 2010 and 2009.
The weighted-average remaining contractual life for exercisable awards as of December 31, 2011 was 3.3 years. A total of 16.9 million shares are authorized to be granted under the shareholder-approved plans. At December 31, 2011, 4.4 million shares were available for future issuance under the plans. During 2009, our shareholders approved the Directors’ Stock Plan of 2009, which authorizes 300,000 shares to be granted to our directors. During 2011 we granted 24,492 shares of common stock to our directors for 2010 board service fees. We currently issue new shares or use treasury shares for stock-based compensation award issues or exercises.
Service-based restricted stock units are granted to associates at fair value of the shares on the date of grant less the present value of the dividends that holders of restricted stock units will not receive on the shares underlying the restricted stock units during the vesting period. Service-based restricted stock units cliff vest three years after the date of grant. Service-based restricted stock units vested during the year had an intrinsic value of $13 million and $5 million for the years ended December, 31, 2011 and 2010, respectively. There were no performance-based restricted stock units that lapsed during the years ended December 31, 2011 and 2010. Both service-based and performance-based restricted stock units that vested or lapsed had intrinsic value less than $1 million during the year ended December 31, 2009.
· Expected volatility is based on our stock price over a historical period that approximates the expected term. We have used the historical volatilities over a range of 2.59-2.87 for 2011 and 2.76-2.86 years for 2010 grants.
· Dividend yield has been modeled assuming that the holder of the award is not entitled to receive dividends that are paid during the performance period. Dividend yield range from 4.68%-5.26% for 2011 grants and 5.41%-5.94% for 2010 grants.
Here is a summary of restricted stock unit information for 2011:
In the fourth quarter of 2011, we refined our allocation process of property casualty loss expenses. The new allocation estimate for adjusting and other expenses was based on claim count as compared with our previous allocation, which was based on claim dollar amount. As a result of this one-time refinement, adjusting and other expenses incurred increased $23 million for the personal lines segment and decreased $23 million for the commercial lines segment with various impacts to their respective lines of business.
We report as Other the non-investment operations of the parent company and its non-insurer subsidiary, CFC Investment Company. Also included in 2009 results for this segment are the operations of a former subsidiary, CinFin Capital Management.
· Income before income taxes for the insurance segments is defined as underwriting income or loss.
· Loss before income taxes for the Other category is primarily due to interest expense from debt of the parent company and operating expenses of our headquarters.
This table includes unaudited quarterly financial information for the years ended December 31, 2011 and 2010:
Note: The sum of the quarterly reported per share amounts may not equal the full year as each is computed independently.