Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building has approximately 1,508,200 total square feet of available space. The property, including land, is carried in our financial statements at $145 million as of December 31, 2012, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (less than 1 percent). This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.
Through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on 2012 direct 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.
Recent years have been challenging for the U.S. economy, the insurance industry and our company. Our long-term perspective has allowed us to address the immediate challenges of such times while also 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.
We believe this non-GAAP measure is a useful supplement to GAAP information. With the continuation of economic and market uncertainty in recent years, the long-term nature of this measure provides a meaningful measure of our long-term progress in creating shareholder value. A reconciliation of this non-GAAP measure to comparable GAAP measures is shown in the table below.
* Change in book value divided by the beginning of year book value as originally reported
In 2012, our value creation ratio of 12.6 percent was within the range of our performance objective. It improved significantly from 2011, 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 2012, our direct written premiums totaled $3.909 billion. The compound annual growth rate of our net written premiums was 2.2 percent over the five-year period 2008 through 2012, higher than the 0.7 percent estimated growth rate for the property casualty insurance industry. The industry’s growth rate excludes its mortgage and financial guaranty lines of business.
o Over the five years ended December 31, 2012, our compound annual equity portfolio return was 0.8 percent compared with a compound annual total return of 1.7 percent for the Index. Our equity portfolio underperformed the market for the five-year period primarily because of the 2008 decline in the market value of our previously large holdings in the financial services sector. For the year 2012, our annual equity portfolio return was 10.9 percent, compared with 16.0 percent for the Index, as the large-cap, dividend paying stocks that we prefer were outperformed by the broader equity market.
Management has worked to identify a strategy that can lead to long-term success, with concurrence by the board of directors. Our strategy is intended to position us to compete successfully in the markets we have targeted while appropriately managing risk. We discuss our long-term, proven strategy in Item 1, Our Business and Our Strategy, Page 3. We believe successful implementation of initiatives that support our strategy will help us better serve our agent customers and reduce volatility in our financial results while we also grow earnings and book value over the long-term, successfully navigating challenging economic, market or industry pricing cycles.
Net income in 2012 rose $257 million or 157 percent compared with 2011, due primarily to the after-tax effects of property casualty underwriting results that improved by $270 million, including $44 million from lower natural catastrophe losses, and net realized investment gains that were $17 million lower. Net income decreased $211 million in 2011, compared with 2010, reflecting the after-tax net effect of two major contributing items: a $149 million decline in property casualty underwriting results, including $165 million from higher catastrophe losses, and a $58 million decline in net realized investment gains.
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.
· We expect the insurance marketplace to remain competitive, which is likely to cause carriers to pursue strategies that they believe could lead to economies of scale, market share gains or the potential for an improved competitive posture.
We discuss in our Item 1A, Risk Factors, Page 26, many potential risks to our business and our ability to achieve our qualitative and quantitative objectives. These are real risks, but their probability of occurring may not be high. We also believe that our risk management programs generally could mitigate their
· We will incur the cost of continued investment in our business, including technology, recent entry in new states and process initiatives to create long-term value. In addition, we will not see the full advantage of some of these investments for several years.
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 112. 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 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, we calculate reserves based on an analysis of the relationship between paid losses and paid AOE. Reserves for AOE are allocated to company, line of business and accident year based on a claim count algorithm.
Our actuarial staff uses diagnostics provided by stochastic reserving software to evaluate the appropriateness of the models and methods listed above. The software’s diagnostics have indicated that the appropriateness of these models and methods for estimating IBNR reserves for our lines of business tends
to depend on a line's tail. Tail refers to the time interval between a typical claim's occurrence and its settlement. For our long-tail lines such as workers’ compensation and commercial casualty, models from the probabilistic trend family tend to provide superior fits and to validate well compared with models underlying the loss development and Bornhuetter-Ferguson methods. The loss development and Bornhuetter-Ferguson methods, particularly the reported loss variations, tend to produce the more appropriate IBNR reserve estimates for our short-tail lines such as homeowner and commercial property. For our mid-tail lines such as personal and commercial auto liability, all models and methods provide useful insights.
Quarterly, our actuarial staff summarizes their reserve analysis by preparing an actuarial best estimate and a range of reasonable IBNR reserves intended to reflect the uncertainty of the estimate. An inter-departmental committee that includes our actuarial management team reviews the results of each quarterly reserve analysis. The committee establishes management’s best estimate of IBNR reserves, which is the amount that is included in each period’s financial statements. In addition to the information provided by actuarial staff, the committee also considers factors such as the following:
· Claims having atypical emergence patterns. Characteristics of certain subsets of claims, such as high frequency, high severity, or mass tort claims, have the potential to distort patterns contained in historical paid loss, reported loss and paid defense and cost containment expense data. When testing indicates this to be the case for a particular subset of claims, our actuaries segregate these claims from the data and analyze them separately. Subsets of claims that could fall into this category include hurricane claims or claims for other weather events where total losses we incurred were very large, individual large claims and asbestos and environmental claims.
The application of our impairment policy resulted in other-than-temporary impairment (OTTI) charges that reduced our income before income taxes by $33 million in 2012, $57 million in 2011 and $36 million in 2010. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, the value is not expected to be recouped within a designated recovery period. OTTI losses represent noncash charges to income and are reported as realized investment losses.
For each of our equity securities in an unrealized loss position at December 31, 2012, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong surplus, liquidity and cash flow, provide us the ability to hold these investments through what we believe to be slightly longer recovery periods occasioned by the recession and historic levels of market volatility. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is other-than-temporarily impaired.
Valuation of financial instruments, primarily securities held in our investment portfolio, is a critical component of our year-end financial statement preparation. Fair Value Measurements and Disclosures, Accounting Standards Codification (ASC) 820-10, defines fair value as the exit price or the amount that would be (1) received to sell an asset or (2) paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. When determining an exit price, we must, whenever possible, rely upon observable market data.
Over 99 percent of the $12.466 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, 2012, total Level 3 assets were less than 1 percent of our investment portfolio measured at fair value. Broker quotes are obtained for thinly traded securities that subsequently fall within the Level 3 hierarchy. We have generally obtained and evaluated two nonbinding quotes from brokers; our investment professionals determine our best estimate of fair value.
We have a defined benefit pension plan that was modified during 2008; refer to Item 8, Note 13 of the Consolidated Financial Statements, Page 130, for additional information. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates, expected return on plan assets and compensation increase rates, which are updated annually. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions.
Key assumptions used in developing the 2012 benefit obligation for our qualified plan were a 4.20 percent discount rate and rates of compensation increases ranging from 2.75 percent to 3.25 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.
Holding all other assumptions constant, a 0.5 percentage-point decrease in the discount rate would decrease our 2013 income before income taxes by $1 million. A 0.5 percentage point decrease in the expected return on plan assets would decrease our 2013 income before income taxes by $1 million.
The fair value of the plan assets was $44 million less than the accumulated benefit obligation at year-end 2012 and $20 million less at year-end 2011. The fair value of the plan assets was $82 million less than the projected plan benefit obligation at year-end 2012 and $65 million less at year-end 2011. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. During the third quarter of 2012, we contributed $14 million to our qualified plan. We contributed $15 million to our qualified plan during the first quarter of 2013.
Information about recent accounting pronouncements is provided in Item 8, Note 1, of the Consolidated Financial Statements, Page 112. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
Earned and net written premiums for our consolidated property casualty operations grew in 2012, reflecting better pricing and strategic initiatives for targeted growth. A key measure of property casualty profitability is underwriting profit or loss. Our 2012 underwriting profit of $137 million represents a $415 million improvement over the 2011 underwriting loss of $278 million. Part of the improvement was due to a $68 million decrease in natural catastrophe losses, mostly from severe weather. More importantly, underwriting results before catastrophe losses improved, demonstrating ongoing benefits from various recent-year profit improvement and premium growth initiatives that were designed to improve results over time.
Other written premiums - primarily premiums ceded to our reinsurers as part of our reinsurance program - contributed $49 million to the $384 million of growth in 2012 net written premiums. The change in other written premiums was primarily due to $42 million of ceded premiums in 2011 to reinstate coverage layers of our property catastrophe reinsurance treaty. There were no material ceded premium effects during 2012 or 2010 from unusual items such as reinstatement.
· Combined ratio - The 2012 combined ratio improved 13.2 percentage points compared with 2011, largely reflecting better pricing and other efforts that are lowering loss ratios before catastrophe losses. Lower catastrophe losses contributed 3.3 percentage points to the improved 2012 combined ratio. In 2011, additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty contributed 1.4 percentage points to the 2011 combined ratio.
Catastrophe loss trends are an important factor in assessing trends for overall underwriting results. Our 10-year historical annual average contribution of catastrophe losses to the combined ratio was 6.1 percentage points at December 31, 2012. Our five-year average was 8.2 percentage points, below the 10.0 percent experienced for the year 2012. 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 following table shows catastrophe losses incurred, net of reinsurance, for the past three years, as well as the effect of loss development on prior period catastrophe reserves.
Catastrophe loss trends, discussed above, explain much of the movement in current accident year loss and loss expense ratios for years 2010 through 2012. Catastrophe losses added 11.1 percentage points for 2012, 13.4 points for 2011 and 5.6 points for 2010 to the respective consolidated property casualty accident year loss and loss expense ratios in the table above.
The refined allocation in 2011 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, with the refined allocation to lines of business based on claim counts rather than the previous basis of claim dollar amounts. As a result of the allocation refinement, loss expense reserves for AOE at December 31, 2011, increased by $23 million for our personal lines insurance segment and decreased by $23 million for our commercial lines insurance segment. Discussion of AOE reserves is included in Critical Accounting Estimates, How Reserves Are Established, Page 43.
Consolidated property casualty commission expenses rose $70 million or 12 percent, with profit-sharing commissions for agencies rising by $34 million. Commission expenses as a percent of earned premium increased during 2012, reflecting a 10 percent increase in earned premiums that was lower than the 12 percent increase in commission expenses.
Salaries, benefits and payroll taxes for our associates account for approximately half of our property casualty other underwriting expenses. Most of our associates either provide direct service to the property casualty portion of our agencies’ business or provide support to those associates. Since the end of 2009, the total number of associates, on a consolidated basis, declined 3 percent, reflecting careful management of our noncommission expenses. The total number of field associates providing direct service to agencies rose by 6 percent, reflecting our emphasis on providing excellent service in addition to territory expansion.
· Combined ratio - The 2012 combined ratio improved 12.3 percentage points, largely due to a lower ratio for current accident year losses and loss expenses before catastrophe losses that benefited 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.
In 2012, our commercial lines new business premiums written by our agencies grew 15 percent, up from 6 percent in 2011. For new business, our field associates are frequently in our agents’ offices helping to judge the quality of each account, emphasizing the Cincinnati value proposition, calling on sales prospects with those agents, carefully evaluating risk exposure and providing their best quotes. Some of our new business comes from accounts that are not new to the agent. We believe these seasoned accounts tend to be priced more accurately than business that may be less familiar to our agent in cases where it was recently obtained from a competing agent. As we appoint new agencies who choose to move accounts to us, we report these accounts as new business to us.
property-oriented lines of business. The executive risk portion of bond and executive risk showed improvement in 2012, after experiencing several years of unfavorable effects from the U.S. credit crisis of 2008. Since the credit crisis, many of our financial institution policies have been nonrenewed, reducing exposure for this portion of our bond and executive risk business.
Improving economic conditions also contributed to growth through higher premiums from audits that confirmed or adjusted initial premium estimates. As discussed in the commercial lines insurance premiums section of Commercial Lines Insurance Results of Operations, Page 57, 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.
In 2011, we began fully using predictive modeling tools for property coverages in our commercial package accounts to improve our pricing precision. We believe these initiatives will improve profitability over time.
Net written premiums and earned premiums for commercial auto rose in 2012, primarily due to higher pricing. Higher new business written premiums accounted for only $4 million of the $39 million increase in net written premiums, in part reflecting our efforts to increase pricing.
In early 2013, we formed a multi-department, multi-disciplinary taskforce that has been reviewing our commercial auto business to determine ways to improve profitability, similar to the approach we used to improve workers’ compensation results.
The 2011 current accident year loss and loss expense ratio before catastrophe losses rose 4.5 percentage points, compared with accident year 2010, primarily due to a rise in loss cost trends that may relate to the improving economy, combined with pricing that improved more slowly. Noncatastrophe weather losses also had a slight adverse effect on the ratio.
Workers’ compensation net written premiums and earned premiums rose in 2012, primarily due to higher pricing. Improving economic conditions contributed to growth through higher premiums from audits that confirmed or adjusted initial premium estimates. As discussed in the commercial lines insurance premiums section of Commercial Lines Insurance Results of Operations, Page 57, economic trends cause corresponding changes in underlying insured exposures, including workers’ compensation coverage where the premium amount is heavily influenced by economically-driven measures of risk exposure such as payroll volume.
The 2012 total loss and loss expense ratio improved 4.6 percentage points compared with 2011, reflecting lower current accident year losses and loss expenses that were partially offset by a lower amount of favorable development on prior accident year reserves. We continue to see loss emergence that was less than expected for nearly every accident year, resulting in another year of net favorable development. Development trends are further discussed in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92.
The 2011 current accident year loss and loss expense ratio declined 9.9 percentage points compared with accident year 2010, estimated as of December 31, 2010. In addition to the favorable effect of the refined line of business allocation process for loss expenses, the loss portion of the ratio improved, reflecting initiatives discussed below.
Since we pay a lower commission rate on workers’ compensation business, relative to our other commercial lines of business, this line has a higher calendar year loss and loss expense ratio breakeven point than our other commercial business lines. We believe various initiatives in recent years contributed to improved profitability. During 2009, we began using a predictive modeling tool to improve risk selection and pricing precision. In 2010, we added to our staff of loss control field representatives, premium audit field representatives and field claims representatives specializing in workers’ compensation risks. We also implemented direct reporting of workers’ compensation claims, allowing us to quickly obtain detailed information from policyholders to promptly assign the appropriate level of claims handling expertise to each case. Obtaining more information sooner for specific claims allows for medical care appropriate to the nature of each injury, benefiting injured workers, employers and agents while ultimately lowering overall loss costs.
The 2011 current accident year loss and loss expense ratio before catastrophe losses also increased, compared with accident year 2010, largely due to noncatastrophe weather and the effects of reinstatement premiums.
Net written premiums and earned premiums for surety and executive risk rose in 2012, with approximately one-third of the increase from renewal premiums that reflected higher pricing. Premiums ceded to reinsurers had less of a downward effect, by approximately $6 million, on net written premiums and earned premiums in both 2012 and 2011, compared with the respective prior year. Ceded premiums were reduced largely due to better than expected loss experience in recent years, resulting in lower rates charged by reinsurers.
· Marketing primarily to nonprofit organizations, accounting for approximately 81 percent of the policies and 50 percent of the premium volume in force for 2012 director and officer liability business.
· Closely monitoring our for-profit policyholders - At year-end 2012, our director and officer liability policies in force provided coverage to 13 nonfinancial publicly traded companies, including two Fortune 1000 companies. We also provided this coverage to approximately 450 banks, savings and loans and other financial institutions. The majority of these financial institution policyholders are smaller community banks, and we believe they have no unusual exposure to credit-market concerns, including subprime mortgages. Based on new policy data or information from the most recent policy renewal, only 11 of our banks have assets greater than $2 billion; only 24 have assets from $1 billion to $2 billion; and 69 have assets from $500 million to $1 billion. The remaining 292 banks have assets below $500 million.
Net written premiums for the commercial lines industry, excluding the mortgage and financial guaranty lines of business, are projected to increase approximately 4 percent in 2013, with the industry statutory combined ratio estimated at approximately 103 percent. Over the past several years, renewal and new business pricing has experienced significant competitive pressure, reinforcing the need for more pricing analytics and careful risk selection. While competition remains intense, industrywide commercial lines market pricing turned positive toward the end of 2011 and continued to firm in 2012, according to several industry surveys. Average renewal pricing for our commercial lines segment also turned positive. Opinions vary, according to a variety of reports that focus on the commercial lines market, regarding the sustainability of improved pricing. According to A.M. Best, commercial lines pricing is anticipated to continue to improve during 2013, but will moderate slightly compared with rate increases in 2012. Despite challenging market conditions, we believe we can manage our business and execute strategic initiatives to offset market pressures to some extent and still profitably grow our commercial lines segment.
In Item 1, Strategic Initiatives, Page 10, we discuss the initiatives we are implementing to achieve our corporate performance objectives. We discuss factors influencing future results of our property casualty insurance operations in the Executive Summary, Page 38.
As discussed below in Personal Lines Insurance Premiums, in recent years we have increased our use of pricing precision and implemented numerous rate increases to improve our personal lines segment results. Since early 2008, we have worked to improve our geographic diversification by expanding our personal lines operation to several states less prone to catastrophes, including the western states of Arizona, Idaho, Montana and Utah. We have also nonrenewed approximately 2,300 homeowner policies in Florida and Alabama that we believe were the most exposed to losses from hurricane damage. Our progress in geographic diversification is demonstrated by higher premium growth rates in our smaller states, in terms of personal lines premium volume. Personal lines earned premiums in the six states with our largest personal lines volume increased 10 percent in 2012 while increasing 22 percent in the remaining states. Our new business written premiums rose 17 percent in 2012, with those six states declining 2 percent, while rising 34 percent in all other states.
The 11 percent increase in 2012 agency renewal written premiums reflected various rate changes during recent years. In October 2012, we began our fourth round of increases for the homeowner line of business, averaging approximately 9 percent, with some individual policy rate increases lower or higher based on attributes of risk that characterize the insured exposure. That followed rate changes over successive years averaging approximately 7 percent annually that were implemented beginning the fourth quarter of 2009 for states representing the majority of our personal lines business. Beginning in the first half of 2013, we are implementing rate changes for our personal auto line of business in the majority of the 31 states where we market personal lines policies. The average rate change is an increase in the low-single-digit range, with some individual policies experiencing lower or higher rates based on enhanced pricing precision enabled by predictive models. Rate changes for personal auto implemented beginning late 2011 and 2010 also represented an annual average rate increase in the low-single-digit range.
Other written premiums primarily consist of premiums that are ceded to reinsurers and that lower our net written premiums. Other written premiums contributed $20 million to 2012 net written premium growth. The change in 2012 other written premiums, compared with 2011, was driven by additional ceded premiums in 2011 for our property catastrophe reinsurance treaty.
Personal lines reserve development on prior accident years continued to net to a favorable amount in 2012, as $99 million was recognized, higher than $42 million in 2011 and $34 million in 2010. The homeowner line of business represented more than half of the 2012 increase. Approximately 50 percent of our personal lines reserve development on prior accident years recognized during 2012 occurred in our homeowner line of business and nearly 30 percent occurred in our other personal line of business. Development recognized during 2011 was mostly from those same lines of business and in 2010 was most of it was 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 71, and in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92.
In 2012, personal lines total large losses incurred increased by $6 million or 7 percent, net of reinsurance. The corresponding ratio decreased 0.7 percentage points, as earned premium growth doubled the rate of growth in total large losses. The majority of the 2012 increase was for homeowner fire claims. In 2011 total large losses increased over 2010, primarily due to higher 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.
Personal lines commission expense as a percent of earned premium increased in 2012, primarily due to higher agency profit-sharing commissions. In 2011, lower agency profit-sharing commission drove the decrease.
Other underwriting expenses as a percent of earned premium decreased in 2012, as earned premium growth outpaced a modest increase in expenses. Other underwriting expenses decreased in 2011, primarily due to a first-quarter 2010 provision for matters involving contingent liabilities.
Net written premiums for personal auto increased in 2012, reflecting rate increases in recent years, ongoing high levels of policy retention, premium growth initiatives and a higher level of insured exposures.
The total loss and loss expense ratio improved 7.7 percentage points, largely due to a 3.9 point decrease in the ratio for the current accident year before catastrophe losses that included a 2.1 point decline in paid losses. Catastrophe losses that declined 0.5 percentage points and a larger amount of favorable reserve development on prior accident years also contributed to the improved total loss and loss expense ratio. Large losses above $250,000 per claim were approximately 40 percent higher in both 2012 and 2011, compared with 2010, contributing to the higher total loss and loss expense ratio for the past two years.
The 2011 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 rose $66 million or 21 percent in 2012, with higher renewal premiums driving almost two-thirds of the increase. Lower ceded premiums for reinsurance contributed $19 million of the increase in net written premiums. Premiums ceded for reinsurance, which reduce premium revenue, were $21 million in 2012, $40 million in 2011 and $18 million in 2010. The total ceded premiums for 2011 increased primarily from premiums to reinstate coverage layers of our property catastrophe reinsurance treaty.
We continue efforts to improve pricing precision through predictive analytics, which we believe will help to achieve long-term profitability. Rate increases in recent years, discussed in Personal Lines Insurance Premiums, Page 69, should help lower loss ratios as the rate increases are earned. Those rate changes were implemented beginning in October of 2012, 2011, 2010 and 2009 and averaged approximately 9 percent, 8 percent, 7 percent and 6 percent, respectively. In 2013, we are increasing our use of higher loss deductibles and actual cash value claims settlement for insured damage to older roofs. In addition, we are increasing the number of property inspections conducted when homeowner policies renew, providing more opportunities for underwriting or pricing actions on a case-by-case basis. We also continue our gradual expansion into states less prone to catastrophe losses, which we believe will reduce variability in the long-term future catastrophe loss ratio. In recent years, we have nonrenewed approximately 2,300 policies in Florida and Alabama that we believe were the most exposed to losses from hurricane damage. Together these actions represent important steps we are taking to improve homeowner results.
The current accident year loss and loss expense ratio before catastrophe losses for 2012 decreased 11.3 percentage points compared with the 2011 ratio, largely due to the same noncatastrophe weather-related losses and reinsurance reinstatement effects noted above that raised the 2011 total loss and loss expense ratio.
Other personal premiums increased in 2012 and 2011, 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 5 percent in 2013, with an industry statutory combined ratio estimated at approximately 101 percent. Due to rate increases 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 2013. In Item 1, Strategic Initiatives, Page 10, and Personal Lines Results of Operations, beginning on Page 68, we discuss various actions we are taking to address the unsatisfactory performance of our personal lines segment, in particular the homeowner line of business. 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.
Our excess and surplus lines segment includes results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources Inc. The year 2012 represented our fifth full year of operations for our excess and surplus lines segment. Performance highlights for the excess and surplus lines segment include:
· Premiums - Earned premiums continued to climb in 2012, a result of strong growth in net written premiums, similar to 2011. Growth of net written premiums in 2012 was driven by higher renewal written premiums that included rising average renewal price increases. New business written premiums for 2012 rose compared with 2011, reflecting higher pricing in an excess and surplus lines market that continued to experience strong competition.
New business written premiums for the year 2012 rose 9 percent, compared with 2011, primarily due to higher pricing as the excess and surplus lines market remained competitive, including activity 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 opportunities 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 for 2012 increased relative to 2011, reflecting higher written premiums subject to reinsurance. 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 that generally provided less favorable pricing. Reinsurance arrangements are further discussed in 2013 Reinsurance Programs, Page 95.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses, as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in our excess and surplus lines segment three-year highlights table on Page 74 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than 20 percent of our 2012 excess and surplus lines current accident year incurred losses and loss expenses represents net paid losses, a large majority represents reserves for our estimate of unpaid losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 85.0 percent accident year 2010 loss and loss expense ratio reported as of December 31, 2010, developed favorably by 13.9 percentage points to 71.1 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2012. Accident years 2011 and 2010 for this segment have both developed favorably, as indicated by the progression over time of the ratios in the table.
The 2012 increase of 1.8 percentage points in the current accident year loss and loss expense ratio before catastrophe losses was primarily due to trends in large losses incurred relative to earned premium trends, as shown in the table below. New losses of $250,000 or more per claim totaled $18 million in 2012, compared with $13 million in 2011. Relative to growth in earned premiums, the increase in new large losses raised the ratio by 1.2 percentage points.
In 2012, total large losses incurred increased by $7 million or 41 percent, net of reinsurance, exceeding earned premium growth at 33 percent, helping to raise the corresponding ratio by 1.3 percentage points, compared with 2011. The ratio for the year 2011 trended in the opposite direction, as earned premium growth significantly outpaced the rate of growth in total large 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 excess and surplus lines markets are expected to see continued firming in 2013, according to several industry reports. Competition is expected to remain strong, in part due to standard market insurance companies insuring businesses that previously were written by excess and surplus lines insurers. While soft market conditions for commercial lines business overall is the driver of this trend, firming is expected primarily for property coverage due to industry catastrophe losses and for select casualty classes of business where loss costs are exceeding rates, such as habitational and lessors-risk classes. The slowly recovering U.S. economy, another major factor in demand for insurance products, is also expected to contribute to modestly increasing premium volume during 2012 for the excess and surplus lines industry.
· 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 2012 and 2011, following a $6 million profit in 2010, and has averaged a $1 million profit over the past six years.
Separate account investment management fee income contributed $1 million to total revenue in 2012, compared with $2 million in 2011 and $1 million in 2010.
Over the past several years, we have worked to maintain a portfolio of simple, yet competitive products, primarily under the LifeHorizons banner. Our product development efforts emphasize death benefit protection and guarantees. Distribution expansion within our property casualty insurance agencies remains a high priority. In the past several years, we have added life field marketing representatives for the western, southeastern and northeastern states. Our 32 life field marketing representatives work in partnership with our 127 property casualty field marketing representatives. Approximately 69 percent of our term and other life insurance product premiums were generated through our property casualty insurance agency relationships.
Despite all of this, we retain a positive outlook for 2013. Our core product line, term life insurance, is not as sensitive to interest rates as other products. And because of our distribution system, we are able to grow our business as the footprint of our property and casualty parent expands. We also 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.
We look for continued price increases on life products that have a heavy investment component. The term life insurance market looks to have stabilized for the time being and will likely remain little changed as companies wait to see how aggressively state legislatures move to pass a new principles-based reserve approach that was recently adopted by the National Association of Insurance Commissioners. Principles-based reserves, once effective, could prompt a wave of repricing activity, with rate reductions for term life insurance. While its ultimate passage is still not certain, industry consensus is that the beginning of 2015 would be the earliest implementation date for the new reserve law.
Our property casualty agencies remain the main distribution system for our life insurance segment, and we continue to emphasize securing an increasing share of the life insurance premium produced by these agencies. While other life insurers expand nontraditional distribution channels such as direct sales, we intend to market through agencies affiliated with our property casualty insurance operations or independent life-only agencies. In 2012, our property casualty agencies produced approximately 69 percent and our life-only agencies 31 percent of our life insurance premium.
Improvements in our operational technology continue to make it easier for our agents to do business with us. We recently introduced electronic enrollment software for our voluntary worksite marketing segment. We look for that segment to continue to grow as more and more employers are looking to supplement their employee benefit programs with voluntary options. We also plan to roll-out application functionality for the iPad, which we expect to increase agent use of our electronic application process. Finally, we recently introduced a new commission system which will allow for more flexible compensation agreements with our independent agency force.
Pretax investment income increased 1 percent in 2011, primarily because of a higher average dividend payment rate for common stocks in our equity portfolio.
In 2012, we continued to invest available cash flow in both fixed income and equity securities in a manner that we believe balances current income needs with longer-term invested asset growth goals. While our bond portfolio more than covers our insurance reserve liabilities, we believe our diversified common stock portfolio of mainly blue chip, dividend-paying companies represents one of our best investment opportunities for the long term. We position our portfolio with consideration to both the challenges presented by the current low interest rate environment and the risks presented by potential future inflation. As bonds in our generally laddered portfolio mature or are called over the near term, we will be challenged to replace their current yield. Approximately 23 percent of our fixed-maturity investments mature during 2013 through 2015 with an average pretax yield-to-amortized cost of 4.6 percent, including 6.6 percent of the portfolio maturing during 2013 and yielding 4.5 percent, 7.4 percent of the portfolio maturing during 2014 and yielding 4.9 percent and 8.8 percent of the portfolio maturing during 2015 and yielding 4.5 percent.
We discussed our portfolio strategies in Item 1, Investments Segment, Page 20. We discuss risks related to our investment income and our fixed-maturity and equity investment portfolios in Item 7a, Quantitative and Qualitative Disclosures About Market Risk, Page 100.
Net realized investment gains and losses totaling $42 million for the year ended December 31, 2012, included:
· $35 million in gains from fixed-maturity security sales and calls.
· $33 million in OTTI charges to write down holdings of equity and fixed-maturity securities.
In 2010, most of the $185 million net realized investment gains and losses were due to a $128 million gain from the sale of Verisk Analytics Inc. (NYSE: VRSK).
OTTI charges from the investment portfolio by the asset classes we described in Item 1, Investments Segment, Page 20, are summarized below:
The general market view is that, in light of Federal Reserve commentary, interest rates are likely to remain well below historic averages for at least the next two years. This will continue to apply pressure on investment income.
Revenues in 2012 for our Other operations increased $1 million, compared with 2011, while expenses remained at the same level. Other includes noninvestment operations of the parent company and its subsidiary, CFC Investment Company. Losses before income taxes for Other were largely driven by interest expense from debt of the parent company.
We had $145 million of federal income tax expense in 2012 compared with $9 million in 2011 and $123 million in 2010. Our corporate effective tax rate for 2012 was 25.6 percent compared with 5.2 percent in 2011 and 24.7 percent in 2010.
The parent company’s primary sources of cash inflows are dividends from our insurance subsidiary, investment income, maturity of fixed income securities and sale proceeds from investments. The parent company’s cash outflows are primarily interest and principal payments on long- and short-term debt, dividends to shareholders, common stock repurchases, pension contributions, investment purchases and general operating expenses. As of December 31, 2012, the parent company had $1.151 billion in cash and marketable securities, providing strong liquidity to fund cash outflows, as needed.
The table below shows a summary, by the direct method, of the major sources and uses of cash flow by the parent company. Dividends received from subsidiaries in 2012 were $115 million more than 2011 due to lower catastrophe losses that increased net cash provided by operating activities. We expect 2013 sources of cash flows to be similar to 2012, assuming similar catastrophe losses. The majority of expenditures for the parent company have been consistent during the last three years, and we expect future expenditures to remain fairly stable. Share repurchases are discretionary, depending on cash availability and capital management decisions.
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 shareholder dividends is invested in fixed-maturity and equity securities. Equity securities provide the potential for future increases in dividend income and for capital appreciation.
· $391 million aggregate principal amount of 6.92% senior debentures due 2028.
· $28 million aggregate principal amount of 6.9% senior debentures due 2028.
The company’s senior debt is rated investment grade by independent rating firms. None of the four rating agencies made changes to our debt ratings in 2012. Our debt ratings at February 25, 2013, were: a- from A.M. Best, BBB+ from Fitch Ratings, A3 from Moody’s Investors Service and BBB from Standard & Poor’s Ratings Services.
Our $225 million unsecured revolving line of credit is administered by PNC Bank, N.A., a subsidiary of The PNC Financial Services Group Inc. (NYSE:PNC). It was established in 2012 and will expire in May 2017. Our subsidiary CFC Investment Company also is a borrower under this line of credit. PNC Bank is the lead participant bookrunner with a $65 million share. Fifth Third Bancorp (Nasdaq:FITB) is the syndication agent with a $65 million share. U.S. Bancorp (NYSE:USB), BB&T Corp (NYSE:BBT) and Huntington Bancshares, Inc. (Nasdaq:HBAN) each provide $25 million of capacity, and Northern Trust Corporation (Nasdaq:NTRS), provides $20 million of capacity.
As of December 31, 2012, we estimate our future contractual obligations as follows:
Our two most significant contractual obligations are discussed in conjunction with related insurance reserves in Property Casualty Loss and Loss Expense Obligations and Reserves and Life Insurance Policyholder Obligations and Reserves beginning on Pages 88 and 94, respectively. Other future contractual obligations include:
· 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 2013 profit-sharing commission payments of approximately $102 million.
· Computer hardware and software - We expect to spend $41 million over the next three years for current material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discuss below the noncontractual expenses we anticipate for computer hardware and software in 2013.
At December 31, 2012, we believe our most significant other commitments are:
· Other operating expenses - Many of our operating expenses are not contractual obligations but reflect the ongoing expenses of our business. In addition to contractual obligations for hardware and software discussed above, we anticipate capitalizing approximately $5 million in spending for key technology initiatives in 2013. Capitalized development costs related to key technology initiatives totaled $4 million in 2012 and $5 million in 2011. 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 benefitting our policyholders, agents, shareholders and associates over time. Our 2012 insurance results met our combined ratio objective of being consistently within the range of 95 percent to 100 percent, although it was not met in 2011. Our capital position has improved significantly since year-end 2009, providing adequate financial cushion when short-term operating results do not meet our objectives.
At December 31, 2012, we had $487 million in cash and cash equivalents. That strong liquidity and our consistent cash flows give us the flexibility to meet current obligations and commitments while building value by prudently investing where we see potential for both current income and long-term return.
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, as occurred in the second quarter of 2011. We responded with a reduced insurance subsidiary dividend to our parent company in 2011. There could also be additional obligations for our insurance operations due to increasing severity or frequency of noncatastrophe claims. To address the risk of unusually large insurance loss obligations including catastrophe events, we maintain property casualty reinsurance contracts with highly rated reinsurers, as discussed under 2013 Reinsurance Programs, Page 95. We also monitor the financial condition of our
reinsurers because insolvency could place in jeopardy a portion of our $615 million in outstanding reinsurance recoverable at December 31, 2012.
Further, parent company liquidity could be constrained by Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay. During 2013, our insurance subsidiary can pay $391 million in dividends to our parent company without regulatory approval.
For the business lines in the commercial and personal lines insurance segments, and in total for the excess and surplus lines segment, the following table details gross reserves among case, IBNR and loss expense reserves, net of salvage and subrogation. Reserving practices are discussed in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 43.
The decrease in total gross reserves was largely due to a $93 million reduction in case reserves for our commercial casualty and workers’ compensation lines of business in total. The majority of the $40 million decrease in IBNR reserves was from a $31 million reduction in for our commercial property and homeowner lines of business in total, in part due to lower catastrophe losses. Total gross reserves for our excess and surplus lines insurance segment rose $45 million, reflecting a 33 percent increase in earned premiums.
Additionally, since 2002, we have revised policy terms where permitted by state regulation to limit our exposure to mold claims prospectively and further reduce our exposure to other environmental claims
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2012 and 2011. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
We reconcile the beginning and ending balances of our reserves for loss and loss expenses at December 31, 2012, 2011 and 2010, in Item 8, Note 4 of the Consolidated Financial Statements, Page 125. The reconciliation of our year-end 2011 reserve balance to net incurred losses one year later recognizes approximately $396 million of favorable reserve development.
· Section A shows our total property casualty loss and loss expense reserves recorded at the balance sheet date for each of the indicated calendar years on a gross and net basis. Those reserves represent the estimated amount of unpaid loss and loss expenses for claims arising in the indicated calendar year and all prior accident years at the balance sheet date, including losses that were incurred but not yet reported to the company.
· Section D, cumulative net reserve development, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 2002, had developed favorably by $305 million over 10 years, net of reinsurance, which was reflected in income over the 10 years. The table shows favorable reserve development as a negative number. Favorable reserve development on prior accident years, which represents a negative expense, is favorable to income. The “One year later” line in the table shows the effects on income before income taxes in 2012, 2011 and 2010 of changes in estimates of the reserves for loss and loss expenses for all accident years. The effect was favorable to pretax income for those three years by $396 million, $285 million, and $304 million, respectively.
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 2012 but incurred in 2006 are included in the cumulative deficiency or redundancy amount for 2006 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.
The following table shows net reserve changes at year-end 2012, 2011 and 2010 by property casualty segment and accident year:
· Commercial auto loss emergence - Commercial auto developed slightly unfavorably during calendar year 2012. This line has become troublesome for the industry as a whole, perhaps due to an improving economy. We continue to watch it closely.
· Workers’ compensation trends and initiatives - We continue to see favorable calendar year development for this line. Loss emergence during 2012 was less than expected for nearly every accident year. The trend for payments to be made in future calendar years is down slightly. However, we are watching this line closely, as a sudden increase in trend for future payments has a highly leveraged effect. Initiatives to improve profitability of our workers’ compensation line of business are discussed in Commercial Lines Insurance Results of Operations, Commercial Lines of Business Analysis, Page 60.
coverage in the other personal line of business. Among the factors that appeared to be causing moderating loss cost trends were a slow economic recovery, favorable court decisions, policy form restrictions and claims department initiatives.
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 $45 million from year-end 2011 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 74. Favorable development during 2012 of $5 million for excess and surplus lines insurance segment reserves, shown in the table above, illustrates the potential for revisions inherent in estimating reserves. During 2011, we began to rely more heavily on development patterns from our own excess and surplus lines business, contributing to the modest decrease in reserves, especially for the defense and cost containment portion of loss expense reserves.
Our estimates of gross life, annuity and disability obligations do not reflect net recoveries from reinsurance agreements. Ceded life reinsurance receivables were $235 million at year-end 2012. As discussed in 2013 Reinsurance Programs, Page 95, we purchase reinsurance to mitigate our life insurance risk exposure. At year-end 2012, ceded death benefits represented approximately 44.6 percent of our total policy face amounts in force.
Gross life policy reserves were $2.295 billion at year-end 2012, compared with $2.214 billion at year-end 2011. The increase was primarily due to reserves for traditional life insurance contracts. We establish reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
To help determine appropriate reinsurance coverage for hurricane, earthquake, and tornado/hail exposures, we use the RMS and AIR models to estimate the probable maximum loss from a single event or multiple events occurring in a one-year period. The models are proprietary in nature, and the vendors that provide them periodically update the models, sometimes resulting in significant changes to their estimate of probable maximum loss. As of the end of 2012, both models indicated that a hurricane event represents our largest amount of exposure to losses. The table below summarizes estimated probabilities and the corresponding probable maximum loss from a single hurricane event occurring in a one-year period, and indicates the effect of such losses on consolidated shareholders’ equity as of December 31, 2012. Net losses are net of reinsurance and income taxes.
The modeled losses according to RMS in the table are based on its RiskLink version 11.0 catastrophe model and use a near-term storm catalog methodology. The near-term storm catalog theory is a more conservative approach and places a higher weighting on the increased hurricane activity of the past several years, thus producing higher probable maximum loss projections than a longer-term view. The modeled losses according to AIR in the table are based on its AIR Clasic/2 version 13 catastrophe model and use a long-term methodology. The AIR storm catalog includes decades of documented weather events used in simulations for probable maximum loss projections.
Currently participating on our standard market property and casualty per-risk and per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of which had A.M. Best insurer financial strength ratings of A+ (Superior) or better as of December 31, 2012. Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and the European markets. The largest participant in our property catastrophe program, representing approximately 46 percent of total participation, is the Lloyds of London placement that features numerous syndicates, with R.J. Kiln & Company Limited and the Catlin Syndicate taking the largest participations. Other primary participants in our property catastrophe program include Liberty Syndicates, Alterra, Argo Re and MAPFRE RE.
· Property excess treaty - For 2013, we made our initial purchase of a property reinsurance treaty that provides an additional $10 million in protection for property losses. This treaty, along with the property per risk treaty, provides a total of $35 million of protection. The ceded premium is estimated at approximately $5 million in 2013, and should lower premiums for facultative reinsurance that was formerly obtained for certain individual risks with insured values in excess of $25 million.
The Cincinnati Specialty Underwriters Insurance Company has separate property and casualty reinsurance treaties for 2013 through The Cincinnati Insurance Company. Primary components of the treaties include:
· Property per risk treaty - The property treaty provides limits up to $5 million, which is adequate capacity for the risk profile we insure. It also includes protection for extra-contractual liability coverage losses. Cincinnati Specialty Underwriters retains the first $500,000 of any policy loss. Losses between $500,000 and $5 million are reinsured at 100 percent by Cincinnati Insurance.
· Casualty treaties - The casualty treaty is written on an excess of loss basis and provide limits up to $6 million, which is adequate capacity for the risk profile we insure. A second treaty layer of $5 million excess of $6 million is written to provide coverage for extra contractual obligations or clash exposures. The maximum retention for any one casualty loss is $1 million by Cincinnati Specialty Underwriters. Losses between $1 million and $11 million are reinsured at 100 percent by Cincinnati Insurance.
The Cincinnati Insurance Company’s reinsurance program for 2013 includes participation in two assumed reinsurance treaties with R.J. Kiln & Company Limited, a reinsurer that spreads its losses to its property book of business among many reinsurers. The exposure to loss is usually triggered as a result of very high catastrophe losses. The First Surplus treaty has exposure for us of up to nearly $2 million of assumed losses from a single event and the Second Surplus treaty has exposure for us of up to nearly $3 million of assumed losses from a single event. The treaties with Kiln Group Limited were in place during 2012 at similar exposure levels.
· Recession or other economic conditions resulting in lower demand for insurance products or increased payment delinquencies
· Declines in overall stock market values negatively affecting the company’s equity portfolio and book value
· Actions of insurance departments, state attorneys general or other regulatory agencies, including a change to a federal system of regulation from a state-based system, that:
o Place the insurance industry under greater regulatory scrutiny or result in new statutes, rules and regulations
o Add assessments for guaranty funds, other insurance related assessments or mandatory reinsurance arrangements; or that impair our ability to recover such assessments through future surcharges or other rate changes
o Increase our provision for federal income taxes due to changes in tax law
· Events, such as an epidemic, natural catastrophe or terrorism, that could hamper our ability to assemble our workforce at our headquarters location
The company’s independent registered public accounting firm has issued an audit report on our internal control over financial reporting as of December 31, 2012. This report appears on Page 107.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012. 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, 2012, 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.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2012 and 2011 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Net income per common share is based on the weighted average number of common shares outstanding during each of the respective years. We calculate net income per common share (diluted) assuming the exercise of stock-based awards.
Property casualty written premiums are deferred and recorded as earned premiums on a pro rata basis over the terms of the policies. We record as unearned premiums the portion of written premiums that applies to unexpired policy terms. Certain expenses associated with successfully acquiring insurance policies - primarily commissions, premium taxes and underwriting costs - are deferred and amortized over the terms of the policies. All acquisition costs reflect the retrospective adoption of ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which we adopted on January 1, 2012. We assess recoverability of deferred acquisition costs at the segment level, consistent with the way we acquire, service and manage insurance policies and measure profitability. We analyze our acquisition cost assumptions to reflect actual experience, and we test for potential premium deficiencies.
The consolidated property casualty companies actively write property casualty insurance through independent agencies in 39 states. Our 10 largest states generated 65.4 percent and 66.5 percent of total earned premiums in 2012 and 2011, respectively. Ohio, our largest state, accounted for 19.1 percent and 19.5 percent of total earned premiums in 2012 and 2011, respectively. Illinois, Indiana, Pennsylvania, Georgia, North Carolina and Michigan each accounted for between 4 percent and 8 percent of total earned premiums in 2012. Our largest single agency relationship accounted for approximately 0.9 percent of our total property casualty earned premiums in 2012. 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 2012.
We offer several types of life insurance and disability income insurance, and we account for each according to the duration of the contract. Short-duration contracts are written to cover claims that arise during a short, fixed term of coverage. We generally have the right to change the amount of premium charged or cancel the coverage at the end of each contract term. Group life insurance is an example. We record premiums for short-duration life and health contracts similarly to property casualty contracts.
Long-duration contracts are written to provide coverage for an extended period of time. Traditional long-duration contracts require policyholders to pay scheduled gross premiums, generally not less frequently than annually, over the term of the coverage. Premiums for these contracts are recognized as revenue when due. Whole life insurance and disability income insurance are examples. Some traditional long-duration contracts have premium payment periods shorter than the period over which coverage is provided. For these contracts, the excess of premium over the amount required to pay expenses and benefits is recognized over the term of the coverage rather than over the premium payment period. Ten-pay whole life insurance is an example.
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 comprehensive 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 record land at cost, and record building and equipment at cost less accumulated depreciation. Equipment held under capital leases also is classified as property and equipment with the related lease obligations recorded as liabilities. We capitalize and amortize costs for internally developed computer software during the application development stage. These costs generally consist of external consulting, payroll and payroll-related costs. Our depreciation is based on estimated useful lives (ranging from three years to 39½ years) using straight-line and accelerated methods. Depreciation expense was $37 million in 2012, $46 million in 2011, and $40 million in 2010. We monitor land, building and equipment and software assets for potential impairments. Potential impairments may include a significant decrease in the fair values of the assets, considerable cost overruns on projects, a change in legal factors or business climate or other factors that indicate that the carrying amount may not be recoverable or useful. There were no recorded land, building and equipment impairments for 2012, 2011 or 2010.
We calculate deferred income tax liabilities and assets using tax rates in effect when temporary differences in financial statement income and taxable income are expected to reverse. We recognize deferred income taxes for numerous temporary differences between our taxable income and financial statement income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains and losses on investments and differences in the recognition of deferred acquisition costs, unearned premium and insurance reserves. We charge deferred income taxes associated with unrealized appreciation and depreciation of investments (except the amounts related to the effect of income tax rate changes) to shareholders’ equity in AOCI. We charge deferred taxes associated with other differences to income.
See Note 11, Income Taxes, Page 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 comprehensive income.
· In February 2013, the FASB issued ASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. ASU 2013-02 requires entities to present in either a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source and the income statement line items affected by the reclassification. Items not required to be reclassified to net income in their entirety are cross referenced to a related footnote for additional information. The ASU is effective for interim and annual periods beginning after December 15, 2012. 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 October 2010, the FASB issued ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. ASU 2010-26 modified the definitions of the type of costs incurred by insurance entities that can be capitalized in the successful acquisition of new and renewal contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. We retrospectively adopted as of January 1, 2008, ASU 2010-26 on January 1, 2012.
The following table illustrates the effect of adopting ASU 2010-26 in the consolidated balance sheets:
· 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. The company adopted ASU 2011-04 during the first quarter of 2012, and it did 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 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 company adopted ASU 2011-12 and ASU 2011-05 during the first quarter of 2012, and it did not have a material impact on our company’s financial position, cash flows or results of operations.
At December 31, 2012, fixed-maturity investments with amortized cost of $85 million and fair value of $93 million were on deposit with various states in compliance with regulatory requirements.
During 2012, we other-than-temporarily impaired 13 securities. At December 31, 2012, four fixed-maturity investments with a total unrealized loss of $1 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity investments had fair values below 70 percent of amortized cost. There were no equity investments in an unrealized loss position for 12 months or more as of December 31, 2012.
When determining OTTI charges for our fixed-maturity portfolio, management places significant emphasis on whether issuers of debt are current on contractual payments and whether future contractual amounts are likely to be paid. As required by ASC 320, our invested asset impairment policy for fixed-maturity securities states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed-maturity security or (2) if it is more likely than not we will be required to sell the impaired fixed-maturity security before recovery of its 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 cost basis, and a realized loss is recorded in the period in which it is recognized. When we believe that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount to the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the period in which it occurred. The difference between the fair value and the net present value of the
cash flows of the security, the noncredit loss, is recognized in other comprehensive income as an unrealized loss.
For each of our equity securities in an unrealized loss position at December 31, 2012, we applied the objective qualitative and quantitative criteria of our invested asset impairment policy for OTTI. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong surplus, liquidity and cash flow, supports our ability to hold these investments to recovery. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is other-than-temporarily impaired.
· Level 1 - Financial assets and liabilities for which inputs are observable and are obtained from reliable quoted prices for identical assets or liabilities in active markets. This is the most reliable fair value measurement and includes, for example, active exchange-traded equity securities.
o Quotes from brokers or other external sources that are not considered binding;
o Quotes from brokers or other external sources where it cannot be determined that market participants would in fact transact for the asset or liability at the quoted price; or
o Quotes from brokers or other external sources where the inputs are not deemed observable.
The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis for the years ended December 31, 2012 and 2011. We do not have any material liabilities carried at fair value. There were no transfers between Level 1 and Level 2.
The following tables provide the change in Level 3 assets during 2012 and 2011:
With the exception of the Level 3 reconciliation table, additional disclosure for the Level 3 category is not material.
Fair value of the note payable was determined based upon the outstanding balance at December 31, 2012, because it is short term and tied to a variable interest rate. The note payable was classified as Level 2 as a market does not exist.
We use actuarial methods, models and judgment to estimate, as of a financial statement date, the property casualty loss and loss expense reserves required to pay for and settle all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date. The actuarial estimate is subject to review and adjustment by an inter-departmental committee that includes actuarial management that is familiar with relevant company and industry business, claims and underwriting trends, as well as general economic and legal trends, that could affect future loss and loss expense payments. The amount we will actually have to pay for claims can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. The reserve for loss and loss expenses in the consolidated balance sheets also includes $61 million, $59 million and $63 million for certain life and health loss reserves at December 31, 2012, 2011 and 2010, respectively.
During 2012, we experienced $396 million of favorable loss and loss expense reserve development on prior accident years including $292 million in commercial lines. Favorable development in 2012 was $111 million more than in 2011, in part due to $39 million for catastrophe losses. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $177 million for the commercial casualty line, $74 million for the workers’ compensation line and $52 million for the homeowner line due to reduced uncertainty of these lines one year later.
During 2011, we experienced $285 million of favorable loss development on prior accident years including $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 $97 million for the workers’ compensation line due to reduced uncertainty of these lines one year later.
We carried $67 million of net loss and loss expense reserves for asbestos and environmental claims and $54 million of reserves for mold claims at year-end 2012, compared with $74 million and $62 million, respectively, for such claims at year-end 2011. The asbestos and environmental claims amounts for each respective year constituted 1.8 percent and 1.9 percent of total loss and loss expense reserves at these year-end dates.
No premium deficiencies were recorded in the consolidated statements of comprehensive income, as the sum of the anticipated loss and loss adjustment expenses, policyholder dividends and unamortized deferred acquisition expenses did not exceed the related unearned premiums and anticipated investment income.
We have one line of credit with multiple commercial banks with a borrowing capacity of $225 million, with an additional $50 million accordion feature. At December 31, 2012, $104 million was drawn on the line of credit. This credit agreement replaces the two lines of credit with commercial banks with an aggregate borrowing capacity of $225 million at December 31, 2011. The 2012 credit agreement is a new $225 million unsecured revolving credit facility with a term of five years expiring May 31, 2017. We had no compensating balance requirements on short-term debt for either 2012 or 2011. The interest rate charged on our borrowings on this credit agreement ranged from 0.7 percent to 2.58 percent during 2012.
Below are the expected capital lease obligations, totaling $37 million, excluding an insignificant amount of interest, that we expect to pay over the next five years:
As of December 31, 2012, 9.3 million shares of common stock were available for future equity award grants.
Our consolidated statements of comprehensive income include earned consolidated property casualty insurance premiums on assumed and ceded business:
Our consolidated statements of comprehensive income include incurred consolidated property casualty insurance loss and loss expenses on assumed and ceded business:
The ceded benefits incurred can vary depending on the type of life insurance policy held and the year the policy was sold.
The provision for federal income taxes is based upon filing a consolidated income tax return for the company and its subsidiaries. As of December 31, 2012, we had no operating or capital loss carry forwards. The change in our effective tax rate was primarily due to changes in pretax income from underwriting results, changes in investment income and the amount of realized investment gains and losses. Changes to tax-exempt interest and the dividend received deduction in the current year compared with prior years also contributed to the change.
The statute of limitations for federal and state income tax purposes have closed for tax years 2008 and earlier. In November, 2011, the IRS began its audit of tax years 2009 and 2010. In December 2012, the IRS Exam Team completed its phase of the audit with no material changes to the returns as filed. As is standard practice whenever large refunds are received, the Joint Committee on Taxation in Washington DC is currently reviewing the 2009 and 2010 IRS audit and is expected to complete its review by mid-2013. Income taxes paid in our Consolidated Statements of Cash Flows are shown net of refunds received of $11 million, $2 million and $10 million for 2012, 2011 and 2010, respectively.
The current sources of dilution of our common shares are certain equity-based awards as discussed in Note 17 Stock-Based Associate Compensation Plans, Page 135. The above table includes the number of anti-dilutive stock-based awards at year-end 2012, 2011 and 2010. We did not include these stock-based awards in the computation of net income per common share (diluted) because their exercise would have anti-dilutive effects.
To determine the discount rate for each plan, 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 for each plan was determined based on the anticipated yield of the constructed portfolio. Based on this analysis, we decreased the rate from the prior year by 0.90 percentage points for the qualified plan and by 0.80 percentage points for the SERP due to market interest rate conditions at year-end 2012. Compensation increase assumptions reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases. We decreased our compensation assumption to reflect the current demographics of participants in the plans and expectations of near-term salary increases.
The discount rate was decreased by 0.75 percentage points for the qualified pension plan and 0.80 percentage points for the SERP due to market interest rate conditions at the beginning of 2012. 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 assumption from 8.00 percent to 7.50 percent during 2011, which is consistent with 2012 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 in 2012 reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases.
The change in the amount recognized in other comprehensive income is largely due to the decrease in discount rate and corresponding decreases in assumed lump sum rates. We assume that 100 percent of participants will choose lump sum payments.
Excluding cash, during 2012 we held approximately 75 percent of our pension portfolio in domestic common equity investments, which reflect the long-term time horizon of pension obligations. The remainder of the portfolio consists of 15 percent in states, municipalities and taxable political subdivisions fixed-maturity investments and 10 percent in domestic corporate fixed-maturity investments. Our common equity portfolio consists of 22 percent in the financial sector, 19 percent in the information technology sector, 13 percent in the healthcare sector, 11 percent in the industrial sector and 10 percent in the consumer discretionary sector during 2012. We had no additional sectors which accounted for 10 percent or more of our common equity portfolio balance at year end 2012. We had $3 million of cash on hand at December 31, 2012, 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 2013.
Our pension plan assets included 567,113 shares of the company’s common stock, which had a fair value of $22 million and $17 million at December 31, 2012 and 2011. The defined benefit pension plan did not purchase any shares of our common stock during 2012 and 2011. No shares of our common stock were sold during 2012. During 2011, the pension plan sold 75,000 shares of the company’s common stock for a realized gain of $2 million. The company paid $1 million in cash dividends on our common stock to the pension plan in both 2012 and 2011.
We contributed $15 million to our qualified plan during the first quarter of 2013 and expect to contribute $3 million of benefit payments from the SERP during 2013. We expect to make the following benefit payments for our qualified plan and SERP, reflecting expected future service:
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $5 million in 2012 and $6 in 2011 and 2010, on premium volume of approximately $35 million, $34 million and $36 million for 2012, 2011 and 2010, respectively.
In the ordinary course of conducting business, the company and its subsidiaries are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving the company’s insurance subsidiaries in which the company is either defending or providing indemnity for third-party claims brought against insureds who are litigating first-party coverage claims. The company accounts for such activity through the establishment of unpaid loss and loss adjustment expense reserves. We believe that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, is immaterial to our consolidated financial condition, results of operations and cash flows.
Four equity compensation plans currently permit us to grant various types of equity awards. We currently grant incentive stock options, nonqualified stock options, service-based restricted stock units and performance-based restricted stock units to associates, including some with market-based performance objectives under our shareholder-approved plans. We also have a Holiday Stock Plan that permits annual awards of one share of common stock to each full-time associate for each full calendar year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant stock to our outside directors as a component of their annual compensation.
Stock-based compensation cost after tax was $11 million, $9 million and $8 million for the years ended December 31, 2012, 2011 and 2010, respectively. The related income tax benefit recognized was $5 million, $4 million and $3 million for the years ended December 31, 2012, 2011 and 2010, respectively. Options exercised during the year ended December 31, 2012, had intrinsic value of $6 million. Options exercised during the years ended December 31, 2011 and 2010 had intrinsic value less than $1 million. (Intrinsic value is the market price less the exercise price.) Options vested during the year ended December 31, 2012, 2011 and 2010 had total intrinsic value of $5 million, $2 million, and $1 million, respectively.
· Weighted-average expected term is based on historical experience of similar awards with consideration for current exercise trends.
· Risk-free rates are the implied yield currently available on zero-coupon U.S. Treasury issues with a remaining term approximating the expected term.
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 less than $1 million, $13 million and $5 million for the years ended December, 31, 2012, 2011 and 2010, respectively. Service-based shares are issued out of treasury shares.
· Correlation coefficients are based upon the price data used to calculate the historical volatilities. The correlation coefficients are used to model the way in which each entity tends to move in relation to each other.
· Dividend yield has been modeled assuming that the holder of the award is not entitled to receive dividends that are paid during the performance period. Dividend yields of 4.51% for 2012 grants and 4.68%-5.26% for 2011 grants were used.
This is a summary of restricted stock unit and performance-based share information, assuming a target payout for performance-based shares, for the year 2012:
· Our investment operations’ revenues consist of pretax net investment income and realized investment gains and losses.
o For the life insurance segment, we calculate underwriting profit or loss as premiums earned and separate account investment management fees, minus contract holders’ benefits and expenses incurred, plus investment interest credited to contract holders.
This table includes unaudited quarterly financial information for the years ended December 31, 2012 and 2011:
* Revenues including realized investment gains and losses, which are integral to our financial results over the long term, may cause this value to fluctuate substantially because we have substantial discretion in the timing of investment sales. 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 79.