For some lines of business that we write, a considerable and uncertain amount of time can elapse between the occurrence, reporting and payment of insured claims. The amount we will actually have to pay for such claims also can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. Gross loss and loss expense reserves were $4.280 billion at year-end 2011 compared with $4.137 billion at year-end 2010.
· Exposure levels. Historical earned premiums, when adjusted to reflect common levels of product pricing and loss cost inflation, can serve as a proxy for historical exposures. Our actuaries require this assumption to estimate expected loss ratios and expected defense and cost containment expense ratios used by the Bornhuetter-Ferguson reserving methods. They may also use this assumption to establish exposure levels for recent accident years, characterized by “green” or immature data, when working with probabilistic trend family models.
For each of our equity securities in an unrealized loss position at December 31, 2011, 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.
Consolidated financial results primarily reflect the results of our five reporting segments. These segments are defined based on financial information we use to evaluate performance and to determine the allocation of assets.
Other written premiums - primarily premiums ceded to our reinsurers as part of our reinsurance program - contributed negative $63 million to the $135 million of growth in 2011 net written premiums. The change in other written premiums was primarily due to $42 million of ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty. During the second quarter of 2011, we purchased reinsurance to replenish coverage for certain layers of our property catastrophe treaty that were used by the first-half 2011 catastrophe events discussed below. This coverage, also known as third and fourth event cover, added $26 million of ceded premiums for 2011. There were no material ceded premium effects during 2010 or 2009 from unusual items such as reinstatement premiums or the third and fourth event cover.
Premiums resulting from audits of actual sales or payrolls that confirmed or adjusted initial premium estimates significantly affected premium trends in recent years. On an earned premium basis, audits contributed $46 million of the $43 million earned premiums increase in 2011 and $15 million of the $45 million earned premiums decrease in 2010. On a net written premium basis, audits contributed $34 million of the $63 million net written premiums increase in 2011 and $23 million of the $26 million net written premiums decrease in 2010.
Other underwriting expenses decreased $13 million in 2011, primarily due to a first-quarter 2010 provision for matters involving prior years and related to Note 16, Commitments and Contingent Liabilities, Page 134. The provision also accounted for the majority of the increase in 2010.
We continue efforts to improve pricing precision through predictive analytics, which we believe will help to achieve long-term profitability. Various rate changes should help lower loss ratios as the rate increases are earned. Those rate changes were implemented beginning in October of 2011, 2010 and 2009 and averaged approximately 8 percent, 7 percent and 6 percent, respectively. We also continued 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 non-renewed approximately 2,600 policies in Florida and Alabama that we believe were the most exposed to losses from hurricane damage. These actions represent important steps we are taking to improve homeowner results.
· Premiums - Higher earned premiums in 2011 resulted from ongoing strong growth in net written premiums. The year 2011 represented our fourth full year of operations for our excess and surplus lines segment. Growth of net written premiums in 2011 was driven by higher renewal written premiums that included rising average renewal price increases. New business written premiums for 2011 were essentially flat compared with 2010, reflecting strong competition in the excess and surplus lines market.
· Interest income was essentially flat for 2011 as the average fixed-maturity pretax yield declined by approximately 20 basis points, offsetting a slightly rising fixed-maturity portfolio on an amortized cost basis. It rose 5 percent in 2010 due to investing our typical allocation of net cash flow from operations in fixed-maturity securities.
Revenues in 2011 for our Other businesses matched 2010. Other includes non-investment operations of the parent company and its subsidiary, CFC Investment Company, and former subsidiary CinFin Capital Management Company. Losses before income taxes for Other were largely driven by interest expense from debt of the parent company.
The table below shows a summary of operating cash flow for property casualty insurance (direct method). Lower operating cash flow for 2011 reflected the unusually high level of catastrophe losses.
We provide details of our three long-term notes in Item 8, Note 8 of the Consolidated Financial Statements, Page 127. None of the notes are encumbered by rating triggers:
At December 31, 2011, we believe our most significant other commitments are:
Until 2002 we participated in USAIG, a joint underwriting association of individual insurance companies that collectively functions as a worldwide insurance market for all types of aviation and aerospace accounts. Our participation was terminated after policy year 2002. At year-end 2011, 17.4 percent, or $108 million, of our total reinsurance receivables were related to USAIG, primarily for events of September 11, 2001, offset by $116 million due to USAIG, the third-party administrator for pool participants. If the pool participants and reinsurers were unable to fulfill their financial obligations and all security collateral that supports the participants’ obligations became worthless, we could be liable for an additional pool liability of $220 million and our financial position and results of operations could be materially affected. Currently all pool participants and reinsurers are financially solvent.
· Casualty treaties - The casualty treaty is written on an excess of loss basis and provide limits up to $6 million, which is adequate capacity for the risk profile we insure. A second treaty layer of $5 million excess of $6 million is written to provide coverage for extra contractual obligations or clash exposures. The maximum retention for any one casualty loss is $1 million by The Cincinnati Specialty Underwriters Insurance Company. Losses between $1 million and $11 million are reinsured at 100 percent by The Cincinnati Insurance Company.
· Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
Property casualty written premiums are deferred and recorded as earned premiums on a pro rata basis over the terms of the policies. We record as unearned premiums the portion of written premiums that applies to unexpired policy terms. The expenses associated with issuing insurance policies - primarily commissions, premium taxes and underwriting costs - are deferred and amortized over the terms of the policies. We assess recoverability of deferred acquisition costs at the segment level, consistent with the 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.
ASC 820 defines fair value as the exit price or the amount that would be (1) received to sell an asset or (2) paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. When determining an exit price, we rely upon observable market data whenever possible. We primarily base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on prices from a pricing vendor, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. The company obtains and reviews the pricing service’s valuation methodologies and related inputs and validates these prices by replicating a sample across each asset class using a discounted cash flow model. When a price is not available from these sources, as in the case of securities that are not publicly traded, we determine the fair value using various inputs including quotes from independent brokers. The fair value of investments not priced by a pricing vendor is less than 1 percent of the fair value of our total investment portfolio. See Note 3, Fair Value Measurements, Page 123, for further details.
Our leasing subsidiary provides auto and equipment direct financing (leases and loans) to commercial and individual clients. We generally transfer ownership of the property to the client as the terms of the leases expire. Our lease contracts contain bargain purchase options. We account for these leases and loans as direct financing-type leases. We record income over the financing term using the effective interest method. Finance receivables are reviewed for impairment on a quarterly basis. Impairment of our finance receivables is considered insignificant to our consolidated financial condition, results of operations and cash flows.
During 2009, we other-than-temporarily impaired 50 securities. At December 31, 2009, 121 fixed-maturity investments with a total unrealized loss of $25 million had been in an unrealized loss position for 12 months or more. Of that total, eight fixed-maturity investments had fair values below 70 percent of amortized cost with a total unrealized loss of $2 million. Ten equity investments with a total unrealized loss of $26 million had been in an unrealized loss position for 12 months or more as of December 31, 2009. Of that total, no equity investments were trading below 70 percent of cost.
For each of our equity securities in an unrealized loss position at December 31, 2011, 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 2 - Financial assets and liabilities for which values are based on quoted prices in markets that are not active or for which values are based on similar assets and liabilities that are actively traded. This also includes pricing models for which the inputs are corroborated by market data.
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Primary components of our property and casualty reinsurance program include a property per risk treaty, casualty per occurrence treaty and property catastrophe treaty.
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 0.75 percentage points for the qualified plan and by 0.80 percentage points for the SERP due to market interest rate conditions at year-end 2011. Compensation increase assumptions reflect anticipated rates of inflation, real return on wage growth and merit and promotional increases.