We have studied the option of providing excess and surplus lines coverage for several years and believe it could contribute to our long-term objectives. Among the potential benefits, we could gain opportunities to compete for additional accounts by having more flexibility in pricing and policy terms and conditions.
Our consolidated property casualty insurance underwriting profit declined in 2006 after rising in 2005, matching the trend in our combined ratio. (The combined ratio is the percentage of each premium dollar spent on claims plus all expenses - the lower the ratio, the better the performance.) 2006 performance was tempered by higher catastrophe losses, increased loss severity and less savings from favorable development on prior period losses as well as higher underwriting expenses.
We provide more detail on our reinsurance programs in 2007 Reinsurance Programs, Page 69.
A reserve change of $32 million would have a 1 percentage point effect on the loss and loss expense ratio, based on 2006 earned premiums, a $21 million effect on income and a 12 cent effect on net income per share.
Other-than-temporary and permanent impairments are distinct from the ordinary fluctuations seen in the value of a security when considered in the context of overall economic and market conditions. Securities considered to have a temporary decline would be expected to recover their market value, which may be at maturity. Under the same accounting treatment as market value gains, temporary declines (changes in the fair value of these securities) are reflected on our balance sheet in accumulated other comprehensive income, net of tax, and have no impact on reported net income.
In addition, the fair value of the plan assets exceeded the accumulated benefit obligation by $8 million at year-end 2006 and $8 million at year-end 2005. The fair value of the plan assets was less than the projected plan benefit obligation by $58 million at year-end 2006 and $62 million at year-end 2005. The 2005 accumulated benefit obligation and projected benefit obligation amounts were increased by $6 million and $9 million, respectively, to include the company’s supplemental retirement plan (SERP). Market conditions and interest rates significantly affect future assets and liabilities of the pension plan.
We believe our strong new business growth in 2006 and 2005 primarily was due to the local relationships and efforts of our agents and the field marketing teams that work with them. Our field associates are in our agents’ offices emphasizing the Cincinnati value proposition, calling on prospects with those agents, carefully evaluating risk exposure and working up their best quotes for good accounts.
2004 - Favorable development lowered the loss and loss expense ratio by 20.0 percentage points.
2006 - Reserve strengthening raised the loss and loss expense ratio by 1.6 percentage points.
Industrywide commercial lines written premiums are expected to decline approximately 1.0 percent in 2007. During 2006, agents again reported that renewal pricing pressure had risen and new business pricing was requiring even more flexibility and more careful risk selection. During 2006, we continued to need to use credits more frequently to retain renewals of quality business - the larger the account, the higher the credits, with variations by geographic region and class of business. By year-end 2006, our field marketing representatives reported pricing down about 10 percent to 15 percent on average to write the same piece of new business we would have quoted in 2005. By comparison, 5 percent to 10 percent rate declines seem to be typical for renewal business.
Personal lines insurance is a strategic component of our overall relationship with many of our agencies and an important component of agency relationships with their clients. We believe agents recommend Cincinnati personal insurance products for their value-oriented clients who seek to balance quality and price and are attracted by Cincinnati’s superior claims service and the benefits of our package approach.
A refinement and subsequent release of a contingent commission over accrual from 2004 in the first three months of 2005 was responsible for 0.2 percentage points of the decline in 2005. The refinement reflected the use of final 2004 financial data to calculate the contingent commissions paid in 2005. Our 2006 contingent commission accrual reflected our estimate of the profit-sharing commissions that will be paid to our agencies in early 2007.
In each of the last three calendar years, activity in the reserves for prior period losses contributed to the changes in the loss and loss expense ratio.
2005 - Favorable development lowered the loss and loss expense ratio by 1.9 percentage points.
2004 - Reserve strengthening raised the loss and loss expense ratio by 0.2 percentage points.
Industry experts currently anticipate industrywide personal lines written premiums will rise approximately 1.2 percent in 2007. While the rise in new business levels and policy retention rates in the second half of 2006 are positive indications for our personal lines business, we believe our growth rate will be below that of the industry in 2007.
Realized investment gains in the past three years largely were due to the sale of equity holdings. We buy and sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives.
This table shows a summary of cash flow of the insurance subsidiary (direct method):
We had $791 million of long-term debt and $49 million in borrowings on our short-term lines of credit. We generally have minimized our reliance on debt financing although we may utilize lines of credit to fund short-term cash needs.
In October 2006, we completed the necessary requirements for the interest-rate swap to qualify for hedge accounting treatment under SFAS No. 133. We expect that the interest-rate swap will be a highly effective hedge and that future changes in the fair value of the interest-rate swap will be recorded as a component of accumulated other comprehensive income. As a result, we do not expect any significant amounts to be reclassified into earnings in the next 12 months.
Many of our operating expenses are not contractual obligations, but reflect the ongoing expenses of our business. Staffing is the largest component of our operating expenses and is expected to rise again in 2007, reflecting the 2.9 percent average annual growth in our associate base over the past three years. Our associate base has grown as we focus on enhancing service to our agencies and staffing additional field territories. Other expenses should rise in line with our growth.
As we discuss in Personal Lines Insurance Segment Reserves, Page 68, we are seeking to improve our personal lines segment performance, in particular the homeowner business line, partially by reducing risk exposure through changes in policy terms and conditions. We do not expect our actions in personal lines to have a material impact on loss reserve trends, largely due to the relatively short-tail nature of homeowner claims.
We generally wrote commercial accounts after the development of coverage forms that exclude asbestos cleanup costs. We believe our exposure to risks associated with past production and/or installation of asbestos materials is minimal because we primarily were a personal lines company when most of the asbestos exposure occurred. The commercial coverage we did offer was predominantly related to local market construction activity rather than asbestos manufacturing. Further, over the past four years we have revised policy terms where permitted by state regulation to limit our exposure to mold and other environmental risks going forward. We continue to evaluate our exposure to silicosis and welding claims, but believe our exposure is minimal.
Property per risk treaty - The primary purpose of the property treaty is to provide capacity up to $25 million, supplying adequate capacity for the majority of the risks we write and also includes protection for extra-contractual liability coverage losses. The ceded premium is estimated to be $35 million for 2007, compared with $30 million in 2006 and $29 million in 2005. We retain the first $4 million of each loss. Losses between $4 million and $25 million are reinsured at 100 percent.
We adopted SFAS No. 155 on January 1, 2007, to permit fair value re-measurement for our hybrid financial instruments that contain embedded derivatives that required bifurcation under the original provisions of SFAS No. 133. The adoption is not expected to have a material impact on our results of operations or financial position.
The adoption of SFAS No. 158 resulted in an increase in liabilities of approximately $32 million on an after-tax basis with a corresponding reduction in accumulated other comprehensive income and shareholders’ equity. SFAS No. 158 did not change the amount of net periodic benefit expense recognized in an entity’s results of operations.
Declared cash dividends per share were $1.34, $1.21 and $1.04 for the years ended December 31, 2006, 2005 and 2004, respectively.
The provision for federal income taxes is based upon a consolidated income tax return for the company and subsidiaries. As of December 31, 2006, we had no capital loss carry forwards.
Limited opportunities to purchase equity securities that hold the potential for market value appreciation. Historically, the holding company has successfully invested in equity securities that provided both income
compensation cost for all non-vested stock options that have nonsubstantive vesting requirements, such as those to associates who are eligible for retirement.
We report as “Other” the non-investment operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding client investment activities), as well as other income of our insurance subsidiary.