Invested assets grew 6 percent during 2012 on a fair value basis, with market gains outpacing an increase in the cost basis of invested assets of approximately 3 percent. Entering 2013, we believe the portfolio continues to be well diversified, and it is well positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, Page 20, and results for the segment in Investment Results of Operations, Page 79. Total assets rose 6 percent, primarily due to the increase in invested assets.
· Premiums - Strong growth in renewal and new business written premiums drove double-digit increases in 2012 earned premiums and net written premiums. The 2012 rate of growth for earned and net written premiums more than doubled that of 2011 as premium volume rose significantly in each of our property casualty segments. Higher and more precise pricing continues to benefit operating results and is further discussed in the results of operations sections below by segment. A fifth straight year of higher new business premiums reflected our premium growth initiatives from recent years that continue to favorably affect current year growth, particularly as newer agency relationships mature over time. Agents appointed during 2011 or 2012 produced an increase in standard lines new business of $35 million during 2012, compared with 2011. A higher level of insured exposures, reflecting improvement in some areas of the economy, also favorably affected premium growth, primarily in our commercial lines segment. The contributions to premiums from audits, which are significantly affected by economic trends, are further discussed in Commercial Lines Insurance Results of Operations beginning on Page 57.
Commission expenses include our profit-sharing commissions, which are primarily based on one-year and three-year profitability of an agency’s business. The aggregate profit trend for agencies that earn these profit-based commissions can differ from the aggregate profit trend for all agencies reflected in our consolidated property casualty results. In 2011, the ratio for property casualty profit-sharing commissions declined slightly while the ratio for total commissions rose slightly, netting to a small increase of 0.1 percentage point.
Our commercial lines statutory combined ratio was 92.1 percent in 2012 compared with 104.2 percent in 2011 and 99.6 percent in 2010. The estimated commercial lines combined ratios for the industry were 109.0 percent in 2012, 106.7 percent in 2011 and 102.7 percent in 2010, with the industry’s ratio excluding its mortgage and financial guaranty lines of business. The contribution of catastrophe losses to our commercial lines statutory combined ratio was 8.2 percentage points in 2012, 10.4 percent points in 2011 and 4.1 percentage points in 2010, compared with an estimated 9.3, 7.4 and 3.5 percentage points, respectively, for the industry.
· Combined ratio - The 2012 combined ratio improved 18.7 percentage points compared with 2011, in part due to natural catastrophe losses that were 6.8 percentage points lower, plus better pricing and a decrease in other weather-related losses. Such losses, typically referred to as noncatastrophe weather losses, were not identified as part of designated catastrophe events for the property casualty industry. Additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty and the effect of a refined line of business allocation process for loss expenses each contributed approximately 3 points to the 2011 combined ratio.
In 2012, our personal lines new business premiums written by our agencies grew 17 percent, following 2011 growth at a rate of 6 percent. We believe the increased growth rate reflects the contribution from new agency appointments in addition to the effect of higher pricing from rate increases.
Total investment return rose in 2012, compared with 2011, primarily due to higher amounts of the change in unrealized investment gains and losses. The contribution from the combination of net investment gains, both realized and the change in unrealized, rose 0.9 percentage points and offset a 0.1 point decrease in the contribution of investment income. As discussed above, investment income yields have been pressured by the low interest rate environment.
· Dividend income rose $11 million or 11 percent in 2012 after rising 5 percent in 2011. Increases in dividend payment rates for many of the holdings in our common stock portfolio during 2012, plus a greater asset allocation of available funds into equity securities drove the increase in dividend income. In addition, several of our common stock holdings in total issued an additional $5 million in 2012 dividends not typically paid in the fourth quarter, as a result of anticipated dividend tax rate changes effective for 2013.
The $128 million net realized investment gains and losses in 2011 were primarily due to $111 million in net realized gains from equity security sales.
Our insurance subsidiary’s primary sources of cash inflows are collection of premiums, investment income, maturity of fixed income securities and sale proceeds from investments. Property casualty insurance premiums generally are received before losses are paid under the policies purchased with those premiums. Our insurance subsidiary’s cash outflows are primarily property casualty loss and loss expenses, commissions, salaries, taxes, operating expenses and investment purchases. Over the past three years, premium receipts and investment income have been more than sufficient to pay claims and operating expenses. Excess cash flows were partially used to pay dividends to the parent company. We are not aware of any known trends that would materially change historical cash flow results over the next 12 months, other than fluctuations in catastrophe claims and other large losses either individually or in aggregate.
Our debt totaled $894 million at year-end 2012, consisting of $790 million of noncallable long-term debt and $104 million in borrowings on our short-term line of credit. We generally have minimized our reliance on debt financing although we may use the line to fund short-term cash needs.
At December 31, 2012, we had a $225 million line of credit with commercial banks, with $104 million borrowed. There was no change in the amount of the $104 million short-term debt during 2012. During 2011, there was a $55 million increase to the previous balance of $49 million in short-term debt by the parent company, primarily to fund share repurchases. Access to this line of credit requires compliance with various covenants, including maintaining a minimum consolidated net worth and not exceeding 30 percent debt to capital, as defined by the agreement. The minimum consolidated net worth requirement is $3 billion plus 50 percent of consolidated net income and net cash proceeds from issuance of equity securities after March 31, 2012. At December 31, 2012, we were well within compliance with all covenants under the credit agreements and believe we will remain in compliance.
We do not expect future pension contributions to constrain our liquidity. The fair value of plan assets is 84 percent of the accumulated benefit obligation at December 31, 2012.
For our homeowner line of business, the $52 million favorable reserve development on prior accident years recorded during 2012 was primarily due to a reduction in case reserves for losses, including an $18 million reduction for catastrophe losses. Total homeowner favorable reserve development included $39 million for accident year 2011 and $7 million for accident year 2010.
These estimated cash outflows are undiscounted with respect to interest. As a result, the sum of the cash outflows for all years of $4.235 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy and investment contract reserves and separate accounts for future policy benefits and claims of $2.943 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $27 million of separate accounts liabilities.
· Changing consumer insurance-buying habits and consolidation of independent insurance agencies that could alter our competitive advantages
The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2012, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment was based on the criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and was designed to provide reasonable assurance that the company maintained effective internal control over financial reporting as of December 31, 2012. The assessment led management to conclude that, as of December 31, 2012, the company’s internal control over financial reporting was effective based on those criteria.
Included within our other invested assets are $37 million of life policy loans and $31 million of venture capital fund investments. Life policy loans are carried at the receivable value, which approximates fair value. The venture capital funds provide their financial statements to us and generally report investments on their balance sheets at fair value. We use the equity method of accounting for venture capital fund investments.
Fair values for deferred annuities are calculated based upon internally developed models because active, observable markets do not exist for those items. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at December 31, 2012, to account for nonperformance risk; (2) the rate of interest credited to policyholders is the portfolio net earned interest rate less a spread for expenses and profit; and (3) additional lapses occur when the credited interest rate is exceeded by an assumed competitor credited rate, which is a function of the risk-free rate of the economic scenario being modeled.
Expenses associated with successfully acquiring insurance policies - primarily commissions, premium taxes and underwriting costs - are deferred and amortized over the terms of the policies. We update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate the costs for recoverability. All acquisition costs reflect ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which we retrospectively adopted on January 1, 2012. The table below shows the deferred policy acquisition costs and asset reconciliation.
Cash received from the exercise of options was $10 million and $1 million for the years ended December 31, 2012 and 2011, and less than $1 million for the year ended 2010. We acquired 311,524 shares totaling $12 million from associates in consideration for option exercises during 2012.
Options outstanding and exercisable consisted of the following at December 31, 2012: