Realized investment gains and losses are integral to our financial results over the long term, but our substantial discretion in the timing of investment sales may cause this value to fluctuate substantially. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 64.
Management has worked to identify the strategies that can lead to long-term success, with concurrence by the board of directors. Our strategies are intended to position us to compete successfully in the markets we have targeted while appropriately managing risk. We believe successful implementation of the initiatives that support our strategies will help us better serve our agent customers, reduce volatility in our financial results and weather difficult economic, market or industry pricing cycles.
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. Direct writers will continue to be a factor in the personal insurance market.
The value creation ratio discussed in the Executive Summary, Page 34, was 19.7 percent in 2009, negative 23.5 percent in 2008 and negative 5.7 percent in 2007. The book value per share growth component of the value creation ratio was 13.6 percent during 2009, largely reflecting improved valuation of our investment portfolio in addition to earnings. In both 2008 and 2007, a decline in unrealized gains on our investment portfolio was the most significant factor in the decline in book value as discussed below. In 2009 and 2008, net income also was significantly below the level of 2007.
We also establish incurred but not reported (IBNR) reserves to provide for all unpaid loss and loss expenses not accounted for by case reserves:
For all other claims and events, IBNR reserves are calculated as the difference between an actuarial estimate of the ultimate cost of total loss and loss expenses incurred reduced by the sum of total loss and loss expense payments and total case reserves estimated for individual claims. We discuss below the development of actuarially based estimates of the ultimate cost of total loss and loss expenses incurred.
In accordance with ASC 820-10, we have categorized our financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level that is significant to the fair value measurement of the instrument.
In 2009, the net pension expense was $11 million. In 2010, we expect the net pension expense to be $12 million.
Combined ratio - Our commercial lines combined ratio rose to 101.6 percent in 2009 from 97.0 percent in 2008, following a very strong performance in 2007. Compared with 2008, results for 2009 reflected approximately half as much benefit from net favorable reserve development on prior accident years, accounting for 5.2 percentage points of the 4.6 percentage-point combined ratio increase. The reduction in the net favorable reserve development on prior accident years occurred primarily for our commercial casualty and workers’ compensation lines of business. We continue to focus on sound underwriting fundamentals and obtaining adequate premiums for risks insured by each individual policy. The 2009 and 2008 ratios for current accident year before catastrophe losses largely reflect loss cost trends that are outpacing earned premium trends. Approximately $49 million, or 2.1 percentage points, of the rise in 2008 accident year loss and loss expenses was due to refinements made to the allocation of IBNR reserves by accident year. We discuss factors affecting the combined ratio and reserve development by line of business below.
In 2009, non-commission underwriting expenses declined slightly, but to a lesser extent than earned premiums, causing the non-commission underwriting expense ratio component of the underwriting expense ratio to rise. In 2008, non-commission underwriting expenses rose on declining earned premiums, which also led to unfavorable deferred acquisition expense comparisons. Further, in 2008, the salary cost contribution rose by approximately 0.8 percentage points and the change in our pension plan contributed 0.5 percentage points to the ratio. Refinements in the allocation of expenses between our commercial lines and personal lines segments also contributed to minor variations in the non-commission underwriting expenses.
The 2009 current accident year loss and loss expense ratio before catastrophe losses also improved compared with 2008. A portion of the higher 2008 ratio was due to a higher loss expense allocation because of the level of non-catastrophe weather-related losses. In addition, the refinement in the allocation of IBNR reserves by accident year accounted for approximately 2 percentage points of the difference between the 2007 and 2008 ratios.
The calendar year loss and loss expense ratio improved during 2009 due in part to a higher amount of favorable development on prior accident year reserves. The 2009 accident year loss and loss expense ratio also improved, reflecting more favorable loss experience due in part to the general slump in U.S. economic activity and also reflecting volatility in the number of commercial auto losses greater than $1 million.
Premiums - Very strong competition in our personal lines markets continued in 2009 and we continued to adjust pricing in an effort to return to consistent profitability in our personal lines segment. Net written premiums grew slightly, driven by new business growth that included expansion into new states where we previously offered only commercial lines policies. Industry average written premium growth was estimated at negative 1.1 percent in 2009 and negative 0.7 percent in 2008 after being flat in 2007.
Non-commission underwriting expenses declined in 2009 primarily due to lower depreciation expense on previously capitalized software expenditures. In 2008 there was an unusual expense of $3 million due to a pension charge. Refinements in the allocation of expenses between our commercial lines and personal lines segments also contributed to minor variations between year-to-year comparisons in the non-commission underwriting expenses.
Revenues - Driven by higher term life insurance premiums, earned premiums have grown over the past three years. Gross in-force policy face amounts increased to $69.815 billion at year-end 2009 from $65.888 billion at year-end 2008 and $61.875 billion at year-end 2007.
$624 million in realized gains from equity sales including $161 million from the merger of Wyeth with Pfizer (NYSE: PFE); $133 million from the sale of ExxonMobil (NYSE: XOM); $100 million from the sale of Procter & Gamble; $67 million from the sale of Fifth Third Bancorp (NASDAQ: FITB); $52 million from the sale of Piedmont Natural Gas (NYSE: PNY); and $111 million from the sale of various other equity holdings.
The decrease in other-than-temporary impairment charges in 2009 was largely due to the improvement in values as asset markets rebounded. The increase in other-than-temporary impairment charges in 2008 was largely due to write-downs of holdings of bonds and common and preferred stocks of financial services issuers, reflecting our historical weighting in this sector and the decline in overall stock market values during 2008.
The above points cover drivers of commercial casualty and workers’ compensation reserve development in 2009 attributable to unusual deviations from expectations and changes in methods, models, and procedures. An examination of factors contributing to the remaining $41 million of commercial lines favorable reserve development, not accounted for by the commercial casualty and workers’ compensation lines, did not turn up any abnormal or unexpected variations. As noted in Critical Accounting Estimates, Key Assumptions - Loss Reserving, Page 40, our models predict that actual loss and loss expense emergence will differ from projections, and we do not attempt to monitor or identify such normal variations.
Unusually high levels of catastrophe losses due to risk concentrations, changes in weather patterns, environmental events, terrorism incidents or other causes
We account for derivative financial instruments as defined by ASC 815, Derivatives and Hedging. The hedging definitions included in ASC 815 guide our recognition of the changes in the fair value of derivative financial instruments as realized gains or losses in the consolidated statements of income or as a component of accumulated other comprehensive income in shareholder’s equity in the period for which they occur.
The following table provides the amount of credit losses on fixed-maturity securities for which a portion of OTTI has been recognized in other comprehensive income:
During 2008, we impaired 126 securities. At December 31, 2008, 142 fixed-maturity investments with a total unrealized loss of $78 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity investments were trading below 70 percent of book value. Six equity investments with a total unrealized loss of $41 million had been in an unrealized loss position for 12 months or more as of December 31, 2008, with two trading below 70 percent of book value. As a result of this evaluation, we did not record impairment on the six equity securities in an unrealized loss position in excess of 12 months at December 31, 2008.
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 the new accounting standard for fixed-maturity securities, our invested asset impairment policy states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed maturity security; (2) if it is more likely than not we will be required to sell the fixed maturity security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. If we intend to sell or it is more likely than not we will be required to sell, the book value 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 non-credit loss, is recognized in other comprehensive income as an unrealized loss.
Below is the unrecognized tax benefit for the years ended December 31:
In 2010, we expect to contribute $25 million to our qualified plan. We expect to make the following benefit payments for our qualified plan and SERP, reflecting expected future service:
Statutory capital and surplus for our insurance subsidiary, The Cincinnati Insurance Company, includes capital and surplus of its four insurance subsidiaries.