UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark one)
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the quarterly period ended June 30, 2012.
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from _____________________ to _____________________.
Commission file number 0-4604
CINCINNATI FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (513) 870-2000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
þYes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company" in Rule 12b-2 of the Exchange Act.
þ Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):
¨Yes þ No
As of July 23, 2012, there were 162,521,638 shares of common stock outstanding.
Cincinnati Financial Corporation Second-Quarter 2012 10Q
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FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2012
TABLE OF CONTENTS
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Part I – Financial Information
Item 1. Financial Statements (unaudited)
Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Balance Sheets
Accompanying notes are an integral part of these condensed consolidated financial statements.
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Condensed Consolidated Statements of Comprehensive Operations
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Condensed Consolidated Statements of Shareholders’ Equity
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Condensed Consolidated Statements of Cash Flows
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Notes to Condensed Consolidated Financial Statements(unaudited)
Note 1 — Accounting Policies
The condensed consolidated financial statements include the accounts of Cincinnati Financial Corporation and its consolidated subsidiaries, each of which is wholly owned. These statements are presented in conformity with accounting principles generally accepted in the United States of America (GAAP). All intercompany balances and transactions have been eliminated in consolidation.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Our actual results could differ from those estimates. The December 31, 2011, condensed consolidated balance sheet amounts are derived from the audited financial statements but do not include all disclosures required by GAAP.
Our June 30, 2012, condensed consolidated financial statements are unaudited. Certain financial information that is included in annual financial statements prepared in accordance with GAAP is not required for interim reporting and has been condensed or omitted. We believe that we have made all adjustments, consisting only of normal recurring accruals, that are necessary for fair presentation. These condensed consolidated financial statements should be read in conjunction with our consolidated financial statements included in our 2011 Annual Report on Form 10-K. The results of operations for interim periods do not necessarily indicate results to be expected for the full year.
Adopted Accounting Updates
ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
In October 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (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 ASU 2010-26 on January 1, 2012.
The following table illustrates the effect of adopting ASU 2010-26 in the condensed consolidated balance sheets:
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The following table illustrates the effect of adopting ASU 2010-26 in the condensed consolidated statements of comprehensive operations:
ASU 2011-04, Fair Value Measurements, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS
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.
ASU 2011-05, Presentation of Comprehensive Income
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 deferral of those changes allows the FASB time to redeliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income for all periods presented. 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.
Note 2 – Segment Information
We operate primarily in two industries, property casualty insurance and life insurance. We regularly review our reporting segments to make decisions about allocating resources and assessing performance:
We report as Other the non-investment operations of the parent company and its non-insurer subsidiary, CFC Investment Company. See our 2011 Annual Report on Form 10-K, Item 8, Note 18, Segment Information, Page 136, for a description of revenue, income or loss before income taxes and identifiable assets for each of the five segments.
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Segment information is summarized in the following table:
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Note 3 – Investments
The following table provides cost or amortized cost, gross unrealized gains, gross unrealized losses and fair value for our invested assets:
The net unrealized investment gains in our fixed-maturity portfolio are primarily the result of the current low interest rate environment that increased the fair value of our fixed-maturity portfolio. Included in corporate fixed maturities are $13 million of AAA rated commercial mortgage-backed securities. The three largest net unrealized investment gains in our common stock portfolio are from Exxon Mobil Corporation (NYSE:XOM), The Procter & Gamble Company (NYSE:PG) and Chevron Corporation (NYSE:CVX), which had a combined net gain position of $269 million. At June 30, 2012, we had $51 million fair value of hybrid securities included in fixed maturities that follow Accounting Standards Codification (ASC) 815-15-25, Accounting for Certain Hybrid Financial Instruments. The hybrid securities are carried at fair value, and the changes in fair value are included in realized investment gains and losses. At June 30, 2012, and December 31, 2011, there were no other-than-temporary impairments included within accumulated other comprehensive income (AOCI).
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The table below provides fair values and unrealized losses by investment category and by the duration of the securities’ continuous unrealized loss position:
The following table provides realized investment gains and losses and the change in unrealized investment gains and losses and other items:
During the three and six months ended June 30, 2012 and 2011, there were no credit losses on fixed-maturity securities for which a portion of other-than-temporary impairment (OTTI) has been recognized in other comprehensive income.
During the quarter ended June 30, 2012, we other-than-temporarily impaired four securities. At June 30, 2012, 16 fixed-maturity investments with a total unrealized loss of $4 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. Three equity investments with a total unrealized loss of less than $1 million had been in an unrealized loss position for 12 months or more as of June 30, 2012. Of that total, no equity investments were trading below 70 percent of cost.
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At December 31, 2011, 20 fixed-maturity investments with a total unrealized loss of $5 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. Two equity investments with a total unrealized loss of less than $1 million had been in an unrealized loss position for 12 months or more as of December 31, 2011. Of that total, no equity investments were trading below 70 percent of cost.
Note 4 – Fair Value Measurements
Fair Value Hierarchy
In accordance with accounting guidance for fair value measurements and disclosures, we categorized our financial instruments, based on the priority of the observable and market-based data for the valuation technique used, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3). When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used. Our valuation techniques have not changed from those used at December 31, 2011, and ultimately management determines fair value.
Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:
We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. 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 nationally recognized 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. We have generally obtained and evaluated two non-binding quotes from brokers, our investment professionals determine our best estimate of fair value. 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. Reclassification of certain financial instruments may occur when input observability changes. All reclassifications are reported as transfers in or out of the Level 3 category as of the beginning of the quarter in which the reclassification occurred.
The technique used for the Level 2 fixed-maturity securities and taxable fixed maturities in separate accounts is the application of matrix pricing. The inputs used include relevant market information by asset class, trade activity of like securities, yield to maturity and economic events. All of the Level 2 fixed-maturity securities are priced by a nationally recognized pricing vendor.
The Level 2 preferred equities technique used is the application of matrix pricing. The inputs used, similar to those used by the pricing vendor for our fixed-maturity securities, include relevant market information, trade activity of like securities, yield to maturity, corporate action notices and economic events. All of the Level 2 preferred equities are priced by a nationally recognized pricing vendor.
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Fair Value Disclosures for Assets
The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis at June 30, 2012, and December 31, 2011. We do not have any material liabilities carried at fair value. There were no transfers between Level 1 and Level 2.
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is identified in the tables below by security type with a summary of changes in fair value as of June 30, 2012. Total Level 3 assets continue to be less than 1 percent of financial assets measured at fair value in the condensed consolidated balance sheets. Assets presented in the table below were valued based primarily on broker/dealer quotes for which there is a lack of transparency as to inputs used to develop the valuations. The quantitative detail of these unobservable inputs is neither provided nor reasonably available to us.
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The following tables provide the change in Level 3 assets for the three months ended June 30:
The following tables provide the change in Level 3 assets for the six months ended June 30:
With the exception of the Level 3 reconciliation table, additional disclosure for the Level 3 category is not material.
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Fair Value Disclosure for Assets and Liabilities Not Carried at Fair Value
The disclosures below are presented to provide timely information about the effects of current market conditions on financial instruments that are not reported at fair value in our condensed consolidated financial statements.
This table summarizes the amortized cost and principal amounts of our long-term debt:
The following table shows fair values of our note payable and long-term debt subject to fair value disclosure requirements:
Fair value of the note payable is determined based upon the outstanding balance at June 30, 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.
The fair value of our long-term debt approximated $814 million at year-end 2011. Fair value was determined under the fair value measurements and disclosure accounting rules based on market pricing of similar debt instruments that are actively trading. We determine fair value for our debt the same way that corporate fixed-maturities are valued in our investment portfolio. Fair value can vary with macroeconomic conditions. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt is $793 million. None of the long-term debt is encumbered by rating triggers.
The following table shows the fair value of our life policy loans, included in other invested assets, subject to fair value disclosure requirements:
The fair value of life policy loans outstanding principal and interest approximated $43 million at December 31, 2011. Outstanding principal and interest for these life policy loans was $36 million and $37 million at June 30, 2012, and December 31, 2011, respectively. 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 as non-performance risk is minimal; and (2) the loan repayment rate by which policyholders pay off their loan balances is in line with past experience.
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The following table shows fair values of our deferred annuities and structured settlements, included in life policy and investment contract reserves, subject to fair value disclosure requirements:
The fair value for deferred annuities and structured settlements were $794 million and $208 million, respectively, at December 31, 2011. Recorded reserves for the deferred annuities and structured settlements were $1.039 billion and $1.025 billion at June 30, 2012, and December 31, 2011, respectively.
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 June 30, 2012, to account for non-performance 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.
Determination of fair value for structured settlements assumes 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 June 30, 2012, to account for non-performance risk.
Note 5 – Property Casualty Loss and Loss Expenses
This table summarizes activity for our consolidated property casualty loss and loss expense reserves:
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 and 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 condensed consolidated balance sheets also includes $59 million at June 30, 2012, and $56 million at June 30, 2011, for certain life and health loss and loss expense reserves.
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During the second quarter of 2012, we experienced $85 million of favorable development on prior accident years. There was $5 million from favorable development of catastrophe losses compared with no favorable development of catastrophe losses at June 30, 2011. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tailed lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $56 million for the commercial casualty line and favorable development of $12 million for the workers’ compensation line due to reduced uncertainty of prior accident year loss and loss adjustment expense for these lines.
During the first half of 2012, we experienced $201 million of favorable development on prior accident years. There was $27 million from favorable development of catastrophe losses compared with $1 million at June 30, 2011. We recognized favorable reserve development of $104 million for the commercial casualty line and favorable development of $28 million for the workers’ compensation line due to reduced uncertainty of prior accident year loss and loss adjustment expense for these lines.
Note 6 – Deferred Acquisition Costs
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 update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate our deferred acquisition costs for recoverability. All acquisition costs reflect ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which we adopted on January 1, 2012. The table below shows the deferred policy acquisition costs and asset reconciliation, including the amortized deferred policy acquisition costs.
There were no premium deficiencies recorded in the reported condensed 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.
Note 7 – Life Policy and Investment Contract Reserves
We establish the 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 as well as for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
We establish reserves for the company’s universal life, deferred annuity and structured settlement policies equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals. Some of our universal life policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance, based on expected no-lapse guarantee benefits and expected policy assessments.
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Note 8 – Reinsurance
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 risk treaty, casualty per occurrence treaty and property catastrophe treaty.
Our condensed consolidated statements of comprehensive operations include earned consolidated property casualty insurance premiums on assumed and ceded business:
The decrease in ceded earned premiums for 2012 compared with 2011 is related to earned reinstatement premiums as a result of the increase in catastrophe losses in the second quarter of 2011.
Our condensed consolidated statements of comprehensive income include incurred consolidated property casualty insurance loss and loss expenses on assumed and ceded business:
The decrease in ceded loss and loss expenses for 2012 compared with 2011 is related to the higher catastrophe losses in the second quarter of 2011.
Our life insurance company purchases reinsurance for protection of a portion of the risk that is written. Primary components of our life reinsurance program include individual mortality coverage and aggregate catastrophe and accidental death coverage in excess of certain deductibles. Our condensed consolidated statements of comprehensive operations include earned life insurance premiums on ceded business:
Our condensed consolidated statements of comprehensive operations include life insurance contract holders’ benefits incurred on ceded business:
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Note 9 – Net Income Per Common Share
Basic earnings per share are computed based on the weighted average number of shares outstanding. Diluted earnings per share are computed based on the weighted average number of common and dilutive potential common shares outstanding.
Here are calculations for basic and diluted earnings per share:
The current sources of dilution of our common shares are certain equity-based awards as discussed in our 2011 Annual Report on Form 10-K, Item 8, Note 17, Stock-Based Associate Compensation Plans, Page 134. The above table shows the number of anti-dilutive stock-based awards for the three and six months ended June 30, 2012 and 2011. 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. Due to the net loss in the second quarter of 2011, the assumed exercise of certain stock options and nonvested shares were excluded from the computation of diluted loss per share.
Note 10 – Employee Retirement Benefits
The following summarizes the components of net periodic costs for our qualified and supplemental pension plans:
See our 2011 Annual Report on Form 10-K, Item 8, Note 13, Employee Retirement Benefits, Page 130, for information on our retirement benefits. We made matching contributions of $3 million and $2 million to our 401(k) and Top Hat savings plans during the second quarter of 2012 and 2011 and contributions of $5 million and $4 million for the first halves of 2012 and 2011, respectively.
We made no contribution to the pension plan during the first half of 2012. We anticipate contributing $14 million in the third quarter of 2012 to our qualified pension plan as indicated in our 2011 Annual Report on Form 10-K.
Note 11 – Stock-Based Compensation Plans
We currently have four equity compensation plans that permit us to grant various types of equity awards. We currently grant incentive stock options, non-qualified stock options, service-based restricted stock units and performance-based restricted stock units, including some with market-based performance objectives, under our shareholder-approved plans to associates. 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. For additional information about our equity compensation plans, see our 2011 Annual Report on Form 10-K, Item 8, Note 17, Stock-Based Associate Compensation Plans, Page 134.
A total of 17.3 million shares are authorized to be granted under the shareholder-approved plans. At June 30, 2012, 9.3 million shares were available for future issuance under the plans.
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Stock-Based Awards
Stock-based awards were granted to associates during 2012 and are summarized in the tables below. Stock-based compensation cost after tax was $3 million for both the three months ended June 30, 2012 and 2011 and $5 million for both the six months ended June 30, 2012 and 2011, respectively. As of June 30, 2012, $27 million of unrecognized compensation costs related to non-vested awards is expected to be recognized over a weighted-average period of 2.2 years.
Here is a summary of option information:
Here is a summary of restricted stock unit information:
Note 12 – Income Taxes
As of June 30, 2012, and December 31, 2011, we had no liability for unrecognized tax benefits. Details about our liability for unrecognized tax benefits are found in our 2011 Annual Report on Form 10-K, Item 8, Note 11, Income Taxes, Pages 129 and 130.
The differences between the 35 percent statutory income tax rate and our effective income tax rate were as follows:
The change in our effective tax rate was primarily due to changes in pretax income from underwriting results and realized investment gains and losses.
Note 13 – Commitments and Contingent Liabilities
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.
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The company and its subsidiaries also are occasionally involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, breach of an alleged duty to search national data bases to ascertain unreported deaths of insureds under life insurance policies. The company’s insurance subsidiaries also are occasionally parties to individual actions in which extra-contractual damages, punitive damages or penalties are sought, such as claims alleging bad faith in the handling of insurance claims or claims alleging discrimination by former associates.
On a quarterly basis, we review these outstanding matters. Under current accounting guidance, we establish accruals when it is probable that a loss has been incurred and we can reasonably estimate its potential exposure. The company accounts for such probable and estimable losses, if any, through the establishment of legal expense reserves. Based on our quarterly review, we believe that our accruals for probable and estimable losses are reasonable and that the amounts accrued do not have a material effect on our consolidated financial condition or results of operations. However, if any one or more of these matters results in a judgment against us or settlement for an amount that is significantly greater than the amount accrued, the resulting liability could have a material effect on the company’s consolidated results of operations or cash flows. Based on our quarterly review, for any other matter for which the risk of loss is more than remote we are unable to reasonably estimate the potential loss or establish a reasonable range of loss.
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The following discussion highlights significant factors influencing the consolidated results of operations and financial position of Cincinnati Financial Corporation (CFC). It should be read in conjunction with the consolidated financial statements and related notes included in our 2011 Annual Report on Form 10-K. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory basis. When we provide our results on a comparable statutory basis, we label it as such; all other company data is presented in accordance with accounting principles generally accepted in the United States of America (GAAP).
As discussed in Item 1, Note 1, Accounting Policies, Page 7, effective January 1, 2012, we adopted ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. We adjusted applicable financial statements. Related financial data shown in Management’s Discussion and Analysis of Financial Condition and Results of Operations also have been adjusted.
We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and dividends. Dollar amounts are rounded to millions; calculations of percent changes are based on dollar amounts rounded to the nearest million. Certain percentage changes are identified as not meaningful (nm).
Safe Harbor Statement
This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. Some of those risks and uncertainties are discussed in our 2011 Annual Report on Form 10-K, Item 1A, Risk Factors, Page 26.
Factors that could cause or contribute to such differences include, but are not limited to:
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Further, the company’s insurance businesses are subject to the effects of changing social, economic and regulatory environments. Public and regulatory initiatives have included efforts to adversely influence and restrict premium rates, restrict the ability to cancel policies, impose underwriting standards and expand overall regulation. The company also is subject to public and regulatory initiatives that can affect the market value for its common stock, such as measures affecting corporate financial reporting and governance. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
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Introduction
Corporate Financial Highlights
Statements of Comprehensive Income and Per Share Data
Revenues rose for the second quarter and the first six months of 2012 compared with the same periods of 2011, primarily due to growth in earned premiums. Premium and investment revenue trends are discussed further in the respective sections of Results of Operations, Page 30.
Realized investment gains and losses are recognized on the sales of investments or as otherwise required by GAAP. We have substantial discretion in the timing of investment sales, and that timing generally is independent of the insurance underwriting process. GAAP also requires us to recognize in net income the gains or losses from certain changes in fair values of securities even though we continue to hold the securities.
Net income for the second quarter of 2012 compared with the 2011 second quarter increased $82 million, reflecting stronger property casualty underwriting income that rose $124 million after taxes. Lower catastrophe losses, mostly weather related, reduced net-of-taxes property casualty underwriting results by $93 million less than the second quarter of 2011, in addition to better underwriting results before catastrophes. After-tax investment income in our investment segment results for the second quarter of 2012 rose $1 million compared with the second quarter of 2011, while life insurance segment results on a pretax basis declined by $3 million. Second-quarter 2012 after-tax net realized investment gains and losses were $40 million lower than a year earlier.
For the six-month period ended June 30, 2012, net income increased compared with the same period of 2011, also primarily due to higher property casualty underwriting results that rose $149 million after taxes, including $62 million from lower catastrophe losses. After-tax investment income rose by $1 million while after-tax net realized investment gains and losses were $38 million lower. Life insurance segment results on a pretax basis were $3 million lower.
Performance by segment is discussed below in Results of Operations, beginning on Page 30. As discussed in our 2011 Annual Report on Form 10-K, Item 7, Factors Influencing Our Future Performance, Page 41, there are several reasons that our performance during 2012 may be below our long-term targets. In that annual report, as part of Results of Operations, we also discussed the full-year 2012 outlook for each reporting segment.
The board of directors is committed to rewarding shareholders directly through cash dividends and through share repurchase authorizations. Through 2011, the company had increased the indicated annual cash dividend rate for 51 consecutive years, a record we believe was matched by only nine other publicly traded companies. Cash dividends declared during the first six months of 2012 increased approximately 1 percent compared with the same period of 2011. Our board regularly evaluates relevant factors in share repurchase- and dividend-related decisions, and the 2011 dividend increase signaled confidence in our strong capital, liquidity and financial flexibility, as well as progress through our initiatives to improve earnings performance.
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Balance Sheet Data and Performance Measures
Total assets increased 3 percent compared with year-end 2011, largely due to growth in invested assets that was driven by additional purchases of securities and to a lesser extent by higher market valuation. Shareholders’ equity rose 2 percent and book value per share was up 2 percent during the first six months of 2012. Our debt-to-total-capital ratio (capital is the sum of debt plus shareholders’ equity) decreased compared with year-end 2011. The value creation ratio, a non-GAAP measure defined below, was higher for the first six months of 2012 compared with 2011, primarily due to growth in unrealized investment gains and net income. The $0.63 increase in book value per share during the first six months of 2012 contributed 2.0 percentage points to the value creation ratio while dividends declared at $0.805 per share during the first six months of 2012 contributed 2.6 points. Value creation ratio trends and a reconciliation of the non-GAAP measure to comparable GAAP measures are shown in the tables below.
Progress Toward Long-Term Value Creation
Operating through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on 2011 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 our 2011 Annual Report on Form 10-K, Item 1, Our Business and Our Strategy, Page 3.
We maintain a long-term perspective that guides us in addressing immediate challenges or opportunities while focusing on the major decisions that best position our company for success through all market cycles. We believe that this forward-looking view has consistently benefited our policyholders, agents, shareholders and associates.
To measure our long-term progress in creating shareholder value, we have defined a value creation metric that we believe captures the contribution of our insurance operations, the success of our investment strategy and the importance we place on paying cash dividends to shareholders. This measure, our value creation ratio or VCR, is made up of two primary components: (1) our rate of growth in book value per share plus (2) the ratio of dividends declared per share to beginning book value per share. For the period 2010 through 2014, an annual value creation ratio averaging 12 percent to 15 percent is our primary performance target. Management believes this non-GAAP measure is a useful supplement to GAAP information.
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Performance Drivers
When looking at our long-term objectives, we see three performance drivers:
Highlights of Our Strategy and Supporting Initiatives
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. Further description of our long-term, proven strategy can be found in our 2011 Annual Report on Form 10-K, Item 1, Our Business and Our Strategy, Page 3. We believe successful implementation of initiatives that support our strategy, summarized below, will help us better serve our agent customers and reduce variability 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.
We discuss initiatives supporting each of these strategies below, along with metrics we use to assess our progress.
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Improve Insurance Profitability
The main initiatives to improve our insurance profitability include:
During the second quarter of 2012, development for our second generation workers’ compensation predictive model was completed. Once further integration with our policy administration systems is complete, all of our commercial lines predictive models will operate on the same platform. Additional integration should enhance the ability of underwriters to target profitability and to discuss pricing impacts with agency personnel. The updated version of the workers’ compensation predictive modeling tool is expected to be deployed to our underwriters for new business and renewal policy processing during the third quarter.
In late 2011, we developed tools to improve pricing precision for small business policies written through our new product known as CinciPakTM. Plans to implement these tools for underwriters’ use include rolling them out to eight states by the end of 2012. During the first quarter we began to pilot CinciPak for a few dozen agencies in one state, as scheduled. Progress during the second quarter included introducing CinciPak in two additional states, and introduction in two more states is planned for the third quarter.
For our personal lines business, we will continue to enhance our pricing model attributes and expand our pricing points to add more precision during 2012. These enhancements should help us continue to be competitive on the most desirable business and to adapt more rapidly to changes in market conditions. During the first quarter, we completed a homeowner policy rate proposal based on our most recent modeled results. Rate changes based on the proposal will be filed in the majority of our states with effective dates in the fourth quarter of 2012. Progress during the second quarter included completion of a personal auto rate proposal based on recent modeled results. Rate changes based on this proposal will be filed in the majority of our states with effective dates in early 2013.
Continued development for additional coverages in our commercial lines policy administration system is expected to facilitate important internal process improvement initiatives. Progress during the second quarter included completion of requirements for these coverages and initiation of their development. Delivery of the first iteration to 10 states is expected by the end of 2012, followed by additional states in 2013. In addition, at the beginning of the third quarter of 2012, we launched the system, known as e-CLAS® CPP, in an additional state, the 35th in our 39-state operating territory for commercial lines.
For our personal lines business, we have also been developing business rules and parameters to allow future processing of some policies without intervention by an underwriter, for risks that meet qualifying underwriting criteria. The objective is to streamline processing for our agents and associates, permitting more time for risks that need additional service or attention while also reducing internal costs. During the first quarter, we expanded our pilot to automate renewal underwriting into three additional states, for a total of four states. Progress during the second quarter included expansion into two additional states for a total of six states. We also introduced automated processing of certain endorsements.
We measure the overall success of our strategy to improve insurance profitability primarily through our GAAP combined ratio for property casualty results, which we believe can be consistently within the range of 95 percent to 100 percent for any five-year period. We also compare our statutory combined ratio to the industry average to gauge our progress, as discussed in the Performance Drivers section above.
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In addition, we expect these initiatives to contribute to our rank as the No. 1 or No. 2 carrier based on premium volume in agencies that have represented us for at least five years. In 2011, we again earned that rank in approximately 75 percent of the agencies that have represented Cincinnati Insurance for more than five years, based on 2010 premiums. We are working to increase the percentage of agencies where we achieve that rank.
Drive Premium Growth
Primary initiatives to drive premium growth include:
During the first quarter we placed two new personal lines field marketing representatives to provide service to additional agencies located in the Northeast and Mid-Atlantic areas, for a total of 10 in various parts of our personal lines operating territory.
For our excess and surplus lines operation, we have been approved as a non-admitted carrier and brokerage in Delaware and Rhode Island. During the first half of 2012, we expanded our field underwriting presence and now have 10 field underwriting territories. During the first half of 2012, we also introduced a new quick-issue offering for special event policies and began more broadly marketing our expertise in large accounts.
Expansion of our personal lines operation is planned for additional states where we currently offer commercial lines products but do not offer personal lines products. We entered the state of New York during the first quarter of 2012. We plan to expand to one additional state by the end of 2012 and another state in the first half of 2013.
We also continue to develop and coordinate targeted marketing, including cross-selling opportunities, through our Target Markets department. This area focuses on commercial product development, including identification and promotional support for promising classes of business. We offered nine target markets programs to our agencies by the end of 2011. During the first quarter of 2012, we completed one of the four additional target market programs we plan to launch by the end of the year, with plans to launch our second program early in the third quarter. In each of the first two quarters, we also rolled out additional coverage forms for our existing programs.
We seek to build a close, long-term relationship with each agency we appoint. We carefully evaluate the marketing reach of each new appointment to ensure the territory can support both current and new agencies. During April 2012, we staffed two new marketing territories for commercial lines. Our 127 commercial lines field marketing territories are staffed by marketing representatives averaging 19 years of industry experience and nearly 10 years as a Cincinnati Insurance field marketing representative. The team of field associates in each territory works together with headquarters support associates to form our agent-centered business model, providing local expertise, helping us better understand the accounts we underwrite and creating market advantages for our agents. We help our agents grow their business by attracting more clients in their communities through unique Cincinnati-style service, and generally have earned a 10 percent share of an agency’s business within 10 years of its appointment.
We measure the overall success of our strategy to drive premium growth primarily through changes in net written premiums, as discussed in the Performance Drivers section above. In addition to tracking our progress toward our year-end 2015 direct written premiums target, we believe we can grow faster than the industry average over any five-year period.
An important part of our long-term strategy is financial strength, which is described in our 2011 Annual Report on Form 10-K, Item 1, Our Business and Our Strategy, Financial Strength, Page 5. One aspect of our financial strength is prudent use of reinsurance to help manage financial performance variability due to catastrophe loss experience. A description of how we use reinsurance is included in our 2011 Annual Report on Form 10-K, Item 7, Liquidity and Capital Resources, 2012 Reinsurance Programs, Page 98.
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Another aspect is our investment portfolios, which remain well-diversified as discussed in Item 3, Quantitative and Qualitative Disclosures about Market Risk, Page 51. We continue to maintain strong parent company liquidity and financial strength that increases our flexibility through all periods to maintain our cash dividend and to continue to invest in and expand our insurance operations. At June 30, 2012, we held $1.025 billion of our cash and invested assets at the parent company level, of which $872 million, or 85.1 percent, was invested in common stocks, and $23 million, or 2.3 percent, was cash or cash equivalents. Our debt-to-total-capital ratio at 14.8 percent remains well below our target limit of 20 percent. Another important indicator of financial strength is our ratio of property casualty net written premiums to statutory surplus, which was 0.9-to-1 for the 12 months ended June 30, 2012, up from 0.8-to-1 at year-end 2011.
Our financial strength ratings by independent ratings firms also are important. In addition to rating our parent company’s senior debt, four firms award insurer financial strength ratings to our property casualty insurance companies and three firms rate our life insurance company based on their quantitative and qualitative analyses. These ratings primarily assess an insurer’s ability to meet financial obligations to policyholders and do not necessarily address all of the matters that may be important to investors. Ratings may be subject to revision or withdrawal at any time by the rating agency, and each rating should be evaluated independently of any other rating.
As of July 25, 2012, our insurer financial strength ratings were:
All of our insurance subsidiaries continue to be highly rated.
On May 3, 2012, Fitch Ratings affirmed our ratings that it had assigned in September 2010, continuing its stable outlook. Fitch noted that ratings strengths include conservative capitalization, moderate holding company leverage and strong liquidity. Fitch noted our reserve adequacy and implementation of initiatives anticipated to improve underwriting results. Fitch said rating concerns include challenges from a competitive market and exposure to regional natural catastrophes and weather-related losses.
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Results of Operations
The consolidated results of operations reflect the operating results of each of our five segments along with the parent company and other activities reported as “Other.” The five segments are:
We report as Other the non-investment operations of the parent company and its non-insurer subsidiary, CFC Investment Company. See Item 1, Note 12, Segment Information, Page 20, for discussion of the calculations of segment data. Results of operations for each of the five segments are discussed below.
Consolidated Property Casualty Insurance Results of Operations
Consolidated property casualty insurance results include premiums and expenses for our standard market insurance (commercial lines and personal lines segments) as well as our surplus lines operations.
Our consolidated property casualty insurance operations generated an underwriting loss of $77 million and $68 million for the three and six months ended June 30, 2012, compared with an underwriting loss of $267 million and $297 million for the three and six months ended June 30, 2011. The primary causes of the improved underwriting results were lower losses from natural catastrophes and improving trends in pricing relative to loss costs. We believe the favorable trends for loss experience before catastrophes are in part due to our initiatives to improve pricing precision and loss experience related to claims and to loss control practices. Details of property casualty insurance results are discussed below, including our commercial lines, personal lines and excess and surplus lines segments.
We measure and analyze property casualty underwriting results primarily by the combined ratio and its component ratios. The GAAP-basis combined ratio is the percentage of incurred losses plus all expenses per each earned premium dollar – the lower the ratio, the better the performance. An underwriting profit results when the combined ratio is below 100 percent. A combined ratio above 100 percent indicates that an insurance company’s losses and expenses exceeded premiums.
The combined ratio can be affected significantly by natural catastrophe losses and other large losses as discussed in detail below. The combined ratio can also be affected by updated estimates of loss and loss expense reserves established for claims that occurred in prior periods, referred to as prior accident years. Net favorable development on prior accident year reserves, including reserves for catastrophe losses, improved the combined ratio by 12.4 percentage points in the first six months of 2012, or 2.1 percentage
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points more compared with 10.3 percentage points in the same period of 2011. On a before-catastrophe losses basis, net favorable development on prior accident year reserves for the first six months of 2012 was 0.5 percentage points more. Net favorable development for the first six months of 2012 is discussed in further detail in results of operations by property casualty insurance segment, Pages 34 through 44.
Our consolidated property casualty combined ratio for the second quarter improved 27.2 percentage points, and for the first six months of 2012 it improved 15.8 points, both compared with the same periods of 2011. In addition to catastrophe losses that were 22.0 and 7.9 percentage points lower, the loss and loss expenses ratio before catastrophe losses were 4.6 and 6.9 points lower, together accounting for most of the improvement.
The ratio for current accident year loss and loss expenses before catastrophe losses improved. The 68.8 percent ratio for the first six months of 2012 improved 6.4 percentage points compared with the 75.2 percent accident year 2011 ratio measured as of June 30, 2011, in part reflecting recent-year initiatives to improve pricing precision and loss experience related to claims and to loss control practices and improving market conditions. Lower new large losses incurred, shown on the table on Page 32, decreased the 2012 ratio by 2.0 percentage points and were partly responsible for the ratio’s improvement. The effect of the $38 million ceded in 2011 to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 1.9 percentage points. We believe the remaining reduction of 2.5 percentage points is largely due to initiatives to improve pricing precision and loss experience related to claims and loss control practices, somewhat offset by normal loss cost inflation.
The underwriting expense ratio improved for the second quarter and first six months of 2012 compared with the same periods a year ago, primarily due to higher earned premiums.
The trends in net written premiums and earned premiums summarized in the table above largely reflect the effects of our premium growth strategies, better pricing and the unfavorable effect on 2011 premiums due to additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty. Reinsurance reinstatement premiums lowered net written and earned premiums by $38 million during the second quarter and first six months of 2011.
Consolidated property casualty net written premiums for the three and six months ended June 30, 2012, grew $135 million and $199 million compared with the same periods of 2011. Ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty lowered net written and earned premiums by $38 million during the second quarter and first six months of 2011. On a percentage basis, 2011 reinsurance reinstatement premiums accounted for 6 percent and 3 percent of net written premium growth for the three and six months ended June 30, 2012, respectively. Each of our property casualty segments grew during the second quarter and first six months of 2012. Our premium growth initiatives from prior years continue to favorably affect current year growth, particularly as newer agency relationships mature over time. Improving insured exposure-level comparatives reflecting some improving areas of the economy also favorably affected premium growth. We discuss current initiatives in Highlights of Our Strategy and Supporting Initiatives, Page 26. The main drivers of trends for 2012 are discussed by segment on Pages 34, 39 and 43.
Consolidated property casualty agency new business written premiums for the three and six months ended June 30, 2012, increased $14 million and $20 million compared with the same periods of 2011. We continued to experience new business growth related to initiatives for geographic expansion into new and underserved areas. Agents appointed during 2011 or 2012 produced an increase in standard lines new business of $18 million for the first six months of 2012 compared with the same period in 2011. As we appoint new agencies that choose to move accounts to us, we report these accounts as new business. While this business is new to us, in many cases it is 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 upon obtaining it from a competing agent.
Other written premiums – primarily including premiums ceded to our reinsurers as part of our reinsurance program – contributed $40 million and $44 million to net written premium growth for the three and six months ended June 30, 2012, compared with the same periods of 2011. The $38 million unfavorable effect on 2011 premiums from additional ceded premiums to reinstate coverage layers of our
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property catastrophe reinsurance treaty accounted for much of the contribution. In addition to lower total ceded written premiums, other written premiums also benefited from a more favorable adjustment, compared with the second quarter of last year, for estimated direct written premiums of policies in effect but not yet processed. The adjustment had an immaterial effect on earned premiums.
Catastrophe losses typically have a meaningful effect on property casualty results and can vary significantly from period to period. Losses from natural catastrophes contributed 17.8 and 14.6 percentage points to the combined ratio in the three and six months ended June 30, 2012, compared with 39.8 and 22.5 percentage points in the same periods of 2011. The following table shows catastrophe losses and loss expenses incurred, net of reinsurance, as well as the effect of loss development on prior period catastrophe events. One of the second-quarter 2012 catastrophe events had losses estimated at June 30, 2012, that exceeded our $75 million loss retention for our property catastrophe reinsurance treaty. Terms of the treaty include one automatic reinstatement by layer of reinsurance. The first layer provides recovery of 48.3 percent of per-event losses between $75 million and $100 million. Amounts recovered and reinstatement premiums related to the second quarter of 2012 were immaterial. We individually list catastrophe events for which our incurred losses reached or exceeded $5 million.
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The following table includes data for losses incurred of $250,000 or more per claim, net of reinsurance.
Consolidated Property Casualty Insurance Losses by Size
We believe the inherent variability 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 variability in addition to general inflationary trends in loss costs. Our analysis continues to indicate no unexpected concentration of these large losses and case reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. The second-quarter 2012 property casualty total large losses incurred of $164 million, net of reinsurance, matched the $164 million quarterly average during 2011 and higher than the $141 million for the second quarter of 2011. The ratio for these large losses and case reserve increases was 0.7 percentage points higher compared with last year’s second quarter, with new losses up 0.9 points and case reserve development down 0.2 points. The second-quarter increase in losses added to the ratio for total large losses incurred for the first six months of 2012, which also included a first-quarter 2012 ratio that was 1.0 point lower than the first quarter of 2011. We believe results for the three-month and six-month periods largely reflected normal fluctuations in loss patterns and normal variability in large case reserves for claims above $250,000. Losses by size are discussed in further detail in results of operations by property casualty insurance segment, Pages 34 through 44.
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Commercial Lines Insurance Results of Operations
Overview
Performance highlights for the commercial lines segment include:
Agency renewal written premiums rose 10 percent and 8 percent for the second quarter and the first six months of 2012, reflecting higher pricing and improving economic conditions. To better manage our business in the highly competitive commercial lines marketplace, we continue to increase our use of predictive analytics tools to improve pricing precision while also leveraging our local relationships with agents through the efforts of our teams that work closely with them. We believe our field focus is unique and has several advantages, including providing us with high-quality intelligence on local market conditions. We seek to maintain appropriate pricing discipline for both new and renewal business as management emphasizes the importance of our agencies and underwriters assessing account quality to make careful decisions on a case-by-case basis whether to write or renew a policy. Rate credits may be used to retain renewals of high-quality business and to earn new business, but we do so selectively in order to avoid commercial accounts that we believe have insufficient profit margins.
We measure average changes in commercial lines renewal pricing as the rate of change in renewal premium for the new policy period compared with the premium for the expiring policy period, assuming no change in the level of insured exposures or policy coverage between those periods for respective policies. During the second quarter of 2012, our standard commercial lines policies averaged estimated price change increases in a mid-single-digit range, improving somewhat compared with the first quarter of 2012. Our average commercial lines pricing change includes the flat pricing effect of certain coverages within package policies written for a three-year term that were in force but did not expire during the period being measured. Therefore, the average commercial lines pricing change we report reflects a blend of three-year policies that did not expire and other policies that did expire during the measurement period. For the commercial lines policies that expired and were subsequently renewed during the second quarter of 2012, we estimate that the average pricing
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change was solidly in a mid-single-digit range, with workers’ compensation and commercial property policies experiencing higher than average renewal price increases.
Renewal premiums for our commercial casualty and workers’ compensation business include the result of policy audits that adjust initial premium amounts based on differences between estimated and actual sales or payroll related to a specific policy. Net written premiums from audits during the second quarter and the first six months of 2012 netted to positive $9 million and $15 million, respectively. Audits contributed $7 million to the $89 million net increase in net written premiums for the second quarter of 2012 and $16 million to the $127 million net increase in net written premiums for the first six months of 2012, both compared with the same periods a year ago. The $85 million increase in earned premiums during the first six months of 2012, compared with 2011, included a $14 million increase from audit premiums.
New business written premiums for commercial lines increased 12 percent and 9 percent during the second quarter and first six months of 2012 compared with the same period last year. The increase was broad-based as nearly two-thirds of the 39 states where we offer standard market commercial lines policies had higher new business written premiums for the first half of 2012 compared with the same period of 2011.
Other written premiums included a lower total amount ceded to reinsurers for the first half of 2012 compared with the same period of 2011, because 2011 premiums were reduced by $23 million of additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty. Other written premiums also included a more favorable adjustment, compared with the first six months of last year, for estimated direct written premiums of policies in effect but not yet processed. The adjustment had an immaterial effect on earned premiums.
Commercial Lines Insurance Premiums
Catastrophe losses accounted for 15.2 and 11.2 percentage points of the combined ratio for the three and six months ended June 30, 2012, compared with 29.7 and 17.2 percentage points for the same periods last year. The 10-year annual average through 2011 for the commercial lines segment was 3.7 percentage points, and the five-year annual average was 4.3 percentage points.
The ratio for current accident year loss and loss expenses before catastrophe losses improved. The 67.5 percent ratio for the first six months of 2012 improved 7.7 percentage points compared with the 75.2 percent accident year 2011 ratio measured as of June 30, 2011, in part reflecting recent-year initiatives to improve pricing precision and loss experience related to claims and to loss control practices and improving market conditions. Lower new large losses incurred, shown on the table on Page 33, decreased the 2012 ratio by 3.0 percentage points and were responsible for some of the ratio’s improvement. The effect of the $23 million ceded to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 1.5 percentage points. We believe the remaining reduction of 3.2 percentage points in the first half of 2012 is largely due to initiatives to improve pricing precision and loss experience related to claims and loss control practices, somewhat offset by normal loss cost inflation.
The net effect of reserve development on prior accident years during the second quarter and first six months of 2012 was favorable for commercial lines overall by $72 million and $162 million compared with net favorable development of $79 million and $130 million for the same periods in 2011. For the six months ended June 30, 2012, favorable reserve development on prior accident years in the commercial casualty line of business represented 64 percent of the commercial lines favorable development. Workers’ compensation accounted for 17 percent of the favorable development, while most of the remaining commercial lines favorable reserve development for the first six months of 2012 was almost evenly split between the commercial property and commercial auto lines of business. The favorable reserve development recognized during the first six months of
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2012 for commercial lines included approximately 11 percent for accident year 2011 and nearly 50 percent for combined accident years 2009 and 2010, and was primarily due to reduced volatility in paid losses, reduced volatility in projections of future calendar year trends and lower than anticipated loss emergence on known claims. Reserve estimates are inherently uncertain as described in our 2011 Annual Report on Form 10-K, Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 42.
The commercial lines underwriting expense ratio for the second quarter of 2012 matches the second quarter of 2011 and the first six months of 2012 improved primarily due to higher earned premiums.
Underwriting results and related measures for the combined ratio are summarized in the first table of Commercial Lines Insurance Results of Operations. The tables and discussion below provide additional details for certain primary drivers of underwriting results.
Commercial Lines Insurance Losses by Size
We continue to monitor new losses and case reserve increases greater than $250,000 for trends in factors such as initial reserve levels, loss cost inflation and claim settlement expenses. Our analysis continues to indicate no unexpected concentration of these large losses and case reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. The second-quarter 2012 commercial lines total large losses incurred of $124 million, net of reinsurance, was lower than the $137 million quarterly average during 2011 and higher than the $121 million for the second quarter of 2011. The ratio for these large losses and case reserve increases was 1.6 percentage points lower compared with last year’s second quarter, as higher earned premiums more than offset higher incurred losses for our commercial auto line of business. The second-quarter increase in losses added to the ratio for total large losses incurred for the first six months of 2012, which also included a higher number of claims and higher incurred losses for our general liability line of business during the first quarter. We believe results for the three-month and six-month periods largely reflected normal fluctuations in loss patterns and normal variability in large case reserves for claims above $250,000.
Commercial Lines of Business Analysis
Approximately 95 percent of our commercial lines premiums relate to accounts with coverages from more than one of our business lines. As a result, we believe that the commercial lines segment is best measured and evaluated on a segment basis. However, we provide line of business data to summarize premium and loss trends separately for each line. The ratios shown in the table below are components of loss and loss expenses as a percentage of earned premiums.
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As discussed above, the loss and loss expenses ratio component of the combined ratio is an important measure of underwriting profit and performance. Catastrophe losses are volatile and can distort short-term profitability trends, particularly for certain lines of business. Development of loss and loss expense reserves on prior accident years can also distort trends in measures of profitability for recently written business. To illustrate these effects, we separate their impact on the ratios shown in the table above. For the three and six months ended June 30, 2012, the commercial line of business with the most significant profitability challenge was surety and executive risk, assuming future weather-related loss experience for commercial property is at an average level that aligns with premium rates, including pricing increases of recent quarters. As discussed in Commercial Lines Insurance Results of Operations, Overview, Page 34, policies with commercial property coverages experienced higher than average renewal price increases in the second quarter of 2012, consistent with prior discussion for the first quarter. In addition, a multi-department, multi-disciplinary taskforce has been reviewing our property book of business and continues to seek ways to improve profitability, similar to the approach we used to improve workers’ compensation results. Several profit improvement initiatives are already underway, such as increased specialization among selected claims and loss control associates.
Our second-quarter and first-half 2012 surety and executive risk results included unfavorable development on prior accident years reserves for director and officer liability related to financial institutions. As discussed in our 2011 Annual Report on Form 10-K, Item 7, Commercial Lines Insurance Results of Operations, Page 67, we have taken steps to actively manage the potentially high risk of writing director and officer liability.
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Personal Lines Insurance Results of Operations
Performance highlights for the personal lines segment include:
Agency renewal written premiums increased 11 percent in both the second quarter and the first six months of 2012 because of rate increases in recent years, ongoing high levels of policy retention, premium growth initiatives and a higher level of insured exposures. In October 2011, we began our third round of increases for the homeowner line of business, averaging approximately 8 percent, with some individual policy rate increases being lower or higher based on attributes of risk that characterize the insured exposure. That followed rate changes averaging approximately 7 percent that were implemented beginning the fourth quarter of 2010 for states representing the majority of our personal lines business. Similar homeowner rate changes averaging approximately 6 percent were implemented beginning October 2009. During the second quarter of 2012, we began implementing rate changes for our personal auto line of business in the majority of the 30 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 the fourth quarter of 2010 also represented an average rate increase in the low-single-digit range.
Second-quarter and first-half 2012 personal lines new business written premiums continued to grow, up 12 percent and 10 percent, respectively, compared with the second quarter and first six months of 2011. We continue to believe we are successful in attracting more of our agents’ preferred business that is priced more accurately based on insured exposure. Some of what we report as new business came from accounts that were not new to our agents. We believe our agents’ seasoned accounts tend to be priced more accurately than business that may be less familiar to them.
Other written premiums – which primarily include premiums ceded to our reinsurers as part of our reinsurance program – contributed $15 million and $14 million to net written premium growth for the three and six months ended June 30, 2012, compared with the same period of 2011. Other written
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premiums included a lower total amount ceded to reinsurers for the first half of 2012 compared with the same period of 2011 because in 2011 we ceded an additional $15 million of premiums to reinstate coverage layers of our property catastrophe reinsurance treaty.
We continue to implement strategies discussed in our 2011 Annual Report on Form 10-K, Item 1, Strategic Initiatives, Page 10, to enhance our response to marketplace changes and help achieve our long-term objectives for personal lines growth and profitability. These strategies include plans to expand of our personal lines operation into two new states during 2012 and one in 2013.
Personal Lines Insurance Premiums
Catastrophe losses accounted for 26.6 and 25.0 percentage points of the combined ratio for the three and six months ended June 30, 2012, compared with 73.4 and 39.4 percentage points for the same periods last year. The 10-year annual average through 2011 catastrophe loss ratio for the personal lines segment was 10.5 percentage points, and the five-year annual average was 12.7 percentage points.
The ratios for current accident year loss and loss expenses before catastrophe losses for the three and six months ended June 30, 2012, were lower than the 2011 periods. The 71.6 percent ratio for the first six months of 2012 improved 2.8 percentage points compared with the 74.4 percent accident year 2011 ratio measured as of June 30, 2011, in part reflecting recent-year initiatives to improve pricing precision. Higher new large losses incurred, shown on the table on Page 41, increased the 2012 ratio by 0.9 percentage points, partially offsetting the initiatives’ effect. The effect of the $15 million ceded to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 3.0 percentage points. We believe the remaining reduction of 0.7 percentage points reflects initiatives to improve pricing precision, somewhat offset by normal loss cost inflation.
In addition to the rate increases discussed above, we continue to refine our pricing to better match premiums to the risk of loss on individual policies. The results of improved pricing per risk and broad-based rate increases are expected to improve the combined ratio over the next several quarters. In addition, greater geographic diversification is expected over time to reduce the volatility of homeowner loss ratios attributable to weather-related catastrophe losses.
Personal lines reserve development on prior accident years continued to emerge favorably during the second quarter and first six months of 2012. Favorable reserve development was $23 million higher for the first six months of 2012, compared with the same period of 2011, with catastrophe loss development contributing $10 million of the increase. The remainder was primarily for liability coverages, reflecting reduced volatility in paid losses and reduced volatility in projections of future calendar year trends. Approximately half of the favorable reserve development on prior accident years recognized during the first six months of 2012 occurred in the homeowner line of business and roughly one-third occurred in the personal auto line of business. Approximately half of the personal lines favorable reserve development recognized during the first six months of 2012 was for accident year 2011 and approximately one-third was for accident years 2009 and 2010. Reserve estimates are inherently uncertain as described in our 2011 Annual Report on Form 10-K, Item 7, Property Casualty Insurance Loss and Loss Expense Reserves, Page 42.
The underwriting expense ratio was lower for the second quarter and first six months of 2012 compared with the same periods of 2011, as higher premiums and lower technology related costs offset higher agency commissions.
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Personal Lines Insurance Losses by Size
We continue to monitor new losses and case reserve increases greater than $250,000 for trends in factors such as initial reserve levels, loss cost inflation and claim settlement expenses. Our analysis continues to indicate no unexpected concentration of these large losses and case reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. In the second quarter of 2012, the personal lines total ratio for these losses and case reserve increases, net of reinsurance, was 6.3 percentage points higher compared with last year’s second quarter, primarily due to a higher number of homeowner fire claims and incurred losses. The second-quarter increase added to the ratio for total large losses incurred for the first six months of 2012, which also includes an offsetting effect from a lower number of claims and incurred losses for our homeowner line of business during the first quarter. We believe results for the three-month and six-month periods largely reflected normal fluctuations in loss patterns and normal variability in large case reserves for claims above $250,000.
Personal Lines of Business Analysis
We prefer to write personal lines coverages on an account basis that includes both auto and homeowner coverages as well as coverages from the other personal business line. As a result, we believe that the personal lines segment is best measured and evaluated on a segment basis. However, we provide the line of business data to summarize premium and loss trends separately for each line. The ratios shown in the table below are components of loss and loss expenses as a percentage of earned premiums.
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As discussed above, the loss and loss expense ratio component of the combined ratio is an important measure of underwriting profit and performance. Catastrophe losses are volatile and can distort short-term profitability trends, particularly for certain lines of business. Development of loss and loss expense reserves on prior accident years can also distort trends in measures of profitability for recently written business. To illustrate these effects, we separate their impact on the ratios shown in the table above. For the three and six months ended June 30, 2012, the personal line of business with the most significant profitability challenge was homeowner. As discussed in Personal Lines Insurance Results of Operations, Overview, Page 39, above, we continue actions to improve pricing per risk and overall rates, which are expected to improve future profitability for both the homeowner and the personal auto lines of business. In addition, we anticipate that the long-term future average for the catastrophe loss ratio would improve due to gradual geographic diversification into states less prone to catastrophe losses.
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Excess And Surplus Lines Insurance Results of Operations
Performance highlights for the excess and surplus lines segment include:
Renewal written premiums grew 58 percent and 59 percent for the second quarter and first six months of 2012, compared with the same periods of 2011, reflecting the opportunity to renew many accounts for the first time as well as higher renewal pricing. Renewal pricing change estimated for our excess and surplus lines policies on average continued in a high-single-digit range. We measure average changes in excess and surplus lines renewal pricing as the rate of change in renewal premium for the new policy period compared with the premium for the expiring policy period, assuming no change in the level of insured exposures or policy coverage between those periods for respective policies.
New business written premiums increased for the second quarter and the first six months of 2012, compared with the same periods of 2011, reflecting somewhat less activity by standard market insurance companies in the excess and surplus lines market. Some of what we report as new business came from accounts that were not new to our agents. We believe our agents’ seasoned accounts tend to be priced more accurately than business that may be less familiar to them.
Excess and Surplus Lines Insurance Premiums
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The 76.4 percent ratio for current accident year loss and loss expenses before catastrophe losses for the first six months of 2012 increased 5.4 percentage points compared with the 71.0 percent full accident year 2011 ratio measured as of December 31, 2011, primarily due to new losses incurred of $250,000 or more that were 6.1 points higher for the first six months of 2012 compared with full-year 2011.
Catastrophe losses accounted for 3.5 percentage points of the combined ratio for both the three and six months ended June 30, 2012, compared with 4.4 and 3.6 percentage points in the same periods of 2011.
Excess and surplus reserve development on prior accident years was minimal for the first six months of 2012, compared with 21.4 percentage points of favorable reserve development for the same period of 2011. The 2011 favorable development was primarily due to a change toward placing more reliance on claims experience emergence patterns from our historical excess and surplus lines business for IBNR loss and loss expense estimates, while placing relatively less reliance on historical claims experience emergence patterns from similar lines of business included in our standard commercial lines business. The second quarter of 2011 was the first occurrence of a significant effect from this change. Reserve estimates are inherently uncertain as described in our 2011 Annual Report on Form 10-K, Item 7, Property Casualty Insurance Loss and Loss Expense Reserves, Page 42.
The underwriting expense ratio for the second quarter and the first six months of 2012 was lower than the same periods of 2011, primarily due to higher earned premiums.
Excess and Surplus Lines Insurance Losses by Size
We continue to monitor new losses and case reserve increases greater than $250,000 for trends in factors such as initial reserve levels, loss cost inflation and claim settlement expenses. Our analysis continues to indicate no unexpected concentration of these large losses and case reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. In the second quarter of 2012, the excess and surplus line total ratio for these losses and case reserve increases, net of reinsurance, was 12.5 percentage points higher compared with last year’s second quarter, largely due to a higher frequency of large losses. The second-quarter increase in losses added to the ratio for total large losses incurred for the first six months of 2012, which also includes a higher number of claims and incurred losses for two $1 million losses during the first quarter. We believe results for the three-month and six-month period ended June 30, 2012, largely reflected normal fluctuations in loss patterns and normal variability in large case reserves for claims above $250,000.
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Life Insurance Results of Operations
Performance highlights for the life insurance segment include:
Gross in-force life insurance policy face amounts increased to $79.560 billion at June 30, 2012, from $77.691 billion at year-end 2011.
Fixed annuity deposits received for the three and six months ended June 30, 2012, were $13 million and $30 million compared with $28 million and $89 million for the same periods of 2011. Fixed annuity deposits have a minimal impact to earned premiums because deposits received are initially recorded as liabilities. Profit is earned over time by way of interest rate spreads. We do not write variable or equity annuities and are currently de-emphasizing fixed annuity sales due to the low interest rate environment.
Life Insurance Premiums
Although we report most of our life insurance company investment income in our investments segment results, we recognize that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life products. On a basis that includes investment income and realized gains or losses from life insurance related invested assets, the life insurance company reported a net profit of $11 million and $18 million in the three and six months ended June 30, 2012, compared with a net profit of $16 million and $4 million for the same periods of 2011. The life insurance company portfolio had after-tax realized investment gains of less than $1 million and $1 million in the three and six months ended June 30, 2012, compared with after-tax realized investment gains of $3 million and after-tax realized investment losses of $16 million for the same periods of 2011.
Life segment benefits and expenses consist principally of contract holders’ (policyholders’) benefits incurred related to traditional life and interest-sensitive products and operating expenses incurred, net of deferred acquisition costs. Total benefits increased in the first six months of 2012 due to increased levels of net death claims. Although net death claims increased, they remained within our range of pricing expectations. Operating expenses increased compared with the first six months of 2011 as the amount of expenses deferred to future periods was decreased through a one-time actuarial adjustment and also because of the effects of interest rate compression on deferred acquisition cost amortization.
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Investments Results of Operations
The investments segment contributes investment income and realized gains and losses to results of operations. Investments traditionally are our primary source of pretax and after-tax profits.
Investment Income
Pretax investment income for the three months ended June 30, 2012, matched the same period of 2011. Investment income from interest on bonds trended flat as a larger portfolio base of fixed-maturity invested assets offset a slightly lower average yield. Dividend income for the three-month period also matched the year-ago amount. Average yields in the table below are based on the average invested asset and cash amounts indicated in the table, using fixed-maturity securities valued at amortized cost and all other securities at fair value. In our 2011 Annual Report on Form 10-K, Item 1, Investments Segment, Page 20, and Item 7, Investments Outlook, Page 84, we discussed our portfolio strategies. We discuss risks related to our investment income and our fixed-maturity and equity investment portfolios in Item 3, Quantitative and Qualitative Disclosures About Market Risk, Page 51.
We continue to 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 18 percent of our fixed-maturity investments mature during July 2012 through December 2014 with an average pretax yield-to-amortized cost of 4.9 percent, including 2.9 percent of the portfolio maturing during the last six months of 2012 also yielding 4.9 percent. 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.
Investment Results
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Net Realized Gains and Losses
We reported net realized investment gains of $6 million and $19 million in the three and six months ended June 30, 2012, as net gains from investment sales and bond calls were partially offset by other-than-temporary impairment (OTTI) charges. OTTI charges during the three-month and six-month periods ended June 30, 2012, were $14 million and $30 million, respectively. We reported net realized investment gains of $67 million and $79 million for the three and six months ended June 30, 2011, as net gains from investment sales and bond calls offset OTTI charges.
Investment gains or losses are recognized upon the sales of investments or as otherwise required under GAAP. The timing of realized gains or losses from sales can have a material effect on results in any quarter. However, such gains or losses usually have little, if any, effect on total shareholders’ equity because most equity and fixed-maturity investments are carried at fair value, with the unrealized gain or loss included as a component of other comprehensive income. Accounting requirements for OTTI charges for the fixed-maturity portfolio are disclosed in our 2011 Annual Report on Form 10-K, Item 8, Note 1, Summary of Significant Accounting Policies, Page 117.
The total net realized investment gains for the first six months of 2012 include:
The $30 million in OTTI charges was nearly all from four common stocks, with less than $1 million from two fixed-maturity securities.
Of the 2,776 securities in the portfolio, no securities were trading below 70 percent of amortized cost at June 30, 2012. Our asset impairment committee regularly monitors the portfolio, including a quarterly review of the entire portfolio for potential OTTI charges. We believe that if the improving liquidity in the markets were to reverse, or the economic recovery were to significantly stall, we could experience declines in portfolio values and possible additional OTTI charges.
The table below provides additional detail for OTTI charges.
Other
We report as Other the non-investment operations of the parent company and a non-insurer subsidiary, CFC Investment Company.
Losses before income taxes for Other were largely driven by interest expense from debt of the parent company.
Taxes
We had an income tax benefit of $3 million in the second quarter and income tax expense of $23 million in the six months ended June 30, 2012, compared with an income tax benefit of $49 million and $35 million for the same periods of 2011. The effective tax rate for the three and six months ended June 30, 2012, was negative 10.3 percent and positive 16.3 percent compared with positive 49.5 percent and 145.8 percent for the same periods last year.
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Historically, we have pursued a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. See Tax-Exempt Fixed Maturities, Page 53 for further discussion on municipal bond purchases in our fixed-maturity investment portfolio. For our insurance subsidiaries, approximately 85 percent of income from tax-advantaged fixed-maturity investments is exempt from federal tax. Our non-insurance companies own an immaterial amount of tax-advantaged fixed-maturity investments. For our insurance subsidiaries, the dividend received deduction, after the dividend proration of the 1986 Tax Reform Act, exempts approximately 60 percent of dividends from qualified equities from federal tax. For our non-insurance companies, the dividend received deduction exempts 70 percent of dividends from qualified equities. Details about our effective tax rate are found in our 2011 Annual Report on Form 10-K, Item 8, Note 11, Income Taxes, Page 129, and in Item 1, Note 11 – Income Taxes, Page 19.
Liquidity and Capital Resources
At June 30, 2012, shareholders’ equity was $5.144 billion compared with $5.033 billion at December 31, 2011. Total debt was $894 million at June 30, 2012, and at December 31, 2011. At June 30, 2012, cash and cash equivalents totaled $263 million compared with $438 million at December 31, 2011.
Sources of Liquidity
Subsidiary Dividends
Our lead insurance subsidiary declared dividends of $150 million to the parent company during the first six months of 2012 compared with $60 million for the same period of 2011. For the full-year 2011, subsidiary dividends declared totaled $180 million. State of Ohio regulatory requirements restrict the dividends our insurance subsidiary can pay. During 2012, total dividends that our insurance subsidiary could pay to our parent company without regulatory approval are approximately $375 million.
Investing Activities
Investment income is a source of liquidity for both the parent company and its insurance subsidiary. We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth.
Parent company obligations can be funded with income on investments held at the parent company level or through sales of securities in that portfolio, although we prefer to follow an investment philosophy seeking to compound cash flows over the long term. These sources of capital can help minimize subsidiary dividends to the parent company, protecting insurance subsidiary capital.
We own no European sovereign debt. Our European-based securities held at year-end 2011 are summarized by country in our 2011 Annual Report on Form 10-K, Item 7A, Qualitative and Quantitative Disclosures About Market Risk, Page 102. See our 2011 Annual Report on Form 10-K, Item 1, Investment Segment, Page 20, for a discussion of our historic investment strategy, portfolio allocation and quality.
Insurance Underwriting
Our property casualty and life insurance underwriting operations provide liquidity because we generally receive premiums before paying losses under the policies purchased with those premiums. After satisfying our cash requirements, we use excess cash flows for investment, increasing future investment income.
Historically, cash receipts from property casualty and life insurance premiums, along with investment income, have been more than sufficient to pay claims, operating expenses and dividends to the parent company.
The table below shows a summary of cash flow for property casualty insurance (direct method):
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Collected premiums for property casualty insurance rose $194 million during the first six months of 2012. Loss and loss expenses paid were $51 million lower, largely due to lower catastrophe losses paid.
We discuss our future obligations for claims payments and for underwriting expenses in our 2011 Annual Report on Form 10-K, Item 7, Contractual Obligations, Page 87, and Other Commitments, Page 88.
Capital Resources
At June 30, 2012, our debt-to-total-capital ratio was 14.8 percent, with $790 million in long-term debt and $104 million in borrowing on our revolving short-term line of credit. In May 2012, we executed a new five-year $225 million credit facility, replacing two credit facilities that totaled $225 million. Terms and conditions for the new credit facility were described in a Current Report dated May 31, 2012.There was no change in the amount of the $104 million short-term debt during the first six months of 2012. Based on our present capital requirements, we do not anticipate a material increase in debt levels during the remainder of 2012. As a result, we expect changes in our debt-to-total-capital ratio to continue to be largely a function of the contribution of unrealized investment gains or losses to shareholders’ equity.
We provide details of our three long-term notes in our 2011 Annual Report on Form 10-K, Item 8, Note 8, Senior Debt, Page 127. None of the notes are encumbered by rating triggers.
Four independent ratings firms also award insurer financial strength ratings to our property casualty insurance companies and three firms rate our life insurance company. Those firms made no changes to our debt ratings occurred during the first six months of 2012. Our debt ratings are discussed in our 2011 Annual Report on Form 10-K, Item 7, Liquidity and Capital Resources, Additional Sources of Liquidity, Page 86.
Off-Balance Sheet Arrangements
We do not use any special-purpose financing vehicles or have any undisclosed off-balance sheet arrangements (as that term is defined in applicable SEC rules) that are reasonably likely to have a current or future material effect on the company’s financial condition, results of operation, liquidity, capital expenditures or capital resources. Similarly, the company holds no fair-value contracts for which a lack of marketplace quotations would necessitate the use of fair-value techniques.
Uses of Liquidity
Our parent company and insurance subsidiary have contractual obligations and other commitments. In addition, one of our primary uses of cash is to enhance shareholder return.
Contractual Obligations
In our 2011 Annual Report on Form 10-K, Item 7, Contractual Obligations, Page 87, we estimated our future contractual obligations as of December 31, 2011. There have been no material changes to our estimates of future contractual obligations.
Other Commitments
In addition to our contractual obligations, we have other property casualty operational commitments.
We made no contribution to our qualified pension plan during the first six months of 2012. We anticipate contributing $14 million in the third quarter of 2012.
After fulfilling operating requirements, we invest cash flows from underwriting, investment and other corporate activities in fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. We discuss our investment strategy and certain portfolio attributes in Item 3, Quantitative and Qualitative Disclosures about Market Risk, Page 51.
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Uses of Capital
Uses of cash to enhance shareholder return include dividends to shareholders. In February and May 2012, the board of directors declared a regular quarterly cash dividend of 40.25 cents per share for an indicated annual rate of $1.61 per share. During the first six months of 2012, we used $128 million to pay cash dividends to shareholders.
Property Casualty Insurance Reserves
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 reserves. Reserving practices are discussed in our 2011 Annual Report on Form 10-K, Item 7, Property Casualty Insurance Loss and Loss Expense Obligations and Reserves, Page 88.
The rise in total gross reserves was primarily due to higher IBNR reserves for our commercial property and homeowner lines of business. Losses from natural catastrophes accounted for most of the increase.
Property and Casualty Gross Reserves
Life Policy and Investment Contract Reserves
Gross life policy and investment contract reserves were $2.256 billion at June 30, 2012, compared with $2.214 billion at year-end 2011, reflecting continued growth in life insurance policies in force. We discuss our life insurance reserving practices in our 2011 Annual Report on Form 10-K, Item 7, Life Insurance Policyholder Obligations and Reserves, Page 97.
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Other Matters
Significant Accounting Policies
Our significant accounting policies are discussed in our 2011 Annual Report on Form 10-K, Item 8, Note 1, Summary Of Significant Accounting Policies, Page 114, and updated in Item 1, Note 1, Accounting Policies, beginning on Page 7.
In conjunction with those discussions, in the Management’s Discussion and Analysis in the 2011 Annual Report on Form 10-K, management reviewed the estimates and assumptions used to develop reported amounts related to the most significant policies. Management discussed the development and selection of those accounting estimates with the audit committee of the board of directors.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Our greatest exposure to market risk is through our investment portfolio. Market risk is the potential for a decrease in securities’ fair value resulting from broad yet uncontrollable forces such as: inflation, economic growth or recession, interest rates, world political conditions or other widespread unpredictable events. It is comprised of many individual risks that, when combined, create a macroeconomic impact.
Our view of potential risks and our sensitivity to such risks is discussed in our 2011 Annual Report on Form 10-K, Item 7a, Quantitative and Qualitative Disclosures about Market Risk, Page 102.
The fair value of our investment portfolio was $12.164 billion at June 30, 2012, compared with $11.735 billion at year-end 2011.
Our consolidated investment portfolio contains $13 million of assets for which values are based on prices or valuation techniques that require significant management judgment (Level 3 assets). We have generally obtained and evaluated two non-binding quotes from brokers, then our investment professionals determine our best estimate of fair value. These investments include private placements, small issues and various thinly traded securities.
At June 30, 2012, total Level 3 assets were less than 1 percent of investment portfolio assets measured at fair value. See Item 1, Note 4, Fair Value Measurements, Page 12, for additional discussion of our valuation techniques.
In addition to our investment portfolio, the total investments amount reported in our condensed consolidated balance sheets includes Other invested assets. Other invested assets included $36 million of life policy loans and liens plus $31 million of venture capital fund investments at June 30, 2012.
Fixed-Maturity Investments
By maintaining a well-diversified fixed-maturity portfolio, we attempt to reduce overall risk. We invest new money in the bond market on a regular basis, targeting what we believe to be optimal risk-adjusted after-tax yields. Risk, in this context, includes interest rate, call, reinvestment rate, credit and liquidity risk. We do not make a concerted effort to alter duration on a portfolio basis in response to anticipated movements in interest rates. By regularly investing in the bond market, we build a broad, diversified portfolio that we believe mitigates the impact of adverse economic factors.
Our investment portfolio had no European sovereign debt holdings at June 30, 2012. At that time we owned other European-based securities, primarily corporate bonds, totaling less than $500 million in fair value. We discussed our European-based holdings in our 2011 Annual Report on Form 10-K, Item 7a, Quantitative and Qualitative Disclosures about Market Risk, Page 103. The composition of our European-based holdings at June 30, 2012, was similar to the composition at year-end 2011.
In the first six months of 2012, the increase in fair value of our fixed-maturity portfolio was due to a multitude of factors. In addition to purchases, contributors included tightening credit spreads in the corporate and municipal markets and a general decrease in treasury market yields. At June 30, 2012, our fixed-maturity portfolio was valued at 109.4 percent of its amortized cost, compared with 108.6 percent at December 31, 2011.
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Credit ratings at June 30, 2012, compared with December 31, 2011, for the fixed-maturity and short-term portfolios were:
Attributes of the fixed-maturity portfolio include:
We discuss maturities of our fixed-maturity portfolio in our 2011 Annual Report on Form 10-K, Item 8, Note 2, Investments, Page 121, and Item 2, Investments Results of Operations, Page 46.
Taxable Fixed Maturities
Our taxable fixed-maturity portfolio, with a fair value of $6.075 billion at June 30, 2012, included:
Our strategy typically is to buy and hold fixed-maturity investments to maturity, but we monitor credit profiles and fair value movements when determining holding periods for individual securities. With the exception of U.S. agency issues that include United States government and government sponsored enterprises, no individual issuer's securities accounted for more than 1.0 percent of the taxable fixed-maturity portfolio at June 30, 2012. Investment grade corporate bonds had an average rating of Baa1 by Moody’s or BBB+ by Standard & Poor’s and represented 88.9 percent of the taxable fixed-maturity portfolio’s fair value at June 30, 2012, compared with 87.2 percent at year-end 2011.
The heaviest concentration in our investment-grade corporate bond portfolio, based on fair value at June 30, 2012, is the financial-related sectors – including banking, financial services and insurance – representing 30.5 percent, compared with 29.3 percent at year-end 2011. We believe our weighting in financial-related sectors is below the average for the corporate bond market as a whole.
Most of the $333 million of securities issued by states, municipalities and political subdivisions included in our taxable fixed maturity portfolio at June 30, 2012, were Build America Bonds.
Our taxable fixed maturity portfolio at June 30, 2012, included $13 million of AAA rated commercial mortgage-backed securities.
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Tax-Exempt Fixed Maturities
At June 30, 2012, we had $2.950 billion of tax-exempt fixed-maturity securities with an average rating of Aa2/AA by Moody’s and Standard & Poor’s. We traditionally have purchased municipal bonds focusing on general obligation and essential services issues, such as water, waste disposal or others. The portfolio is well diversified among approximately 1,000 municipal bond issuers. No single municipal issuer accounted for more than 0.7 percent of the tax-exempt fixed maturity portfolio at June 30, 2012. The following table shows our municipal bond holdings in our larger states:
Interest Rate Sensitivity Analysis
Because of our strong surplus, long-term investment horizon and ability to hold most fixed-maturity investments until maturity, we believe the company is adequately positioned if interest rates were to rise. Although the fair values of our existing holdings may suffer, a higher rate environment would provide the opportunity to invest cash flow in higher yielding securities, while reducing the likelihood of untimely redemptions of currently callable securities. While higher interest rates would be expected to continue to increase the number of fixed-maturity holdings trading below 100 percent of amortized cost, we believe lower fixed-maturity security values due solely to interest rate changes would not signal a decline in credit quality. We continue to manage the portfolio with an eye toward both meeting current income needs and managing interest rate risk.
Our dynamic financial planning model uses analytical tools to assess market risks. As part of this model, the effective duration of the fixed-maturity portfolio is continually monitored by our investment department to evaluate the theoretical impact of interest rate movements.
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The table below summarizes the effect of hypothetical changes in interest rates on the fair value of the fixed-maturity portfolio:
The effective duration of the fixed-maturity portfolio as of June 30, 2012, was 4.3 years, compared with 4.4 years at year-end 2011. The above table is a theoretical presentation showing that an instantaneous, parallel shift in the yield curve of 100 basis points could produce an approximately 4.4 percent change in the fair value of the fixed-maturity portfolio. Generally speaking, the higher a bond is rated, the more directly correlated movements in its fair value are to changes in the general level of interest rates, exclusive of call features. The fair values of average- to lower-rated corporate bonds are additionally influenced by the expansion or contraction of credit spreads.
In our dynamic financial planning model, the selected interest rate change of 100 to 200 basis points represents our view of a shift in rates that is quite possible over a one-year period. The rates modeled should not be considered a prediction of future events as interest rates may be much more volatile in the future. The analysis is not intended to provide a precise forecast of the effect of changes in rates on our results or financial condition, nor does it take into account any actions that we might take to reduce exposure to such risks.
Equity Investments
Our equity investments, with a fair value totaling $3.139 billion at June 30, 2012, include $3.007 billion of common stock securities of companies generally with strong indications of paying and growing their dividends. Other criteria we evaluate include increasing sales and earnings, proven management and a favorable outlook. We believe our equity investment style is an appropriate long-term strategy. While our long-term financial position would be affected by prolonged changes in the market valuation of our investments, we believe our strong surplus position and cash flow provide a cushion against short-term fluctuations in valuation. Continued payment of cash dividends by the issuers of the common equities we hold can provide a floor to their valuation. A $100 million unrealized change in the value of the common stocks owned at period end would cause a change of $65 million, or approximately 40 cents per share, in our shareholders’ equity.
At June 30, 2012, our largest holding had a fair value of 4.7 percent of our publicly-traded common stock portfolio. Pepsico Inc. (NYSE:PEP) was our largest single common stock investment, comprising 1.2 percent of the investment portfolio as of the end of the second quarter of 2012.
Common Stock Portfolio Industry Sector Distribution
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Unrealized Investment Gains and Losses
At June 30, 2012, unrealized investment gains before taxes for the consolidated investment portfolio totaled $1.673 billion and unrealized investment losses amounted to $9 million.
The unrealized investment gains at June 30, 2012, were due to a pretax net gain position in our fixed maturity portfolio of $773 million and a net gain position in our equity portfolio of $891 million. The net gain position in our fixed-maturity portfolio has grown since year-end 2007 due largely to a declining interest rate environment in recent years. The net gain position for our current fixed-maturity holdings will naturally decline over time as individual securities mature. In addition, changes in interest rates can cause rapid, significant changes in fair values of fixed-maturity securities and the net gain position, as discussed on Pages 51 to 54. The three largest contributors to our equity portfolio net gain position were ExxonMobil, Procter & Gamble and Chevron common stocks, which had a combined net gain position of $269 million.
Unrealized Investment Losses
We expect the number of securities trading below amortized cost to fluctuate as interest rates rise or fall and credit spreads expand or contract due to prevailing economic conditions. Further, amortized costs for some securities are revised through OTTI recognized in prior periods. At June 30, 2012, 106 of the 2,776 securities we owned had fair values below amortized cost compared with 137 of the 2,724 securities we owned at year-end 2011. The 106 holdings with fair values below cost or amortized cost at June 30, 2012, represented 3.2 percent of fair value of our investment portfolio and $9 million in unrealized losses.
The table below reviews fair values and unrealized losses by investment category and by the overall duration of the securities’ continuous unrealized loss position.
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At June 30, 2012, 16 fixed-maturity securities with a total unrealized loss of $4 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity securities had fair values under 70 percent of amortized cost; three fixed-maturity securities with a fair value of $17 million had a fair value from 70 percent to less than 90 percent of amortized cost and accounted for $3 million in unrealized losses; and 13 fixed-maturity securities with a fair value of $43 million had fair values from 90 percent to less than 100 percent of amortized cost and accounted for $1 million in unrealized losses.
At June 30, 2012, three equity securities had been in an unrealized loss position for 12 months or more. Of that total, none were trading under 70 percent of cost and none were trading from 70 percent to less than 90 percent of cost; three equity securities with a fair value of $7 million were trading from 90 percent to less than 100 percent of cost and accounted for less than $1 million in unrealized losses.
At June 30, 2012, applying our invested asset impairment policy, we determined that the $9 million in total unrealized losses in the table above were not other-than-temporarily impaired.
During the second quarter of 2012, four securities were written down through impairment charges, including one new security impairment, for a total of six during the six months ended June 30, 2012. OTTI resulted in pretax, non-cash charges of $14 million and $30 million for the three months and six months ended June 30, 2012. During the same periods of 2011, we wrote down securities resulting in less than $1 million and $30 million in OTTI charges.
During full-year 2011, we wrote down 12 securities and recorded $57 million in OTTI charges. At December 31, 2011, 20 fixed-maturity investments with a total unrealized loss of $5 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. Two equity investments with a total unrealized loss of less than $1 million had been in an unrealized loss position for 12 months or more as of December 31, 2011. Of that total, no equity investments were trading below 70 percent of amortized cost.
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The following table summarizes the investment portfolio by severity of decline:
See our 2011 Annual Report on Form 10-K, Item 7, Critical Accounting Estimates, Asset Impairment, Page 46.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures – The company maintains disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (Exchange Act)).
Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. The company’s management, with the participation of the company’s chief executive officer and chief financial officer, has evaluated the effectiveness of the design and operation of the company’s disclosure controls and procedures as of June 30, 2012. Based upon that evaluation, the company’s chief executive officer and chief financial officer concluded that the design and operation of the company’s disclosure controls and procedures provided reasonable assurance that the disclosure controls and procedures are effective to ensure:
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Changes in Internal Control over Financial Reporting – During the three months ended June 30, 2012, there were no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Part II – Other Information
Item 1. Legal Proceedings
Neither the company nor any of our subsidiaries is involved in any litigation believed to be material other than ordinary, routine litigation incidental to the nature of our business.
Item 1A. Risk Factors
Our risk factors have not changed materially since they were described in our 2011 Annual Report on Form 10-K filed February 29, 2012.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
We did not sell any of our shares that were not registered under the Securities Act during the first six months of 2012. The board of directors has authorized share repurchases since 1996. Purchases are expected to be made generally through open market transactions. The board gives management discretion to purchase shares at reasonable prices in light of circumstances at the time of purchase, subject to SEC regulations. On October 24, 2007, the board of directors expanded the existing repurchase authorization to approximately 13 million shares. We did not repurchase any shares during the first six months of 2012. We have 7,438,762 shares available for purchase under our programs at June 30, 2012. We discuss the board authorization in our 2011 Annual Report on Form 10-K, Item 7, Liquidity and Capital Resources, Parent Company Liquidity, Page 85.
Item 3. Defaults upon Senior Securities
We have not defaulted on any interest or principal payment, and no arrearage in the payment of dividends has occurred.
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
None.
Item 6. Exhibits
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Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: July 26, 2012
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