10-K 1 v329482_10k.htm 10-K

 

United States Securities and Exchange Commission

Washington, D.C. 20549

 

Form 10-K

 

þANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

 

For the fiscal year ended December 31, 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)

 

Ohio 31-0746871
(State of incorporation) (I.R.S. Employer Identification No.)

 

6200 S. Gilmore Road

Fairfield, Ohio 45014-5141

(Address of principal executive offices) (Zip Code)

(513) 870-2000

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

$2.00 par, common stock

(Title of Class)

6.125% Senior Notes due 2034

(Title of Class)

6.9% Senior Debentures due 2028

(Title of Class)

6.92% Senior Debentures due 2028

(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ      No ¨

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨      Noþ

 

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. Yes þ      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 if 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). Yes þ      No ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

 

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 the definitions of "large accelerated filer,” “accelerated filer" and smaller reporting company in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer þ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No þ

 

The aggregate market value of voting stock held by nonaffiliates of the Registrant was $5,608,134,376 as of June 30, 2012.

 

As of February 21, 2013, there were 163,227,008 shares of common stock outstanding.

 

Document Incorporated by Reference

 

Portions of the definitive Proxy Statement for Cincinnati Financial Corporation’s Annual Meeting of Shareholders to be held on April 27, 2013, are incorporated by reference into Part III of this Form 10-K.

 

 
 

 

2012 Annual Report on Form 10-K

 

Table of Contents

 

Part I   3
Item 1. Business 3
Cincinnati Financial Corporation – Introduction 3
Our Business and Our Strategy 3
Our Segments 12
Other 23
Regulation 24
Item 1A. Risk Factors 26
Item 1B. Unresolved Staff Comments 33
Item 2. Properties 33
Item 3. Legal Proceedings 33
Item 4. Mine Safety Disclosures 33
Part II   34
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 34
Item 6. Selected Financial Data 37
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 38
Introduction 38
Executive Summary 38
Critical Accounting Estimates 43
Recent Accounting Pronouncements 50
Results of Operations 51
Liquidity and Capital Resources 83
Safe Harbor Statement 98
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 100
Introduction 100
Fixed-Maturity Investments 101
Equity Investments 102
Application of Asset Impairment Policy 102
Item 8. Financial Statements and Supplementary Data 105
Responsibility for Financial Statements 105
Management’s Annual Report on Internal Control Over Financial Reporting 106
Report of Independent Registered Public Accounting Firm 107
Consolidated Balance Sheets 108
Consolidated Statements of Comprehensive Income 109
Consolidated Statements of Shareholders’ Equity 110
Consolidated Statements of Cash Flows 111
Notes to Consolidated Financial Statements 112
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 140
Item 9A. Controls and Procedures 140
Item 9B. Other Information 140
Part III   141
Item 10. Directors, Executive Officers and Corporate Governance 141
Item 11. Executive Compensation 143
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 143
Item 13. Certain Relationships and Related Transactions, and Director Independence 143
Item 14. Principal Accounting Fees and Services 143
Part IV   143
Item 15. Exhibits, Financial Statement Schedules 143

 

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Part I

 

Item 1. Business

 

Cincinnati Financial Corporation – Introduction

 

We are an Ohio corporation formed in 1968. Our lead subsidiary, The Cincinnati Insurance Company, was founded in 1950. Our main business is property casualty insurance marketed through independent insurance agencies in 39 states. Our headquarters is in Fairfield, Ohio. At year-end 2012, we employed 4,057 associates, with 2,784 headquarters associates providing support to 1,273 field associates.

 

Cincinnati Financial Corporation owns 100 percent of three subsidiaries: The Cincinnati Insurance Company, CSU Producer Resources Inc. and CFC Investment Company. In addition, the parent company has an investment portfolio, owns the headquarters property and is responsible for corporate borrowings and shareholder dividends.

 

The Cincinnati Insurance Company owns 100 percent of our four additional insurance subsidiaries. Our standard market property casualty insurance group includes two of those subsidiaries – The Cincinnati Casualty Company and The Cincinnati Indemnity Company. This group writes a broad range of business, homeowner and auto policies. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which provides life insurance, disability income policies and fixed annuities, and The Cincinnati Specialty Underwriters Insurance Company, which offers excess and surplus lines insurance products.

 

The two noninsurance subsidiaries of Cincinnati Financial Corporation are CSU Producer Resources, which offers insurance brokerage services to our independent agencies so their clients can access our excess and surplus lines insurance products; and CFC Investment Company, which offers commercial leasing and financing services to our agencies, their clients and other customers.

 

Our filings with the U.S. Securities and Exchange Commission (SEC) are available, free of charge, on our website, www.cinfin.com/investors, as soon as possible after they have been filed with the SEC. These filings include annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. In the following pages we reference various websites. These websites, including our own, are not incorporated by reference in this Annual Report on Form 10-K.

 

Periodically, we refer to estimated industry data so that we can give information about our performance versus the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and insurer financial strength and credit rating organization. Information from A.M. Best is presented on a statutory accounting basis. When we provide our results on a comparable statutory accounting 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).

 

Our Business and Our Strategy

 

Introduction

 

The Cincinnati Insurance Company was founded over 60 years ago by four independent insurance agents. They established the mission that continues to guide all of the companies in the Cincinnati Financial Corporation family – to grow profitably and enhance the ability of local independent insurance agents to deliver quality financial protection to the people and businesses they serve by:

 

·providing insurance market stability through financial strength

 

·producing competitive, up-to-date products and services

 

·developing associates committed to superior service

 

A select group of independent agencies in 39 states actively markets our property casualty insurance within their communities. At year-end 2012, standard market commercial lines and excess and surplus lines policies were marketed in all of those states, while personal lines policies were marketed in 31 of those states. Within our select group of agencies, we also seek to become the life insurance carrier of choice and to help agents and their clients – our policyholders – by offering leasing and financing services.

 

Three competitive advantages distinguish our company, positioning us to build shareholder value and to be successful overall:

 

·Commitment to our network of professional independent insurance agencies and to their continued success

 

·Financial strength that lets us be a consistent market for our agents’ business, supporting stability and confidence

 

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·Operating structure that supports local decision making, showcasing our claims excellence and allowing us to balance growth with underwriting discipline

 

Independent Insurance Agency Marketplace

 

The U.S. property casualty insurance industry is a highly competitive marketplace with more than 2,000 stock and mutual companies operating independently or in groups. No single company or group dominates across all product lines and states. Standard market insurance companies (carriers) can market a broad array of products nationally or:

 

·choose to sell a limited product line or only one type of insurance (monoline carrier)

 

·target a certain segment of the market (for example, personal insurance)

 

·focus on one or more states or regions (regional carrier)

 

Standard market property casualty insurers generally offer insurance products through one or more distribution channels:

 

·independent agents, who represent multiple carriers

 

·captive agents, who represent one carrier exclusively

 

·direct marketing to consumers

 

For the most part, we compete with standard market insurance companies that market through independent insurance agents. Agencies marketing our commercial lines products typically represent six to 12 standard market insurance carriers for commercial lines products, including both national and regional carriers, most of which are mutual companies. Our agencies typically represent four to six standard personal lines carriers, and we also compete with carriers that market personal lines products through captive agents and direct writers. Distribution through independent insurance agents or brokers represents approximately half of overall U.S. property casualty insurance premiums and approximately two-thirds of commercial property casualty insurance premiums, according to the Insurance Information Institute.

 

We are committed exclusively to the independent agency channel. The independent agencies that we choose to market our standard lines insurance products share our philosophies. They do business person to person; offer broad, value-added services; maintain sound balance sheets; and manage their agencies professionally, targeting long-term success. We develop our relationships with agencies that are active in their local communities, providing important knowledge of local market trends, opportunities and challenges.

 

In addition to providing standard market property casualty insurance products, we operate our own excess and surplus lines insurance brokerage firm and insurance carrier so that we can offer our excess and surplus lines products exclusively to the independent agencies who market our other property casualty insurance products. We also market life insurance products through the agencies that market our property casualty products and through other independent agencies that represent The Cincinnati Life Insurance Company without also representing our other subsidiaries. Offering insurance solutions beyond our standard market property casualty insurance products helps our agencies meet the broader needs of their clients and also serves to increase and diversify agency revenues and profitability.

 

The excess and surplus lines market exists due to a regulatory distinction. Generally, excess and surplus lines insurance carriers provide insurance that is unavailable in the standard market due to market conditions or characteristics of the insured person or organization that are caused by nature, the insured's claim history or the characteristics of their business. Insurers operating in the excess and surplus lines marketplace generally market business through excess and surplus lines insurance brokers, whether they are small specialty insurers or specialized divisions of larger insurance organizations. We established an excess and surplus lines operation in response to requests to help meet the needs of agency clients when insurance is unavailable in the standard market. By providing superior service, we can help our agencies grow while also profitably growing our property casualty business.

 

At year-end 2012, our 1,408 property casualty agency relationships were marketing our standard market insurance products from 1,758 reporting locations. An increasing number of agencies have multiple, separately identifiable locations, reflecting their growth and consolidation of ownership within the independent agency marketplace. The number of reporting agency locations indicates our agents’ regional scope and the extent of our presence within our 39 active states. At year-end 2011, our 1,312 agency relationships had 1,648 reporting locations. At year-end 2010, our 1,245 agency relationships had 1,544 reporting locations.

 

We made 140, 133 and 93 new agency appointments in 2012, 2011 and 2010, respectively. Of these new appointments, 109, 93 and 70, respectively, were new relationships. The remainder included new branch offices opened by existing Cincinnati agencies and appointment of agencies that merged with a Cincinnati agency. These new appointments and other changes in agency structures or appointment status led to a net increase in agency relationships of 96, 67 and 65 and a net increase in reporting agency locations of 110, 104 and 81 in 2012, 2011 and 2010, respectively.

 

4
 

 

On average, we have a 12.6 percent share of the standard lines property casualty insurance purchased through our reporting agency locations, according to data from agency surveys. Our share is 17.7 percent in reporting agency locations that have represented us for more than 10 years; 8.5 percent in agencies that have represented us for six to 10 years; 4.3 percent in agencies that have represented us for two to five years; and 1.2 percent in agencies that have represented us for one year or less.

 

Our largest single agency relationship accounted for approximately 0.9 percent of our total property casualty earned premiums in 2012. No aggregate locations under a single ownership structure accounted for more than 2.1 percent of our earned premiums in 2012.

 

Financial Strength

 

We believe that our financial strength and strong surplus position, reflected in our insurer financial strength ratings, are clear, competitive advantages in the segments of the insurance marketplace that we serve. This strength supports the consistent, predictable performance that our policyholders, agents, associates and shareholders have always expected and received, helping us withstand significant challenges.

 

While the potential exists for short-term financial performance variability due to our exposures to potential catastrophes or significant capital market losses, the rating agencies consistently have asserted that we have built appropriate financial strength and flexibility to manage that variability. We remain committed to strategies that emphasize being a consistent, stable market for our agents’ business over short-term benefits that might accrue by quick, opportunistic reaction to changes in market conditions.

 

We use various principles and practices such as diversification and enterprise risk management to maintain strong capital. For example, we maintain a diversified investment portfolio by reviewing and applying diversification parameters and tolerances.

 

·Our $9.093 billion fixed-maturity portfolio is diversified and exceeds total insurance reserves. The portfolio had an average rating of A2/A, and its fair value exceeded total insurance reserve liability by nearly 40 percent at December 31, 2012. No corporate bond exposure accounted for more than 0.7 percent of our fixed-maturity portfolio, and no municipal exposure accounted for more than 0.2 percent.

 

·The strength of our fixed-maturity portfolio provides an opportunity to invest for potential capital appreciation by purchasing equity securities. Our $3.373 billion equity portfolio minimizes concentrations in single stocks or industries. At December 31, 2012, no single security accounted for more than 4.2 percent of our portfolio of publicly traded common stocks, and no single sector accounted for more than 16 percent.

 

Strong liquidity increases our flexibility through all periods to maintain our cash dividend and to continue to invest in and expand our insurance operations. At December 31, 2012, we held $1.182 billion of our cash and invested assets at the parent company level, of which $958 million, or 81.0 percent, was invested in common stocks, and $90 million, or 7.6 percent, was cash or cash equivalents.

 

We minimize reliance on debt as a source of capital, maintaining the ratio of debt-to-total-capital below 20 percent. At December 31, 2012, this ratio at 14.1 percent was well below the target limit as capital remained strong while debt levels did not change from year-end 2011. Long-term debt at year-end 2012 totaled $790 million and our short-term debt was $104 million. The long-term debt consists of three nonconvertible, noncallable debentures, two due in 2028 and one in 2034. Ratings for our long-term debt are discussed in Item 7, Liquidity and Capital Resources, Additional Sources of Liquidity, Page 84.

 

At year-end 2012 and 2011, risk-based capital (RBC) for our standard and excess and surplus lines property casualty operations and life operations was very strong, far exceeding regulatory requirements.

 

·We ended 2012 with a 0.9-to-1 ratio of property casualty premiums to surplus, a key measure of property casualty insurance company capacity and security. A lower ratio indicates more security for policyholders and greater capacity for growth by an insurer. We believe our ratio provides ample flexibility to diversify risk by expanding our operations into new geographies and product areas. The estimated industry average ratio was 0.8-to-1 at year-end 2012.

 

·We ended 2012 with an 11.1 percent ratio of life statutory adjusted risk-based surplus to liabilities, a key measure of life insurance company capital strength. The estimated industry average ratio was 11.1 percent at year-end 2012. A higher ratio indicates an insurer’s stronger security for policyholders and capacity to support business growth.

 

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Statutory Information

 

(Dollars in millions)  At December 31, 
   2012   2011 
         
Standard market property casualty insurance subsidiary          
Statutory surplus  $3,914   $3,747 
Risk-based capital (RBC)   3,928    3,754 
Authorized control level risk-based capital   487    474 
Ratio of risk-based capital to authorized control level risk-based capital   8.1    7.9 
Written premium to surplus ratio   0.9    0.8 
           
Life insurance subsidiary          
Statutory surplus  $276   $281 
Risk-based capital (RBC)   290    288 
Authorized control level risk-based capital   29    36 
Ratio of risk-based capital to authorized control level risk-based capital   10.1    7.9 
Total liabilities excluding separate account business   2,626    2,454 
Life statutory risk-based adjusted surplus to liabilities ratio   11.1    11.8 
           
Excess and surplus insurance subsidiary          
Statutory surplus  $199   $186 
Risk-based capital (RBC)   199    186 
Authorized control level risk-based capital   20    13 
Ratio of risk-based capital to authorized control level risk-based capital   10.2    13.9 
Written premium to surplus ratio   0.5    0.4 

 

The consolidated property casualty insurance group’s ratio of investments in common stock to statutory surplus was 58.1 percent at year-end 2012 compared with 54.5 percent at year-end 2011.

 

Cincinnati Financial Corporation’s senior debt is rated by four independent rating firms. In addition, the rating firms award our property casualty and life operations insurance financial strength ratings based on their quantitative and qualitative analyses. These ratings 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 shareholders. Ratings may be subject to revision or withdrawal at any time by the ratings agency, and each rating should be evaluated independently of any other rating.

 

All of our insurance subsidiaries continue to be highly rated. During 2012, three of the four ratings firms affirmed our insurance financial strength ratings and continued their stable outlook on the ratings. No other rating agency actions occurred during 2012.

 

As of February 25, 2013, our insurance financial strength ratings were:

 

    Insurer Financial Strength Ratings  
Rating
agency
 

Standard market property

casualty insurance subsidiary

  Life insurance
subsidiary
  Excess and surplus
insurance subsidiary
 

Date of most recent

affirmation or action

        Rating Tier       Rating Tier      

Rating

Tier

   
A. M. Best Co.   A+ Superior 2 of 16   A Excellent 3 of 16   A Excellent 3 of 16   Stable outlook (12/19/12)
Fitch Ratings   A+ Strong 5 of 21   A+ Strong 5 of 21   - - -   Stable outlook (11/20/12)
Moody's Investors Service   A1 Good 5 of 21   - - -   - - -   Negative outlook (10/21/11)
Standard & Poor's Ratings Services   A Strong 6 of 21   A Strong 6 of 21   - - -   Stable outlook (7/30/12)

 

On December 19, 2012, A.M. Best affirmed our financial strength ratings that it had assigned in December 2008, continuing its stable outlook. A.M. Best cited our superior risk-adjusted capitalization, conservative loss reserving standards and growing use of predictive analytic modeling tools along with our historically strong operating performance. Concerns noted included geographic concentration and weakened underwriting results in recent years, primarily from above-average catastrophe-related losses. A.M. Best acknowledged the strong franchise value of our insurance subsidiaries and the financial flexibility of the holding company.

 

On November 20, 2012, Fitch Ratings affirmed our insurer financial strength ratings that it had assigned in August 2009, continuing its stable outlook. Fitch cited ratings strengths including our conservative operating subsidiary capitalization supported by strong holding company cash and marketable securities position and moderate holding company leverage, and well-managed reserves. Fitch added that we have implemented predictive modeling tools that are anticipated to improve underwriting expertise and loss ratios over time. Rating concerns noted principally related to challenges from competitive market conditions and exposure to regional natural catastrophes and other weather-related losses.

 

On July 30, 2012, Standard & Poor’s Ratings Services affirmed our insurer financial ratings that it had assigned in July 2010, continuing its stable outlook. S&P said its rating was based on our strong competitive position, which is reinforced by a loyal and productive agency force and a low-cost infrastructure. S&P also

 

6
 

 

cited our very strong capitalization and high degree of financial flexibility. S&P noted that our strengths are partially offset by deteriorating property casualty underwriting results due to weather-related losses, and earnings volatility stemming from regional concentration and low reinsurance utilization.

 

Our debt ratings are discussed in Item 7, Liquidity and Capital Resources, Additional Sources of Liquidity, Page 84.

 

Operating Structure

 

We offer our broad array of insurance products through the independent agency distribution channel. We recognize that locally based independent agencies have relationships in their communities and local marketplace intelligence that can lead to policyholder satisfaction, loyalty and profitable business. Several of our strategic initiatives are intended not only to help us compete but also to enhance support of agencies that represent us, thereby contributing to agency success. We seek to be a consistent and predictable property casualty carrier that agencies can rely on to serve their clients. For our standard market business, field and headquarters underwriters make risk-specific decisions about both new business and renewals.

 

In our 10 highest volume states for consolidated property casualty premiums, 1,039 reporting agency locations wrote 65.4 percent of our 2012 consolidated property casualty earned premium volume compared with 992 locations and 66.5 percent in 2011.

 

Consolidated Property Casualty Insurance Earned Premiums by State

 

(Dollars in millions)  Earned
premiums
   % of total
earned
   Agency
locations
   Average
premium per
location
 
Year ended December 31, 2012                    
Ohio  $640    19.1%   235   $2.7 
Illinois   263    7.9    127    2.1 
Indiana   228    6.8    110    2.1 
Pennsylvania   196    5.9    91    2.2 
Georgia   170    5.1    88    1.9 
North Carolina   163    4.9    91    1.8 
Michigan   153    4.6    134    1.1 
Virginia   128    3.8    65    2.0 
Kentucky   122    3.7    43    2.8 
Tennessee   120    3.6    55    2.2 
Year ended December 31, 2011                    
Ohio  $591    19.5%   233   $2.5 
Illinois   250    8.3    124    2.0 
Indiana   208    6.9    107    1.9 
Pennsylvania   184    6.1    85    2.2 
Georgia   154    5.1    80    1.9 
North Carolina   149    4.9    85    1.8 
Michigan   134    4.4    118    1.1 
Virginia   123    4.1    66    1.9 
Kentucky   114    3.8    43    2.7 
Wisconsin   103    3.4    51    2.0 

 

Field Focus

 

We rely on our force of 1,273 field associates to provide service and be accountable to our agencies for decisions we make at the local level. These associates live in the communities our agents serve, working from offices in their homes and providing 24/7 availability to our agents. Headquarters associates support agencies and field associates with underwriting, accounting, technology assistance and training and other services. Company executives, headquarters underwriters and special teams regularly travel to visit agencies, strengthening the personal relationships we have with these organizations. Agents have opportunities for direct, personal conversations with our senior management team, and headquarters associates have opportunities to refresh their knowledge of marketplace conditions and field activities.

 

The field team is coordinated by field marketing representatives responsible for underwriting new commercial lines business. They are joined by field representatives specializing in claims, loss control, personal lines, excess and surplus lines, machinery and equipment, bond, premium audit and life insurance. The field team provides many services for agencies and policyholders; for example, our loss control field representatives and others specializing in machinery and equipment risks perform inspections and recommend specific actions to improve the safety of the policyholder’s operations and the quality of the agent’s account.

 

Agents work with us to carefully select risks and help assure pricing adequacy. They appreciate the time our associates invest in creating solutions for their clients while protecting profitability, whether that means working on an individual case or customizing policy terms and conditions that preserve flexibility, choice and other sales advantages. We seek to develop long-term relationships by understanding the unique needs of their clients, who are also our policyholders.

 

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We also are responsive to agent needs for well designed property casualty products. Our commercial lines products are structured to allow flexible combinations of property and liability coverages in a single package with a single expiration date and several payment options. This approach brings policyholders convenience, discounts and a reduced risk of coverage gaps or disputes. At the same time, it increases account retention and saves time and expense for the agency and our company.

 

We employ technology solutions and business process improvements that:

 

·allow our field and headquarters associates to collaborate with each other and with agencies more efficiently

 

·provide our agencies the ability to access our systems and data from their agency management systems to process business transactions from their offices

 

·allow policyholders to directly access, from their systems and mobile devices, pertinent policy information online in order to further improve efficiency for our agencies

 

·automate our internal processes so our associates can spend more time serving agents and policyholders

 

·reduce duplicated effort or friction points in technology processes, introducing more efficiency that reduces company and agency costs

 

Agencies access our systems and other electronic services via their agency management systems or CinciLink®, our secure agency-only website. CinciLink provides an array of web-based services and content that makes doing business with us easier, such as commercial and personal lines rating and processing systems, policy loss information, educational courses about our products and services, accounting services, and electronic libraries for property and casualty coverage forms, state rating manuals and marketing materials.

 

Superior Claims Service

 

Our claims philosophy reflects our belief that we prosper as a company by responding to claims person to person, paying covered claims promptly, preventing false claims from unfairly adding to overall premiums and building financial strength to meet future obligations.

 

Our 770 locally based field claims associates work from their homes, assigned to specific agencies. They respond personally to policyholders and claimants, typically within 24 hours of receiving an agency’s claim report. We believe we have a competitive advantage because of the person-to-person approach and the resulting high level of service that our field claims representatives provide. We also help our agencies provide prompt service to policyholders by giving agencies authority to immediately pay most first-party claims under standard market policies up to $2,500. We believe this same local approach to handling claims is a competitive advantage for our agents providing excess and surplus lines coverage in their communities. Handling of these claims includes guidance from headquarters-based excess and surplus lines claims managers.

 

Our property casualty claims operation uses CMS, our claims management system, to streamline processes and achieve operational efficiencies. CMS allows field and headquarters claims associates to collaborate on reported claims through a virtual claim file. Our field claims representatives use tablet computers to view and enter information into CMS from any location, including an insured’s home or agent’s office, and to print claim checks using portable printers. Agencies also can access selected CMS information such as activity notes on open claims.

 

Catastrophe response teams are comprised of volunteers from our experienced field claims staff, and we give them the authority they need to do their jobs. In times of widespread loss, our field claims representatives confidently and quickly resolve claims, often writing checks on the same day they inspect the loss. CMS introduced new efficiencies that are especially evident during catastrophes. Electronic claim files allow for fast initial contact with policyholders and easy sharing of information and data by rotating storm teams, headquarters and local field claims representatives. When hurricanes or other weather events are predicted, we can identify through mapping technologies the expected number of our policyholders that may be impacted by the event and choose to have catastrophe response team members travel to strategic locations near the expected impact area. They are in position to quickly get to the affected area, set up temporary offices and start calling on policyholders.

 

Our claims associates work to control costs where appropriate. They use vendor resources that provide negotiated pricing to our insureds and claimants. Our field claims representatives also are educated continuously on new techniques and repair trends. They can leverage their local knowledge and experience with area body shops, which helps them negotiate the right price with any facility the policyholder chooses.

 

We staff a Special Investigations Unit (SIU) with former law enforcement and claims professionals whose qualifications make them well suited to gathering facts to uncover potential fraud. While we believe our job is to pay what is due under each policy contract, we also want to prevent false claims from unfairly increasing overall premiums. Our SIU also operates a computer forensics lab, using sophisticated software to recover data and mitigate the cost of computer-related claims for business interruption and loss of records.

 

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Insurance Products

 

We actively market property casualty insurance in 39 states through a select group of independent insurance agencies. For most agencies that represent us, we believe we offer insurance solutions for approximately 75 percent of the typical insurable risks of their clients. Our standard market commercial lines products and our excess and surplus lines are marketed in all 39 states while our standard market personal lines products are marketed in 31, offering insurance coverage that includes business property and liability, automobile and homeowner as well as umbrella liability. We discuss our commercial lines, personal lines and excess and surplus lines insurance operations and products in Commercial Lines Property Casualty Insurance Segment, Page 13, Personal Lines Property Casualty Insurance Segment, Page 15, and Excess and Surplus Lines Property Casualty Insurance Segment, Page 16.

 

The Cincinnati Specialty Underwriters Insurance Company began excess and surplus lines insurance operations in January 2008. We structured this operation to exclusively serve the needs of the independent agencies that currently market our standard market insurance policies. When all or a portion of a current or potential client’s insurance program requires excess and surplus lines coverages, those agencies can write the whole account with Cincinnati, gaining benefits not often found in the broader excess and surplus lines market. Agencies have access to The Cincinnati Specialty Underwriters Insurance Company’s product line through CSU Producer Resources, the wholly owned insurance brokerage subsidiary of parent-company Cincinnati Financial Corporation.

 

We also support the independent agencies affiliated with our property casualty operations in their programs to sell life insurance. The life insurance, disability and fixed annuity products offered by our life insurance subsidiary round out and protect accounts and improve account persistency. At the same time, our life operation increases diversification of revenue and profitability sources for both the agency and our company.

 

Our property casualty agencies make up the main distribution system for our life insurance products. To help build scale, we also develop life business from other independent life insurance agencies in geographic markets underserved through our property casualty agencies. We are careful to solicit business from these other agencies in a manner that does not compete with the life insurance marketing and sales efforts of our property casualty agencies. Our life insurance operation emphasizes up-to-date products, responsive underwriting, high-quality service and competitive pricing.

 

Other Services to Agencies

 

We complement the insurance operations by providing products and services that help attract and retain high-quality independent insurance agencies. When we appoint agencies, we look for organizations with knowledgeable, professional staffs. In turn, we make an exceptionally strong commitment to assist them in keeping their knowledge up to date and educating new people they bring on board as they grow. Numerous activities fulfill this commitment at our headquarters, in regional and agency locations and online.

 

Except for travel-related expenses to classes held at our headquarters, most programs are offered at no cost to our agencies. While that approach may be extraordinary in our industry today, the result is quality service for our policyholders and increased success for our independent agencies.

 

In addition to broad education and training support, we make available noninsurance financial services. CFC Investment Company offers equipment and vehicle leases and loans for independent insurance agencies, their commercial clients and other businesses. We also provide commercial real estate loans or other financial assistance to help agencies operate, expand and perpetuate their businesses. We believe that providing these services enhances agency relationships with the company and their clients, increasing loyalty while diversifying the agency’s revenues.

 

We’re studying opportunities to begin developing our consumer brand. Our goal is to better support our independent agents as we serve their clients, who are our current and prospective policyholders. As part of that study, we are running a small consumer advertising campaign in 2013.

 

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Strategic Initiatives

  

Management has identified strategies that can position us for long-term success. The board of directors and management expect execution of our strategic plan to create significant value for shareholders over time. We broadly group these strategies into two areas of focus – improving insurance profitability and driving premium growth – correlating with important ways we measure our progress toward our long-term financial objectives. A primary profitability long-term target is to produce a GAAP combined ratio over any five-year period that is consistently within the range of 95 percent to 100 percent. A primary premium growth long-term target is to profitably grow to reach $5 billion of property casualty and life insurance annual direct written premiums by the end of 2015.

  

Effective capital management is an important part of creating shareholder value, serving as a foundation to support other strategies focused on profitable growth of our insurance business, with the overall objective of long-term benefit for shareholders. Our capital management philosophy is intended to preserve and build our capital while maintaining appropriate liquidity. A strong capital position provides the capacity to support premium growth, and liquidity provides for our investment in the people and infrastructure needed to implement our other strategic initiatives. Our strong capital and liquidity also provide financial flexibility for shareholder dividends or other capital management actions.

 

Our strategies seek to position us to compete successfully in the markets we have targeted while optimizing the balance of risk and returns. We believe successful implementation of key initiatives that support our strategies will help us better serve our agent customers, reduce volatility in our financial results and achieve our long-term objectives despite shorter-term effects of difficult economic, market or pricing cycles. We describe our expectations for the results of these initiatives in Item 7, Executive Summary of Management’s Discussion and Analysis, Page 38.

 

Improve Insurance Profitability

 

Implementation of the initiatives described below is intended to enhance underwriting expertise and knowledge for our property casualty business, improving our ability to manage our business while also providing greater efficiency. By improving our capabilities to determine individual insurance policy pricing with better alignment to risk attributes, we can increase our effectiveness in managing profit margins. By improving internal processes and further developing performance metrics, we can further improve efficiency and effectiveness. These initiatives also support the ability of the agencies that represent us to grow profitably by allowing them to serve clients faster and more efficiently manage expenses. Important initiatives for 2013 to improve insurance profitability include:

 

·Enhance underwriting expertise and knowledge – We continue to increase our use of information and develop our skills for improved underwriting performance, focusing on areas that will benefit most from additional effort. We also continue to expand our pricing capabilities by using predictive analytics, expecting cumulative benefits of these efforts to improve loss ratios over time. Expanded capabilities include streamlining and optimizing data to improve accuracy, timeliness and ease of use. Development of additional business data to support more accurate underwriting, more granular pricing and other business decision-making also continues through a multi-year, phased project. Project deliverables include enhancing our data management program in phases, including further developing our data warehouse used in our property casualty and life insurance operations.

 

Initiatives enhancing our ability to more profitably underwrite property coverages for various lines of business are an area of emphasis for 2013. 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 have been completed, such as filing with regulators certain modified deductible features of policy forms and revised underwriting guidelines. These features will be applied over time to existing policies as they renew. Other initiatives still in progress should also improve property-related underwriting results over time. Some of the more important commercial lines initiatives include increased specialization among selected claims and loss control associates, who bring enhanced expertise for property risks; increased commercial property inspections that give us enhanced underwriting knowledge for both new and renewal business; wind and hail deductibles in areas prone to convective storm losses; and use of new guidelines for underwriting hail risk. Some of the more important personal lines initiatives include increased use of higher loss deductibles and actual cash value claims settlement for insured damage to older roofs, and increased property inspections when homeowner policies renew, thereby providing more opportunities for underwriting or pricing actions on a case-by-case basis.

 

Initiatives for 2013 also include improving or expanding pricing precision with ongoing enhancement of analytics and predictive modeling tools. We continue to further integrate such tools with policy administration systems to help our underwriting associates better target profitability and discuss pricing impacts with agency personnel. Use of enhanced pricing precision tools and techniques with our existing policies as they renew should improve loss ratios over time, allowing us to ensure we are competitive on the most desirable business and able to adapt more rapidly to changes in market

 

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conditions. We began using the second generation of our workers’ compensation predictive modeling tool in the second half of 2012. Since late 2011, we have used pricing precision tools for our commercial auto line of business and also for general liability and commercial property coverages in commercial package accounts. Similar tools for small business policies written through our CinciPakTM product began being used in several states in 2012 and will be implemented for many more states in 2013. We also continue to enhance our model attributes used for personal auto and homeowner policies, expanding our pricing points to add more precision to models used in past years. We plan to introduce predictive modeling for dwelling fire policies in 2013. In addition, we are working to improve pricing precision for homeowner policies in select states over time through by-peril rating that allows for pricing in line with the unique combination and magnitude of hazards affecting a particular insured risk.

 

·Improve internal processes – Improved processes support our strategic goals, reducing internal costs and allowing us to focus more resources on providing agency services. Important process improvement efforts include additional streamlining of policy processing between company and agency management systems, such as reduction of data entry by leveraging existing internal and external data. This allows for processing of some personal lines or small commercial lines business without intervention by an underwriter, for risks that meet qualifying underwriting criteria, and routing of complex work items to the most appropriate associate for optimal service. In 2013, we plan to expand this form of streamlined processing to personal lines policy renewal transactions, following successful 2012 implementation for new business policies. For small commercial lines policies that meet qualifying underwriting criteria, we plan to expand streamlined processing of renewal transactions to most states by the end of 2013, building on a pilot program implemented for a limited number of states and policy coverages. We also plan to add workers’ compensation policy processing to our e-CLAS® CPP commercial lines policy administration system.

 

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.

 

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 nearly 75 percent of the agencies that have represented Cincinnati Insurance for more than five years, based on 2011 premiums. We are working to increase the percentage of agencies where we achieve that rank.

 

Drive Premium Growth

 

Implementation of the operational initiatives below is intended to further penetrate each market we serve through our independent agency network. We expect strategies aimed at specific market opportunities, along with service enhancements, to help our agents grow and increase our share of their business. Our strategy includes new initiatives and execution of prior year growth initiatives, including use of profitability and growth models or plans at an agency level to facilitate coordination and decision-making. In addition to estimating planned premium growth from existing agencies, these plans help project the number of additional agencies needed to achieve premium targets. Our focus remains on the key components of agent satisfaction based on factors agents tell us are most important. Significant 2013 initiatives to drive premium growth include:

 

·Expansion of our marketing and service capabilities – We continue to enhance our generalist approach to allow our appointed agencies to better compete in the marketplace by providing services an agent’s clients want and need. During 2013, we 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 of and promotional support for promising classes of business. We offered 13 target markets programs to our agencies at the end of 2012, and we plan to launch additional programs during 2013, in addition to expanding product offerings within various programs.

 

We will pilot additional services in 2013 to select agencies that opt to use a customer care center we are developing for small commercial business policies. Our services will include various policy administration functions routinely provided by agencies, allowing agency personnel to focus more on marketing efforts and on providing additional service to their clients as needed. We will also continue to add field marketing representatives where needed for additional agency support in targeted areas, including some specializing in personal lines or excess and surplus lines. Associates in our life insurance segment plan to increase opportunities for agencies to cross-sell to their clients by providing additional service, including realigned territories for field associates and more product education.

 

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·New agency appointments – We continue to appoint new agencies to develop additional points of distribution, focusing on markets where our market share is less than 1 percent while also considering economic and catastrophe risk factors. In 2013, we are targeting approximately 65 appointments of independent agencies that write in aggregate $750 million or more in property casualty business annually with various insurance carriers. While this target is lower than in recent years, we believe it is appropriate based on our long-term premium volume objective while also considering the geographic marketing reach assessment and the multi-year nature of premium growth from past agency appointments, as noted below. We are also targeting approximately 75 appointments of additional independent agencies to offer only our life insurance products and service, in addition to ones among the 65 noted above that also want to represent us for life insurance.

 

We seek to build a close, long-term relationship with each agency we appoint. The contribution of new agencies to our property casualty premium growth should occur over several years, as time is required to fully realize the benefits of our agency relationships. We generally earn a 10 percent share of an agency’s business within 10 years of its appointment. We also help our agents grow their business by attracting more clients in their communities through unique Cincinnati-style service. We carefully evaluate the marketing reach of each new appointment to ensure the territory can support both current and new agencies. In counting new agency appointments, we include appointment of new agency relationships with property casualty insurance group subsidiaries of The Cincinnati Insurance Companies. For those that we believe will produce a meaningful amount of new business premiums, we also count appointments of agencies that merge with a Cincinnati agency and new branch offices opened by existing Cincinnati agencies. We made 140, 133 and 93 new appointments in 2012, 2011 and 2010, respectively, with 109, 93 and 70 representing new relationships.

 

We measure the overall success of our strategy to drive premium growth primarily through changes in net written premiums. Other important indicators that we are successfully executing initiatives to drive premium growth include tracking our progress toward our year-end 2015 direct written premiums target. We believe we can grow premiums faster than the industry average over any five-year period, while also achieving our long-term objective for underwriting profitability.

 

Our Segments

 

Consolidated financial results primarily reflect the results of our five reporting segments. These segments are defined based on financial information we use to evaluate performance and to determine the allocation of assets.

 

·Commercial lines property casualty insurance

 

·Personal lines property casualty insurance

 

·Excess and surplus lines property casualty insurance

 

·Life insurance

 

·Investments

 

We also evaluate results for our consolidated property casualty operations, which is the total of our commercial lines, personal lines and excess and surplus lines results.

 

Revenues, income before income taxes and identifiable assets for each segment are shown in a table in Item 8, Note 18 of the Consolidated Financial Statements, Page 137. Some of that information also is discussed in this section of this report, where we explain the business operations of each segment. The financial performance of each segment is discussed in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, which begins on Page 38.

 

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Commercial Lines Property Casualty Insurance Segment

 

The commercial lines property casualty insurance segment contributed net earned premiums of $2.383 billion to consolidated total revenues, or 58.0 percent of that total, and reported profit before income taxes of $181 million in 2012. Commercial lines net earned premiums rose 8 percent in 2012 and 2 percent in 2011, following a decline of 2 percent in 2010.

 

Approximately 95 percent of our commercial lines premiums are written to provide accounts with coverages from more than one of our business lines. As a result, we believe that our commercial lines business is best measured and evaluated on a segment basis. However, we provide line of business data to summarize growth and profitability trends separately for our business lines. The seven commercial business lines are:

 

·Commercial casualty – Provides coverage to businesses against third-party liability from accidents occurring on their premises or arising out of their operations, including liability coverage for injuries sustained from products sold as well as coverage for professional services, such as dentistry. Specialized casualty policies may include liability coverage for employment practices liability (EPLI), which protects businesses against claims by employees that their legal rights as employees of the company have been violated, and against other acts or failures to act under specified circumstances; and excess insurance and umbrella liability, including personal umbrella liability written as an endorsement to commercial umbrella coverages. The commercial casualty business line includes liability coverage written on both a nondiscounted and discounted basis as part of commercial package policies.

 

·Commercial property – Provides coverage for loss or damage to buildings, inventory and equipment caused by covered causes of loss such as fire, wind, hail, water, theft and vandalism, as well as business interruption resulting from a covered loss. Commercial property also includes crime insurance, which provides coverage for losses such as embezzlement or misappropriation of funds by an employee, among others; and inland marine insurance, which provides coverage for builder’s risk, cargo, electronic data processing equipment and a variety of mobile equipment, such as contractor’s equipment. Various property coverages can be written as stand-alone policies or can be added to a package policy. The commercial property business line includes property coverage written on both a nondiscounted and discounted basis as part of commercial package policies.

 

·Commercial auto – Protects businesses against liability to others for both bodily injury and property damage, medical payments to insureds and occupants of their vehicles, physical damage to an insured’s own vehicle from collision and various other perils, and damages caused by uninsured motorists.

 

·Workers’ compensation – Protects employers against specified benefits payable under state or federal law for workplace injuries to employees. We write workers’ compensation coverage in all of our active states except North Dakota, Ohio, Washington and Wyoming, where coverage is provided solely by the state instead of by private insurers.

 

·Specialty packages – Includes coverages for property, liability and business interruption tailored to meet the needs of specific industry classes such as artisan contractors, dentists, garage operators, financial institutions, metalworkers, printers, religious institutions or smaller main street businesses. Businessowners policies, which combine property, liability and business interruption coverages for small businesses, are included in specialty packages.

 

·Surety and executive risk – This business line includes:

 

oContract and commercial surety bonds, which guarantee a payment or reimbursement for financial losses resulting from dishonesty, failure to perform and other acts.

 

oFidelity bonds, which cover losses that policyholders incur as a result of fraudulent acts by specified individuals or dishonest acts by employees.

 

oDirector and officer (D&O) liability insurance, which covers liability for actual or alleged errors in judgment, breaches of duty or other wrongful acts related to activities of for-profit or nonprofit organizations. Approximately 81 percent of our D&O policies and 50 percent of the premium volume in force for 2012 were for nonprofit entities. Our director and officer liability policy can optionally include EPLI coverage.

 

·Machinery and equipment – Specialized coverage provides protection for loss or damage to boilers and machinery, including production and computer equipment, due to sudden and accidental mechanical breakdown, steam explosion or artificially generated electrical current.

 

Our emphasis is on products that agents can market to small to midsized businesses in their communities. Of our 1,758 reporting agency locations, 15 market only our surety and executive risk products and 26 market only our personal lines products. The remaining 1,717 locations, located in all states in which we actively market, offer some or all of our standard market commercial insurance products.

 

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In 2012, our 10 highest volume commercial lines states generated 62.3 percent of our earned premiums compared with 63.3 percent in 2011 and 64.3 percent in 2010 as we continued efforts to geographically diversify our property casualty risks. Earned premiums in the 10 highest volume states increased 7 percent in 2012 and increased 12 percent in the remaining 29 states. The number of reporting agency locations in our 10 highest volume states increased to 1,035 in 2012 from 985 in 2011.

 

Commercial Lines Earned Premiums by State

 

(Dollars in millions)  Earned
premiums
   % of
total
earned
   Agency
locations
   Average
premium per
location
 
Year ended December 31, 2012                    
Ohio  $364    15.3%   234   $1.6 
Illinois   195    8.2    127    1.5 
Pennsylvania   172    7.2    91    1.9 
Indiana   148    6.2    108    1.4 
North Carolina   123    5.2    88    1.4 
Michigan   107    4.5    131    0.8 
Virginia   103    4.3    65    1.6 
Georgia   92    3.9    83    1.1 
Wisconsin   91    3.8    53    1.7 
Tennessee   88    3.7    55    1.6 
Year ended December 31, 2011                    
Ohio  $341    15.5%   232   $1.5 
Illinois   189    8.6    123    1.5 
Pennsylvania   163    7.4    85    1.9 
Indiana   138    6.3    106    1.3 
North Carolina   118    5.4    82    1.4 
Virginia   101    4.6    66    1.5 
Michigan   99    4.5    115    0.9 
Georgia   83    3.8    75    1.1 
Wisconsin   82    3.7    51    1.6 
Tennessee   77    3.5    50    1.5 

 

For new commercial lines business, case-by-case underwriting and pricing is coordinated by our locally based field marketing representatives. Our agents and our field marketing, claims, loss control, premium audit, bond and machinery and equipment representatives get to know the people and businesses in their communities and can make informed decisions about each risk. These field marketing representatives also are responsible for selecting new independent agencies, coordinating field teams of specialized company representatives and promoting all of the company’s products within the agencies they serve.

 

Commercial lines policy renewals are managed by headquarters underwriters who are assigned to specific agencies and consult with local field staff as needed. As part of our team approach, headquarters underwriters also help oversee agency growth and profitability. They are responsible for formal issuance of all new business and renewal policies as well as policy endorsements. Further, the headquarters underwriters provide day-to-day customer service to agencies and marketing representatives by offering product training, answering underwriting questions, helping to determine underwriting eligibility and assisting with the mechanics of premium determination.

 

Our emphasis on small to midsized businesses is reflected in the mix of our commercial lines premium volume by policy size. Approximately 85 percent of our commercial in-force policies have annual premiums of $10,000 or less, accounting in total for approximately one-third of our 2012 commercial lines premium volume. The remainder of policies have annual premiums greater than $10,000, including in-force policies with annual premiums greater than $100,000 that account for slightly less than 15 percent of our 2012 commercial lines premium volume.

 

Our commercial lines packages typically are offered on a three-year policy term for most insurance coverages, a key competitive advantage. In our experience, multi-year packages appeal to the quality-conscious insurance buyers who we believe are typical clients of our independent agents. Customized insurance programs on a three-year term complement the long-term relationships these policyholders typically have with their agents and with the company. By reducing annual administrative efforts, multi-year policies lower expenses for our company and for our agents. The commitment we make to policyholders encourages long-term relationships and reduces their need to annually re-evaluate their insurance carrier or agency. We believe that the advantages of three-year policies in terms of improved policyholder convenience, increased account retention and reduced administrative costs outweigh the potential disadvantage of these policies, even in periods of rising rates.

 

Although we offer three-year policy terms, premiums for some coverages within those policies are adjustable at anniversary for the next annual period, and policies may be canceled at any time at the discretion of the policyholder. Contract terms often provide that rates for property, general liability, inland marine and crime coverages, as well as policy terms and conditions, are fixed for the term of the policy.

 

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The general liability exposure basis may be audited annually. Commercial auto, workers’ compensation, professional liability and most umbrella liability coverages within multi-year packages are rated at each of the policy's annual anniversaries for the next one-year period. The annual pricing could incorporate rate changes approved by state insurance regulatory authorities between the date the policy was written and its annual anniversary date, as well as changes in risk exposures and premium credits or debits relating to loss experience and other underwriting judgment factors. We estimate that approximately 75 percent of 2012 commercial premiums were subject to annual rating or were written on a one-year policy term.

 

We believe our commercial lines segment premiums reflect a higher concentration, relative to industry commercial lines premiums, in contractor-related businesses. Since economic activity related to construction, which can heavily influence insured exposures of contractors, may experience cycles that vary significantly with the economy as a whole, our commercial lines premium trends could vary from commercial lines premium trends for the property casualty insurance industry. In 2012, we estimated that policyholders with a contractor-related Insurance Services Office (ISO) general liability code accounted for approximately 34 percent of our general liability premiums, which are included in the commercial casualty line of business, and that policyholders with a contractor-related National Council on Compensation Insurance Inc. (NCCI) workers’ compensation code accounted for approximately 47 percent of our workers’ compensation premiums.

 

Understanding evolving market conditions is a critical function for our success, accomplished in both an informal and a formal manner. Informally, our field marketing representatives, underwriters and Target Markets department associates are routinely in receipt of market intelligence from the agencies with which they work, providing us with feedback. Our commercial lines product management group and field marketing representatives obtain competitive intelligence through various means. This market information helps identify the top competitors by line of business or specialty program and also identifies our market strengths and weaknesses. The information obtained encompasses pricing, breadth of coverage and underwriting/eligibility issues.

 

In addition to reviewing our competitive position, our product management group and our underwriting audit group review compliance with our underwriting standards as well as the pricing adequacy of our commercial insurance programs and coverages. Further, our Target Markets department analyzes opportunities and develops new products and services, new coverage options and improvements to existing insurance products.

 

We support our commercial lines operations with a variety of technology tools. e-CLAS CPP for commercial package and auto coverages now has rolled out to all of our appointed agencies in 36 states. It is being developed for additional coverages and remaining states that will be deployed over time. Since the initial deployment of e-CLAS in late 2009, approximately three-quarters of our non-workers’ compensation commercial lines policies in force at the end of 2012 have been processed through e-CLAS. In addition to increasing efficiency for our associates, the system allows our agencies options to quote and produce commercial package policies in paper or electronic format from their offices and to bill policies through their agencies or through us. These features increase their ease of doing business with us. The e-CLAS platform also makes use of our real-time agency interface, CinciBridge®, which allows the automated movement of key underwriting data from an agency’s management system to e-CLAS. This reduces agents’ data entry tasks and allows seamless quoting, rating and issuance capability.

 

Personal Lines Property Casualty Insurance Segment

 

The personal lines property casualty insurance segment contributed net earned premiums of $868 million to consolidated total revenues, or 21.1 percent of the total, and reported a loss before income taxes of $43 million in 2012. Personal lines net earned premiums rose 14 percent in 2012, 6 percent in 2011 and 5 percent in 2010.

 

We prefer to write personal lines coverage in accounts that include both auto and homeowner coverages as well as coverages that are part of our other personal business line. At the end of 2012, for example, 76 percent of our homeowner policies were accompanied by a personal auto policy in the same account. As a result of our account-based approach, we believe that our personal lines business is best measured and evaluated on a segment basis. However, we provide line of business data to summarize growth and profitability trends separately for three business lines:

 

·Personal auto – Protects against liability to others for both bodily injury and property damage, medical payments to insureds and occupants of their vehicle, physical damage to an insured’s own vehicle from collision and various other perils, and damages caused by uninsured motorists. In addition, many states require policies to provide first-party personal injury protection, frequently referred to as no-fault coverage.

 

·Homeowner – Protects against losses to dwellings and contents from a wide variety of perils, as well as liability arising out of personal activities both on and off the covered premises. We also offer coverage for condominium unit owners and renters.

 

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·Other personal lines – This includes the variety of other types of insurance products we offer to individuals such as dwelling fire, inland marine, personal umbrella liability and watercraft coverages.

 

At year-end, we marketed personal lines insurance products through 1,321 or approximately 75 percent of our 1,758 reporting agency locations. The 1,321 personal lines agency locations are in 31 of the 39 states in which we offer standard market commercial lines insurance. We continue to evaluate opportunities to expand our marketing of personal lines to other states. Primary factors considered in the evaluation of a potential new state include weather-related catastrophe history and the legal climate.

 

In 2012, our 10 highest volume personal lines states generated 80.6 percent of our earned premiums compared with 80.7 percent in 2011 and 82.2 percent in 2010. Earned premiums in the six highest volume states increased 10 percent in 2012 while increasing 22 percent in the remaining states, reflecting progress toward our long-term objective of geographic diversification through new states for our personal lines operation. The number of reporting agency locations in our 10 highest volume states increased 6 percent to 847 in 2012 from 798 in 2011.

 

Personal Lines Earned Premiums by State

 

(Dollars in millions)  Earned
premiums
   % of
total
earned
   Agency
locations
   Average
premium per
location
 
Year ended December 31, 2012                    
Ohio  $265    30.6%   208   $1.3 
Georgia   72    8.2    78    0.9 
Indiana   71    8.2    88    0.8 
Illinois   62    7.2    95    0.7 
Alabama   49    5.7    43    1.1 
Kentucky   47    5.4    37    1.3 
Michigan   42    4.8    114    0.4 
North Carolina   37    4.3    81    0.5 
Tennessee   29    3.4    50    0.6 
Minnesota   24    2.8    53    0.5 
Year ended December 31, 2011                    
Ohio  $242    31.7%   207   $1.2 
Georgia   66    8.6    71    0.9 
Indiana   64    8.4    85    0.8 
Illinois   56    7.4    90    0.6 
Kentucky   44    5.7    38    1.2 
Alabama   42    5.5    41    1.0 
Michigan   32    4.2    97    0.3 
North Carolina   28    3.7    77    0.4 
Tennessee   22    2.8    45    0.5 
Virginia   20    2.7    47    0.4 

 

New and renewal personal lines business reflects our risk-specific underwriting philosophy. Each agency selects personal lines business primarily from within the geographic territory that it serves, based on the agent’s knowledge of the risks in those communities or familiarity with the policyholder. Personal lines activities are supported by headquarters associates assigned to individual agencies. At year-end 2012, we had 11 full-time personal lines field marketing representatives who have underwriting authority and visit agencies on a regular basis. They focus primarily on key states targeted for growth, reinforcing the advantages of our personal lines products and offering training in the use of our processing system.

 

All of our personal lines policies are written for a one-year term. Competitive advantages of our personal lines operation include broad coverage forms, flexible underwriting, superior claims service and endorsements allowing customization of coverage for both personal auto and homeowner policies. Our personal lines products are processed through Diamond, our web-based real-time personal lines policy processing system that supports streamlined processing. Diamond incorporates features frequently requested by our agencies such as pre-filling of selected data for improved efficiency, easy-to-use screens, local and headquarters policy printing options, data transfer to and from popular agency management systems and real-time integration with third-party data such as insurance scores, motor vehicle reports and address verification.

 

Excess and Surplus Lines Property Casualty Insurance Segment

 

The excess and surplus lines property casualty segment contributed net earned premiums of $93 million to consolidated total revenues, or 2.3 percent of the total, and reported a loss before income taxes of $1 million in 2012, its fifth year of operation. Excess and surplus lines net earned premium increased 33 percent in 2012, 43 percent in 2011 and 81 percent in 2010.

 

Our excess and surplus lines policies typically cover business risks with unique characteristics, such as the nature of the business or its claim history, that are difficult to profitably insure in the standard commercial lines market. Excess and surplus lines insurers have more flexibility in coverage terms and rates compared

 

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with standard lines companies, generally resulting in policies with higher rates and terms and conditions customized for specific risks, including restricted coverage where appropriate. We target small to midsized risks, seeking to avoid those we consider exotic in nature. Our average excess and surplus lines policy size is approximately $5,000 in annual premiums, and policyholders in many cases also have standard market insurance with one of The Cincinnati Insurance Companies. All of our excess and surplus lines policies are written for a maximum term of one year. Approximately 85 percent of our 2012 premium volume for the excess and surplus lines segment provided commercial casualty coverages and about 15 percent provided commercial property coverages. Those coverages are described below.

 

·Commercial casualty – Covers businesses for third-party liability from accidents occurring on their premises or arising out of their operations, including products and completed operations. The majority of these policies have coverage limits of $1 million or less. Miscellaneous errors and omissions and professional coverage for liability from actual or alleged errors in judgment, breaches of duty or other wrongful acts related to activities of insured businesses is also available, as is excess liability coverage that adds another layer of protection to the insured’s other liability insurance policies. Typical businesses covered include contractors, consultants, bars or taverns and manufacturers. Policies covering liability at special events are also available.

 

·Commercial property – Insures loss or damage to buildings, inventory, equipment and business income from causes of loss such as fire, wind, hail, water, theft and vandalism. Examples of property we commonly insure with excess and surplus lines policies include temporarily vacant buildings, restaurants and relatively higher-hazard manufacturing classes.

 

At the end of 2012, we marketed excess and surplus lines insurance products in each of the 39 states in which we offer standard market commercial lines insurance. Offering excess and surplus lines helps agencies representing The Cincinnati Insurance Companies meet the insurance needs of their clients when coverage is unavailable in the standard market. By providing outstanding service, we can help agencies grow and prosper while also profitably growing our property casualty business.

 

In 2012, our 10 highest volume excess and surplus lines states generated 62.2 percent of our earned premiums compared with 62.8 percent in 2011 and 65.1 percent in 2010.

 

Excess and Surplus Lines Earned Premiums by State

 

(Dollars in millions)  Earned
premiums
   % of total
earned
 
Year ended December 31, 2012          
Ohio  $11    11.5%
Indiana   9    9.3 
Texas   7    7.5 
Georgia   6    6.8 
Illinois   6    6.4 
Missouri   5    4.9 
Michigan   4    4.4 
Alabama   4    4.1 
Pennsylvania   3    3.7 
Kentucky   3    3.6 
Year ended December 31, 2011          
Ohio  $9    12.4%
Indiana   7    9.7 
Illinois   5    6.8 
Georgia   5    6.6 
Texas   4    6.3 
Missouri   4    5.4 
Pennsylvania   3    4.2 
Michigan   3    4.0 
Kentucky   3    3.7 
North Carolina   3    3.7 

 

Agencies representing The Cincinnati Insurance Companies produce over $2 billion in annual premiums for all carriers writing excess and surplus lines policies for their clients. We estimate that approximately half of that premium volume matches the targeted business types and coverages we offer through our excess and surplus lines segment. We structured the operations of this segment to meet the needs of these agencies and to market exclusively through them.

 

Agencies have access to The Cincinnati Specialty Underwriters Insurance Company’s product line through CSU Producer Resources, the wholly owned insurance brokerage subsidiary of parent-company Cincinnati Financial Corporation. CSU Producer Resources has binding authority on all classes of business written through The Cincinnati Specialty Underwriters Insurance Company and maintains appropriate agent and surplus lines licenses to process nonadmitted business.

 

We seek to earn a share of each agency’s best excess and surplus lines accounts by offering several unique benefits. Agency producers have direct access through CSU Producer Resources to a group of our underwriters who focus exclusively on excess and surplus lines business. Those underwriters can tap into broader Cincinnati services to provide policyholders additional value and help agents build the relationship through experienced and responsive loss control and claims handling. CSU Producer Resources gives extra support to our independent agency producers by remitting surplus lines taxes and stamping fees and retaining admitted market diligent search affidavits, where required. Agencies marketing through CSU Producer Resources instead of a competing brokerage generally receive a higher commission because use of our internal brokerage subsidiary eliminates some of the intermediary costs. This business is also factored in their profit-sharing agreement with The Cincinnati Insurance Companies.

 

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We use a web-based excess and surplus lines policy administration system to quote, bind, issue and deliver policies electronically to agents. This system provides integration to existing document management and data management systems, allowing for real-time processing of policies and billing. It provides a specimen policy detailing coverages when a policy is quoted and delivers electronic copies of policies to independent agency producers within minutes of underwriting approval and policy issue. In 2012, more than 95 percent of policies were issued within 24 hours of a request to bind a policy.

 

Life Insurance Segment

 

The life insurance segment contributed $178 million of net earned premiums, representing 4.3 percent of consolidated total revenues, and negative $3 million of income before income taxes in 2012. Life insurance segment profitability is discussed in detail in Item 7, Life Insurance Results of Operations, Page 77. Life insurance net earned premiums grew 8 percent in 2012, 4 percent in 2011 and 10 percent in 2010.

 

The Cincinnati Life Insurance Company supports our agency-centered business model. Cincinnati Life helps meet the needs of our agencies, including increasing and diversifying agency revenues. We primarily focus on life products that feature a steady stream of premium payments and that have the potential for generating revenue growth through increasing demand. By diversifying revenue and profitability for both the agency and our company, this strategy enhances the already strong relationship built by the combination of the property casualty and life companies.

 

Life Insurance Business Lines

 

Four lines of business – term life insurance, universal life insurance, worksite products and whole life insurance – account for 96.5 percent of the life insurance segment’s revenues:

 

·Term life insurance – policies under which a death benefit is payable only if the insured dies during a specific period of time. For policies without a return of premium provision, no benefit is payable if the insured person survives to the end of the term. For policies in force with a return of premium provision, a benefit equal to the sum of all paid base premiums is payable if the insured person survives to the end of the term. Premiums are fixed, and they must be paid as scheduled. The policies are fully underwritten.

 

·Universal life insurance – long-duration life insurance policies. Contract premiums are neither fixed nor guaranteed; however, the contract does specify a minimum interest crediting rate and a maximum cost of insurance charge and expense charge. Premiums are not fixed and may be varied by the contract owner. The cash values, available as a loan collateralized by the cash surrender value, are not guaranteed and depend on the amount and timing of actual premium payments and the amount of actual contract assessments. The policies are fully underwritten.

 

·Worksite products – term life insurance, return of premium term life insurance, whole life insurance, universal life and disability insurance offered to employees through their employer. Premiums are collected by the employer using payroll deduction. Policies are issued using a simplified underwriting approach and on a guaranteed issue basis. Worksite insurance products provide our property casualty agency force with excellent cross-serving opportunities for both commercial and personal accounts. Agents report that offering worksite marketing to employees of their commercial accounts provides a benefit to the employees at no cost to the employer. Worksite marketing also connects agents with new customers who may not have previously benefited from receiving the services of a professional independent insurance agent.

 

·Whole life insurance – policies that provide life insurance for the entire lifetime of the insured. The death benefit is guaranteed never to decrease and premiums are guaranteed never to increase. While premiums are fixed, they must be paid as scheduled. These policies provide guaranteed cash values that are available as loans collateralized by the cash surrender value. The policies are fully underwritten.

 

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In addition, Cincinnati Life markets:

 

·Disability income insurance that provides monthly benefits to offset the loss of income when the insured person is unable to work due to accident or illness.

 

·Deferred annuities that provide regular income payments that commence after the end of a specified period or when the annuitant attains a specified age. During the deferral period, any payments made under the contract accumulate at the crediting rate declared by the company but not less than a contract-specified guaranteed minimum interest rate. A deferred annuity may be surrendered during the deferral period for a cash value equal to the accumulated payments plus interest less the surrender charge, if any.

 

·Immediate annuities that provide some combination of regular income and lump sum payments in exchange for a single premium.

 

Life Insurance Distribution

 

Our life insurance subsidiary is licensed in 49 states and the District of Columbia. At year-end 2012, almost 87 percent of our 1,758 agency reporting locations offered Cincinnati Life products to their clients. We also develop life business from approximately 600 other independent life insurance agencies. We are careful to solicit business from these other agencies in a manner that does not conflict with or compete with the marketing and sales efforts of our property casualty agencies.

 

When marketing through our property casualty agencies, we have specific competitive advantages:

 

·Because our property casualty operations are held in high regard, property casualty agency management is predisposed to consider selling our life products.

 

·Marketing efforts for both our property casualty and life insurance businesses are directed by our field marketing department, which assures consistency of communication and operations. Life field marketing representatives are available to meet face-to-face with agency personnel and their clients as well.

 

·Our life headquarters underwriters and other associates are available to the agents and field team to assist in the placement of business. Fewer and fewer of our competitors provide direct, personal support between the agent and the insurance carrier.

 

We continue to emphasize the cross-serving opportunities of our life insurance, including term and worksite products, for the property casualty agency’s personal and commercial accounts. In both the property casualty and independent life agency distribution systems, we enjoy the advantages of offering competitive, up-to-date products, providing close personal attention in combination with financial strength and stability.

 

·We primarily offer products addressing the needs of businesses with key person and buy-sell coverages. We offer quality, personal life insurance coverage to personal and commercial clients of our agencies.

 

·Term life insurance is our largest life insurance product line. We continue to introduce new term products with features our agents indicate are important, such as a return of premium benefit.

 

Because of our strong capital position, we can offer a competitive product portfolio including guaranteed products, giving our agents a marketing edge. Our life insurance company maintains strong insurer financial strength ratings: A.M. Best, A (Excellent); Fitch, A+ (Strong); and Standard & Poor’s A (Strong); as discussed in Financial Strength, Page 5. Our life insurance company has chosen not to establish a Moody’s rating.

 

In 2012 and 2011, the principal geographic distribution of life insurance premiums, based on information contained in statements filed with state insurance departments, is reflected in the table below.

 

Life Insurance Premiums by State

 

(Dollars in millions)  Earned
premiums
   % of total
earned
 
Year ended December 31, 2012          
Ohio  $44    18.4%
Pennsylvania   18    7.5 
Indiana   17    7.1 
Illinois   16    6.7 
Michigan   12    5.0 
Year ended December 31, 2011          
Ohio  $42    18.9%
Pennsylvania   17    7.7 
Indiana   15    6.8 
Illinois   16    7.2 
Michigan   12    5.4 

 

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Investments Segment

 

Revenues of the investments segment are primarily from net investment income and from realized investment gains and losses from investment portfolios managed for the holding company and each of the operating subsidiaries.

 

Our investment department operates under guidelines set forth in our investment policy statement along with oversight of the investment committee of our board of directors. These guidelines set parameters for risk tolerances governing, among other items, the allocation of the portfolio as well as security and sector concentrations. These parameters are part of an integrated corporate risk management program.

 

The fair value of our investment portfolio was $12.466 billion and $11.735 billion at year-end 2012 and 2011, respectively. The overall portfolio remained in an unrealized gain position as equity and fixed income markets experienced strong returns in 2012.

 

The cash we generate from insurance operations historically has been invested in two broad categories of investments:

 

·Fixed-maturity investments – Includes taxable and tax-exempt bonds and redeemable preferred stocks. During 2012 and 2011, purchases and market value gains more than offset sales and calls.

 

·Equity investments – Includes common and nonredeemable preferred stocks. During 2012, purchases and fair value gains more than offset sales. During 2011, purchases and fair value gains partially offset sales.

 

(In millions)  At December 31, 2012   At December 31, 2011 
   Cost or   Percent       Percent   Cost or   Percent       Percent 
   amortized cost   of total   Fair value   of total   amortized cost   of total   Fair value   of total 
Taxable fixed maturities  $5,473    51.7%  $6,137    49.2%  $5,369    52.4%  $5,847    49.8%
Tax-exempt fixed maturities   2,749    26.0    2,956    23.7    2,715    26.5    2,932    25.0 
Common equities   2,270    21.4    3,238    26.0    2,088    20.4    2,854    24.3 
Preferred equities   99    0.9    135    1.1    74    0.7    102    0.9 
Total  $10,591    100.0%  $12,466    100.0%  $10,246    100.0%  $11,735    100.0%

 

When allocating cash to various asset classes, we consider market-based factors such as risk adjusted after-tax yields as well as internal measures based on regulatory and rating agency guidance. During 2012, approximately one-half of new cash flow was invested in equity securities, exceeding our long-term historic average. This was our first year since 2007 of positive net investment into common stocks. In 2011, we had net dispositions in all asset classes except investment grade corporate bonds. The primary driver of this was routine portfolio management as well as less new cash available for investment as a result of our unusual level of catastrophe activity.

 

At year-end 2012, less than 1 percent of the value of our investment portfolio was made up of securities that are classified as Level 3 assets and that require management’s judgment to develop pricing or valuation techniques. We generally obtain at least two outside valuations for these assets and generally use the more conservative estimate. These investments include private placements, small issues and various thinly traded securities. See Item 7, Fair Value Measurements, Page 48, and Item 8, Note 3 of the Consolidated Financial Statements, Page 121, for additional discussion of our valuation techniques.

 

In addition to securities held in our investment portfolio, at year-end 2012, other invested assets included $37 million of life policy loans and $31 million of venture capital fund investments.

 

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Fixed-Maturity Investments

 

By maintaining a well diversified fixed-maturity portfolio, we attempt to manage overall interest rate, reinvestment, credit and liquidity risk. We pursue a buy-and-hold strategy and do not attempt to make large-scale changes to the portfolio in anticipation of rate movements. By investing new money on a regular basis and analyzing risk-adjusted after-tax yields, we work to achieve a laddering effect to our portfolio that may mitigate some of the effects of adverse interest rate movements.

 

Fixed-Maturity Portfolio Ratings

 

At year-end 2012, this portfolio’s fair value was 110.6 percent of amortized cost, up from last year as a result of both a general decline in interest rates and further credit spread tightening.

 

The portfolio grew in 2012 due to a combination of market performance and purchases, most heavily concentrated in the investment grade corporate sector. The majority of our nonrated securities are tax-exempt municipal bonds from smaller municipalities that chose not to pursue a credit rating. Credit ratings at year-end 2012 and 2011 for the fixed-maturity portfolio were:

 

(In millions)  At December 31, 2012   At December 31, 2011 
  Fair
value
   Percent
of total
   Fair
value
   Percent
of total
 
Moody's Ratings and Standard & Poor's Ratings combined:                    
Aaa, Aa, A, AAA, AA, A  $5,544    61.0%  $5,507    62.7%
Baa, BBB   3,180    35.0    2,842    32.4 
Ba, BB   168    1.8    195    2.2 
B, B   20    0.2    33    0.4 
Caa, CCC   2    0.0    5    0.1 
Daa, Da, D   1    0.0    2    0.0 
Non-rated   178    2.0    195    2.2 
Total  $9,093    100.0%  $8,779    100.0%

 

Our fixed-maturity portfolio as of December 31, 2012, included approximate maturing amounts with pretax average yields-to-book value as follows: 6.6 percent maturing in 2013 with a 4.5 percent yield, 7.4 percent in 2014 with a 4.9 percent yield, and 8.8 percent in 2015 with a 4.5 percent yield. Additional maturity periods for our fixed-maturity portfolio are shown in Item 8, Note 2 of the Consolidated Financial Statements, Page 118. Attributes of the fixed-maturity portfolio include:

 

   At December 31, 
   2012   2011 
Weighted average yield-to-amortized cost   5.0%   5.3%
Weighted average maturity   6.3yrs   6.7yrs
Effective duration   4.2yrs   4.4yrs

 

Taxable Fixed Maturities

 

The fair values of our taxable fixed-maturity portfolio for the last two years were:

 

(In millions)  At December 31, 
   2012   2011 
Investment-grade corporate  $5,388   $5,100 
States, municipalities and political subdivisions   334    320 
Below investment-grade corporate   182    198 
Government sponsored enterprises   164    160 
Convertibles and bonds with warrants attached   31    59 
United States government   7    7 
Foreign government   3    3 
Commercial mortgage backed securities   28    - 
Total  $6,137   $5,847 

 

While our strategy typically is to buy and hold fixed-maturity investments to maturity, we monitor credit profiles and fair value movements when determining holding periods for individual securities. With the exception of U.S. agency issues, no individual issuer's securities accounted for more than 1.1 percent of the taxable fixed-maturity portfolio at year-end 2012. Investment grade corporate bonds had an average rating of Baa1 by Moody’s or BBB+ by Standard & Poor’s and represented 87.8 percent of the taxable fixed-maturity portfolio’s fair value at year end 2012, compared with 87.2 percent in 2011.

 

The investment-grade corporate bond portfolio is most heavily concentrated in the financial-related sectors, including banking, financial services and insurance. The financial sectors represented 31.2 percent of fair value of this portfolio at year-end 2012, compared with 29.3 percent, at year-end 2011. Although the financial-related sectors make up our largest group of investment-grade corporate bonds, we believe our concentration is below the average for the corporate bond market as a whole. No other sector exceeded 10 percent of our investment-grade corporate bond portfolio at year-end 2012.

 

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Most of the $334 million of securities issued by states, municipalities and political subdivisions included in our taxable fixed-maturity portfolio at the end of 2012 were Build America Bonds.

 

Tax-Exempt Fixed Maturities

 

Our tax-exempt fixed-maturity portfolio’s fair value was $2.956 billion at December 31, 2012. The portfolio is well diversified among approximately 1,000 municipal bond issuers. No single municipal issuer accounted for more than 0.8 percent of the tax-exempt fixed-maturity portfolio at year-end 2012. Municipal bond holdings in our larger states were:

 

(In millions)
At December 31, 2012
  State issued general
obligation bonds
   Local issued general 
obligation bonds
   Special revenue
bonds
   Total   Percent of
total
 
Texas  $-   $398   $95   $493    16.7%
Indiana   -    15    286    301    10.2 
Michigan   -    260    12    272    9.2 
Illinois   -    226    20    246    8.3 
Ohio   -    135    96    231    7.8 
Washington   3    174    39    216    7.3 
Wisconsin   3    106    27    136    4.6 
Pennsylvania   -    83    8    91    3.1 
Florida   -    21    65    86    2.9 
Arizona   -    55    26    81    2.7 
Colorado   -    45    19    64    2.2 
New Jersey   -    38    17    55    1.9 
New York   -    29    24    53    1.8 
Kansas   -    28    21    49    1.7 
Minnesota   -    36    6    42    1.4 
All other states   2    285    253    540    18.2 
Total  $8   $1,934   $1,014   $2,956    100.0%
                          
At December 31, 2011               
Texas  $-   $425   $99   $524    17.9%
Indiana   -    16    316    332    11.3 
Michigan   -    257    12    269    9.2 
Illinois   -    226    23    249    8.5 
Ohio   -    132    107    239    8.2 
Washington   3    174    39    216    7.4 
Wisconsin   2    115    25    142    4.8 
Pennsylvania   -    76    8    84    2.9 
Florida   -    21    61    82    2.8 
Arizona   -    51    27    78    2.7 
Colorado   -    40    15    55    1.9 
Kansas   -    27    20    47    1.6 
New Jersey   -    30    17    47    1.6 
New York   -    18    24    42    1.4 
Utah   -    21    19    40    1.4 
All other states   1    264    221    486    16.4 
Total  $6   $1,893   $1,033   $2,932    100.0%

 

At year-end 2012, our tax-exempt fixed-maturity portfolio, with a fair value of $2.956 billion, had an average rating of Aa2/AA. Over 68 percent or $2.020 billion of the portfolio is insured, and approximately 96 percent of the insured portion carried an underlying rating of at least A3 or A- by Moody’s or Standard & Poor’s at year end. We strongly prefer general obligation or essential services bonds, which we believe provide a superior risk profile. The top three revenue resources of the $1.014 billion in special revenue bonds owned at year-end 2012 were 37 percent from leasing, 24 percent from water and sewer and 9 percent from higher education.

 

Equity Investments

 

After covering both our intermediate and long-range insurance obligations with fixed-maturity investments, we historically used available cash flow to invest in equity securities. Investment in equity securities has played an important role in achieving our portfolio objectives and has contributed to portfolio appreciation. We remain committed to our long-term equity focus, which we believe is key to our company’s long-term growth and stability.

 

Common Stocks

 

Our cash allocation for common stock purchases is implemented only after we ensure that our insurance reserves are adequately covered by our fixed-maturity investments. We believe our strategy of primarily investing in a diversified selection of larger capitalization, high quality, dividend-increasing companies generally results in reduced volatility relative to the broader equity markets.

 

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At year-end 2012 and 2011, no holding had a fair value equal to or greater than 5 percent of our publicly traded common stock portfolio. Pepsico Inc. (NYSE:PEP) was our largest single common stock investment at year end, comprising 4.2 percent of the publicly traded common stock portfolio and 1.1 percent of the entire investment portfolio.

 

At year-end 2012, 29.6 percent of our common stock holdings (measured by fair value) were held at the parent company level. The distribution of the portfolio among industry sectors is shown in the table below.

 

Common Stock Portfolio Industry Sector Distribution

 

   Percent of Publicly Traded Common Stock Portfolio 
   At December 31, 2012   At December 31, 2011 
   Cincinnati
Financial
   S&P 500 Industry
Weightings
   Cincinnati
Financial
   S&P 500 Industry
Weightings
 
Sector:                    
Information technology   16.0%   19.1%   16.9%   19.0%
Industrials   12.9    10.1    11.8    10.7 
Healthcare   12.2    12.0    12.0    11.8 
Energy   12.0    11.0    14.0    12.3 
Consumer staples   11.7    10.6    12.3    11.5 
Financial   11.2    15.6    8.5    13.4 
Consumer discretionary   9.7    11.5    9.4    10.7 
Materials   5.7    3.6    5.7    3.5 
Utilities   4.8    3.4    5.5    3.9 
Telecomm services   3.8    3.1    3.9    3.2 
Total   100.0%   100.0%   100.0%   100.0%

 

Preferred Stocks

 

We evaluate preferred stocks in a manner similar to our evaluation of fixed-maturity investments, seeking attractive relative yields. We generally focus on investment-grade preferred stocks issued by companies with strong histories of paying common dividends, providing us with another layer of protection. When possible, we seek out preferred stocks that offer a dividend received deduction for income tax purposes. We purchased $27 million in this portfolio in 2012 and sold $2 million. We made no purchases or sales for this portfolio during 2011.

 

Additional information about the composition of investments is included in Item 8, Note 2 of the Consolidated Financial Statements, Page 118. A detailed listing of our portfolio is updated on our website, www.cinfin.com/investors, each quarter when we report our quarterly financial results.

 

Other

 

We report as Other the noninvestment operations of the parent company and its noninsurer subsidiary CFC Investment Company. This subsidiary offers commercial leasing and financing services to our agencies, their clients and other customers. At year-end 2012, CFC Investment Company had 2,562 accounts and $75 million in receivables, compared with 2,217 accounts and $76 million in receivables at year-end 2011.

 

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Regulation

 

The business of insurance primarily is regulated by state law. All of our insurance company subsidiaries are domiciled in the state of Ohio except The Cincinnati Specialty Underwriters Insurance Company, which is domiciled in Delaware. Each insurance subsidiary is governed by the insurance laws and regulations in its respective state of domicile. We also are subject to state regulatory authorities of all states in which we write insurance. The state laws and regulations that have the most significant effect on our insurance operations and financial reporting are discussed below.

 

·Insurance Holding Company Regulation – We are regulated as an insurance holding company system in the respective states of domicile of our primary standard market property casualty company subsidiary and its surplus lines and life insurance subsidiaries. These regulations require that we annually furnish financial and other information about the operations of the individual companies within the holding company system. All transactions within a holding company affecting insurers must be fair and equitable. Notice to the state insurance commissioner is required prior to the consummation of transactions affecting the ownership or control of an insurer and prior to certain material transactions between an insurer and any person or entity in its holding company group. In addition, some of those transactions cannot be consummated without the commissioner’s prior approval. Recent amendments to the Model Insurance Holding Company System Regulatory Act and Regulation, adopted by the National Association of Insurance Commissioners (NAIC), and passed by a number of state legislatures, requires insurance holding company systems to provide regulators with more information about the risks posed by any noninsurance company subsidiaries in the holding company system.

 

·Subsidiary Dividends – The Cincinnati Insurance Company is 100 percent owned by Cincinnati Financial Corporation. The dividend-paying capacity of The Cincinnati Insurance Company and its 100 percent owned subsidiaries is regulated by the laws of the applicable state of domicile. Under these laws, our insurance subsidiaries must provide a 10-day advance informational notice to the insurance commissioner for the domiciliary state prior to payment of any dividend or distribution to its shareholders. Generally, the most our insurance subsidiary can pay without prior regulatory approval is the greater of 10 percent of policyholder surplus or 100 percent of statutory net income for the prior calendar year.

 

The insurance company subsidiaries must give 30 days’ notice to and obtain prior approval from the state insurance commissioner before the payment of an extraordinary dividend as defined by the state’s insurance code. You can find information about the dividends paid by our insurance subsidiary in 2012 in Item 8, Note 9 of the Consolidated Financial Statements, Page 127

 

·Insurance Operations – All of our insurance subsidiaries are subject to licensing and supervision by departments of insurance in the states in which they do business. The nature and extent of such regulations vary, but generally are rooted in statutes that delegate regulatory, supervisory and administrative powers to state insurance departments. Such regulations, supervision and administration of the insurance subsidiaries include, among others, the standards of solvency that must be met and maintained; the licensing of insurers and their agents and brokers; the nature and limitations on investments; deposits of securities for the benefit of policyholders; regulation of standard market policy forms and premium rates; policy cancellations and nonrenewals; periodic examination of the affairs of insurance companies; annual and other reports required to be filed on the financial condition of insurers or for other purposes; requirements regarding reserves for unearned premiums, losses and other matters; the nature of and limitations on dividends to policyholders and shareholders; the nature and extent of required participation in insurance guaranty funds; the involuntary assumption of hard-to-place or high-risk insurance business, primarily workers’ compensation insurance; and the collection, remittance and reporting of certain taxes and fees. Our primary insurance regulators have adopted the Model Audit Rule for annual statutory financial reporting. This regulation closely mirrors the Sarbanes-Oxley Act on matters such as auditor independence, corporate governance and internal controls over financial reporting. The regulation permits the audit committee of Cincinnati Financial Corporation’s board of directors to also serve as the audit committee of each of our insurance subsidiaries for purposes of this regulation.

 

·Insurance Guaranty Associations – Each state has insurance guaranty association laws under which the associations may assess life and property casualty insurers doing business in the state for certain obligations of insolvent insurance companies to policyholders and claimants. Typically, states assess each member insurer in an amount related to the insurer’s proportionate share of business written by all member insurers in the state. Our insurance companies received a savings of less than $1 million from guaranty association refunds in both 2012 and 2011. We cannot predict the amount and timing of any future assessments or refunds on our insurance subsidiaries under these laws.

 

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·Shared Market and Joint Underwriting Plans – State insurance regulation requires insurers to participate in assigned risk plans, reinsurance facilities and joint underwriting associations, which are mechanisms that generally provide applicants with various basic insurance coverages when they are not available in voluntary markets. Such mechanisms are most commonly instituted for automobile and workers’ compensation insurance, but many states also mandate participation in FAIR Plans or Windstorm Plans, which provide basic property coverages. Participation is based upon the amount of a company’s voluntary market share in a particular state for the classes of insurance involved. Underwriting results related to these organizations could be adverse to our company.

 

·Statutory Accounting – For public reporting, insurance companies prepare financial statements in accordance with GAAP. However, certain data also must be calculated according to statutory accounting rules as defined in the NAIC’s Accounting Practices and Procedures Manual. While not a substitute for any GAAP measure of performance, statutory data frequently is used by industry analysts and other recognized reporting sources to facilitate comparisons of the performance of insurance companies.

 

·Insurance Reserves – State insurance laws require that property casualty and life insurers annually analyze the adequacy of reserves. Our appointed actuaries must submit an opinion that reserves are adequate for policy claims-paying obligations and related expenses.

 

·Investment Regulation – Insurance company investments must comply with laws and regulations pertaining to the type, quality and concentration of investments. Such laws and regulations permit investments in federal, state and municipal obligations, corporate bonds, preferred and common equity securities, mortgage loans, real estate and certain other investments, subject to specified limits and other qualifications. At December 31, 2012, the company believes it was in compliance with these laws and regulations in all material respects.

 

·Risk-Based Capital Requirements – The NAIC’s risk-based capital (RBC) requirements for property casualty and life insurers serve as an early warning tool for the NAIC and state regulators to identify companies that may be undercapitalized and may merit further regulatory action. The NAIC has a standard formula for annually assessing RBC. The formula for calculating RBC for property casualty companies takes into account asset and credit risks but places more emphasis on underwriting factors for reserving and pricing. The formula for calculating RBC for life insurance companies takes into account factors relating to insurance, business, asset and interest rate risks.

 

Although the federal government and its regulatory agencies generally do not directly regulate the business of insurance, federal legislation and administrative rules adopted to implement them do affect our business. Privacy laws, such as the Gramm-Leach-Bliley Act, the Fair Credit Reporting Act and the Health Insurance Portability and Accounting Act (HIPAA) are the federal laws that most affect our day-to-day operations. These apply to us because we gather and use personal nonpublic information to underwrite insurance and process claims. We also are subject to other federal laws, such as the Terrorism Risk Insurance Act (TRIA), anti-money laundering statute (AML), the Nonadmitted and Reinsurance Reform Act (NRRA), and the rules and regulations of the Office of Foreign Assets Control (OFAC).

 

Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) created the Federal Insurance Office to monitor the insurance industry and gather information to identify issues or gaps in the regulation of insurers that could contribute to a systemic crisis in the insurance industry of the United States financial system, and to recommend to the Financial Stability Oversight Council that it designate an insurer as a systemically significant entity requiring additional supervision by the Federal Reserve Board. We do not expect Dodd-Frank to result in federal oversight of our operations as a systemically significant entity.

 

We do not expect to have any material effects on our expenditures, earnings or competitive position as a result of compliance with any federal, state, or local provisions enacted or adopted relating to the protection of the environment. We currently do not have any material estimated capital expenditures for environmental control facilities.

 

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Item 1A.   Risk Factors

 

Our business involves various risks and uncertainties that may affect achievement of our business objectives. Many of the risks could have ramifications across our organization. For example, while risks related to setting insurance rates and establishing and adjusting loss reserves are insurance activities, errors in these areas could have an impact on our investment activities, growth and overall results.

 

The following discussion should be viewed as a starting point for understanding the significant risks we face. It is not a definitive summary of their potential impacts or of our strategies to manage and control the risks. Please see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, Page 38, for a discussion of those strategies.

 

If any risks or uncertainties discussed here develop into actual events, they could have a material adverse effect on our business, financial condition or results of operations. In that case, the market price of our common stock could decline materially.

 

Readers should carefully consider this information together with the other information we have provided in this report and in other reports and materials we file periodically with the Securities and Exchange Commission as well as news releases and other information we disseminate publicly.

 

We rely exclusively on independent insurance agents to distribute our products.

 

We market our products through independent, nonexclusive insurance agents. These agents are not obligated to promote our products and can and do sell our competitors’ products. We must offer insurance products that meet the needs of these agencies and their clients. We need to maintain good relationships with the agencies that market our products. If we do not, these agencies may market our competitors’ products instead of ours, which may lead to us having a less desirable mix of business and could affect our results of operations.

 

Certain events or conditions could diminish our agents’ desire to produce business for us and the competitive advantage that our independent agencies enjoy, including:

 

·Downgrade of the financial strength ratings of our insurance subsidiaries. We believe our strong insurer financial strength ratings, in particular, the A+ (Superior) ratings from A.M. Best for our standard market property casualty insurance group and each subsidiary, are an important competitive advantage. See Item 1, Financial Strength, Page 5, for additional discussion of our financial strength ratings.

 

·Concerns that doing business with us is difficult or not profitable, perceptions that our level of service is no longer a distinguishing characteristic in the marketplace, perceptions that our products do not meet the needs of our agents’ clients or perceptions that our business practices are not compatible with agents’ business models. Mergers and acquisitions could result in a concentration of a significant amount of premium in one agency.

 

·Delays in the development, implementation, performance and benefits of technology systems and enhancements or independent agent perceptions that our technology solutions do not match their needs.

 

A reduction in the number of independent agencies marketing our products, the failure of agencies to successfully market our products or pay their accounts to us, changes in the strategy or operations of agencies or the choice of agencies to reduce their writings of our products could affect our results of operations if we were unable to replace them with agencies that produce adequate and profitable premiums.

 

Further, policyholders may choose a competitor’s product rather than our own because of real or perceived differences in price, terms and conditions, coverage or service. If the quality of the independent agencies with which we do business were to decline, that also might cause policyholders to purchase their insurance through different agencies or channels. Consumers, especially in the personal insurance segments, may increasingly choose to purchase insurance from distribution channels other than independent insurance agents, such as direct marketers. Increased advertising by insurers, especially direct marketers, could cause consumers to shift their buying habits, bypassing independent agents altogether.

 

Our credit ratings or financial strength ratings of our insurance subsidiaries could be downgraded.

 

A downgrade in one or more of our company’s credit or debt ratings could adversely impact our borrowing costs or limit our access to capital. Financial strength ratings reflect a rating agency’s opinion of our insurance subsidiaries’ financial strength, operating performance, strategic position and ability to meet obligations to policyholders. Our ratings are subject to periodic review and there is no assurance that our ratings will not be changed. Ratings agencies could change or expand their requirements or could find that our insurance subsidiaries no longer meet the criteria established for current ratings. If our property casualty insurer financial strength ratings were to be downgraded, our agents might find it more difficult to market our products or might choose to emphasize the products of other carriers. See Item 7, Liquidity and Capital Resources, Additional Sources of Liquidity, Page 84, for additional discussion of ratings for our long-term debt.

 

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We could experience an unusually high level of losses due to catastrophic, terrorism or pandemic events or risk concentrations.

 

In the normal course of our business, we provide coverage against perils for which estimates of losses are highly uncertain, in particular catastrophic and terrorism events. Catastrophes can be caused by a number of events, including hurricanes, tornadoes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Due to the nature of these events, we are unable to predict precisely the frequency or potential cost of catastrophe occurrences. Various scientists and other experts believe that changing climate conditions have added to the unpredictability, frequency and severity of such natural disasters in certain parts of the world and have created additional uncertainty as to future trends and exposures. We cannot predict the impact that changing climate conditions may have on our results of operations nor can we predict how any legal, regulatory or social responses to concerns about climate change may impact our business. Additionally, man-made events, such as hydraulic fracturing, could cause damage from earth movement or create environmental hazards.

 

The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Our ability to appropriately manage catastrophe risk depends partially on catastrophe models, the accuracy of which may be affected by inaccurate or incomplete data, the uncertainty of the frequency and severity of future events and the uncertain impact of climate change. Additionally, these models are recalibrated and changed over time, with more data availability and changing opinions regarding the effect of current or emerging loss patterns and conditions. Please see Item 7, 2013 Reinsurance Programs, Page 95, for a discussion of modeled losses considered in evaluating our reinsurance strategy.

 

The geographic regions in which we market insurance are exposed to numerous natural catastrophes, such as:

 

·Hurricanes in the gulf, eastern and southeastern coastal regions.

 

·Earthquakes in many regions, most particularly in the New Madrid fault zone, which lies within the central Mississippi valley, extending from northeast Arkansas through southeast Missouri, western Tennessee and western Kentucky to southern Illinois, southern Indiana and parts of Ohio.

 

·Tornado, wind and hail in the Midwest, South, Southeast, Southwest and the mid-Atlantic.

 

The occurrence of terrorist attacks in the geographic areas we serve could result in substantially higher claims under our insurance policies than we have anticipated. While we do insure terrorism risk in all areas we serve, we have identified our major terrorism exposure geographically as general commercial risks in the Tier 1 cities of metropolitan Chicago area, and to a much lesser degree, Washington DC, Houston and Los Angeles. We have a greater amount of business in less hazardous Tier 2 cities such as Atlanta, Phoenix-Mesa, Minneapolis, Cleveland, St. Louis, Denver, Tampa-St. Petersburg, Pittsburgh and Cincinnati. We have exposure to small co-op utilities, water utilities, wholesale fuel distributors, small shopping malls and small colleges throughout our 39 active states and, because of the number of associates located there, our Fairfield, Ohio headquarters. Additionally, our life insurance subsidiary could be adversely affected in the event of a terrorist event or an epidemic such as the avian or swine flu, particularly if the epidemic were to affect a broad range of the population beyond just the very young or the very old. Our associate health plan is self-funded and could similarly be affected.

 

Our results of operations would be adversely affected if the level of losses we experience over a period of time were to exceed our actuarially determined expectations. In addition, our financial condition may be adversely affected if we were required to sell securities prior to maturity or at unfavorable prices to pay an unusually high level of loss and loss expenses. Securities pricing might be even less favorable if a number of insurance or other companies and other investors needed to sell securities during a short period of time because of unusually high losses from catastrophic events.

 

Our geographic concentration ties our performance to business, economic, environmental and regulatory conditions in certain states. We market our standard market property casualty insurance products in 39 states, but our business is concentrated in the Midwest and Southeast. We also have exposure in states where we do not actively market insurance when clients of our independent agencies have businesses or properties in multiple states.

 

The Cincinnati Insurance Company also participates in certain assumed reinsurance treaties with reinsurers that spread the risk of very large catastrophe losses among many insurers. At the beginning of 2013, two surplus share treaties were in effect with the largest treaty representing exposure for us of up to $3 million of assumed losses from a single catastrophic event. If there is a high frequency of very large catastrophe events during a coverage period of the treaty, our financial position and results of operations could be materially affected. Please see Item 7, 2013 Reinsurance Programs, Page 95, for a discussion of our reinsurance treaties.

 

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In the event of a severe catastrophic event or terrorist attack elsewhere in the world, our insurance losses may be immaterial. However, the companies in which we invest might be severely affected, which could affect our financial condition and results of operations. Our reinsurers might experience significant losses, potentially jeopardizing their ability to pay losses we cede to them. It could also reduce the availability of reinsurance. If we cannot obtain adequate coverage at a reasonable cost, it could constrain where we can write business or reduce the amount of business we can write in certain areas. We also may be exposed to state guaranty fund assessments if other carriers in a state cannot meet their obligations to policyholders. A catastrophe or epidemic event also could affect our operations by damaging our headquarters facility, injuring associates and visitors at our Fairfield, Ohio, headquarters or disrupting our associates’ ability to perform their assigned tasks.

 

Our ability to achieve our performance objectives could be affected by changes in the financial, credit and capital markets or the general economy.

 

We invest premiums received from policyholders and other available cash to generate investment income and capital appreciation, while also maintaining sufficient liquidity to pay covered claims and operating expenses, service our debt obligations and pay dividends. The value of our invested assets is an important component of shareholders’ equity, also known as book value. Changes in the valuation of invested assets can significantly affect changes in book value per share, a key performance objective as discussed in Item 7, Executive Summary of the Management’s Discussion and Analysis, Page 38.

 

For fixed-maturity investments such as bonds, which represented approximately 72.5 percent of the fair value of our invested assets at the end of 2012, the inverse relationship between interest rates and bond prices leads to falling bond values during periods of increasing interest rates. A significant increase in the general level of interest rates could have an adverse effect on our shareholders’ equity and our policyholders’ surplus.

 

Investment income is an important component of our revenues and net income. The ability to increase investment income and generate longer-term growth in book value is affected by factors beyond our control, such as: inflation, economic growth, interest rates, world political conditions, changes in laws and regulations, terrorism attacks or threats, adverse events affecting other companies in our industry or the industries in which we invest, market events leading to credit constriction, and other widespread unpredictable events. These events may adversely affect the economy generally and could cause our investment income or the value of securities we own to decrease. A significant decline in our investment income could have an adverse effect on our net income, and thereby on our shareholders’ equity and our policyholders’ surplus. For example, a significant increase in the general level of interest rates could lead to falling bond values. For more detailed discussion of risks associated with our investments, please refer to Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 100.

 

We issue life contracts with guaranteed minimum returns, referred to as bank-owned life insurance contracts (BOLIs). BOLI investment assets must meet certain criteria established by the regulatory authorities in the jurisdiction for which the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded. We could experience losses if the assets in the accounts were less than liabilities at the time of maturity or termination.

 

Our investment performance also could suffer because of the types of investments, industry groups and/or individual securities in which we choose to invest. Market value changes related to these choices could cause a material change in our financial condition or results of operations.

 

At year-end 2012, common stock holdings made up 25.8 percent of our invested assets. Adverse news or events affecting the global or U.S. economy or the equity markets could affect our net income, book value and overall results, as well as our ability to pay our common stock dividend. See Item 7, Investments Results of Operations, Page 79, and Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 100, for discussion of our investment activities.

 

Deterioration in the banking sector or in banks with which we have relationships could affect our results of operations. Our ability to maintain or obtain short-term lines of credit could be affected if the banks from which we obtain these lines are acquired, fail or are otherwise negatively affected. We may lose premium revenue if a bank that owns appointed agencies were to change its strategies. We could experience increased losses in our director and officer liability line of business if claims were made against insured financial institutions.

 

A deterioration of credit and market conditions could also impair our ability to access credit markets and could affect existing or future lending arrangements.

 

Our overall results could be affected if a significant portion of our commercial lines policyholders, including those purchasing surety bonds, are adversely affected by marked or prolonged economic downturns and events such as a downturn in construction and related sectors, tightening credit markets and higher fuel costs. Such events could make it more difficult for policyholders to finance new projects, complete projects or expand their businesses, leading to lower premiums from reduced payrolls and sales and lower

 

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purchases of equipment and vehicles. These events could also cause claims, including surety claims, to increase due to a policyholder’s inability to secure necessary financing to complete projects or to collect on underlying lines of credit in the claims process. Such economic downturns and events could have a greater impact in the construction sector where we have a concentration of risks and in geographic areas that are hardest hit by economic downturns.

 

Deteriorating economic conditions could also increase the degree of credit risk associated with amounts due from independent agents who collect premiums for payment to us and could hamper our ability to recover amounts due from reinsurers.

 

Our ability to properly underwrite and price risks and increased competition could adversely affect our results.

 

Our financial condition, cash flow and results of operations depend on our ability to underwrite and set rates accurately for a full spectrum of risks. We establish our pricing based on assumptions about the level of losses that may occur within classes of business, geographic regions and other criteria.

 

To properly price our products, we must collect, properly analyze and use data to make decisions and take appropriate action; the data must be sufficient, reliable and accessible; we need to develop appropriate rating methodologies and formulae; and we may need to identify and respond to trends quickly. We may overestimate or underestimate loss cost trends or these trends may unexpectedly change, leading to losing business by pricing risks above our competitors or charging rates too low to maintain profitability. Inflation trends, especially outside of historical norms, may make it more difficult to determine adequate pricing. If rates are not accurate, we may not generate enough premiums to offset losses and expenses or we may not be competitive in the marketplace.

 

Our ability to set appropriate rates could be hampered if a state or states where we write business refuses to allow rate increases that we believe are necessary to cover the risks insured. At least one state requires us to purchase reinsurance from a mandatory reinsurance fund. Such reinsurance funds can create a credit risk for insurers if not adequately funded by the state and, in some cases, the existence of a reinsurance fund could affect the prices charged for our policies. The effect of these and similar arrangements could reduce our profitability in any given period or limit our ability to grow our business.

 

The insurance industry is cyclical and intensely competitive. From time to time, the insurance industry goes through prolonged periods of intense competition during which it is more difficult to attract new business, retain existing business and maintain profitability. Competition in our insurance business is based on many factors, including:

 

·Competitiveness of premiums charged

 

·Relationships among carriers, agents, brokers and policyholders

 

·Underwriting and pricing methodologies that allow insurers to identify and flexibly price risks

 

·Compensation provided to agents

 

·Underwriting discipline

 

·Terms and conditions of insurance coverage

 

·Speed with which products are brought to market

 

·Product and marketing innovations, including advertising

 

·Technological competence and innovation

 

·Ability to control expenses

 

·Adequacy of financial strength ratings by independent ratings agencies such as A.M. Best

 

·Quality of services and tools provided to agents and policyholders

 

·Claims satisfaction and reputation

 

If our pricing were incorrect or we were unable to compete effectively because of one or more of these factors, our premium writings could decline and our results of operations and financial condition could be materially adversely affected. Large competitors could intentionally disrupt the market by targeting certain lines or underpricing the market.

 

Please see the discussion of our Commercial Lines, Personal Lines, Excess and Surplus Lines and Life Insurance Segments in Item 1, Page 13, Page 15, Page 16 and Page 18, for a discussion of our competitive position in the insurance marketplace.

 

Our pricing and capital models could be flawed.  

 

We use various predictive pricing models, stochastic models and/or forecasting techniques to help us to understand our business, analyze risk and estimate future trends. The output of these models is used to assist us in making underwriting, pricing, reinsurance, reserving and capital decisions and helps us set our strategic direction. These models contain numerous assumptions and are subject to uncertainties and

 

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limitations inherent in any statistical analysis. Actual results might differ from modeled output, resulting in pricing our products incorrectly, overestimating or underestimating reserves, or inaccurately forecasting the impact of modeled events on our results. This could materially adversely impact the results of our operations.

 

Our loss reserves, our largest liability, are based on estimates and could be inadequate to cover our actual losses.

 

Our consolidated financial statements are prepared using GAAP. These principles require us to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ materially from those estimates. For a discussion of the significant accounting policies we use to prepare our financial statements, the material implications of uncertainties associated with the methods, assumptions and estimates underlying our critical accounting policies and the process used to determine our loss reserves, please refer to Item 8, Note 1 of the Consolidated Financial Statements, Page 112, and Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves and Life Insurance Policy Reserves, Page 43 and Page 47.

 

Our most critical accounting estimate is loss reserves. Loss reserves are the amounts we expect to pay for covered claims and expenses we incur to settle those claims. The loss reserves we establish in our financial statements represent an estimate of amounts needed to pay and administer claims arising from insured events that have already occurred, including events that have not yet been reported to us. Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability. Inflationary scenarios, especially scenarios outside of historical norms or regulatory changes that affect the assumptions underlying our critical accounting estimates, may make it more difficult to estimate loss reserves. Accordingly, our loss reserves for past periods could prove to be inadequate to cover our actual losses and related expenses. Any changes in these estimates are reflected in our results of operations during the period in which the changes are made. An increase in our loss reserves would decrease earnings, while a decrease in our loss reserves would increase earnings.

 

Unforeseen losses, the type and magnitude of which we cannot predict, may emerge in the future. These additional losses could arise from changes in the legal environment, laws and regulations, climate change, catastrophic events, increases in loss severity or frequency, or other causes. Such future losses could be substantial. Inflationary scenarios may cause the cost of claims, especially medical claims, to rise, impacting reserve adequacy and our results of operations.

 

Our ability to obtain or collect on our reinsurance protection could affect our business, financial condition, results of operations and cash flows.

 

We buy property casualty and life reinsurance coverage to mitigate the liquidity risk and earnings volatility risk of an unexpected rise in claims severity or frequency from catastrophic events or a single large loss. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. If we were unable to obtain reinsurance on acceptable terms and in appropriate amounts, our business and financial condition could be adversely affected.

 

In addition, we are subject to credit risk with respect to our reinsurers. Although we purchase reinsurance to manage our risks and exposures to losses, this reinsurance does not discharge our direct obligations under the policies we write. We would remain liable to our policyholders even if we were unable to recover what we believe we are entitled to receive under our reinsurance contracts. Reinsurers might refuse or fail to pay losses that we cede to them, or they might delay payment. For long-tail claims, the creditworthiness of our reinsurers may change before we can recover amounts to which we are entitled. A reinsurer’s insolvency, inability or unwillingness to make payments under the terms of its reinsurance agreement with our insurance subsidiaries could have a material adverse effect on our financial position, results of operations and cash flows.

 

Please see Item 7, 2013 Reinsurance Programs, Page 95, for a discussion of selected reinsurance transactions.

 

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Our business depends on the uninterrupted operation of our facilities, systems and business functions.

 

Our business depends on our associates’ ability to perform necessary business functions, such as processing new and renewal policies and claims. We increasingly rely on technology and systems to accomplish these business functions in an efficient and uninterrupted fashion. Our inability to access our headquarters facilities or a failure of technology, telecommunications or other systems could significantly impair our ability to perform such functions on a timely basis or affect the accuracy of transactions. If sustained or repeated, such a business interruption or system failure could result in a deterioration of our ability to write and process new and renewal business, serve our agents and policyholders, pay claims in a timely manner, collect receivables or perform other necessary business functions. If our disaster recovery and business continuity plans did not sufficiently consider, address or reverse the circumstances of an interruption or failure, this could result in a materially adverse effect on our operating results and financial condition. This risk is exacerbated because approximately 70 percent of our associates work at our Fairfield, Ohio, headquarters.

 

Our ability to successfully execute business functions also depends on hiring and retaining qualified associates. Competition for high-quality executives and other key associates occurs within the insurance industry and from other industries. We also must effectively develop and manage associates, including providing training and resources. Such tools and information can allow them to effectively perform critical business functions and adapt to changing business needs. If we were unable to attract and retain certain associates, or if we fail to provide adequate training or resources, we could limit the success of executing our strategic plans and vital business functions.

 

The effects of changes in industry practices, laws and regulations on our business are uncertain.

 

As industry practices and legal, judicial, legislative, regulatory, political, social and other environmental conditions change, unexpected and unintended issues related to insurance pricing, claims and coverage, may emerge. These issues may adversely affect our business by impeding our ability to obtain adequate rates for covered risks, extending coverage beyond our underwriting intent, by increasing the number or size of claims, by varying assumptions underlying our critical accounting estimates or by increasing duties owed to policyholders beyond contractual obligations. In some instances, unforeseeable emerging and latent claim and coverage issues may not become apparent until sometime after we have issued the insurance policies that could be affected by the changes. As a result, the full extent of liability under our insurance contracts may not be known for many years after a policy is issued and our pricing and reserve estimates may not accurately reflect its effect.

 

We are required to adopt new or revised accounting standards issued by recognized authoritative organizations, including the Financial Accounting Standards Board (FASB) and the SEC. Future changes required to be adopted could change the current accounting treatment that we apply and could result in material adverse effects on our results of operations and financial condition.

 

Our investment income benefits from tax rate preferences for municipal bond interest and dividend income from equity securities. Market valuations for these securities also benefit from the tax-preference aspect of current tax laws, affecting the value of our investment portfolio and also shareholders’ equity. Future changes in tax laws could result in material adverse effects on our results of operations and financial condition.

 

The NAIC, state insurance regulators and state legislators continually re-examine existing laws and regulations governing insurance companies and insurance holding companies, specifically focusing on modifications to statutory accounting principles, interpretations of existing laws, regulations relating to product forms and pricing methodologies and the development of new laws and regulations that affect a variety of financial and nonfinancial components of our business. Any proposed or future legislation, regulation or NAIC initiatives, if adopted, may be more restrictive on our ability to conduct business than current regulatory requirements or may result in higher costs.

 

Federal laws and regulations, including those that may be enacted in the wake of the financial and credit crises, may have adverse effects on our business, potentially including a change from a state-based system of regulation to a system of federal regulation, the repeal of the McCarran Ferguson Act, and/or measures under the Dodd-Frank Act that establish the Federal Insurance Office and provide for a determination that a nonbank financial company presents systemic risk and therefore should be subject to heightened supervision by the Federal Reserve Board. It is not known how this federal office will coordinate and interact with the NAIC and state insurance regulators. Adoption or implementation of any of these measures may restrict our ability to conduct our insurance business, govern our corporate affairs or increase our cost of doing business.

 

The effects of such changes could adversely affect our results of operations. Please see Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves and Life Insurance Policy Reserves, Page 43 and Page 47, for a discussion of our reserving practices.

 

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Managing technology initiatives and meeting data security requirements are significant challenges.

 

While technology can streamline many business processes and ultimately reduce the cost of operations, technology initiatives present short-term cost, and also have implementation and operational risks. In addition, we may have inaccurate expense projections, implementation schedules or expectations regarding the effectiveness and user acceptance of the end product. These issues could escalate over time. If we were unable to find and retain associates with key technical knowledge, our ability to develop and deploy key technology solutions could be hampered.

 

We necessarily collect, use and hold data concerning individuals and businesses with whom we have a relationship. Threats to data security, including unauthorized access and cyber attacks, rapidly emerge and change, exposing us to additional costs for protection or remediation and competing time constraints to secure our data in accordance with customer expectations and statutory and regulatory requirements.

 

While we take all commercially reasonable measures to keep our systems and data secure, it is difficult or impossible to defend against every risk being posed by changing technologies as well as criminals’ intent on committing cyber-crime. Increasing sophistication of cyber-criminals and terrorists make keeping up with new threats difficult and could result in a breach. Patching and other measures to protect existing systems and servers could be inadequate, especially on systems that are being retired. Controls employed by our U.S., off-shore and cloud vendors could prove inadequate. We could also experience a breach by intentional or negligent conduct on the part of associates or other internal sources. Our systems and those of our third-party vendors may become vulnerable to damage or disruption due to circumstances beyond our or their control, such as from catastrophic events, power anomalies or outages, natural disasters, network failures, and viruses and malware.

 

A breach of our security that results in unauthorized access to our data could expose us to a disruption or challenges relating to our daily operations as well as to data loss, litigation, damages, fines and penalties, significant increases in compliance costs, and reputational damage.

 

Our status as an insurance holding company with no direct operations could affect our ability to pay dividends in the future.

 

Cincinnati Financial Corporation is a holding company that transacts substantially all of its business through its subsidiaries. Our primary assets are the stock in our operating subsidiaries and our investments. Consequently, our cash flow to pay cash dividends and interest on our long-term debt depends on dividends we receive from our operating subsidiaries and income earned on investments held at the parent-company level.

 

Dividends paid to our parent company by our insurance subsidiary are restricted by the insurance laws of Ohio, its domiciliary state. These laws establish minimum solvency and liquidity thresholds and limits. In 2013, the maximum dividend that may be paid without prior regulatory approval is limited to the greater of 10 percent of statutory surplus or 100 percent of statutory net income for the prior calendar year, up to the amount of statutory unassigned surplus as of the end of the prior calendar year. Dividends exceeding these limitations may be paid only with prior approval of the Ohio Department of Insurance. Consequently, at times, we might not be able to receive dividends from our insurance subsidiary, or we might not receive dividends in the amounts necessary to meet our debt obligations or to pay dividends on our common stock without liquidating securities. This could affect our financial position.

 

Please see Item 1, Regulation, Page 24, and Item 8, Note 9 of the Consolidated Financial Statements, Page 127, for discussion of insurance holding company dividend regulations.

 

32
 

 

Item 1B.Unresolved Staff Comments

 

None

 

Item 2.Properties

 

Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building has approximately 1,508,200 total square feet of available space. The property, including land, is carried in our financial statements at $145 million as of December 31, 2012, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (less than 1 percent). This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.

 

Cincinnati Financial Corporation also owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property. This four-story office building has approximately 124,000 square feet of available space. The property is carried in the financial statements at $7 million as of December 31, 2012, and is classified as land, building and equipment, net, for company use. Unaffiliated tenants occupy approximately 5 percent. This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.

 

The Cincinnati Insurance Company owns a building used for business continuity, with approximately 48,000 square feet of available space, located approximately six miles from our headquarters. The property, including land, is carried on our financial statements at $10 million as of December 31, 2012, and is classified as land, building and equipment, net, for company use. This property is used by all segments reported in the Consolidated Financial Statements and accompanying Notes.

 

Item 3.Legal Proceedings

 

Neither the company nor any of our subsidiaries is involved in any material litigation other than ordinary, routine litigation incidental to the nature of its business.

 

Item 4.Mine Safety Disclosures

 

This item is not applicable to the company.

 

33
 

 

Part II

 

Item 5.Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Cincinnati Financial Corporation had approximately 76,000 shareholders of record as of December 31, 2012. While approximately 12,700 shareholders are registered, the majority of shareholders are beneficial owners whose shares are held in “street name” by brokers and institutional accounts. We believe many of our independent agent representatives and most of the 4,057 associates of our subsidiaries own the company’s common stock.

 

Our common shares are traded under the symbol CINF on the Nasdaq Global Select Market.

 

(Source: Nasdaq Global Select Market)  2012   2011 
Quarter:  1st    2nd    3rd    4th    1st    2nd    3rd    4th  
High  $36.05   $38.12   $40.22   $40.96   $34.33   $33.55   $29.54   $30.79 
Low   30.06    33.06    36.50    36.96    31.43    27.80    23.65    24.66 
Period-end close   34.51    38.07    37.87    39.16    32.79    29.18    26.33    30.46 
Cash dividends declared   0.4025    0.4025    0.4075    0.4075    0.40    0.40    0.4025    0.4025 

 

We discuss the factors that affect our ability to pay cash dividends and repurchase shares in Item 7, Liquidity and Capital Resources, Page 83. One factor we address is regulatory restrictions on the dividends our insurance subsidiary can pay to the parent company, which also is discussed in Item 8, Note 9 of the Consolidated Financial Statements, Page 127.

 

The following summarizes securities authorized for issuance under our equity compensation plans as of December 31, 2012:

 

Plan category  Number of securities to be
issued upon exercise of
outstanding options,
warrants and rights at
December 31, 2012
   Weighted-average exercise
price of outstanding
options, warrants and rights
   Number of securities remaining
available for future issuance under
equity compensation plan (excluding
securities reflected in column (a)) at
December 31, 2012
 
   (a)   (b)   (c) 
Equity compensation plans approved by security holders   7,937,331   $37.34    9,316,008 
Equity compensation plans not approved by security holders   -    -    - 
Total   7,937,331   $37.34    9,316,008 

 

The number of securities remaining available for future issuance includes: 7 million shares available for issuance under the Cincinnati Financial Corporation 2012 Stock Compensation Plan (the 2012 Plan), 2,095,928 shares available for issuance under the Cincinnati Financial Corporation 2006 Stock Compensation Plan (the 2006 Plan), and 220,080 shares available for issuance of share grants under the Director’s Stock Plan of 2009. Both the 2012 Plan and 2006 Plan allow for issuance of stock options, service-based, or performance-based restricted stock units, stock appreciation rights or other equity-based grants. Awards other than stock options and stock appreciation rights granted from the 2012 and 2006 plans are counted as three shares against the plan for each one share of common stock actually issued. Additional information about stock-based associate compensation granted under our equity compensation plans is available in Item 8, Note 17 of the Consolidated Financial Statements, Page 135.

 

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Period  Total number
of shares
purchased
   Average
price paid
per share
   Total number of shares
purchased as part of
publicly announced
plans or programs
   Maximum number of
shares that may yet be
purchased under the
plans or programs
 
January 1-31, 2012   0   $0.00    0    7,438,762 
February 1-29, 2012   0    0.00    0    7,438,762 
March 1-31, 2012   0    0.00    0    7,438,762 
April 1-30, 2012   0    0.00    0    7,438,762 
May 1-31, 2012   0    0.00    0    7,438,762 
June 1-30, 2012   0    0.00    0    7,438,762 
July 1-31, 2012   1,220    38.17    1,220    7,437,542 
August 1-31, 2012   108,148    38.81    108,148    7,329,394 
September 1-30, 2012   65,182    38.99    65,182    7,264,212 
October 1-31, 2012   10,509    39.12    10,509    7,253,703 
November 1-30, 2012   100,926    39.71    100,926    7,152,777 
December 1-31, 2012   25,539    40.49    25,539    7,127,238 
Totals   311,524    39.28    311,524      

 

We did not sell any of our shares that were not registered under the Securities Act during 2012. The board of directors has authorized share repurchases since 1996. Purchases are expected to be made generally through open market transactions. During 2012, we acquired 311,524 shares for $12 million from associates as consideration for options exercised. The board gives management discretion to purchase shares at reasonable prices in light of circumstances at the time of purchase, subject to SEC regulations. We have 7,127,238 shares available for purchase under our programs at December 31, 2012.

 

On October 24, 2007, the board of directors expanded the existing repurchase authorization to approximately 13 million shares. The prior repurchase program for 10 million shares was announced in 2005, replacing a program that had been in effect since 1999. No repurchase program has expired during the period covered by the above table. Neither the 2005 nor 1999 program had an expiration date, but no further repurchases will occur under the 1999 program.

 

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Cumulative Total Return

 

As depicted in the graph below, the five-year total return on a $100 investment made December 31, 2007, assuming the reinvestment of all dividends, was 29.6 percent for Cincinnati Financial Corporation’s common stock compared with 8.4 percent for the Standard & Poor’s Composite 1500 Property & Casualty Insurance Index and 8.6 percent for the Standard & Poor’s 500 Index.

 

The Standard & Poor’s Composite 1500 Property & Casualty Insurance Index includes 27 companies: Ace Limited., The Allstate Corporation, Amerisafe Inc., Aspen Insurance Holdings Limited., W. R. Berkley Corporation, Berkshire Hathaway Inc., The Chubb Corporation, Cincinnati Financial Corporation, Employers Holdings Inc., Fidelity National Financial Inc., First American Financial Corporation, The Hanover Insurance Group Inc., Infinity Property and Casualty Corporation, Meadowbrook Insurance Group, Inc., Mercury General Corporation, The Navigators Group Inc., Old Republic International Corporation, ProAssurance Corporation, The Progressive Corporation, RLI Corp., Safety Insurance Group Inc., Selective Insurance Group Inc., Stewart Information Services Corporation, Tower Group Inc., The Travelers Companies Inc., United Fire & Casualty Company and XL Group Public Limited Company.

 

The Standard & Poor’s 500 Index includes a representative sample of 500 leading companies in a cross section of industries of the U.S. economy. Although this index focuses on the large capitalization segment of the market, it is widely viewed as a proxy for the total market.

 

 

 

*$100 invested on December 31, 2007, in stock or index, including reinvestment of dividends.

 

Fiscal year ending December 31.

 

36
 

 

Item 6.Selected Financial Data

 

(In millions except per share data, shares outstanding in thousands)  Years ended December 31,     
   2012   2011   2010   2009   2008 
Consolidated Income Statement Data                         
Earned premiums  $3,522   $3,194   $3,082   $3,054   $3,136 
Investment income, net of expenses   531    525    518    501    537 
Realized investment gains and losses*   42    70    159    336    138 
Total revenues   4,111    3,803    3,772    3,903    3,824 
Net income   421    164    375    431    428 
Net income per common share:                         
Basic  $2.59   $1.01   $2.30   $2.65   $2.62 
Diluted   2.57    1.01    2.30    2.65    2.62 
Cash dividends per common share:                         
Declared   1.62    1.605    1.59    1.57    1.56 
Paid   1.615    1.6025    1.585    1.565    1.525 
Weighted average shares outstanding, diluted   163,661    163,259    163,274    162,867    163,362 
Consolidated Balance Sheet Data                         
Total investments  $12,534   $11,801   $11,508   $10,643   $8,890 
Deferred policy acquisition costs   470    477    458    454    482 
Total assets   16,548    15,635    15,065    14,413    13,342 
Gross loss and loss expense reserves   4,230    4,339    4,200    4,142    4,086 
Life policy reserves   2,295    2,214    2,034    1,783    1,551 
Long-term debt   790    790    790    790    791 
Shareholders' equity   5,453    5,033    5,012    4,742    4,169 
Book value per share   33.48    31.03    30.79    29.14    25.67 
Shares outstanding   162,874    162,186    162,782    162,741    162,411 
Value creation ratio   12.6%   6.0%   11.1%   19.7%   (23.5)%
Consolidated Property Casualty Operations                         
Earned premiums  $3,344   $3,029   $2,924   $2,911   $3,010 
Unearned premiums   1,790    1,631    1,551    1,507    1,542 
Gross loss and loss expense reserves   4,169    4,280    4,137    4,096    4,040 
Investment income, net of expenses   351    350    348    336    350 
Loss ratio   53.8%   64.4%   56.5%   58.6%   57.7%
Loss expense ratio   10.1    12.6    12.4    13.1    10.6 
Underwriting expense ratio   32.2    32.3    32.9    32.8    32.2 
Combined ratio   96.1%   109.3%   101.8%   104.5%   100.5%

 

On January 1, 2012, we retrospectively adopted ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. All prior years’ information has been restated.

 

Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2012.

 

*Realized investment gains and losses are integral to our financial results over the long term, but our substantial discretion in the timing of investment sales may cause this value to fluctuate substantially. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 79.

 

37
 

 

Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations

 

Introduction

 

The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial condition. Our Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Page 37, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 108. We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and stock dividends.

 

We begin with an executive summary of our results of operations and outlook, followed by details on critical accounting estimates. In several instances, we refer to estimated industry data so that we can provide information on our performance within the context of the overall insurance industry. 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 accounting basis. When we provide our results on a comparable statutory accounting 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).

 

Executive Summary

 

Through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on 2012 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 Item 1, Our Business and Our Strategy, Page 3.

 

Recent years have been challenging for the U.S. economy, the insurance industry and our company. Our long-term perspective has allowed us to address the immediate challenges of such times while also focusing on the major decisions that best position the company for success through all market cycles. We believe that this forward-looking view has consistently benefited our shareholders, agents, policyholders and associates.

 

To measure our progress, we have defined a measure of value creation 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. We refer to this measure as our value creation ratio, or VCR, and it 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. This measure, intended to be all-inclusive regarding changes in book value per share, uses originally reported book value per share in cases where book value per share has been adjusted, such as the adoption of Accounting Standards Updates with a cumulative effect of a change in accounting. VCR trends are shown in the table below.

 

   One   Three-year   Five-year 
   year   % average   % average 
Value creation ratio               
as of December 31, 2012   12.6%   9.9%   5.2%
as of December 31, 2011   6.0    12.3    1.5 
as of December 31, 2010   11.1    2.4    3.7 

 

For the period 2013 through 2017, an annual value creation ratio averaging 10 percent to 13 percent is our primary performance target. For the period 2009 through 2012, our annual value creation ratio averaged 12.4 percent, within the 12 percent to 15 percent five-year target range established in early 2009, soon after the U.S. credit crisis. Since the credit crisis, interest rates have generally declined and credit spreads have tightened, increasing the VCR contribution from valuation gains from our fixed-maturity securities. As indicated in the table below, those gains contributed between 2 percent and 3 percent to VCR in the past three years. That contribution is not expected to occur in the next five-year period, but management believes the company will produce strong underwriting results.

 

38
 

  

(Dollars are per share)  Years ended December 31, 
   2012   2011   2010 
Book value change per share               
End of year book value  $33.48   $31.03   $30.79 
Less beginning of year book value   31.03    30.79    29.14 
Change in book value  $2.45   $0.24   $1.65 
                
Change in book value per share               
Net income before net realized gains  $2.41   $0.74   $1.67 
Change in net realized and unrealized gains, fixed-maturity securities   0.84    0.83    0.65 
Change in net realized and unrealized gains, equity securities   0.86    0.39    0.84 
Dividend declared to shareholders   (1.62)   (1.61)   (1.59)
Other   (0.04)   (0.11)   0.08 
Total change in book value per share  $2.45   $0.24   $1.65 

 

We believe this non-GAAP measure is a useful supplement to GAAP information. With the continuation of economic and market uncertainty in recent years, the long-term nature of this measure provides a meaningful measure of our long-term progress in creating shareholder value. A reconciliation of this non-GAAP measure to comparable GAAP measures is shown in the table below.

 

(Dollars are per share)  Years ended December 31, 
   2012   2011   2010 
Book value change per share               
Book value as originally reported December 31, 2011       $31.16      
Cumulative effect of a change in accounting for deferred policy acquisition costs, net of tax        (0.13)     
Book value as adjusted December 31, 2011       $31.03      
                
Value creation ratio               
End of year book value - as originally reported  $33.48   $31.16   $30.91 
Less beginning of year book value - as originally reported   31.16    30.91    29.25 
Change in book value - as originally reported  $2.32   $0.25   $1.66 
Dividend declared to shareholders   1.62    1.605    1.59 
Total contribution to value creation ratio  $3.94   $1.855   $3.25 
                
Contribution to value creation ratio from change in book value*   7.4%   0.8%   5.7%
Contribution to value creation ratio from dividends declared to shareholders**   5.2    5.2    5.4 
Value creation ratio   12.6%   6.0%   11.1%

  

* Change in book value divided by the beginning of year book value as originally reported

** Dividend declared to shareholders divided by beginning of year book value as originally reported

 

In 2012, our value creation ratio of 12.6 percent was within the range of our performance objective. It improved significantly from 2011, as discussed in Corporate Financial Highlights below.

 

When looking at our longer-term objectives, we see three performance drivers:

 

·Premium growth – We believe over any five-year period our agency relationships and initiatives can lead to a property casualty written premium growth rate that exceeds the industry average. Our long-term target for profitable premium growth, for our property casualty and life insurance segments in aggregate, is to reach $5 billion of annual direct written premiums by the end of 2015. In 2012, our direct written premiums totaled $3.909 billion. The compound annual growth rate of our net written premiums was 2.2 percent over the five-year period 2008 through 2012, higher than the 0.7 percent estimated growth rate for the property casualty insurance industry. The industry’s growth rate excludes its mortgage and financial guaranty lines of business.

 

·Combined ratio – We believe our underwriting philosophy and initiatives can drive performance to achieve our underwriting profitability target of a GAAP combined ratio over any five-year period that is consistently within the range of 95 percent to 100 percent. Our GAAP combined ratio has averaged 102.4 percent over the five-year period 2008 through 2012. Our combined ratio was below 100 percent in 2012, but above 100 percent for 2008 through 2011, when our average catastrophe loss ratio of 7.7 percentage points was 4.0 points higher than the average for the 10-year period prior to 2008. Performance as measured by the combined ratio is discussed in Consolidated Property Casualty Insurance Results of Operations, Page 52. Our statutory combined ratio averaged 102.2 percent over the five-year period 2008 through 2012 compared with an estimated 102.9 percent for the property casualty industry. The industry’s ratio again excludes its mortgage and financial guaranty lines of business.

 

39
 

 

·Investment contribution – We believe our investment philosophy and initiatives can drive investment income growth and lead to a total return on our equity investment portfolio over a five-year period that exceeds the five-year return of the Standard & Poor’s 500 Index.

 

oInvestment income growth, on a before-tax basis, had a compound annual rate of 2.0 percent over the three-year period 2010 through 2012. It has grown since 2009, when we experienced a dramatic reduction in dividend payouts by financial services companies held in our equity portfolio.

 

oOver the five years ended December 31, 2012, our compound annual equity portfolio return was 0.8 percent compared with a compound annual total return of 1.7 percent for the Index. Our equity portfolio underperformed the market for the five-year period primarily because of the 2008 decline in the market value of our previously large holdings in the financial services sector. For the year 2012, our annual equity portfolio return was 10.9 percent, compared with 16.0 percent for the Index, as the large-cap, dividend paying stocks that we prefer were outperformed by the broader equity market.

 

The board of directors is committed to rewarding shareholders directly through cash dividends and through authorizing share repurchases. The board also has periodically declared stock dividends and splits. Through 2012, the company has increased the indicated annual cash dividend rate for 52 consecutive years, a record we believe is matched by only nine other publicly traded companies. The board regularly evaluates relevant factors in dividend-related decisions, and the increase reflects confidence in our strong capital, liquidity and financial flexibility, as well as progress through our initiatives to improve earnings performance. We discuss our financial position in more detail in Liquidity and Capital Resources, Page 83.

 

Strategic Initiatives Highlights

 

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. We discuss our long-term, proven strategy in Item 1, Our Business and Our Strategy, Page 3. We believe successful implementation of initiatives that support our strategy will help us better serve our agent customers and reduce volatility 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.

 

·Improve insurance profitability – Implementation of these initiatives is intended to enhance underwriting expertise and knowledge, thereby increasing our ability to manage our business while also gaining efficiency. Additional information and more focused action on underperforming product lines, plus expanding pricing capabilities through the use of technology and analytics, can lead to better profit margins. Improved internal processes with additional performance metrics can help us be more efficient and effective. These initiatives also support the ability of the independent agencies that represent us to grow profitably by allowing them to serve clients faster and to more efficiently manage agency expenses.

 

·Drive premium growth – Implementation of these initiatives is intended to further penetrate each market we serve through our independent agency network. Strategies aimed at specific market opportunities, along with service enhancements, can help our agents grow and increase our share of their business. Diversified growth also may reduce variability of losses from weather-related catastrophes.

 

We discuss these strategic initiatives, along with related metrics to assess progress, in Item 1, Strategic Initiatives, Page 10. Below is a review of highlights of our financial results for the past three years. Detailed discussion of these topics appears in Results of Operations, Page 51, and Liquidity and Capital Resources, Page 83.

 

40
 

 

Corporate Financial Highlights

 

The value creation ratio discussed in the Executive Summary, Page 38, included contributions from the major components shown in the table below.

 

   Years ended December 31, 
   2012   2011   2010 
Value creation ratio major components            
Net income before net realized gains   7.7%   2.4%   5.7%
Change in realized and unrealized gains, fixed-maturity securities   2.7    2.7    2.2 
Change in realized and unrealized gains, equity securities   2.8    1.3    2.9 
Other   (0.6)   (0.4)   0.3 
Value creation ratio   12.6%   6.0%   11.1%

 

The 2012 value creation ratio benefited from improved operating results as well as a strong contribution from generally higher valuations in securities markets. The contribution from operating results rose 5.3 percentage points in 2012, compared with 2011, while the contribution from realized gains plus the change in unrealized gains from our investment portfolios rose 1.5 points. The 2011 value creation ratio was depressed primarily due to unusually high catastrophe losses that lowered the ratio by 3.3 percentage points compared with 2010, and also drove a 56 percent decline in net income. Higher valuations for our investment portfolio in recent years benefited the value creation ratio in addition to earnings.

 

Balance Sheet Data

 

(Dollars in millions except share data)  At December 31,   At December 31, 
   2012   2011 
Balance sheet data          
Total investments  $12,534   $11,801 
Total assets   16,548    15,635 
Short-term debt   104    104 
Long-term debt   790    790 
Shareholders' equity   5,453    5,033 
Book value per share   33.48    31.03 
Debt-to-total-capital ratio   14.1%   15.1%

 

Invested assets grew 6 percent during 2012 on a fair value basis, with market gains outpacing an increase in the cost basis of invested assets of approximately 3 percent. Entering 2013, we believe the portfolio continues to be well diversified, and it is well positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, Page 20, and results for the segment in Investment Results of Operations, Page 79. Total assets rose 6 percent, primarily due to the increase in invested assets.

 

The amount of our debt obligations did not change in 2012. Our ratio of debt to total capital (debt plus shareholders’ equity) decreased by 1 percentage point in 2012 and remains comfortably within our target range.

 

Income Statement and Per Share Data

 

(Dollars in millions except share data in thousands)  Twelve months ended December 31,   2012-2011   2011-2010 
   2012   2011   2010   Change %   Change % 
Income statement data                         
Earned premiums  $3,522   $3,194   $3,082    10    4 
Investment income, net of expenses (pretax)   531    525    518    1    1 
Realized investment gains and losses (pretax)   42    70    159    (40)   (56)
Total revenues   4,111    3,803    3,772    8    1 
Net income   421    164    375    157    (56)
Per share data                         
Net income - diluted  $2.57   $1.01   $2.30    154    (56)
Cash dividends declared   1.62    1.605    1.59    1    1 
                          
Weighted average shares outstanding   163,661    163,259    163,274    0    0 

 

Net income in 2012 rose $257 million or 157 percent compared with 2011, due primarily to the after-tax effects of property casualty underwriting results that improved by $270 million, including $44 million from lower natural catastrophe losses, and net realized investment gains that were $17 million lower. Net income decreased $211 million in 2011, compared with 2010, reflecting the after-tax net effect of two major contributing items: a $149 million decline in property casualty underwriting results, including $165 million from higher catastrophe losses, and a $58 million decline in net realized investment gains.

 

As discussed in Investment Results of Operations, Page 79, sales of securities that had appreciated in value led to realized investment gains in all three years. Realized and unrealized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that are recognized in any period. That discretion

 

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generally is independent of the insurance underwriting process. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and for securities with embedded derivatives without actual realization of those gains and losses.

 

Higher dividend income was largely responsible for 1 percent growth in both 2012 and 2011 pretax investment income. In addition to a larger common stock portfolio generating more dividend income in 2012, both 2012 and 2011 benefited from higher average dividend payment rates.

 

Contribution from Insurance Operations

 

(Dollars in millions)  Years ended December 31,   2012-2011   2011-2010 
Consolidated property casualty highlights  2012   2011   2010   Change %   Change % 
Net written premiums  $3,482   $3,098   $2,963    12    5 
Earned premiums   3,344    3,029    2,924    10    4 
Underwriting gain (loss)   137    (278)   (49)   nm    nm 
                          
                              Pt. Change   Pt. Change 
GAAP combined ratio   96.1%   109.3%   101.8%   (13.2)   7.5 
Statutory combined ratio   95.4    108.9    101.8    (13.5)   7.1 
Written premium to statutory surplus   0.9    0.8    0.8    0.1    0.0 

 

Property casualty net written premiums grew 12 percent in 2012 and earned premiums grew 10 percent, largely due to higher pricing and premium growth initiatives. Trends and related factors are discussed in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 57, Page 68 and Page 74, respectively.

 

Our property casualty insurance operations generated an underwriting gain in 2012 after reporting an underwriting loss in each of the preceding four years. The $415 million improvement for 2012, compared with 2011, included a $68 million decrease in losses from natural catastrophe events. A 10 percent rise in 2012 earned premiums drove most of the improvement as noncatastrophe losses and underwriting expenses in total for 2012 were within 1 percent of 2011. The $229 million change in underwriting loss for 2011, compared with 2010, was driven by a $254 million rise in losses from natural catastrophe events.

 

We measure property casualty underwriting profitability primarily by the combined ratio. Our combined ratio measures the percentage of each earned premium dollar spent on claims plus all expenses related to our property casualty operations. A lower ratio indicates more favorable results and better underlying performance. Our combined ratio improved to under 100 percent in 2012 but was over 100 percent in each of the prior three years. Initiatives to improve our combined ratio are discussed in Item 1, Strategic Initiatives, Page 10. In 2012, 2011 and 2010, favorable development on reserves for claims that occurred in prior accident years helped offset remaining incurred loss and loss expenses. Reserve development is discussed further in Property Casualty Loss and Loss Expense Obligations and Reserves, beginning on Page 88. Losses from weather-related catastrophes are another important item influencing the combined ratio and are discussed along with other factors in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 57, Page 68 and Page 74, respectively.

 

Our life insurance segment reported a small loss because most of its investment income is included in our investments segment results. We discuss results for the segment in Life Insurance Results of Operations, Page 77. In addition to investment income, realized investment gains from the life insurance investment portfolio are also included in our investments segment results.

 

Factors Influencing Our Future Performance

 

Our view of the shareholder value we can create over the next five years relies largely on two assumptions about the external environment. First, we anticipate continued firming of commercial and personal insurance pricing throughout 2013. Second, we assume that the economy can maintain a growth track during 2013. If those assumptions prove to be inaccurate, we may not be able to achieve our performance targets even if we accomplish our strategic objectives.

 

Other factors that could influence our ability to achieve our targets include:

 

·We expect the insurance marketplace to remain competitive, which is likely to cause carriers to pursue strategies that they believe could lead to economies of scale, market share gains or the potential for an improved competitive posture.

 

·We expect the independent insurance agency system to remain strong, with continued agency consolidation. If soft insurance market conditions return in 2013, it will create additional risk for agencies.

 

·We expect initiatives that make it easier for agents to do business with us will continue to be a significant factor in agency relationships, with technology being a major driver. Policyholders will increasingly demand online services and access from agents or carriers.

 

We discuss in our Item 1A, Risk Factors, Page 26, many potential risks to our business and our ability to achieve our qualitative and quantitative objectives. These are real risks, but their probability of occurring may not be high. We also believe that our risk management programs generally could mitigate their

 

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potential effects, in the event they would occur. We continue to study emerging risks, including climate change risk and its potential financial effects on our results of operation and on those we insure. These effects include deterioration in credit quality of our municipal or corporate bond portfolios and increased losses without sufficient corresponding increases in premiums. As with any risk, we seek to identify the extent of the risk exposure and possible actions to mitigate potential negative effects of risk, at an enterprise level.

 

We have formal risk management programs overseen by an executive officer and supported by a team of representatives from business areas. The team provides reports to our chairman, our president and chief executive officer and our board of directors, as appropriate, on risk assessments, risk metrics and risk plans. Our use of operational audits, strategic plans and departmental business plans, as well as our culture of open communications and our fundamental respect for our Code of Conduct, continue to help us manage risks on an ongoing basis.

 

For the year 2013, we believe our value creation ratio may be below our long-term target for several reasons.

 

·The rally in financial markets during recent years had a favorable impact on our value creation ratio, offsetting the unfavorable impact of the sharp decline in financial markets during 2008. Financial markets continued to display volatility during 2012, and some predict more turbulence in 2013 from effects of events such as the sovereign debt crisis in several European countries or other geopolitical events that could also affect the U.S. economy and markets. Should financial markets decline during 2013, which could occur as part of typical market volatility patterns, the related component of our 2013 value creation ratio could also register a weak or negative result.

 

·A return of soft insurance market pricing in recent years could significantly affect growth rates and earned premium levels into 2013 and for some time into the future, depending on insurance market conditions. After several years of market conditions that weakened loss ratios and hampered near-term profitability, conditions affecting property casualty markets improved in 2012. In the future, economic factors, including inflation, may increase our claims and settlement expenses related to medical care, litigation and construction.

 

·The slowly recovering economy helped increase the value of business and personal insurable assets owned by policyholders in 2012. If the economy falters, we may experience low or no premium growth for the property casualty industry. Property casualty written premium growth also may lag as some of our growth initiatives require more time to reach their full contribution.

 

·We will incur the cost of continued investment in our business, including technology, recent entry in new states and process initiatives to create long-term value. In addition, we will not see the full advantage of some of these investments for several years.

 

Critical Accounting Estimates

 

Cincinnati Financial Corporation’s financial statements are prepared using GAAP. These principles require management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ materially from those estimates.

 

The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 of the Consolidated Financial Statements, Page 112. In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company’s critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate.

 

Property Casualty Insurance Loss and Loss Expense Reserves

 

We establish loss and loss expense reserves for our property casualty insurance business as balance sheet liabilities. These reserves account for unpaid loss and loss expenses as of a financial statement date. Unpaid loss and loss expenses are the estimated amounts necessary to pay for and settle all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date.

 

For some lines of business that we write, a considerable and uncertain amount of time can elapse between the occurrence, reporting and payment of insured claims. The amount we will actually have to pay for such claims also can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. Gross loss and loss expense reserves were $4.169 billion at year-end 2012 compared with $4.280 billion at year-end 2011.

 

How Reserves Are Established

 

Our field claims representatives establish case reserves when claims are reported to the company to provide for our unpaid loss and loss expense obligation associated with individual claims. Field claims

 

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managers supervise and review all claims with case reserves less than $35,000. Experienced headquarters claims supervisors review individual case reserves greater than $35,000 that were established by field claims representatives. Headquarters claims managers also review case reserves greater than $100,000.

 

Our claims representatives base their case reserve estimates primarily upon case-by-case evaluations that consider:

 

·type of claim involved

 

·circumstances surrounding each claim

 

·policy provisions pertaining to each claim

 

·potential for subrogation or salvage recoverable

 

·general insurance reserving practices

 

Case reserves of all sizes are subject to review on a 90-day cycle, or more frequently if new information about a loss becomes available. As part of the review process, we monitor industry trends, cost trends, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional loss exposures.

 

We also establish IBNR reserves to provide for all unpaid loss and loss expenses not accounted for by case reserves:

 

·For weather events designated as catastrophes, we calculate bulk reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Once case reserves are established for a weather event, we reduce the bulk reserves. Our claims department management coordinates the assessment of these events and prepares the related bulk reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the event, of policyholder exposures within the affected geographic area and of available claims intelligence. Depending on the nature of the event, available claims intelligence could include surveys of field claims associates within the affected geographic area, feedback from a catastrophe claims team sent into the area, as well as data on claims reported as of the financial statement date. To determine whether an event is designated as a catastrophe, we generally use the catastrophe definition provided by Property Claims Service (PCS), a division of Insurance Services Office (ISO). PCS defines a catastrophe as an event that causes countrywide damage of $25 million or more in insured property losses and affects a significant number of policyholders and insureds.

 

·For asbestos and environmental claims, we calculate IBNR reserves by deriving an actuarially-based estimate of total unpaid loss and loss expenses. We then reduce the estimate by total case reserves. We discuss the reserve analysis that applies to asbestos and environmental reserves in Asbestos and Environmental Reserves, Page 88.

 

·For loss expenses that pertain primarily to salaries and other costs related to our claims department associates, also referred to as adjusting and other expense or AOE for statutory accounting, we calculate reserves based on an analysis of the relationship between paid losses and paid AOE. Reserves for AOE are allocated to company, line of business and accident year based on a claim count algorithm.

 

·For all other claims and events, IBNR reserves are calculated as the difference between an actuarial estimate of the ultimate cost of total loss and loss expenses incurred reduced by the sum of total loss and loss expense payments and total case reserves estimated for individual claims. We discuss below the development of actuarially based estimates of the ultimate cost of total loss and loss expenses incurred.

 

Our actuarial staff applies significant judgment in selecting models and estimating model parameters when preparing reserve analyses. In addition, unpaid loss and loss expenses are inherently uncertain as to timing and amount. Uncertainties relating to model appropriateness, parameter estimates and actual loss and loss expense amounts are referred to as model, parameter and process uncertainty, respectively. Our management and actuarial staff address these uncertainties in the reserving process in a variety of ways.

 

Our actuarial staff bases its IBNR reserve estimates for these losses primarily on the indications of methods and models that analyze accident year data. Accident year is the year in which an insured claim, loss or loss expense occurred. The specific methods and models that our actuaries have used for the past several years are:

 

·paid and reported loss development methods

 

·paid and reported loss Bornhuetter-Ferguson methods

 

·individual and multiple probabilistic trend family models

 

Our actuarial staff uses diagnostics provided by stochastic reserving software to evaluate the appropriateness of the models and methods listed above. The software’s diagnostics have indicated that the appropriateness of these models and methods for estimating IBNR reserves for our lines of business tends

 

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to depend on a line's tail. Tail refers to the time interval between a typical claim's occurrence and its settlement. For our long-tail lines such as workers’ compensation and commercial casualty, models from the probabilistic trend family tend to provide superior fits and to validate well compared with models underlying the loss development and Bornhuetter-Ferguson methods. The loss development and Bornhuetter-Ferguson methods, particularly the reported loss variations, tend to produce the more appropriate IBNR reserve estimates for our short-tail lines such as homeowner and commercial property. For our mid-tail lines such as personal and commercial auto liability, all models and methods provide useful insights.

 

Our actuarial staff also devotes significant time and effort to the estimation of model and method parameters. The loss development and Bornhuetter-Ferguson methods require the estimation of numerous loss development factors. The Bornhuetter-Ferguson methods also involve the estimation of numerous ultimate loss ratios by accident year. Models from the probabilistic trend family require the estimation of development trends, calendar year inflation trends and exposure levels. Consequently, our actuarial staff monitors a number of trends and measures to gain key business insights necessary for exercising appropriate judgment when estimating the parameters mentioned.

 

These trends and measures include:

 

·company and industry pricing

 

·company and industry exposure

 

·company and industry loss frequency and severity

 

·past large loss events such as hurricanes

 

·company and industry premium

 

·company in-force policy count

 

These trends and measures also support the estimation of ultimate accident year loss ratios needed for applying the Bornhuetter-Ferguson methods and for assessing the reasonability of all IBNR reserve estimates computed. Our actuarial staff reviews these trends and measures quarterly, updating parameters derived from them as necessary.

 

Quarterly, our actuarial staff summarizes their reserve analysis by preparing an actuarial best estimate and a range of reasonable IBNR reserves intended to reflect the uncertainty of the estimate. An inter-departmental committee that includes our actuarial management team reviews the results of each quarterly reserve analysis. The committee establishes management’s best estimate of IBNR reserves, which is the amount that is included in each period’s financial statements. In addition to the information provided by actuarial staff, the committee also considers factors such as the following:

 

·large loss activity and trends in large losses

 

·new business activity

 

·judicial decisions

 

·general economic trends such as inflation

 

·trends in litigiousness and legal expenses

 

·product and underwriting changes

 

·changes in claims practices

 

The determination of management's best estimate, like the preparation of the reserve analysis that supports it, involves considerable judgment. Changes in reserving data or the trends and factors that influence reserving data may signal fundamental shifts or may simply reflect single-period anomalies. Even if a change reflects a fundamental shift, the full extent of the change may not become evident until years later. Moreover, since our methods and models do not explicitly relate many of the factors we consider directly to reserve levels, we typically cannot quantify the precise impact of such factors on the adequacy of reserves prospectively or retrospectively.

 

Due to the uncertainties described above, our ultimate loss experience could prove better or worse than our carried reserves reflect. To the extent that reserves are inadequate and increased, the amount of the increase is a charge in the period that the deficiency is recognized, raising our loss and loss expense ratio and reducing earnings. To the extent that reserves are redundant and released, the amount of the release is a credit in the period that the redundancy is recognized, reducing our loss and loss expense ratio and increasing earnings.

 

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Key Assumptions - Loss Reserving

 

Our actuarial staff makes a number of key assumptions when using their methods and models to derive IBNR reserve estimates. Appropriate reliance on these key assumptions essentially entails determinations of the likelihood that statistically significant patterns in historical data may extend into the future. The four most significant of the key assumptions used by our actuarial staff and approved by management are:

 

·Emergence of loss and defense and cost containment expenses on an accident year basis. Historical paid loss, reported loss and paid defense and cost containment expense data for the business lines we analyze contain patterns that reflect how unpaid losses, unreported losses and unpaid defense and cost containment expenses as of a financial statement date will emerge in the future on an accident year basis. Unless our actuarial staff or management identifies reasons or factors that invalidate the extension of historical patterns into the future, these patterns can be used to make projections necessary for estimating IBNR reserves. Our actuaries significantly rely on this assumption in the application of all methods and models mentioned above.

 

·Calendar year inflation. For long-tail and mid-tail business lines, calendar year inflation trends for future paid losses and paid defense and cost containment expenses do not vary significantly from a stable, long-term average. Our actuaries base reserve estimates derived from probabilistic trend family models on this assumption.

 

·Exposure levels. Historical earned premiums, when adjusted to reflect common levels of product pricing and loss cost inflation, can serve as a proxy for historical exposures. Our actuaries require this assumption to estimate expected loss ratios and expected defense and cost containment expense ratios used by the Bornhuetter-Ferguson reserving methods. They may also use this assumption to establish exposure levels for recent accident years, characterized by “green” or immature data, when working with probabilistic trend family models.

 

·Claims having atypical emergence patterns. Characteristics of certain subsets of claims, such as high frequency, high severity, or mass tort claims, have the potential to distort patterns contained in historical paid loss, reported loss and paid defense and cost containment expense data. When testing indicates this to be the case for a particular subset of claims, our actuaries segregate these claims from the data and analyze them separately. Subsets of claims that could fall into this category include hurricane claims or claims for other weather events where total losses we incurred were very large, individual large claims and asbestos and environmental claims.

 

These key assumptions have not changed since 2005, when our actuarial staff began using probabilistic trend family models to estimate IBNR reserves.

 

Paid losses, reported losses and paid defense and cost containment expenses are subject to random as well as systematic influences. As a result, actual paid losses, reported losses and paid defense and cost containment expenses are virtually certain to differ from projections. Such differences are consistent with what specific models for our business lines predict and with the related patterns in the historical data used to develop these models. As a result, management does not closely monitor statistically insignificant differences between actual and projected data.

 

Reserve Estimate Variability

 

Management believes that the standard error of a reserve estimate, a measure of the estimate's variability, provides the most appropriate measure of the estimate's sensitivity. The reserves we establish depend on the models we use and the related parameters we estimate in the course of conducting reserve analyses. However, the actual amount required to settle all outstanding insured claims, including IBNR claims, as of a financial statement date depends on stochastic, or random, elements as well as the systematic elements captured by our models and estimated model parameters. For the lines of business we write, process uncertainty – the inherent variability of loss and loss expense payments – typically contributes more to the imprecision of a reserve estimate than parameter uncertainty.

 

Consequently, a sensitivity measure that ignores process uncertainty would provide an incomplete picture of the reserve estimate's sensitivity. Since a reserve estimate's standard error accounts for both process and parameter uncertainty, it reflects the estimate's full sensitivity to a range of reasonably likely scenarios.

 

The table below provides standard errors and reserve ranges by major property casualty lines of business and in total for loss and loss expense reserves as well as the potential effects on our net income, assuming a 35 percent federal tax rate. Standard errors and reserve ranges for assorted groupings of these lines of business cannot be computed by simply adding the standard errors and reserve ranges of the component lines of business, since such an approach would ignore the effects of product diversification. See Range of Reasonable Reserves, Page 89, for more details on our total reserve range. While the table reflects our assessment of the most likely range within which each line's actual unpaid loss and loss expenses may fall, one or more lines' actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.

 

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(In millions)  Net loss and loss expense range of reserves     
   Carried   Low   High   Standard   Net income 
   reserves   point   point   error   effect 
At December 31, 2012                         
Total  $3,813   $3,598   $3,918           
                          
Commercial casualty  $1,512   $1,341   $1,588   $123   $80 
Commercial property   222    199    245    23    15 
Commercial auto   351    333    370    19    12 
Workers' compensation   931    845    1,018    87    57 
Personal auto   182    174    191    9    6 
Homeowners   120    112    127    8    5 
                          
At December 31, 2011                         
Total  $3,905   $3,677   $4,056           
                          
Commercial casualty  $1,613   $1,432   $1,750   $159   $103 
Commercial property   209    175    229    27    18 
Commercial auto   349    333    365    16    10 
Workers' compensation   966    875    1,056    90    59 
Personal auto   176    168    184    8    5 
Homeowners   121    107    129    11    7 

 

If actual unpaid loss and loss expenses fall within these ranges, our cash flow and fixed-maturity investments should provide sufficient liquidity to make the subsequent payments. To date, our operating cash flow has covered our loss and loss expense payments, and we have never had to sell investments to make these payments. If this were to become necessary, however, our fixed-maturity investments should provide us with ample liquidity. At year-end 2012, consolidated fixed-maturity investments exceeded total insurance reserves (including life policy reserves) by $2.568 billion.

 

Life Insurance Policy 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. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.

 

We establish reserves for our universal life, deferred annuity and investment contracts equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals. Some of our universal life insurance 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.

 

Asset Impairment

 

Our fixed-maturity and equity investment portfolios are our largest assets. The company’s asset impairment committee continually monitors the holdings in these portfolios and all other assets for signs of other-than-temporary or permanent impairment. The committee monitors decreases in the fair value of invested assets; an accumulation of costs in excess of the amount originally expected to acquire or construct an asset; uncollectability of all receivable assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure to pay interest or dividends; signs indicating that the receivable carrying amount may not be recoverable; and changes in legal factors or in the business climate.

 

The application of our impairment policy resulted in other-than-temporary impairment (OTTI) charges that reduced our income before income taxes by $33 million in 2012, $57 million in 2011 and $36 million in 2010. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, the value is not expected to be recouped within a designated recovery period. OTTI losses represent noncash charges to income and are reported as realized investment losses.

 

Our internal investment portfolio managers monitor their assigned portfolios. If a security is valued below cost or amortized cost, the portfolio managers undertake additional reviews. Such declines often occur in conjunction with events taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing organization. Managers review quantitative measurements such as a declining trend in fair value, the extent of the fair value decline and the length of time the value of the security has been depressed, as well as qualitative measures such as pending events, credit ratings and issuer liquidity. We are even more proactive when these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and market conditions. We provide information about valuation of our invested assets in Item 8, Note 2, of the Consolidated Financial Statements, Page 118.

 

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All securities valued below 100 percent of cost or amortized cost are reported to the asset impairment committee for evaluation. Securities valued between 95 percent and 100 percent of cost or amortized cost are reviewed but not monitored separately by the committee. When evaluating for OTTI, the committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost. Because of the company's financial strength and other factors discussed below, management may not impair certain securities even when they are fair valued below cost or amortized cost.

 

Securities that have previously been other-than-temporarily impaired are evaluated based on their adjusted cost or amortized cost and further written down, if deemed appropriate. We provide detailed information about securities fair valued in a continuous loss position at year-end 2012 in Item 7A, Application of Asset Impairment Policy, Page 102.

 

When determining OTTI charges for our fixed-maturity portfolio, management places significant emphasis on whether issuers of debt are current on contractual payments and whether future contractual amounts are likely to be paid. Our fixed-maturity invested asset impairment policy states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed-maturity security; (2) if it is more likely than not we will be required to sell the fixed-maturity security before recovery of its amortized cost basis; or (3) if the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. If we intend to sell or it is more likely than not we will be required to sell, the amortized cost of any such securities is reduced to fair value as the new amortized cost basis, and a realized loss is recorded in the quarter in which it is recognized. When we believe that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount to the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the quarter in which it occurs. The difference between the fair value and the net present value of the cash flows of the security, the noncredit loss, is recognized in other comprehensive income as an unrealized loss.

 

When determining OTTI charges for our equity portfolio, our invested asset impairment policy considers qualitative and quantitative factors, including facts and circumstances specific to individual securities, asset classes, the financial condition of the issuer, changes in dividend payment, the length of time fair value had been less than cost, the severity of the decline in fair value below cost, the volatility of the security and our ability and intent to hold each position until its forecasted recovery.

 

For each of our equity securities in an unrealized loss position at December 31, 2012, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong surplus, liquidity and cash flow, provide us the ability to hold these investments through what we believe to be slightly longer recovery periods occasioned by the recession and historic levels of market volatility. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is other-than-temporarily impaired.

 

Securities considered to have a temporary decline would be expected to recover their cost or amortized cost, which may be at maturity. Under the same accounting treatment as fair value gains, temporary declines (changes in the fair value of these securities) are reflected in shareholders’ equity on our balance sheet in accumulated other comprehensive income (AOCI), net of tax, and have no impact on net income.

 

Fair Value Measurements

 

Valuation of Financial Instruments

 

Valuation of financial instruments, primarily securities held in our investment portfolio, is a critical component of our year-end financial statement preparation. Fair Value Measurements and Disclosures, Accounting Standards Codification (ASC) 820-10, defines fair value as the exit price or the amount that would be (1) received to sell an asset or (2) paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. When determining an exit price, we must, whenever possible, rely upon observable market data.

 

In accordance with ASC 820-10, we have categorized our financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level that is significant to the fair value measurement of the instrument. While we consider pricing data from outside services, we ultimately determine whether the data or inputs used by these outside services are observable or unobservable.

 

Financial assets and liabilities recorded on the Consolidated Balance Sheets are categorized based on the inputs to the valuation techniques as described in Item 8, Note 3, Page 121.

 

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Level 1 and Level 2 Valuation Techniques

 

Over 99 percent of the $12.466 billion of securities in our investment portfolio, measured at fair value, are classified as Level 1 or Level 2. Financial assets that fall within Level 1 and Level 2 are priced according to observable data from identical or similar securities that have traded in the marketplace. Also within Level 2 are securities that are valued by outside services or brokers where we have evaluated the pricing methodology and determined that the inputs are observable.

 

Level 3 Valuation Techniques

 

Financial assets that fall within the Level 3 hierarchy are valued based upon unobservable market inputs, normally because they are not actively traded on a public market. Pricing for each Level 3 security is based upon inputs that are market driven, including third-party reviews provided to the issuer or broker quotes. We placed in the Level 3 hierarchy securities for which we were unable to obtain the pricing methodology or we could not consider the price provided as binding. Pricing for securities classified as Level 3 could not be corroborated by similar securities priced using observable inputs.

 

Management ultimately determined the pricing for each Level 3 security that we considered to be the best exit price valuation. As of December 31, 2012, total Level 3 assets were less than 1 percent of our investment portfolio measured at fair value. Broker quotes are obtained for thinly traded securities that subsequently fall within the Level 3 hierarchy. We have generally obtained and evaluated two nonbinding quotes from brokers; our investment professionals determine our best estimate of fair value.

 

Employee Benefit Pension Plan

 

We have a defined benefit pension plan that was modified during 2008; refer to Item 8, Note 13 of the Consolidated Financial Statements, Page 130, for additional information. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates, expected return on plan assets and compensation increase rates, which are updated annually. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions.

 

Key assumptions used in developing the 2012 benefit obligation for our qualified plan were a 4.20 percent discount rate and rates of compensation increases ranging from 2.75 percent to 3.25 percent. To determine the discount rate, a hypothetical diversified portfolio of actual domestic Aa rated bonds was chosen to provide payments approximately matching the plan’s expected benefit payments. A single interest rate was determined based on the anticipated yield of the constructed portfolio.

 

Key assumptions used in developing the 2012 net pension expense for our qualified plan were a 5.10 percent discount rate, a 7.50 percent expected return on plan assets and rates of compensation increases ranging from 3.50 percent to 5.50 percent. See Note 13, Page 130 for additional information on assumptions.

 

In 2012, the net pension expense was $18 million. In 2013, we expect the net pension expense to remain unchanged at $18 million.

 

Holding all other assumptions constant, a 0.5 percentage-point decrease in the discount rate would decrease our 2013 income before income taxes by $1 million. A 0.5 percentage point decrease in the expected return on plan assets would decrease our 2013 income before income taxes by $1 million.

 

The fair value of the plan assets was $44 million less than the accumulated benefit obligation at year-end 2012 and $20 million less at year-end 2011. The fair value of the plan assets was $82 million less than the projected plan benefit obligation at year-end 2012 and $65 million less at year-end 2011. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. During the third quarter of 2012, we contributed $14 million to our qualified plan. We contributed $15 million to our qualified plan during the first quarter of 2013.

 

Deferred Policy Acquisition Costs

 

We establish a deferred asset for expenses associated with successfully acquiring property casualty and life insurance policies, primarily commissions, premium taxes and underwriting costs. Underlying assumptions are updated periodically to reflect actual experience, and we evaluate our deferred acquisition cost recoverability.

 

For property casualty policies, deferred acquisition costs are amortized over the terms of the policies. These costs are principally agent commissions, premium taxes and certain underwriting costs related to successful contract acquisition, which are deferred and amortized into net income as premiums are earned. We assess recoverability of deferred acquisition costs at the segment level, consistent with the ways we acquire, service, manage and measure profitability. Deferred acquisition costs track with the change in premiums. Our property casualty insurance operations consist of three segments, commercial lines, personal lines and excess and surplus lines.

 

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For life insurance policies, acquisition costs are amortized into income either over the premium-paying period of the policies or the life of the policy, depending on the policy type. These costs are principally agent commissions and underwriting costs related to successful contract acquisition. We analyze our acquisition cost assumptions periodically to reflect actual experience; we evaluate our deferred acquisition cost for recoverability; and we regularly conduct reviews for potential premium deficiencies or loss recognition. Changes in the amounts or timing of estimated future profits could result in adjustments to the accumulated amortization of these costs.

 

Profit-Sharing Commission Accrual

 

We establish an accrual for property casualty profit-sharing commissions. We calculate the profit-sharing commission accrual estimate based on property casualty underwriting results. Profit-sharing commissions are paid to agencies using a formula that takes into account agency profitability over one-year and three-year periods and premium volume. Due to the complexity of the calculation, timing of the accrual determination and the variety of allocation factors that can affect profit-sharing commissions for an individual agency, the amount accrued can differ from the actual profit-sharing commissions paid. The profit-sharing commission accrual of $102 million in 2012 contributed 3.1 percentage points to the property casualty combined ratio. If profit-sharing commissions paid were to vary from that amount by 5 percent, it would affect 2013 net income by $2 million (after tax), or 1 cent per share, and the combined ratio by approximately 0.1 percentage point.

 

Recent Accounting Pronouncements

 

Information about recent accounting pronouncements is provided in Item 8, Note 1, of the Consolidated Financial Statements, Page 112. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.

 

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Results of Operations

 

Consolidated financial results primarily reflect the results of our five reporting segments. These segments are defined based on financial information we use to evaluate performance and to determine the allocation of assets.

 

·Commercial lines property casualty insurance

 

·Personal lines property casualty insurance

 

·Excess and surplus lines property casualty insurance

 

·Life insurance

 

·Investments

 

We report as Other the noninvestment operations of the parent company and its noninsurer subsidiary, CFC Investment Company.

 

We measure profit or loss for our commercial lines, personal lines and excess and surplus property casualty and life insurance segments based upon underwriting results (profit or loss), which represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also frequently evaluate results for our consolidated property casualty insurance operations, which is the total of our commercial, personal, and excess and surplus insurance results. Underwriting results and segment pretax operating income are not substitutes for net income determined in accordance with GAAP.

 

For our consolidated property casualty insurance operations as well as the insurance segments, statutory accounting data and ratios are key performance indicators that we use to assess business trends and to make comparisons to industry results, since GAAP-based industry data generally is not as readily available.

 

Investments held by the parent company and the investment portfolios for the insurance subsidiaries are managed and reported as the investments segment, separate from the underwriting businesses. Net investment income and net realized investment gains and losses for our investment portfolios are discussed in the Investment Results of Operations.

 

The calculations of segment data are described in more detail in Item 8, Note 18, of the Consolidated Financial Statements, Page 137. The following sections provide analysis and discussion of results of operations for each of the five segments. Commercial Lines Insurance Results of Operations begins on Page 57, Personal Lines Insurance Results of Operations begins on Page 68, Excess and Surplus Lines Insurance Results of Operations begins on Page 74, Life Insurance Results of Operations begins on Page 77, and Investment Results of Operations begins on Page 79. We begin with an overview of our consolidated property casualty operations.

 

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Consolidated Property Casualty Insurance Results of Operations

 

Earned and net written premiums for our consolidated property casualty operations grew in 2012, reflecting better pricing and strategic initiatives for targeted growth. A key measure of property casualty profitability is underwriting profit or loss. Our 2012 underwriting profit of $137 million represents a $415 million improvement over the 2011 underwriting loss of $278 million. Part of the improvement was due to a $68 million decrease in natural catastrophe losses, mostly from severe weather. More importantly, underwriting results before catastrophe losses improved, demonstrating ongoing benefits from various recent-year profit improvement and premium growth initiatives that were designed to improve results over time.

 

The table below highlights property casualty results of operations, with analysis and discussion in the sections that follow.

 

Overview – Three-Year Highlights

 

(Dollars in millions)  Years ended December 31,   2012-2011   2011-2010 
   2012   2011   2010   Change %   Change % 
                     
Earned premiums  $3,344   $3,029   $2,924    10    4 
Fee revenues   6    4    4    50    0 
Total revenues   3,350    3,033    2,928    10    4 
                          
Loss and loss expenses from:                         
Current accident year before catastrophe losses   2,160    2,213    2,154    (2)   3 
Current accident year catastrophe losses   373    407    165    (8)   147 
Prior accident years before catastrophe losses   (357)   (280)   (287)   (28)   2 
Prior accident years catastrophe losses   (39)   (5)   (17)   (680)   71 
Total loss and loss expenses   2,137    2,335    2,015    (8)   16 
Underwriting expenses   1,076    976    962    10    1 
Underwriting profit (loss)  $137   $(278)  $(49)   nm    nm 
                          
           Pt. Change   Pt. Change 
Ratios as a percent of earned premiums:                         
Current accident year before catastrophe losses   64.6%   73.0%   73.6%   (8.4)   (0.6)
Current accident year catastrophe losses   11.1    13.4    5.6    (2.3)   7.8 
Prior accident years before catastrophe losses   (10.7)   (9.3)   (9.8)   (1.4)   0.5 
Prior accident years catastrophe losses   (1.1)   (0.1)   (0.5)   (1.0)   0.4 
Total loss and loss expenses   63.9    77.0    68.9    (13.1)   8.1 
Underwriting expenses   32.2    32.3    32.9    (0.1)   (0.6)
Combined ratio   96.1%   109.3%   101.8%   (13.2)   7.5 
                          
Combined ratio:   96.1%   109.3%   101.8%   (13.2)   7.5 
Contribution from catastrophe losses and prior years reserve development   (0.7)   4.0    (4.7)   (4.7)   8.7 
Combined ratio before catastrophe losses and prior years reserve development   96.8%   105.3%   106.5%   (8.5)   (1.2)

 

Performance highlights for consolidated property casualty operations include:

 

·Premiums – Strong growth in renewal and new business written premiums drove double-digit increases in 2012 earned premiums and net written premiums. The 2012 rate of growth for earned and net written premiums more than doubled that of 2011 as premium volume rose significantly in each of our property casualty segments. Higher and more precise pricing continues to benefit operating results and is further discussed in the results of operations sections below by segment. A fifth straight year of higher new business premiums reflected our premium growth initiatives from recent years that continue to favorably affect current year growth, particularly as newer agency relationships mature over time. Agents appointed during 2011 or 2012 produced an increase in standard lines new business of $35 million during 2012, compared with 2011. A higher level of insured exposures, reflecting improvement in some areas of the economy, also favorably affected premium growth, primarily in our commercial lines segment. The contributions to premiums from audits, which are significantly affected by economic trends, are further discussed in Commercial Lines Insurance Results of Operations beginning on Page 57.

 

Other written premiums – primarily premiums ceded to our reinsurers as part of our reinsurance program – contributed $49 million to the $384 million of growth in 2012 net written premiums. The change in other written premiums was primarily due to $42 million of ceded premiums in 2011 to reinstate coverage layers of our property catastrophe reinsurance treaty. There were no material ceded premium effects during 2012 or 2010 from unusual items such as reinstatement.

 

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The table below analyzes premium revenue components and trends. Premium trends by segment are further discussed beginning on Page 58, Page 69 and Page 74, for the respective property casualty segments.

 

(Dollars in millions)  Years ended December 31,   2012-2011   2011-2010 
   2012   2011   2010   Change %   Change % 
Agency renewal written premiums  $3,138   $2,867   $2,692    9    7 
Agency new business written premiums   501    437    414    15    6 
Other written premiums   (157)   (206)   (143)   24    (44)
Net written premiums   3,482    3,098    2,963    12    5 
Unearned premium change   (138)   (69)   (39)   (100)   (77)
Earned premiums  $3,344   $3,029   $2,924    10    4 

 

·Combined ratio – The 2012 combined ratio improved 13.2 percentage points compared with 2011, largely reflecting better pricing and other efforts that are lowering loss ratios before catastrophe losses. Lower catastrophe losses contributed 3.3 percentage points to the improved 2012 combined ratio. In 2011, additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty contributed 1.4 percentage points to the 2011 combined ratio.

 

The combined ratio before catastrophe losses and prior year reserve development also improved significantly in 2012, benefiting from recent-year initiatives to improve pricing precision and loss experience related to claims and loss control practices.

 

Our statutory combined ratio was 95.4 percent in 2012 compared with 108.9 percent in 2011 and 101.8 percent in 2010. The estimated statutory combined ratio for the property casualty industry, with the industry’s ratio excluding its mortgage and financial guaranty lines of business, was 106.2 percent in 2012, 106.5 percent in 2011 and 101.0 percent in 2010. The contribution of catastrophe losses to our statutory combined ratio was 10.0 percentage points in 2012, 13.3 percentage points in 2011 and 5.1 percentage points in 2010, compared with an estimated 9.4, 9.6 and 4.5 percentage points, respectively, for the industry. Components of the combined ratio are discussed below, followed by additional discussion by segment.

 

Catastrophe loss trends are an important factor in assessing trends for overall underwriting results. Our 10-year historical annual average contribution of catastrophe losses to the combined ratio was 6.1 percentage points at December 31, 2012. Our five-year average was 8.2 percentage points, below the 10.0 percent experienced for the year 2012. Incurred losses from a May 20-27, 2011, storm system that included Joplin, Missouri, represent the single-largest catastrophe event in our company’s history.

 

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The following table shows catastrophe losses incurred, net of reinsurance, for the past three years, as well as the effect of loss development on prior period catastrophe reserves.

 

Catastrophe Losses Incurred

 

(In millions, net of reinsurance)             Excess     
         Commercial   Personal   and surplus     
Dates  Event  Region  lines   lines   lines   Total 
2012                          
Feb. 28-29  Hail, wind, tornado  Midwest  $19   $6   $-   $25 
Mar. 2-3  Hail, wind, tornado  Midwest, South   30    48    -    78 
Mar. 18-25  Hail, lightning, wind  Northeast, South   2    4    -    6 
Apr. 28-29  Hail, lightning, wind  Midwest, South   53    26    1    80 
Jun. 11-13  Hail, lightning, wind  West, South   9    -    -    9 
Jun. 24-28  Fire  West   7    -    -    7 
Jun. 28-Jul. 2  Hail, lightning, wind  Midwest, Northeast, South   39    42    -    81 
Jul. 2-4  Hail, lightning, wind  Midwest, Northeast   7    5    -    12 
Sep. 7-8  Hail, lightning, wind  Midwest, Northeast, South   5    1    1    7 
Sep. 21-22  Hail, lightning, wind  Midwest   1    5    -    6 
Oct. 28-31  Sandy  Midwest, Northeast, South   20    10    -    30 
All other 2012 catastrophes      19    13    -    32 
Development on 2011 and prior catastrophes      (17)   (22)   -    (39)
Calendar year incurred total     $194   $138   $2   $334 
                           
2011                          
Jan. 31-Feb. 3  Freezing, wind  South, Midwest  $4   $3   $-   $7 
Feb. 21  Earthquake  New Zealand   4    -    -    4 
Feb. 27-28  Hail, wind, tornado  Midwest   3    6    -    9 
Mar. 11  Earthquake  Japan   7    -    -    7 
Mar. 26-28  Hail, wind  South   1    6    -    7 
Apr. 3-5  Hail, wind, tornado  South, Midwest   15    23    -    38 
Apr. 8-11  Hail, wind, tornado  South, Midwest   11    8    -    19 
Apr. 14-16  Hail, wind, tornado  South, Midwest   10    4    -    14 
Apr. 19-20  Hail, wind  South, Midwest   13    11    -    24 
Apr. 22-28  Hail, wind, tornado  South, Midwest   45    31    -    76 
May 20-27  Hail, wind, tornado  South, Midwest   42    51    -    93 
May 29-Jun. 1  Hail, wind, tornado  East, Midwest   2    1    -    3 
Jun. 16-22  Hail, wind, tornado  South, Midwest   7    6    -    13 
Jul. 1-4  Hail, wind, tornado  Midwest   3    2    -    5 
Jul. 10-14  Hail, wind, tornado  Midwest, West   4    6    -    10 
Aug. 18-19  Hail, wind, tornado  Midwest   9    1    -    10 
Aug. 26-28  Hurricane, wind, tornado  East   22    6    -    28 
Sep. 3-6  Tornado, wind  South   9    5    -    14 
All other 2011 catastrophes      14    11    1    26 
Development on 2010 and prior catastrophes      2    (7)   -    (5)
Calendar year incurred total     $227   $174   $1   $402 
                           
2010                          
Jan. 7-12  Freezing, wind  South, Midwest  $4   $1   $-   $5 
Feb. 9-11  Freezing, wind  East, Midwest   4    1    -    5 
Apr. 4-6  Hail, wind, tornado  South, Midwest   4    6    -    10 
Apr. 30-May 3  Hail, wind, tornado  South   21    6    -    27 
May 7-8  Hail, wind, tornado  East, Midwest   2    12    -    14 
May 12-16  Hail, wind, tornado  South, Midwest   7    2    -    9 
Jun. 4-6  Hail, wind, tornado  Midwest   2    2    1    5 
Jun. 17-20  Hail, wind, tornado  Midwest, West   5    3    -    8 
Jun. 21-24  Hail, wind, tornado  Midwest   2    3    -    5 
Jun. 25-28  Hail, wind, tornado  Midwest   3    5    -    8 
Jun. 30-Jul. 1  Hail, wind  West   4    4    -    8 
Jul. 20-23  Hail, wind, tornado  Midwest   12    4    -    16 
Oct. 4-6  Hail, wind  South   6    1    -    7 
Oct. 26-28  Hail, wind, tornado  Midwest   6    4    -    10 
All other 2010 catastrophes      19    9    -    28 
Development on 2009 and prior catastrophes      (12)   (5)   -    (17)
         $89   $58   $1   $148 

 

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Consolidated Property Casualty Insurance Loss and Loss Expenses

 

Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Most of the incurred losses and loss expenses shown in the consolidated property casualty insurance results three-year highlights table on Page 52 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid losses, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 86.4 percent accident year 2011 loss and loss expense ratio reported as of December 31, 2011, developed favorably by 4.9 percentage points to 81.5 percent due to claims settling for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2012. Accident years 2011 and 2010 have both developed favorably, as indicated by the progression over time for the ratios in the table.

  

(Dollars in millions)                        
Accident year loss and loss expenses incurred and ratios to earned premiums:             
Accident Year:  2012   2011   2010   2012   2011   2010 
as of December 31, 2012  $2,533   $2,467   $2,072    75.7%   81.5%   70.9%
as of December 31, 2011        2,620    2,140         86.4    73.2 
as of December 31, 2010             2,319              79.2 

 

Catastrophe loss trends, discussed above, explain much of the movement in current accident year loss and loss expense ratios for years 2010 through 2012. Catastrophe losses added 11.1 percentage points for 2012, 13.4 points for 2011 and 5.6 points for 2010 to the respective consolidated property casualty accident year loss and loss expense ratios in the table above.

 

The 64.6 percent ratio for current accident year loss and loss expenses before catastrophe losses for 2012 declined 8.4 percentage points compared with the 73.0 percent accident year 2011 ratio measured as of December 31, 2011. Large losses described below and the corresponding ratios for new losses above $250,000 caused a 1.9 percentage-point decrease in the 2012 ratio. The effect of the $42 million ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 1.0 percentage point. A refinement to our line of business allocation process for loss expenses reduced the 2011 accident year loss and loss expenses before catastrophes ratio by approximately 1.5 percentage points. We believe the remaining 7.0 percentage points of the reduction 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 refined allocation in 2011 had no effect on earnings or consolidated property casualty ratios reported on a calendar year basis. The allocation refinement pertained to the portion of loss expenses referred to as AOE, with the refined allocation to lines of business based on claim counts rather than the previous basis of claim dollar amounts. As a result of the allocation refinement, loss expense reserves for AOE at December 31, 2011, increased by $23 million for our personal lines insurance segment and decreased by $23 million for our commercial lines insurance segment. Discussion of AOE reserves is included in Critical Accounting Estimates, How Reserves Are Established, Page 43.

 

Reserve development on prior accident years continued to net to a favorable amount in 2012, as $396 million was recognized, higher than $285 million in 2011 and $304 million in 2010. Approximately 63 percent of our reserve development on prior accident years recognized during 2012 occurred in our commercial casualty and workers’ compensation lines of business. In 2011, those lines of business were responsible for approximately 80 percent of the favorable reserve development. As discussed in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92, those lines are considered long-tail lines with potential for revisions inherent in estimating reserves. Development recognized during 2010 was primarily from our commercial casualty line of business. Development by line of business is further analyzed in Consolidated Property Casualty Insurance Development of Estimated Reserves by Accident Year, Page 92.

 

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Consolidated Property Casualty Insurance Losses by Size

 

(Dollars in millions)  Years ended December 31,   2012-2011   2011-2010 
   2012   2011   2010   Change %   Change % 
New losses greater than $4,000,000  $68   $56   $49    21    14 
New losses $1,000,000-$4,000,000   161    173    142    (7)   22 
New losses $250,000-$1,000,000   205    217    200    (6)   9 
Case reserve development above $250,000   250    210    178    19    18 
Total large losses incurred   684    656    569    4    15 
Other losses excluding catastrophe losses   794    898    935    (12)   (4)
Catastrophe losses   321    395    148    (19)   167 
Total net losses incurred  $1,799   $1,949   $1,652    (8)   18 
                          
                 Pt. Change   Pt. Change 
Ratios as a percent of earned premiums:                         
New losses greater than $4,000,000   2.0%   1.9%   1.7%   0.1    0.2 
New losses $1,000,000-$4,000,000   4.8    5.7    4.8    (0.9)   0.9 
New losses $250,000-$1,000,000   6.1    7.2    6.8    (1.1)   0.4 
Case reserve development above $250,000   7.5    6.9    6.1    0.6    0.8 
Total large loss ratio   20.4    21.7    19.4    (1.3)   2.3 
Other losses excluding catastrophe losses   23.8    29.6    32.0    (5.8)   (2.4)
Catastrophe losses   9.6    13.1    5.1    (3.5)   8.0 
Total net loss ratio   53.8%   64.4%   56.5%   (10.6)   7.9 

 

In 2012, total large losses incurred increased by $28 million or 4 percent, net of reinsurance. The corresponding ratio decreased 1.3 percentage points, as earned premium growth more than doubled the rate of growth in total large losses. Large loss trends are further analyzed in the segment discussion and analysis that follows discussion of consolidated property casualty results. Our analysis of large losses incurred indicated no unexpected concentration of these losses and reserve increases by geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility 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 volatility in addition to general inflationary trends in loss costs.

 

Consolidated Property Casualty Insurance Underwriting Expenses

 

(Dollars in millions)  Years ended December 31,   2012-2011   2011-2010 
   2012   2011   2010   Change %   Change %