To Our Shareholders, Friends & Associates:
Steven J. Johnston (left), president and chief executive officer, with Kenneth W. Stecher, chairman of the board.
Highlights
Your company’s 2012 net operating income* of $393 million more than tripled last year’s result. We ended 2012 with shareholders’ equity up 8 percent, reflecting increased policyholder surplus of our property casualty insurance subsidiaries. Cash and marketable securities we hold at the parent-company level add to our stellar financial strength and liquidity.
Improvements made in 2012 and recent years have gained momentum. Their cumulative impact feeds our confidence that our current strategies are the right ones to take us forward. While high catastrophe losses early in the year masked improving trends in our property casualty insurance underwriting, those trends grew strong enough in the second half of 2012 to transform a $68 million first-half underwriting loss into a $137 million underwriting profit for the year.
Our full-year combined ratio was 96.1 percent points. On a statutory basis, it was 95.4 percent, nearly 11 points better than the estimated property casualty industry aggregate of 106.2 percent, per A.M. Best Co. We outperformed by making core underwriting progress, as indicated by 8.4 percentage points of improvement in our loss and loss expense ratio for the current accident year before catastrophe losses. Net written premiums rose 12 percent, boosted by new business premiums that for the first time reached the half-billion dollar mark.
One Team, One Vision
The growth and profitability initiatives that produced those results were designed to strengthen our competitive position and opportunities over the long term. We have more work to do to build on our progress – and more upside to realize from our ongoing efforts. We believe our combined ratio over any five-year period can be consistently within the range of 95 percent to 100 percent, and we can grow faster than the industry average. By the end of 2015, we estimate full-year direct written premiums from our property casualty and life operations can reach $5 billion.
Performing at these levels generates strong cash flow to expand our investment portfolio and increase investment income, further supporting our primary performance target of an annual value creation ratio averaging 10 percent to 13 percent for the period of 2013 through 2017. Our 2012 value creation ratio was 12.6 percent, resulting in a solid 12.4 percent average annual ratio for the four years beginning with 2009, when we adopted this performance metric, which considers increases in the book value of your company and your shareholder dividends.
To achieve our performance target, we have identified goals for every operational area and every individual. With clarity around our shared goals, your company’s management team and associates at every level are energized, focused and accountable. We have improved our data collection, analysis and communication to closely track progress and bring everyone together in support of our priority initiatives.
We are one team, with one vision: to create value by being the best insurance company for independent agents.
A Strong Competitor
We manage our business and our enterprise risks to position your company to perform through all economic and market cycles, supporting market stability for our agency customers. Challenges in the macro environment do create headwinds, and many of our improvements arise from anticipating and preparing for them. Here are four industry issues that have our attention and what we are doing about them.
Interest rates:
Over the past three years, interest rates generally have declined and credit spreads have tightened, depressing investment income from fixed-income securities. We relied in 2012 on dividend income increases from our common stocks to take our investment income up 1 percent, a good result relative to investment income declines for our industry. Our equity investment strategy gives us advantages; it powered $210 million of the $391 million increase in pretax unrealized investment gains and $37 million of net realized gains in 2012.
Low interest rates also led to increased unrealized gains from our fixed-maturity securities. The 2 percent to 3 percent contribution to our value creation ratio that resulted from those gains in the past three years is not expected to occur in the next five-year period. Strong underwriting results can help offset the effect of flat or falling bond valuations on our book value by giving us more cash to invest. During 2012, we invested close to half of net operating cash flow, after paying shareholder dividends, in equity securities. This was our first year since 2007 of positive net investment into common stocks.
Weather:
Many worry that severe convective storms and hurricanes are becoming the new normal. What we know is that while our 2012 catastrophe losses did not rise to the prior year’s record level, the 10 percentage points they added to the combined ratio exceeded our five-year average of 8.2 points and our 10-year average of 6.1 points. Our policyholders in the Midwest and Southeast felt the sting of a midsummer derecho, and policyholders in areas bordering Lake Erie were caught in Superstorm Sandy’s path.
Our property loss mitigation initiatives will help counter worsening storm losses. A multi-departmental, multi-disciplinary task force has reviewed our property business and made changes ranging from increasing the specialized expertise of our claims and loss control staff to revising underwriting guidelines and increasing property inspections. For commercial business, we are seeking approval for wind and hail deductibles in areas prone to convective storm losses, developing a named storm deductible for additional states and using new guidelines for underwriting hail risk.
For personal lines business, we are using more robust deductibles and covering older roofs at actual cash value rather than replacement cost. Homeowner rate increases in recent years also should improve our property results as the higher premiums are earned. In recent years, we nonrenewed policies in southeastern coastal areas that are most exposed to hurricanes, and we continued our gradual expansion into states less prone to catastrophes.
We continue to enhance our property catastrophe reinsurance program. Beginning in 2013, your company’s capital is further protected by a catastrophe bond that provides collateralized reinsurance covering severe convective storm losses in certain regions as well as supplemental coverage in the event of a New Madrid earthquake.
The marketplace:
With many worthy competitors in our industry and industry surplus on the rise, the current price firming in commercial lines could be difficult to sustain. This was only the second year of rate firming, yet some carriers reported competitive pressure that reduced the average size of price increases in the fourth quarter.
We are working diligently to achieve price adequacy, while also teaming with our agents to emphasize the Cincinnati value proposition and provide our best quote. On renewals and new business, we are using modeling tools to help our underwriting associates better target profitability and discuss pricing impacts with agency personnel. In 2012, our standard commercial lines policies averaged an estimated price increase in a mid-single-digit range. The higher pricing, along with improving economic conditions, led to an 8 percent increase in our commercial renewal written premiums. Commercial lines new business premiums rose 15 percent, with newer agencies appointed in 2011 and 2012 contributing more than half of the increase.
Rate increases for our personal lines business in 2012 averaged in the high single digits for homeowner policies and low single digits for auto policies. Personal lines renewal premiums rose 11 percent and new business premiums rose 17 percent, reflecting recent new agency appointments as well as the rate increases. For excess and surplus lines, average renewal pricing rose in the high-single-digit range, and new business premiums rose 9 percent, a lesser increase than for standard-market policies as we declined opportunities to write underpriced policies.
Agency ownership:
Our sampling of the issues we are paying attention to would not be complete without a comment on the changing independent agency landscape. The American Agency System is dynamic and growing, with the number of independent agencies increasing to 38,500, according to the 2012 Agency Universe Study. In 2012, we made 140 new agency appointments, ranging from start-up agencies with no revenues to agencies with over $100 million of premium written annually with all carriers they represent. That broad range is indicative of our full agency plant.
The challenge we embrace is to be the best carrier for each of them, even as they continue to evolve. The pace of mergers and acquisitions affecting our agencies has quickened over the past three years, with almost 60 transactions taking place in 2012. While many agencies remain independent and locally owned, others are independent, locally managed agencies owned by groups, banks or brokers.
For the latter, we maintain relationships at both the local and organizational level. We are committed to providing appropriate products and services that make us a significant contributor to the success of independent agencies of all sizes and ownership types. At the same time, we are willing to provide capital assistance to support private ownership, including new producer training, technology upgrades and perpetuation planning.
Good Returns
Each director who joins our board is an asset that we hope will benefit the company for many years, accumulating and applying knowledge of our company and our industry. In November 2012, we were fortunate to have Dirk J. Debbink return to his directorship after four years of active duty with the U.S. Navy. Dirk served as Reserve deputy commander of the U.S. Pacific Fleet; Commander, Navy Reserve Force; and as a senior member on the staff of the chief of naval operations in the Pentagon. We are proud to renew his relationship with you, our shareholders.
Another standout is the cash dividend record of your company. For 52 straight years, that dividend has increased, and now there are only nine U.S. publicly traded companies with a longer streak. The payout ratio of dividends to net income improved to 63 percent in 2012, and we believe we can further improve the ratio in 2013 by continuing to meet our insurance growth and profitability goals. Through all economic and market cycles, we intend to be predictable and trustworthy, returning value to you.
Respectfully,
/s/ Kenneth W. Stecher
Kenneth W. Stecher
Chairman of the Board
/s/ Steven J. Johnston
Steven J. Johnston, FCAS, MAAA, CFA, CERA
President and Chief Executive Officer
*The Definitions of Non-GAAP Information and Reconciliation to Comparable GAAP Measures are in our quarterly news releases, which are available on the Investors page of our website, www.cinfin.com.
