Cincinnati Financial Corporation
The Cincinnati Insurance Companies
The Cincinnati Insurance Companies
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Cincinnati Financial Corporation The Cincinnati Insurance Companies |
Cincinnati Financial Corporation 2007 Annual Report on Form 10-K February 29, 2008
In addition, you will find information about your company's strategies and initiatives in The Cincinnati Experience,
the Chairman and President's Letter
and our quarterly letters to shareholders, as they become available. Together with the detailed analysis of the
2007 Annual Report on Form 10-K,
these documents comprise a package of information similar to what appeared in our previous annual reports.
 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 to market property casualty insurance, which is our main
business. Our headquarters is in Fairfield, Ohio. At year-end 2007, we had 4,087 associates,
with 2,924 headquarters associates providing support to 1,163 field associates.
Cincinnati Financial Corporation owns 100 percent of four subsidiaries: The Cincinnati
Insurance Company, CSU Producer Resources Inc., CFC Investment Company and CinFin Capital
Management Company. In addition, the parent company has an investment portfolio, owns the
headquarters building and is responsible for corporate borrowings and shareholder dividends.
The Cincinnati Insurance Company owns 100 percent of our four insurance subsidiaries.
In addition to The Cincinnati Insurance Company, our standard market property casualty
insurance group includes subsidiaries The Cincinnati Casualty Company and The Cincinnati
Indemnity Company. This group markets a broad range of business, homeowner and auto policies
in 34 states. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati
Life Insurance Company, which markets life insurance policies, disability income policies
and annuities, and The Cincinnati Specialty Underwriters Insurance Company, which began
offering excess and surplus lines insurance products in January 2008.
The three other subsidiaries of Cincinnati Financial 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; CFC Investment Company, which offers
commercial leasing and financing services to our agents, their clients and other customers;
and CinFin Capital Management Company, which provides asset management services to
institutions, corporations and individuals.
Our filings with the Securities and Exchange Commission are available, free of charge, on
our Web site, www.cinfin.com, as soon as possible after they have been filed with the SEC.
These filings include our annual reports on Form 10-K, our 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 Web sites. These Web sites, 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 basis. When we provide our results on a comparable statutory basis,
we label it as such; all other company data is presented in accordance with accounting
principles generally accepted in the United States of America (GAAP).
Our Business and Our Strategy
Introduction
Our company was founded more than 50 years ago by independent agents to support the ability
of local independent property casualty insurance agents to deliver quality financial
protection to people and businesses in their communities. Today, we operate much the same
way, actively marketing standard market commercial insurance policies in 34 states through a
select group of independent insurance agencies. We actively market all of our personal lines
insurance policies in 22 of those states and began in January 2008 to market excess and
surplus lines policies in five states through the same agencies that offer our standard
market property casualty insurance products. We also seek to become the life insurance
carrier of choice for the agencies that market our property casualty insurance products and
offer other financial services to help agents and their clients, the policyholders.
Our company distinguishes itself in three key ways:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 1 Cultivating Relationships with Independent Insurance Agents
The U.S. property casualty insurance industry is a highly competitive marketplace with over
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:
In addition to the widely known standard market for property casualty insurance, the excess
and surplus lines market exists due to a regulatory distinction. Generally, excess and
surplus lines insurance carriers provide insurance that is unavailable to businesses in the
standard market due to market conditions or due to characteristics of the insured that are
caused by nature, the insured’s history or the nature of their business. Insurers operating
in the surplus lines market are generally small, specialty insurers or specialized divisions
of larger insurance organizations. Each markets through surplus lines insurance brokers.
Standard market property casualty insurers generally offer their products through one or
more distribution channels:
Some carriers use more than one channel. For the most part, we compete with standard market
insurance companies that market through independent insurance agents.
Independent Agency Distribution System
We are committed to the independent agency distribution system, offering our broad array of
insurance products through this channel. We recognize that locally based independent
agencies have relationships in their communities that can lead to policyholder satisfaction,
loyalty and profitable business. Our field associates provide service and accountability to
the agencies, living in the communities they serve and working from offices in their homes,
providing 24/7 availability to our agents.
At year-end 2007, our 1,092 agency relationships had 1,327 reporting agency locations
marketing our standard market insurance products. An increasing number of agencies have
multiple, separately identifiable locations, reflecting their growth and consolidation of
ownership within the independent agency marketplace. Reporting agency locations describes
our agents’ scope of business and our presence within our 34 active states. At year-end
2006, our 1,066 agency relationships had 1,289 reporting agency locations marketing our
insurance products. At year-end 2005, we had 1,024 agency relationships with 1,252 reporting
agency locations. In addition to providing data on reporting agency locations, we continue
to give agency relationships metrics, such as our penetration within each agency
relationship.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 2 Property Casualty Earned Premiums by State
In our 10 highest volume states, 882 reporting agency locations wrote 69.1 percent of our
2007 total standard market property casualty earned premium volume compared with 70.0
percent in 2006.
In 2006, the most recent period for which data is available, Cincinnati Insurance was the
No. 1 or No. 2 carrier in approximately 75 percent of the reporting agency locations that
have represented us for more than five years. The independent agencies that we choose to
market our products share our philosophies. They do business person to person; offer broad,
value-added services; maintain sound balance sheets and manage their agencies
professionally. On average, we have a 14.9 percent share of the property casualty insurance
in our reporting agency locations. Our share is 20.5 percent in reporting agency locations
that have represented us for more than 10 years; 9.7 percent in agencies that have
represented us for five to 10 years; 4.6 percent in agencies that have represented us for
one to five years; and 0.8 percent in agencies that have represented us for less than one
year.
Over the next decade, industry analysts predict successful agencies will have opportunities
to increase their size on average almost three-fold. Agencies are expected to continue to
pursue consolidation opportunities, buying or merging with other agencies to create stronger
organizations and expand service. In addition to the growing networks of agency locations
owned by banks and brokers, other agencies are addressing the consolidation by forming
voluntary associations. These associations, or “clusters,” share back office and other
functions to enhance economies, while maintaining their individual ownership structures.
Our largest single
agency relationship accounted for approximately 1.2 percent of our total agency earned
premiums in 2007. No aggregate of locations under a single ownership structure accounted for
more than 2.5 percent of our total agency earned premiums in 2007.
Strengthening Our Agency Relationships
We follow a number of strategies to strengthen our relationships with the independent
property casualty insurance agencies that market our products.
Emphasis on Relationships and Local Decision-making
We continue to expand the services we provide that support agency opportunities. Accessible
field representatives are the first layer of support. Headquarters associates also provide
agencies with underwriting, accounting and technology assistance and training. Company
executives, headquarters underwriters and special teams regularly travel to visit agencies.
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 marketing representatives are joined by field representatives specializing in
claims, loss control, machinery and equipment, bond, premium audit, life insurance and
leasing. For example, our field machinery and equipment and loss control representatives
perform inspections and recommend specific actions to improve the safety of the
policyholder’s operations and the quality of the agent’s account.
Agents tell us they agree with the need to carefully select risks and assure pricing
adequacy. They appreciate the time our associates invest in creating solutions for their
clients while protecting profitability, whether that
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means working on an individual case or developing modified policy terms and conditions that preserve flexibility, choice and other
sales advantages.
Risk-specific Underwriting
We seek to be a consistent, predictable and reasonable property casualty carrier that
agencies can rely on to serve their clients. Our field and headquarters underwriters make
risk-specific decisions about both new business and renewals. On a case-by-case basis, we
select risks we can cover on acceptable terms and at adequate prices rather than
underwriting solely by geographic location or business class.
For new commercial lines business, this case-by-case underwriting and pricing is coordinated
by the local field marketing representatives. Our agents and our field marketing, 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.
We apply our risk-specific underwriting philosophy to personal lines new and renewal
business in a different process. Each agency selects personal lines business 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. New and renewal business activities are
supported by headquarters associates assigned to individual agencies.
Competitive Insurance Products
We are committed to offering the property casualty products and services local agents need
to serve their clients — the policyholders. Our products are structured to allow flexible
combinations of property and liability coverages in a single package with a single
expiration date. 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.
Our commercial lines packages are typically offered on a three-year policy term for most
insurance coverages, a key competitive advantage. 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 cancelled 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. 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, competition and other underwriting judgment factors. We
estimate that approximately 75 percent of 2007 commercial premiums were subject to annual
rating or were written on a one-year policy term.
In our experience, multi-year packages are somewhat less price sensitive for 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.
Our personal lines policies are offered on a one-year term, except homeowner policies in
three states that represent less than one percent of total personal lines premium volume.
Competitive advantages of our personal lines coverages include our credit structure and
customizable endorsements for both the personal auto and homeowner policies. A newly
introduced personal auto policy endorsement is replacement cost coverage for newly purchased
vehicles. Popular homeowner endorsements include replacement cost for contents, inflation
guard, identity theft expense coverage and advocacy services, flexible water damage
coverages and enhanced replacement cost coverage for older homes.
Technology Solutions
We seek to employ technology solutions and business process improvements that complement our
core values of local underwriting decisions, strong relationships with our independent
agencies and superior claims service.
In recent years, we have made significant investments in state-of-the-art information
technology platforms, systems and Internet-based applications to:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 4
Agencies access our systems and other electronic services via CinciLink®, our secure
agency-only portal. CinciLink provides an array of Web-based services and content that make
it easier to do business with us, such as commercial and personal lines rating and
processing systems, policy loss information, sales and marketing materials, educational
courses on our products and services, and electronic libraries for property and casualty
coverage forms and state rating manuals.
Commercial Lines Technology — WinCPP® is our commercial lines premium quoting system.
WinCPP is available in all of our agency locations in 32 of the 34 states in which we
actively market insurance and provides quoting capabilities for nearly 100 percent of our
new and renewal commercial lines business. In 2008, we plan to introduce WinCPP in our
newest states — Washington and New Mexico. WinCPP provides a real-time agency interface,
CinciBridge™, which allows automated movement of key underwriting data from an agent’s
management system to WinCPP, reducing agents’ data entry and allowing seamless quoting and
rating capabilities.
Many small
business accounts written as Businessowners Policies (BOP) and Dentist’s Package
Policies (DBOP) are eligible to be issued at our agency locations through our Web-based
e-CLAS®
policy processing system. (A businessowners policy combines property, liability and
business interruption coverages for small businesses.) e-CLAS provides full policy lifecycle
transactions including: quoting, issuance, policy changes, renewal processing and policy
printing at the agency location. These features make it easier and more efficient for our
agencies to issue and service these policies. At year-end 2007, e-CLAS was in use in 17
states representing 85 percent of our BOP and DBOP premiums, which are included in the
specialty packages commercial line of business. We continue to roll out e-CLAS to additional
states for these policy types, including two new states since the beginning of 2008. e-CLAS
also utilizes CinciBridge to provide real-time agency interface. Our primary long-term
technology objective is to complete development of e-CLAS for all of our commercial lines of
business.
To respond to agency needs, a direct bill payment option is being made available for
commercial lines policyholders. Our first step is to make the direct bill option available
for policies issued through e-CLAS. We rolled out this capability to selected agencies in
2007 with full agency rollout in early 2008. Similar direct billing capability for selected
commercial policies not issued through e-CLAS is anticipated by the end of 2008 with the
intent to offer this capability for all policies as soon as practicable.
Since 2004, we have been streamlining internal processes and achieving operational
efficiencies in our headquarters commercial lines operations through deployment of iView™, a
policy imaging and workflow system. This system provides online access to electronic copies
of policy files, enabling our underwriters to respond to agent requests and inquiries more
quickly and efficiently. iView also automates internal workflows through electronic routing
of underwriting and processing work tasks. At year-end 2007, more than 74 percent of
in-force non-workers’ compensation commercial lines policy files were administered and
stored electronically in iView.
E&S Technology — Cincinnati Specialty Underwriters and CSU Producer Resources employ a
Web-based policy administration system to quote, bind, issue and deliver policies
electronically to agents. This system also provides integration to existing document
management and data management systems, allowing for straight-through processing of policies
and billing.
Personal Lines Technology — Diamond is a real-time personal lines policy processing system,
supporting all six of our personal lines of business and allowing once and done processing.
Diamond incorporates features frequently requested by our agencies such as direct bill and
monthly payment plans, local and headquarters policy printing options, data transfer to and
from popular agency management systems and real-time integration with data from third-party
sources needed to calculate final premiums such as insurance scores, MVR reports and address
verification. At year-end 2007, Diamond was in use in 17 states representing approximately
97.5 percent of our personal lines premium volume. In 2008, we expect to deploy Diamond to
agencies in eight additional states. Although we already market personal lines products in
Maryland, Montana, New Hampshire, North Carolina and Vermont, we expect agencies in these
states to respond favorably to Diamond’s advantages. We also expect to deploy Diamond to
agencies in Arizona, South Carolina and Utah, new markets for our personal lines products.
In 2006, we introduced PL-efiles, a policy imaging system, to our personal lines operations.
Through year-end 2007, we had transitioned information on current Diamond personal lines
policies to PL-efiles and continue to work on imaging older policy information. The transition replaces paper format with
electronic copies of policy documents. PL-efiles complements the Diamond system by giving
personal lines underwriters and support staff
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 5 online access to policy documents and data
that enable them to respond to agent requests and inquiries quickly and efficiently.
Claims Technology — Our property and casualty claims operation has streamlined processes
and achieved operational efficiencies through the use of CMS, our claims file management
system. Initially deployed in late 2003, CMS allows field and headquarters claims associates
to process all reported claims in a virtual claim file. We continue to refine the system to
add capabilities to make our associates more effective. During 2006, we issued tablet
computers to our field claims representatives. These units allow our claims representatives
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. Agency access to selected
CMS information was tested in the fourth quarter of 2007, with the full rollout due to be
completed in early 2008.
Life Insurance Offerings Strengthen Agency Relationships
We support the independent agencies affiliated with our property casualty operations in
their programs to sell life insurance. The products offered by our life insurance subsidiary
round out and protect accounts and improve account persistency. At the same time, the life
operation looks to increase 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. We also develop life business from other independent life insurance agencies to
provide us with penetration in geographic markets not served through our property casualty
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. We emphasize up-to-date products, responsive underwriting, high quality service
and competitive pricing.
Excess and Surplus Lines Operation Further Enhances Agency Relationships
In January 2008, we began accepting excess and surplus lines business from Cincinnati’s
independent agencies in Georgia, Illinois, Indiana, Ohio and Wisconsin. These agencies have
access to The Cincinnati Specialty Underwriters Insurance Company’s product line through CSU
Producer Resources, the new, wholly owned insurance brokerage subsidiary of parent-company
Cincinnati Financial Corporation. CSU Producer Resources has binding authority on all
classes of business written through CSU and maintains appropriate agent and surplus lines
licenses to process non-admitted business. CSU and CSU Producer Resources plan to expand
into all states except Delaware on an excess and surplus lines basis as the new companies
obtain the necessary state regulatory approvals.
We structured our new E&S operations 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 E&S coverages, those agencies
now can write the whole account with Cincinnati, gaining benefits not often found in the
broader E&S market.
Producers can submit risks to CSU Producer Resources from a variety of classes, reflecting
the mix of accounts Cincinnati agencies currently write in their non-admitted E&S markets.
CSU Producer Resources currently markets and underwrites general liability coverages and
plans to expand this to include commercial property, multi-peril insurance, miscellaneous
professional liability and excess casualty in coming months.
Agency producers have direct access through CSU Producer Resources to our dedicated E&S
underwriters, and they also can tap into their agencies’ broader Cincinnati relationships to
bring their policyholders services such as experienced and responsive loss control and
claims handling. Our new E&S policy administration system delivers electronic copies of
policies to producers within minutes of underwriting approval and policy issue. CSU Producer
Resources gives extra support to our producers by remitting surplus lines taxes and stamping
fees and retaining admitted market affadavits, where required.
CSU was capitalized with $200 million from its parent company, The Cincinnati Insurance
Company. That high level of funding underscores our commitment to help our independent
agencies. Everything we do to increase their competitive advantages and success also helps
us achieve our own long term growth and profitability goals.
Programs, Products and Services to Support Agency Growth
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 at our headquarters, in
regional and agency locations, and online fulfill this commitment:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 6
Except travel-related expenses for courses 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 financial services available
through our non-insurance subsidiaries. We believe that providing these services enhances
agency relationships with their clients, increasing loyalty while diversifying the agency’s
revenues. CFC Investment Company offers equipment and vehicle leases and loans for
independent insurance agencies, their commercial clients and other businesses. It also
provides commercial real estate loans to help agencies operate and expand their businesses.
CinFin Capital Management markets asset management services to agencies and their clients,
as well as other institutions, corporations and individuals.
Superior Financial Strength Ratings
In addition to the ratings of our parent company senior debt, independent ratings firms
award our property casualty and life operations insurer financial strength ratings based on
their quantitative and qualitative analyses. These ratings assess an insurer’s ability to
meet its financial obligations to policyholders and do not necessarily address all of the
matters that may be important to shareholders.
We believe that our strong surplus position and superior insurer financial strength ratings
are clear, competitive advantages in the segment of the insurance marketplace that our
agents serve. Our financial strength supports the consistent, predictable performance that
our policyholders, agents, associates and shareholders have always expected and received,
and it must be able to withstand significant challenges. We seek to ensure that our
performance remains consistent and predictable by aligning agents’ interests with those of
the company, giving them outstanding service and compensation and earning their best
business by enhancing their ability to serve the businesses and individuals in their
communities.
As of February 29, 2008, financial strength ratings were unchanged from those reported for
our standard market property casualty and life operations in our 2006 Annual Report on Form
10-K. As of December 21, 2007, our new excess and surplus lines subsidiary was awarded its
first financial strength rating, an A (Excellent) with a stable outlook, from A.M. Best.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 7
Statutory surplus for our property casualty insurance group was $4.307 billion at year-end
2007, with the ratio of the group’s investments in common stock to statutory surplus at 84.5
percent, in line with our targeted sub-100 percent level. Statutory surplus for our property
casualty insurance subsidiary was $4.750 billion at year-end 2006, with the ratio of the
group’s investments in common stock to statutory surplus to statutory surplus at 96.7
percent. The life insurance company’s statutory surplus was $477 million at year-end 2007,
with the ratio of life insurance company’s investments in common stock to statutory adjusted
capital and surplus at 70.6 percent. Life statutory surplus was $479 million at year-end
2006, with the ratio at 88.8 percent.
Cincinnati Life’s statutory adjusted risk-based surplus decreased 8.9 percent to $506
million at year-end 2007, from $556 million a year earlier. Statutory adjusted risk-based
surplus as a percentage of liabilities, a key measure of life insurance company capital
strength, was 28.5 percent at year-end 2007 compared with an estimated industry average
ratio of 10.9 percent. A higher ratio indicates an insurer’s stronger security for
policyholders and capacity to support business growth.
At year-end 2007 and 2006, the risk-based capital (RBC) for our property casualty and life
operations was exceptionally strong and well above levels that would have required
regulatory action.
We continue to review the risk management and capital requirement changes that rating
agencies have suggested for our industry. Additionally, we began a formal implementation of
enterprise risk management in 2005. Responsibility for enterprise risk management has been
assigned at the officer level, supported by a team of representatives from business areas.
The team reports to our president, our chief executive officer and our board of directors,
as appropriate, on detailed and summary 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.
While the potential for volatility exists due to our catastrophe exposures, investment
philosophy and bias toward incremental change, the ratings agencies consistently have
asserted that we have built appropriate financial strength and flexibility to manage that
volatility. We remain committed to strategies that emphasize long-term stability over
short-term benefits that might accrue by quick reaction to changes in market conditions.
For example, through all market and economic cycles we maintain strong insurance company
statutory surplus, a solid, conservative reinsurance program, sound reserving practices and
low interest rate risk, as well as low debt and strong capital at the parent-company level.
Investments at the parent company give us flexibility to support our capitalization policies
for the subsidiaries, improve the ability of the insurance companies to write additional
premiums and maintain high insurer financial strength ratings for the protection of
policyholders.
We believe that our property catastrophe reinsurance program provides adequate protection
for large loss events. Our strong capital position would allow the payment of claims if an
event exceeded our reinsurance program. Currently participating on our property per risk and
casualty per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance
America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation
and its subsidiaries, all of which have A.M. Best insurer financial strength
ratings of A (Excellent) or A+ (Superior). Over the past several
years, we also modified policyholder deductibles
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 8 for both commercial and personal lines property coverages to reduce our exposure
to a single significant catastrophic event.
Our ratio of property casualty net written premiums to statutory surplus was 0.7 at year-end
2007, 2006 and 2005. This ratio is a common measure of operating leverage used in the
property casualty industry. It serves as an indicator of the company’s premium growth
capacity. The estimated property casualty industry net written premium to statutory surplus
ratio was 0.8 at year-end 2007, 0.9 at year-end 2006 and 1.0 at year-end 2005.
Growing with Our Agencies
One of our primary objectives is to increase our written premiums more rapidly than the
industry. We believe our agencies are growing more rapidly than the industry, and we seek to
maintain or increase our share of each agency’s business as it grows.
To help us maintain or increase our share within each agency, we are further improving
service through the creation of smaller marketing territories that permit our local field
marketing representatives to devote more time to each agency relationship. At year-end 2007,
we had 106 field marketing territories, up from 102 at the end of 2006 and 100 at the end of
2005. In 2007, we also appointed our first agencies in eastern
Washington and New Mexico, our 33rd and 34th states of operation. While we continually study the
regulatory and competitive environment in states where we could decide to actively market
our property casualty products, we have not announced plans to enter any of those states in
the near future.
Another way we seek to increase overall premiums is to expand our agency plant within our
current marketing territories. Our objective is to appoint additional sales offices, or
points of distribution, each year. We are targeting 65 appointments in 2008.
In measuring progress towards this goal, we include appointment of new agency relationships
with Cincinnati (the primary focus of our goal). For those that we believe will produce a
meaningful amount of new business premiums, we also include appointment of agencies that
merge with a Cincinnati agency and new branch offices opened by existing Cincinnati
agencies. We made 66, 55 and 57 new appointments in 2007, 2006 and 2005, respectively. Of
these new appointments, 50, 42 and 41, respectively, were new relationships. These new
appointments and other changes in agency structures led to a net increase in reporting
agency locations of 38 in 2007, 37 in 2006 and 39 in 2005. We are very careful to protect
the franchise for current agencies when selecting and appointing new agencies.
Achieving Claims Excellence
Our claims philosophy reflects our belief that we will 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. We also believe that our company should have the financial strength to pay
claims while also creating value for shareholders, leading to our emphasis on the
establishment of adequate loss reserves.
Superior Claims Service
Our 748 locally based field claims representatives 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.
Catastrophe response teams are comprised of volunteers from our experienced field claims
staff. As hurricanes threaten, these associates travel to strategic locations near the
expected impact area. This puts them in position to quickly get to the affected area, set up
temporary offices and start calling on policyholders. Cincinnati takes pride in giving our
field personnel the tools and authority they need to do their jobs. In times of widespread
loss, our field claims representatives confidently and quickly resolve claims, often writing
checks for damages 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 of policyholders and easy sharing of information between rotating storm
teams, headquarters and local field claims representatives.
Cincinnati’s claims associates work hard to control costs where appropriate. They have
vendor resources that provide negotiated pricing to our insureds and claimants and that help
us determine appropriate pricing for medical cost-related claims. 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 with former law enforcement and claims professionals
who are available to gather facts to uncover potential fraud. While we believe it’s our job
to pay what is due under each policy, we also want to prevent false claims from unfairly
increasing overall premiums. Our SIU also operates a computer
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 9 forensic lab, using sophisticated software to recover data and mitigating the cost of
computer-related claims for business interruption and loss of records.
Loss and Loss Expense Reserves
When claims are made by or against policyholders, any amounts that our property casualty
operations pay or expect to pay for covered claims are termed losses. The costs we incur in
investigating, resolving and processing these claims are termed loss expenses. Our
consolidated financial statements include property casualty loss and loss expense reserves
that estimate the costs of not-yet-paid claims incurred through December 31 of each year.
The reserves include estimates for claims that have been reported to us plus our estimates
for claims that have been incurred but not yet reported called IBNR, along with our estimate
for loss expenses associated with processing and settling those claims. We develop the
various estimates based on individual claim evaluations and statistical projections. We
reduce the loss reserves by an estimate for the amount of salvage and subrogation we expect
to recover. For over 10 years, our annual review has led us to report savings from favorable
development of loss reserves on prior accident years.
We encourage you to review several sections of the Management’s Discussion and Analysis
where we discuss our loss reserves in greater depth. In Item 7, Critical Accounting
Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 37, we discuss
our process for analyzing potential losses and establishing reserves. In Item 7, Property
Casualty Insurance Reserves, Page 65, we review reserve levels, including 10-year
development of our property casualty loss reserves.
Investing For Long-Term Total-Return
While we seek to generate an underwriting profit in our insurance operations, our
investments historically have provided our primary source of net income and contributed to
our financial strength, driving long-term growth in shareholders’ equity and book value.
Under the direction of the investment committee of the board of directors, our investment
department portfolio managers seek to balance current investment income opportunities and
long-term appreciation so that current cash flows can be compounded to achieve above-average
long-term total return. We invest some portion of cash flow in tax-advantaged fixed-maturity
and equity securities to maximize after-tax earnings. Premium payments, generally received
before claims are made, particularly for casualty business lines, create substantial cash
flow for investment.
Insurance regulatory and statutory requirements established to protect policyholders from
investment risk have always influenced our investment decisions on an individual insurance
company basis. 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 significantly to total portfolio net unrealized
investment gains of $3.339 billion (pretax) at year-end 2007. We remain committed to our
long-term equity focus, which we believe is key to our company’s long-term growth and
stability.
Our Segments
Consolidated financial results primarily reflect the results of our four reporting segments.
These segments are defined based on financial information we use to evaluate performance and
to determine the allocation of assets.
We also evaluate results for our consolidated property casualty operations, which is the
total of our commercial lines and personal lines segments. Revenues generated by our
consolidated property casualty operations were a lower percent of the total in 2007 and 2006
due to sales of investment assets, which are included in the investments segment results.
Revenues, income before income taxes, and identifiable assets for each segment are shown in
a table in Item 8, Note 17 of the Consolidated Financial Statements, Page 105. 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 the
Management’s Discussion and Analysis of Financial Condition and Results of Operations, which
begins on Page 32.
Commercial Lines Property Casualty Insurance Segment
The commercial lines property casualty insurance segment contributed $2.411 billion of net
earned premiums to total revenues and $261 million to income before income taxes in 2007.
Commercial lines net earned premiums grew 0.4 percent in 2007, 6.6 percent in 2006 and 6.0
percent in 2005.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 10 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:
Our emphasis is on products that agents can market to small- to mid-size businesses in their
communities. Of our 1,327 reporting agency locations, six market only our surety and
executive risk products and three market only our personal lines products. The remaining
1,318 locations, located in all 34 states in which we actively market, offer some or all of
our standard market commercial insurance products.
In 2007, our 10 highest volume commercial lines states generated 66.7 percent of our earned
premiums compared with 67.7 percent in the prior year. Earned premiums in the 10 highest
volume states decreased 1.1 percent in 2007 but rose 3.5 percent in the remaining 24 states.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 11 Commercial Lines Earned Premiums by State
Commercial Lines Insurance Marketplace
For commercial lines, our competition for the types and sizes of accounts we typically write
in the standard market, predominantly consists of those companies that also distribute
through independent agencies. The independent agencies that market our commercial lines
products typically represent six to 12 standard market insurance carriers, including both
national and regional carriers, some of which may be mutual companies.
Softening market conditions in recent years have blurred the distinctions between national
and regional carriers; however, we often observe certain characteristics as we compete
within each agency. National and many regional carriers are more likely to appoint a greater
number of agencies and focus on specific types of products or certain size accounts. They
often seek to take greatest advantage of tools that enhance their efficiency and the ease of
doing business with their organization. Time-intensive services may be offered only to
larger accounts. They may be less interested in the smaller accounts that require
significant attention. Regional carriers are more likely to utilize an agency strategy,
focusing on differentiating themselves through relationships and service. They often seek to
place decision-making closer to the local market level and have begun to target larger
accounts to develop or retain their position within agencies. In our experience, the level
of competition varies state by state and region by region, regardless of the mix of carriers
represented within a specific agency.
Overall, the softening commercial lines marketplace of the past several years continued to
intensify in 2007. Over this period, anecdotal reports of very aggressive pricing have grown
in frequency. Over the course of 2007, we saw more situations where underwriting discipline
appeared to slip as carriers sought to capture market share. Many carriers appear to be
managing the soft market conditions by working aggressively to protect their renewal
portfolios.
Personal Lines Property Casualty Insurance Segment
The personal lines property casualty insurance segment contributed $714 million of net
earned premiums to total revenues and $43 million to income before income taxes in 2007.
Personal lines net earned premiums declined 6.3 percent in 2007 and 5.3 percent in 2006
after rising 1.4 percent in 2005.
We prefer to write personal lines coverage on an account basis that includes both auto and
homeowner coverages as well as coverages that are part of our other personal business line.
As a result, 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:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 12
We market both homeowner and personal auto insurance products through 812 of our 1,327
reporting agency locations in 22 of the 34 states in which we offer standard market
commercial lines insurance. We market homeowner products through 21 locations in three
additional states (Maryland, North Carolina and West Virginia.) The remaining 494 locations
largely are in states where we do not yet actively market these products. A smaller number
are those where we have determined, in conjunction with agency management, that our personal
lines products are not appropriate for their agencies at this time.
In 2007, our 10 highest volume personal lines states generated 84.9 percent of our earned
premiums compared with 84.7 percent in the prior year. Earned premiums in the 10 highest
volume states declined 6.5 percent in 2007 and declined 5.2 percent in the remaining states.
Personal Lines Earned Premiums by State
Personal Lines Insurance Marketplace
In addition to carriers that market through independent agents, our personal lines
competition also includes carriers that market through captive agents and direct writers,
which our agencies’ clients may investigate independently. The independent agencies that
market our personal lines products typically represent four to six standard personal lines
carriers.
Over the past several years, we have seen increased competition in the personal lines
marketplace, driven by industrywide improvement in results and favorable frequency and
severity trends. The increased competition in the past several years also reflected
implementation of tiered rating systems by a growing number of carriers. Carriers that have
adopted these systems rely on increasingly more data to identify multiple relevant variables
to segment the market, including credit-based information.
We expect that competition in the personal auto and homeowner markets will continue to
increase over the next 12 to 24 months. Many personal lines carriers have reported strong
operating results in the past three years and continue to have healthy capital to support
business growth. We believe these carriers are focused on gaining market share through the
introduction of new products and services and increased advertising expenditures.
Life Insurance Segment
The life
insurance segment contributed $125 million of net earned premiums and $3 million in
income before income taxes in 2007. Life insurance segment profitability is discussed in
detail in Item 7, Life Insurance Results of Operations, Page 56. Life insurance net earned
premiums grew 9.0 percent in 2007, 7.9 percent in 2006 and
5.7 percent in 2005.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 13 The overall mission of our company is supported by The Cincinnati Life Insurance Company.
Cincinnati Life helps meet the needs of our agencies, including increasing and diversifying
agency revenues. We primarily focus on life products that produce revenue growth through a
steady stream of premium payments. 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.
Cincinnati Life seeks to become the life insurance carrier of choice for the independent
agencies that work with our property casualty operations. We emphasize up-to-date products,
responsive underwriting and high quality service as well as competitive commissions. At
year-end 2007, approximately 82 percent of our 1,327 property casualty reporting agency
locations offered Cincinnati Life’s products to their clients. We also develop life business
from 545 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.
Life Insurance Business Lines
Four lines of business — term insurance, universal life insurance, worksite products and
whole life insurance — account for approximately 91.5 percent of the life insurance
segment’s revenues:
In addition, Cincinnati Life markets:
Life Insurance Marketplace
Our property casualty agencies comprise the main distribution system for our life insurance
segment. While other life insurance carriers continue to expand the use of nontraditional
distribution channels, such as banks or direct sales as alternatives to the agency channel,
we intend to market solely through independent agencies,
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 14 with an emphasis on enhancing
relationships with agencies affiliated with our property casualty insurance operations.
When marketing through our property casualty agencies we have specific competitive
advantages:
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 combining financial strength and stability.
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+ (Superior),
Fitch — AA (Very Strong) and Standard & Poor’s — AA- (Very Strong). Our life insurance
company has not chosen to establish a Moody’s rating.
Current statutory laws and regulations require life insurance companies to hold redundant
reserves, particularly for preferred risk underwriting classes. These redundant reserves, in
turn, depress statutory earnings and require a large commitment of capital. Redundant
reserves are a significant issue, not just for our life insurance operations, but for all
writers of term insurance and universal life with secondary guarantees. However, larger
carriers may be able to better absorb or may be able to securitize the statutory reserve
strain associated with competitively priced term insurance and universal life with secondary
guarantees.
The National Association of Insurance Commissioners recognizes the problems caused by
redundant reserves and is considering a principles-based reserving system rather than the
current formulaic system. While still capturing all material risks, a principles-based
system would allow a company to use its own experience, subject to credibility standards and
appropriate margins for uncertainty. Also, under the proposed principles-based system, the
insurer would fully document and disclose all its assumptions and methods to regulatory
officials.
Investments Segment
The investment segment contributed $990 million of our total revenues in 2007, primarily
from net investment income and realized investment gains and losses from investment
portfolios managed for the holding company and each of the operating subsidiaries. After
deducting interest credited to contract holders of the life insurance segment, the
investments segment contributed $931 million of income before
income taxes, or 78.0 percent
of our total income before income taxes.
The fair value (market value) of our investment portfolio was $12.198 billion and $13.699
billion at year-end 2007 and 2006, respectively. The cash we generate from insurance
operations historically has been invested in three broad categories of investments:
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 15 During 2007 and 2006, sales and market value declines of equity securities more than offset
purchases and market value appreciation. Sales of, or reductions in, selected large holdings
are discussed below.
We consider insurance department regulations and ratings agency comments, as well as the
trend in certain ratios, to determine what portion of new cash flow should be invested in
equity securities at the parent and insurance subsidiary levels. Key among these ratios is
the property casualty group’s ratio of investments in common stocks to statutory surplus and
the parent company’s ratio of investment assets to total assets. At year-end 2007, the ratio
of common stock to statutory surplus was 84.5 percent compared with 96.7 percent at year-end
2006. The ratio of investment assets to total assets for the parent company was 28.4 percent
at year-end 2007 compared with 31.5 percent at year-end 2006.
Fixed-maturity and Short-term Investments
By maintaining a well diversified fixed-maturity portfolio, we attempt to reduce overall
risk. We invest new money in the bond market on a continuous basis, targeting what we
believe to be optimal risk-adjusted after-tax yields. Risk, in this context, includes
interest rate, call, reinvestment rate, credit and liquidity risk. We do not make a
concerted effort to alter duration on a portfolio basis in response to anticipated movements
in interest rates. By continuously investing in the bond market, we build a broad,
diversified portfolio that we believe mitigates the impact of adverse economic factors. We
place a strong emphasis on purchasing current income-producing securities for the insurance
companies’ portfolios. Within the fixed-maturity portfolio, we invest in a blend of taxable
and tax-exempt securities with an eye toward maximizing credit adjusted after-tax yields.
With the exception of U.S. agency paper (government-sponsored entities), no individual
issuer’s securities accounted for more than 0.6 percent of the fixed-maturity portfolio at
year-end 2007. Our investment portfolio contains no mortgage loans and our fixed-maturity
portfolio has no mortgage-backed securities.
Fixed-maturity and Short-term Portfolio Ratings
Our investments in U.S. agency paper and insured municipal bonds over the past several years
have led to a significant rise in the percentage of A and higher rated fixed-maturity
holdings, based on fair value. The majority of our non-rated securities are tax-exempt
municipal bonds from smaller municipalities that chose not to pursue a credit rating. Credit
ratings as of December 31 for the fixed-maturity and short-term portfolio were:
Attributes of the fixed-maturity portfolio include:
We discuss the maturity of our fixed-maturity portfolio in Item 8, Note 2 of the
Consolidated Financial Statements, Page 93.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 16 Taxable Fixed-maturities
Our taxable fixed-maturity portfolio (at fair value) includes:
Our strategy typically is to buy and hold fixed-maturity investments to maturity but we
monitor credit profiles and market value movements when determining holding periods for
individual securities.
Similar to the equity portfolio, the taxable fixed-maturity portfolio is most heavily
concentrated in the financial sector, including banks, brokerage, finance and investment and
insurance companies. The financial sector represented 27.5 percent and 27.3 percent,
respectively of book value and fair value of the taxable fixed-maturity portfolio at
year-end 2007, compared with 27.2 percent and 27.7 percent, at year-end 2006. Although it is
our largest concentration in a single sector, we believe our percentage in the financial
sector is below average for the corporate bond market as a whole. No other sector or
industry accounted for more than 10 percent of the taxable fixed-maturity portfolio.
Tax-exempt Fixed-maturities
We traditionally have purchased municipal bonds focusing on general obligation and essential
services bonds, such as sewer, water or others. While no single municipal issuer accounted
for more than 1 percent of the tax-exempt municipal bond portfolio at year-end 2007, there
are higher concentrations within individual states. Holdings in Illinois, Indiana, Michigan,
Ohio and Texas accounted for 62.5 percent of the municipal bond portfolio at year-end 2007.
In recent years, we have purchased insured municipal bonds because of their excellent
credit-adjusted after-tax yields. At year-end 2007, bonds representing $2.212 billion, or 87
percent, of the fair value of our municipal portfolio were insured with an average rating of
AAA. Because of our emphasis on general obligation and essential services bonds, the
underlying rating of our insured municipal bond portfolio is approximately A1. We believe
this portion of the portfolio would experience little, if any, fair value adjustment in the
event of a ratings downgrade of one or more of the major bond insurers.
Short-term Investments
Our short-term investments consist primarily of commercial paper, demand notes or bonds
purchased within one year of maturity. We make short-term investments primarily with funds
to be used to make upcoming cash payments, such as taxes. At year-end 2007, we had $101
million in short-term investments.
Equity Investments
Our equity investment portfolio includes both common stocks and nonredeemable preferred
stocks. Approximately 82.2 percent of the equity portfolio is made up of a core group of
common stocks that we monitor closely to gain an in-depth understanding of their
organizations and industries. The portfolio also includes a broader group of smaller
positions. The average dividend yield-to-cost for our equity investments was 10.2 percent at
year-end 2007 compared with 9.9 percent at year-end 2006.
Common Stocks
At year-end 2007, 32.4 percent of our common stock holdings (measured by fair value) were
held at the parent company level. Our common stock investments generally are securities with
annual dividend yields that meet or exceed that of the overall market and have the potential
for future dividend increases. Other criteria we evaluate include increasing sales and
earnings, proven management and a favorable outlook. When investing in common stock, we seek
to identify a limited group of companies in which we can become well versed. As a corollary,
we frequently accumulate sizeable holdings over a period of time. At year-end 2007, we held
more than 5 percent of two companies: Fifth Third Bancorp and Piedmont Natural Gas Company.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 17 At
year-end 2007, there were 15 holdings in which we held a fair value of at least $100
million:
Largest Common Stock Holdings
In 2007, the most significant changes in the common stock portfolio were:
We sold all of our holdings in Alltel Corporation common stock in 2006. Because of a
restructuring that Alltel announced in late 2005, we determined that it no longer met our
investment parameters.
Our buy-and-hold strategy, along with our emphasis on a small group of equities and
long-term investment horizon has resulted in significant concentrations within the
portfolio. These investments have built up substantial accumulated unrealized appreciation
over a number of years. At year-end 2007, the largest industry concentrations within our
common stock holdings were the financial sector at 56.7 percent of total fair value and the
healthcare sector at 10.1 percent.
Nonredeemable Preferred Stocks
We evaluate preferred stocks in a manner similar to the evaluation we make for
fixed-maturity investments, seeking attractive relative yields. We generally focus on
investment-grade preferred stocks issued by companies that have a strong history of paying
common dividends, which provides us with another layer of protection. When possible we seek
out preferred stocks that offer a dividend received deduction for income tax purposes.
Additional information regarding the composition of investments is included in Item 8, Note
2 of the Consolidated Financial Statements, Page 93.
Other
We report
as “Other” the operations of the parent company, CFC Investment Company, CinFin
Capital Management Company (excluding investment activities) and CSU
Producer Resources as well as other income of our
insurance subsidiary. As of year-end 2007, CFC Investment Company had 2,590 accounts and $92
million in receivables, compared with 2,897 accounts and $108 million in receivables at
year-end 2006. As of year-end 2007 and 2006, CinFin Capital had 64 institutional, corporate
and individual clients. Assets under management were $977 million at year-end 2007 compared
with $960 million at year-end 2006.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 18 Regulation
State 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 the State of Delaware. Each 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.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 19
Federal Regulation
Although the federal government and its regulatory agencies generally do not directly
regulate the business of insurance, federal initiatives often have an impact. Some of the
current and proposed federal measures that may significantly affect our business are
discussed below.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 20 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 integrated
business activities. 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 impact 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 32, for a discussion of those
strategies.
The risks and uncertainties below are not the only ones we face. There are additional risks
and uncertainties that we currently do not believe are material at this time. There also may
be risks and uncertainties of which we are not aware. 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, non-exclusive 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.
Events or conditions that could diminish our agents’ desire to produce business for us and
the competitive advantage that our independent agencies enjoy:
A reduction in the number of independent agencies marketing our products, the failure of
agencies to successfully market our products or the choice of agencies to reduce their
writings of our products could affect our results of operations if we are 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.
Please see Item 1, Our Business and Our Strategy, Page 1, for a discussion of our
relationships with independent insurance agents.
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 regarding the level of losses that will occur within classes of
business, geographic regions and other criteria.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 21 To properly price our products, we must collect and properly analyze data, the data must be
sufficient, reliable and accessible, we need to develop appropriate rating methodologies and
formulae, and identify and respond to trends quickly. 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.
Setting 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:
If our pricing is incorrect or we are 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.
Please see Item 7, Commercial Lines, Personal Lines and Life Insurance Results of
Operations, Page 44, Page 51, and Page 56, for a discussion of our competitive position in
the insurance marketplace.
Managing technology initiatives and meeting new 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, implementation and operational
risks. In addition, we may have inaccurate expense projections, implementation schedules or
expectations regarding the efficacy of the end product. These issues could escalate over
time. If we are unable to find and retain employees 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 rapidly emerge and change, exposing us to
rising costs and competing time constraints to secure our data in accordance with customer
expectations and statutory and regulatory requirements. A breach of our security that
results in unauthorized access to our data could expose us to data loss, litigation,
damages, fines and penalties, significant increases in compliance costs and reputational
damage.
Please see Item 1, Technology Solutions, Page 4 for a discussion of our technology
initiatives.
The effects of changes in industry practices and regulations on our business are uncertain.
As industry practices and legal, judicial, regulatory, 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 or by increasing the number or size of claims. In some instances,
unforeseeable emerging and latent claim and coverage issues may not become apparent until
some time 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.
Further, the National Association of Insurance Commissioners (NAIC) and state insurance
regulators are continually reexamining existing laws and regulations governing insurance
companies and insurance holding
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 22 companies, specifically focusing on modifications to statutory accounting principles,
interpretations of existing laws 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 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.
The effects of such changes could adversely affect our results of operations.
Please see Item 7, Critical Accounting Estimates, Property Casualty and Life Insurance
Reserves, Page 37, for a discussion of our reserving practices.
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 and the material implications of uncertainties associated with the
methods, assumptions and estimates underlying our critical accounting policies, please refer
to Item 8, Note 1 of the Consolidated Financial Statements, Page 87, and Item 7, Critical
Accounting Estimates, Property Casualty and Life Insurance Reserves, Page 37.
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 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. 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.
The estimation process for unpaid loss and loss expense obligations involves uncertainty by
its very nature. We continually review the estimates and adjust the reserves as facts
regarding individual claims develop, additional losses are reported and new information
becomes known. Adjustments due to loss development on prior years are reflected in the
calendar year in which they are identified. The process used to determine our loss reserves
is discussed in Item 7, Critical Accounting Estimates, Property Casualty and Life Insurance
Reserves, Page 37.
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,
catastrophic events, increases in loss severity or frequency, or other causes. Such future
losses could be substantial.
We could experience an unusually high level of losses due to catastrophic or terrorism
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. 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.
We have natural catastrophe exposure to:
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 as general commercial risks in the metropolitan Chicago area as well as small co-op
utilities, small shopping malls and small colleges throughout our 34 active states.
Additionally, our life insurance subsidiary could be adversely affected in the event of a
terrorist event or an epidemic such as the avian 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 experienced
over a period of time exceeded our actuarially determined expectations. In addition, our
financial condition would be adversely
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 23 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 companies 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 property casualty insurance product
in 34 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 business or properties in multiple states.
The Cincinnati Insurance Company also participates in three assumed reinsurance treaties
with two reinsurers that spread the risk of very high catastrophe losses among many
insurers. In 2008, we have exposure of up to $7 million of assumed losses in three layers,
from $1.0 billion to $1.7 billion, from a single event under an assumed reinsurance treaty
for Munich Re Group. The other two assumed reinsurance treaties are immaterial.
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. A catastrophe or epidemic event also could affect our operations
by damaging our headquarters facility or disrupting our associates’ ability to perform their
assigned tasks.
Please see Item 7, Critical Accounting Estimates, Property Casualty and Life Insurance
Reserves, Page 37, for a discussion of our reserving practices.
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 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 are unable to obtain reinsurance on acceptable terms and in
appropriate amounts, our business and financial condition may 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-term cases, 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.
Prior to 2003, we participated in USAIG, a joint underwriting association of individual
insurance companies that collectively functions as a worldwide insurance market for all
types of aviation and aerospace accounts. At year-end 2007, 29.8 percent, or $225 million,
of our total reinsurance receivables were related to USAIG, primarily for September 11,
2001, events. Although more than 99 percent of the reinsurance recoverables associated with
USAIG are backed by securities on deposit, if we are unable to collect these receivables,
our financial position and results of operations could be materially affected. We no longer
participate in new business generated by USAIG and its members.
Please see Item 7, 2008 Reinsurance Programs, Page 70, for a discussion of our reinsurance
treaties.
Our ability to realize our investment objectives could affect our financial condition, our
results of operations or cash flows.
We invest premiums received from policyholders and other available cash to generate
investment income and capital appreciation, maintaining sufficient liquidity to pay covered
claims and operating expenses, service our debt obligations and pay dividends. At year-end
2007, our investment portfolio was $12.198 billion, or 73.3 percent of our total assets. In
2007, our investment segment contributed 21.8 percent of our
revenue and 78.0 percent of our
total income before income taxes.
Investment income is an important component of our revenues and net income. The ability to
achieve our investment objectives is affected by factors that are beyond our control, such
as inflation, economic growth, interest rates, world political conditions, terrorism attacks
or threats, adverse events affecting other companies in our industry or the industries in
which we invest 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 more detailed discussion of risks associated with our investments, please refer to Item
7A, Qualitative and Quantitative Disclosures About Market Risk, Page 73.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 24 Our investment performance also could suffer because of the types or concentrations 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 2007, common stock holdings made up 49.4 percent of our investment portfolio. Of
those equities, 56.7 percent were in financial sector companies. Adverse news or events
affecting equities, and this sector specifically, such as unfavorable developments related
to subprime lending, could affect our net income, book value and overall results.
One of our financial sector investments, Fifth Third, accounted for 28.5 percent of our
shareholders’ equity at year-end 2007 and dividends earned from our Fifth Third investment
were 20.0 percent of our investment income in 2007. Based on 2007 results, a 10 percent
change in dividends earned from our Fifth Third holding would result in a $12 million change
in pretax investment income and an $11 million change in after-tax earnings. Every $1.00
change in the market price of Fifth Third’s common stock has approximately a 26 cent impact
on our book value per share. A 20 percent change in the market price of Fifth Third’s common
stock from its year-end 2007 closing price would result in a $338 million change in assets
and a $220 million change in after tax unrealized gains.
Because we currently own more than 10 percent of Fifth Third’s outstanding shares and
because our CEO serves as a director of Fifth Third, we are limited in the amount of Fifth
Third stock we could sell in any given period and the timing of any sale. This limitation
could lead us to hold a sizeable position in Fifth Third even if it would no longer meet our
investment parameters. This could result in a variety of adverse consequences depending on
the reason we had concluded Fifth Third no longer met our investment parameters. For
example, if Fifth Third were to stop paying dividends on its common stock, we would not be
able to quickly sell a part of our holdings to reinvest in other income-earning investments,
which would have a material effect on our results of operations. We also insure property,
liability, surety and life insurance exposures for Fifth Third and rely on the bank to
service many of our corporate accounts, associate payroll and 401(k) plan.
Please see Item 1, Investments Segment, Page 15, Item 7, Investments Results of
Operations, Page 57, and Liquidity and Capital Resources, Page 60, for discussion of our
investment activities.
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 us 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. Currently, 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. This could affect our financial position.
Please see Item 1, Regulation, Page 19, and Item 8, Note 8 of the Consolidated Financial
Statements, Page 96, for discussion of insurance holding company dividend regulations.
We could make investment decisions or experience market value fluctuations that trigger
restrictions applicable to the parent company under the Investment Company Act of 1940.
Compared with other insurance holding companies, we hold a significant level of investment
assets at the parent company level. If these investment assets grow to account for more than
40 percent of parent company’s total assets, excluding assets of our subsidiaries, we might
become subject to regulation under the Investment Company Act of 1940. Our operations are
limited by the constraint that investment securities held at the holding company level
should remain below the 40 percent threshold described above. Efforts to stay below the
threshold could result in:
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 25
If the parent company’s investment assets were to exceed the 40 percent ratio to its total
assets, excluding investment in its subsidiaries, and if it were determined that the holding
company was an unregistered investment company, the holding company might be unable to
enforce contracts with third parties, and third parties could seek rescission of
transactions with the holding company undertaken during the period that it was an
unregistered investment company, subject to equitable considerations set forth in the
Investment Company Act. In addition, the holding company could become subject to monetary
penalties or injunctive relief, or both, in an action brought by the SEC.
Our business depends on the uninterrupted operation of our facilities, systems and business
functions.
Our business depends on our associate’s 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.
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 contains approximately 800,000 total square feet. The
property, including land, is carried in our financial statements at $68 million as of
December 31, 2007, 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 (1 percent).
Construction of a 690,000 total square foot underground garage and third office tower at our
headquarters building began in early 2005. We estimate a completion date of July 2008 for
the project. We believe this estimated $100 million expansion will accommodate our business
needs for the foreseeable future. The construction project is on schedule and on budget. As
of December 31, 2007, construction costs totaled $86 million, which is classified as land,
building and equipment, net, for company use.
Cincinnati Financial Corporation owns the Fairfield Executive Center, which is located on
the northwest corner of our headquarters property. This is a four-story office building
containing approximately 124,000 square feet. The property is carried in the financial
statements at $7 million as of December 31, 2007, and is classified as land, building and
equipment, net, for company use. Our subsidiaries occupy approximately 90 percent of the
rentable square feet and unaffiliated tenants occupy approximately 10 percent. In 2008,
subsidiary operations in this building will relocate to the third officer tower at our
headquarters location. Portions of this space will be available for
lease during 2008.
In 2007, The Cincinnati Life Insurance Company sold a four-story office building in
Springdale, Ohio. The property was carried in the financial statements at $3 million as of
December 31, 2006, and was classified as other invested assets. A capital gain of $2 million
was realized on the sale of the property.
The Cincinnati Insurance Company owns an unoccupied building on 16 acres of land in
Springfield Township, Ohio, approximately six miles from our headquarters. We plan to
renovate the 51,000 square foot building to serve as a disaster recovery and backup data
processing center at an estimated cost of $26 million. The property, including land, is
carried on our financial statements at $3 million as of December 31, 2007, and is classified
as land, building and equipment, net, for company use.
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. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders of Cincinnati Financial during the
fourth quarter of 2007.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 26 Part II
Cincinnati Financial Corporation had approximately 12,000 shareholders of record and
approximately 46,000 beneficial shareholders as of December 31, 2007. Many of our
independent agent representatives and most of the 4,087 associates of our subsidiaries own
the company’s common stock. We are unable to accurately quantify those holdings because many
are beneficially held.
Our common shares are traded under the symbol CINF on the Nasdaq Global Select Market.
Our ability to pay cash dividends may depend on the ability of our insurance subsidiary to
pay dividends to the parent company. The dividend restrictions of our insurance company
subsidiaries are discussed in Item 8, Note 8 of the Consolidated Financial Statements, Page
96.
The following summarizes securities authorized for issuance under our equity compensation
plans as of December 31, 2007:
Additional information about stock-based associate compensation granted under our equity
compensation plans is available in Item 8, Note 16 of the Consolidated Financial Statements,
Page 102.
The board of directors has authorized share repurchases since 1996. We discuss the board
authorization in Item 7, Liquidity and Capital Resources, Uses of Capital, Page 64. In 2007,
we repurchased a total of 7,454,637 shares.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 27
On October 24, 2007, we entered into an accelerated share repurchase agreement for 4 million shares. At the same time, the board of directors also expanded the existing repurchase
authorization to approximately 13 million shares. Purchases are expected to be made
generally through open market transactions. The board gives management discretion to
purchase shares at reasonable prices in light of circumstances at the time of purchase,
pursuant to SEC regulations.
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. All of the repurchases reported in the table above were
repurchased under our original 2005 program or the expansion announced in October 2007.
Neither the 2005 nor 1999 program had an expiration date, but no further repurchases will
occur under the 1999 program.
Cumulative Total Return
As depicted in the graph below, the five-year total return on a $100 investment made
December 31, 2002, assuming the reinvestment of all dividends, was 34.0 percent for
Cincinnati Financial Corporation’s common stock compared with 62.3 percent for the Standard
& Poor’s Composite 1500 Property & Casualty Insurance Index and 82.9 percent for the
Standard & Poor’s 500 Index.
The Standard & Poor’s Composite 1500 Property & Casualty Insurance Index includes 29
companies: Ace Ltd., Allstate Corporation, AMBAC Financial Group, Berkley (W R) Corporation,
Chubb Corporation, Cincinnati Financial Corporation, Commerce Group Inc., Fidelity National
Financial Inc., First American Corporation, Hanover Insurance Group Inc., Infinity Property
& Casualty Corporation, Landamerica Financial Group, MBIA Inc., Mercury General Corporation,
Old Republic International Corporation, Philadelphia Consolidated Holding Corporation,
Proassurance Corporation, Progressive Corporation, RLI Corporation, Safeco Corporation,
Safety Insurance Group Inc., SCPIE Holdings Inc., Selective Insurance Group Inc., Stewart
Information Services, Tower Group Inc., Travelers Companies Inc., United Fire & Casualty
Company, XL Capital Ltd. and Zenith National Insurance Corporation.
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.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 28
Item 6. Selected Financial Data
continued...
Per share data adjusted to reflect
all stock splits and dividends prior to December 31, 2007. Significant realized gains and one-time charges or adjustments:
2007 — The company sold 3.8 million shares of its holding in Exxon Mobil Corporation common
stock. The sale contributed $217 million (pretax) to realized investment gains and revenues
and $141 million (after tax), or 81 cents per share, to net income. The company divested the
majority of its real estate investment trust holdings. The sales contributed $73 million
(pretax) to realized investment gains and revenues and $47 million (after tax), or 27 cents
per share, to net income. The company sold 5.5 million shares of its holdings in Fifth Third
Bancorp common stock. The sale contributed $64 million (pretax) to realized investment gains
and revenues and $42 million (after tax), or 24 cents per share, to net income. The company
sold all of its holdings in FirstMerit Corporation common stock. The sale contributed $59
million (pretax) to realized investment gains and revenues and $38 million (after tax), or
22 cents per share, to net income.
2006 — The company sold all of its holdings in Alltel Corporation common stock. The sale
contributed $647 million (pretax) to realized investment gains and revenues and $412 million
(after tax), or $2.35 per share, to net income.
2003 — As the result of a settlement negotiated with a vendor, pretax results included the
recovery of $23 million of the $39 million one-time, pretax charge incurred in 2000.
2000 — The company recorded a one-time charge of $39 million, pretax, to write down
previously capitalized costs related to the development of software to process property
casualty policies. The company earned $5 million in interest in the first quarter from a
$303 million single-premium bank-owned life insurance (BOLI) policy booked at the end of
1999 that was segregated as a separate account effective April 1, 2000. Investment income
and realized investment gains and losses
from separate accounts generally accrue directly to the contract holder and, therefore, are
not included in the company’s consolidated financials.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 30 & 31
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
position. Management’s Discussion and Analysis should be read in conjunction with Item 6,
Selected Financial Data, Pages 30 and 31, and Item 8, Consolidated Financial Statements and
related Notes, beginning on Page 80. We present per share data on a diluted basis unless
otherwise noted, and we have adjusted those amounts for all stock splits and stock
dividends.
We begin with an executive summary of our results of operations and outlook, as well as
details on critical accounting policies and estimates. Periodically, we refer to estimated
industry data so that we can give information on our performance versus the overall
insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best, a
leading insurance industry statistical, analytical and financial strength rating
organization. Information from A.M. Best is presented on a statutory basis. When we provide
our results on a comparable statutory basis, we label it as such; all other company data is
presented in accordance with accounting principles generally accepted in the United States
of America (GAAP).
Executive Summary
Through The Cincinnati Insurance Company and its local independent agent representatives,
Cincinnati Financial Corporation has become one of the 25 largest property casualty insurer
groups in the nation, based on premium volume for the approximate 2,000 U.S. stock and
mutual insurer groups. We primarily market standard market property casualty insurance
products through a select group of independent insurance agencies in 34 states. As we
discussed in the business description in Item 1, we believe three key characteristics
distinguish our company and allow us to build shareholder value:
We provide additional detail on these subjects in the Results of Operations and Liquidity
and Capital Resources sections of this discussion.
Among the factors that influence the consolidated results of operations and financial
position of the company, we consider our relationships with independent insurance agents to
be the most significant. We seek to be an indispensable partner in each agency’s success. To
continue to achieve our performance targets, we must maintain these strong relationships,
write a significant portion of each agency’s business and attract new agencies that share
our business philosophy.
We believe consistently applying our long-term strategies rather than taking short-term
actions will allow us to address these challenges. We seek to meet our agents’ needs, with
an eye toward solutions and approaches that will give us an advantage for five, 10 or more
years. As we appoint new agencies, we are looking to build relationships that lead them to
award us a preferred position and a meaningful share of the business they write.
In 2007, we did not achieve some of our objectives for creating shareholder value. For the
year, we wrote less new property casualty business than the prior year and market pricing
trends led to slightly lower written premiums and put some pressure on our current accident
year margins. Nonetheless, we continued to build our company for the long term. Agencies
continued to successfully market our products to their better accounts. They gave us $325
million of new property casualty business and helped us maintain the persistency of renewals
at more than 90 percent of our accounts. Our equity-focused investment strategy led to
another year of record investment income even as declines in the market values of our
financial sector common stocks led to lower invested assets and book value.
We look beyond 2007, recognizing the challenges that will face us and with strategies in
place to address those challenges. We remain committed to providing a stable market for our
agents’ high quality business, underwriting this business carefully and producing steady
value for our shareholders, as represented by the board of directors’ recent decision to
increase our 2008 indicated annual cash dividend by 9.9 percent, which would mark the
48th consecutive year of increase in that measure. We believe we can achieve
above-industry-average growth in written premiums and industry-leading profitability over
the long term by building on our proven strategies: strong agency relationships, local
underwriting, quality claims service, solid reserves and total return investing.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 32
Over our 57 year history, our growth largely has been driven by increasing our share of the
business written by the agencies that market our products, growth of those agencies,
appointment of new agencies and our periodic entry into new states. During 2008, we are
targeting 65 new agency appointments.
Over the years, we have been able to increase our share of our agencies’ business by making
available insurance products that meet the needs of the individuals and businesses in their
communities. In recent years, our agents had indicated their interest in having Cincinnati
available as a market for commercial accounts that require the flexibility of excess and
surplus lines coverage. Preparations that began in early 2007 to initiate excess and surplus
lines operations concluded on schedule in December 2007. Our new subsidiary, The Cincinnati
Specialty Underwriters Insurance Company, received an A (Excellent) rating from A.M. Best,
an independent provider of insurer ratings. As noted in Item 1, Excess and Surplus Lines
Operation Further Enhances Agency Relationships, Page 6, our new wholly owned brokerage CSU
Producer Resources began marketing excess and surplus lines policies to selected agencies in
five states in January 2008.
Below we review highlights of our financial results for the past three years and measures of
the success of our efforts to create shareholder value. Detailed discussion of these topics
appears in Results of Operations, Page 42, and Liquidity and Capital Resources, Page 60.
Corporate Financial Highlights
Income Statement and Per Share Data
Revenues in 2007 and 2006 were significantly higher than in 2005. Both years reflected
significant net realized investment gains from sales of common stock holdings. In both
years, rising pretax investment income offset the slowing growth rate of consolidated
property casualty earned premiums.
Net income and net income per share declined slightly in 2007 from a record level in 2006.
The most significant factors contributing to net income are:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 33
Cash dividends declared per share rose 6.0 percent and 11.2 percent in 2007 and 2006.
Balance Sheet Data and Performance Measures
Invested assets and total assets declined in 2007, primarily due to lower market values of
financial sector equity holdings. Invested assets and total assets rose in 2006 on new
investments and appreciation in the equity portfolio.
Comprehensive income is net income plus the year-over-year difference in unrealized gains on
investments. Comprehensive income moved in concert with the changes in unrealized investment
gains over the three-year period. Unrealized investment gains declined in 2007 because of
lower market values of our financial sector holdings, after rising in 2006. Unrealized gains
were lower in 2005 primarily due to a decline in the market value of our Fifth Third
investment.
Return on equity in 2007 declined slightly due to lower realized gains on investments after
rising in 2006 due to higher realized gains on investments. Return on equity based on
comprehensive income declined in 2007 because of lower comprehensive income due to lower
unrealized investment gains. It rose in 2006 due to the increase in accumulated other
comprehensive income.
Our ratio of long-term debt to capital (long-term debt plus shareholders’ equity) rose in
2007 after declining in 2006. The increase in 2007 was due to share repurchase and lower
unrealized gains, which primarily reflected the lower market values of our financial sector
equity holdings.
Property Casualty Highlights
The trend in overall written premium growth reflected the competitive and market factors
discussed in Item 1, Commercial Lines and Personal Lines Insurance Results of Operations,
Page 44 and Page 51. Our consolidated property casualty insurance underwriting profit rose in
2007 after declining in 2006, matching the trend in our combined ratio. (The combined ratio
is the percentage of each premium dollar spent on claims plus all
expenses — the lower the ratio, the better the performance.) 2007 performance was bolstered
by lower catastrophe losses and higher savings from favorable development on prior period
reserves.
We also measure a variety of non-financial metrics for our property casualty operations. For
example, we monitor our rank within our reporting agency locations. In 2006, we ranked No. 1
or No. 2 by premium volume in 74.2 percent of the locations that have marketed our products
for more than five years. Other measures include subdivision of territories and new agency
appointments. We ended 2007 with 106 field territories, subdividing three new territories
and merging one into the surrounding regions. As discussed in Item 1, Growing with Our
Agencies, Page 9, we made 66 new agency appointments in 2007, 50 of which were new
relationships. These new appointments and other changes in agency structures led to a net
increase in reporting agency locations of 38 in 2007.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 34
Agent satisfaction with our technology solutions is, and will continue to be, a requirement
for maintaining our strong relationships with these agencies. In 2007, we made additional
progress in implementing technology solutions that we believe should make it easier for
agencies to do business with us. Among other 2007 milestones, we deployed our new commercial
lines policy processing system to agencies in 10 states for use in processing new and
renewal businessowners policies, bringing the year-end total to 17 states. We also deployed
our personal lines policy processing system in four states, bringing the year-end total to
17 states, and continued to make important upgrades and enhancements.
In each of the past three years, our results have compared satisfactorily to estimated
industry results. Industry net written premiums were estimated to decline 1.2 percent in
2007. In 2006, industry premiums were estimated to rise 3.9 percent after no change in 2005.
In the past three years, industry premium trends have been obscured by the reinsurance
sector, where premiums were estimated to have declined 8.5 percent in 2007, risen 28.1
percent in 2006 and declined 28.2 percent in 2005. The estimated industry average statutory
combined ratios were 95.6 percent in 2007, 92.4 percent in 2006 as well as 101.2 percent in
2005 when the 144.9 percent estimated reinsurance sector combined ratio obscured the
industry combined ratio.
Measuring Our Success In 2008 And Beyond
Looking into 2008 and beyond, we will continue to measure the success of our strategies:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 35
Factors supporting our outlook for 2008 are discussed in the Results of Operations for each
of the four business segments.
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 87. 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.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 36
Property Casualty Insurance Loss And Loss Expense Reserves
Overview
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 $3.925 billion, or
36.7 percent of total liabilities, at year-end 2007, compared with $3.860 billion, or 37.1
percent of total liabilities, at year-end 2006.
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 these
claims. 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:
Case reserves of all sizes are subject to review on a 90-day cycle or more frequently, if
new information regarding 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 incurred but not reported (IBNR) reserves to provide for all unpaid loss
and loss expenses not accounted for by case reserves. For other than asbestos and
environmental claims, we calculate IBNR reserves quarterly by first deriving an actuarially
based estimate of the ultimate cost of total loss and loss expenses incurred as of the
financial statement date. We then reduce the estimate by total loss and loss expense
payments and total case reserves carried as of the financial statement date.
We calculate IBNR reserves for asbestos and environmental claims by deriving an actuarially
based estimate of total unpaid loss and loss expenses as of the financial statement date. We
then reduce the estimate by total case reserves as of the financial statement date. We
discuss the reserve analysis that applies to claims other than asbestos and environmental
claims below. We discuss the reserve analysis that applies to asbestos and environmental
reserves in Asbestos and Environmental Reserves,
Page 66.
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 control for these uncertainties in the reserving process in a variety of ways.
Our actuarial staff bases its estimates 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 we have used for the past
several years are:
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 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
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 37
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:
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 and updates them as necessary.
Quarterly, our actuarial staff summarizes its 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:
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.
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 regarding the likelihood that statistically significant patterns in
historical data will extend into the future. The four most significant of the key
assumptions used by our actuarial staff and approved by management are:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 38
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 allocated loss expenses are subject to random as well
as systematic influences. As a result, actual paid losses, reported losses and paid
allocated loss 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 for lines of business that
account for 91.6 percent of our 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 below for a 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 will
fall, one or more lines’ actual unpaid loss and loss expenses could nonetheless fall outside
of the indicated ranges.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 39
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 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 2007, fixed
maturity investments exceeded total insurance reserves (including life policy reserves) by
more than $400 million.
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 significant decreases in the market value of invested assets, changes in legal
factors or in the business climate, 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 or signs indicating that the carrying amount may not be
recoverable.
The application of our impairment policy resulted in other-than-temporary impairment charges
and realized investment losses that reduced our income before income taxes by $16 million in
2007 and $1 million in both 2006 and 2005.
Our portfolio managers monitor the status of their assigned portfolios for
indications of potential problems that may be possible impairment issues. If a security is
trading below book value, 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.
Management reviews quantitative measurements such as a declining trend in market value, the
extent of the market value decline and the length of time the value of the security has been
depressed, as well as qualitative measures such as pending events and issuer liquidity.
Generally, these declines in valuation are
greater than might be anticipated when viewed in the context of overall economic and market
conditions. We provide information regarding valuation of our invested assets in Item 8,
Note 2 of the Consolidated Financial Statements, Page 93.
Impairment charges are recorded for other-than-temporary declines in value, if, in the asset
impairment committee’s judgment, there is little expectation that the value will be recouped
in the foreseeable future. A security valued between 95 percent and 100 percent of book
value will not be monitored separately by the committee. These assets generally are at this
value because of interest rate-driven factors. All securities valued below 95 percent of
book value are reported to the asset impairment committee for evaluation.
When evaluating for other-than-temporary impairments, 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 strong capitalization, management may not
impair certain securities even though they are trading below cost. The company can make that
determination based on its ability to hold until their scheduled redemption securities that
have the potential to recover value. In addition to evaluating the security’s current
valuation, the impairment committee reviews objective evidence that indicates the potential
for a recovery in value. Information is evaluated regarding the security, such as financial
performance, near-term prospects and the financial condition of the region and industry in
which the issuer operates.
Securities
that have previously been impaired are evaluated based on their adjusted book value
and written down further, if deemed appropriate. The decision to sell or write down a
security with impairment indications reflects, at least in part, management’s opinion that
the security no longer meets the company’s investment objectives. We provide detailed
information about securities trading in a continuous loss position at year-end 2007 in
Item 7A, Unrealized Investment Gains and Losses, Page 77. An other-than-temporary decline in
the fair value of a security is recognized in net income as realized investment losses.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 40
Permanent impairment charges (write-offs) are defined as those for which management believes
there is little potential for future recovery, for example, following the bankruptcy of the
issuer. A permanent decline in the fair value of a security is written off at the time when
facts and circumstances indicate such write-down is warranted, and is reflected in realized
investment losses.
Other-than-temporary and permanent impairments are distinct from the ordinary fluctuations
seen in the value of a security when considered in the context of overall economic and
market conditions. Securities considered to have a temporary decline would be expected to
recover their market value, which may be at maturity. Under the same accounting treatment as
market value gains, temporary declines (changes in the fair value of these securities) are
reflected on our balance sheet in accumulated other comprehensive income, net of tax, and
have no impact on reported net income.
Employee Benefit Pension Plan
We have a defined benefit pension plan covering substantially all employees. Contributions
and pension costs are developed from annual actuarial valuations. These valuations involve
key assumptions including discount rates and expected return on plan assets, which are
updated each year. 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 2007 net pension obligation were a 6.25 percent
discount rate and rates of compensation increases ranging from 4 percent to 6 percent. Key
assumptions used in developing the 2007 net pension expense were a 5.75 percent discount
rate, an 8 percent expected return on plan assets and rates of compensation increases
ranging from 4 percent to 6 percent.
In 2007, the net pension expense was $21 million. In 2008, we expect a net pension expense
of $19 million, primarily as a result of reduced service costs due to a 0.5 percentage point
increase in the discount rate.
Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate
would lower our 2008 net income before income taxes by $2 million. Likewise, a
0.5 percentage point decline in the expected return on plan assets would lower our 2008
income before income taxes by $1 million.
The fair value of the plan assets exceeded the accumulated benefit obligation by $9 million
at year-end 2007 and $8 million at year-end 2006. The fair value of the plan assets was less
than the projected plan benefit obligation by $54 million at year-end 2007 and $58 million
at year-end 2006. Market conditions and interest rates significantly affect future assets
and liabilities of the pension plan.
Deferred Acquisition Costs
We establish a deferred asset for costs that vary with, and are primarily related to,
acquiring property casualty and life insurance business. These costs are principally agent
commissions, premium taxes and certain underwriting costs, which are deferred and amortized
into income as premiums are earned. Deferred acquisition costs track with the change in
premiums. Underlying assumptions are updated periodically to reflect actual experience.
Changes in the amounts or timing of estimated future profits could result in adjustments to
the accumulated amortization of these costs.
For property casualty policies, deferred acquisition costs are amortized over the terms of
the policies. For life 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.
Contingent Commission Accrual
Another significant estimate relates to our accrual for property casualty contingent
(profit-sharing) commissions. We base the contingent commission accrual estimates on
property casualty underwriting results and on supplemental information. Contingent
commissions are paid to agencies using a formula that takes into account agency
profitability, premium volume and other factors, such as prompt monthly payment of amounts
due to the company. Due to the complexity of the calculation and the variety of factors that
can affect contingent commissions for an individual agency, the amount accrued can differ
from the actual contingent commissions paid. The contingent commission accrual of
$102 million in 2007 contributed 3.3 percentage points to the property casualty combined
ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would
affect 2008 net income by $3 million (after tax), or 2 cents per share, and the combined
ratio by approximately 0.2 percentage points.
Separate Accounts
We issue life contracts, referred to as bank-owned life insurance policies (BOLI). Based on
the specific contract provisions, the assets and liabilities for some BOLIs are legally
segregated and recorded as assets and liabilities of the separate accounts. Other BOLIs are
included in the general account. For separate account BOLIs, minimum investment returns and
account values are guaranteed by the company and also include death benefits to
beneficiaries of the contract holders.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 41
Separate account assets are carried at fair value. Separate account liabilities primarily
represent the contract holders’ claims to the related assets and also are carried at the
fair value of the assets. Generally, investment income and realized investment gains and
losses of the separate accounts accrue directly to the contract holders and, therefore, are
not included in our Consolidated Statements of Income. However, each separate account
contract includes a negotiated realized gain and loss sharing arrangement with the company.
This share is transferred from the separate account to our general account and is recognized
as revenue or expense. In the event that the asset value of contract holders’ accounts is
projected below the value guaranteed by the company, a liability is established through a
charge to our earnings.
For our most significant separate account, written in 1999, realized gains and losses are
retained in the separate account and are deferred and amortized to the contract holder over
a five-year period, subject to certain limitations. Upon termination or maturity of this
separate account contract, any unamortized deferred gains and/or losses will revert to the
general account. In the event this separate account holder were to exchange the contract for
the policy of another carrier in 2008, the account holder would pay a surrender charge equal
to 2 percent of the contract’s account value. The surrender
charge will fall to 1 percent in 2009 and 0 percent in 2010 and beyond.
At year-end 2007, net unamortized realized gains amounted to $1 million. In accordance with
this separate account agreement, the investment assets must meet certain criteria
established by the regulatory authorities to whose jurisdiction 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, and charged to the general
account. Potentially, losses could be material; however, unrealized losses in the separate
account portfolio were less than $6 million at year-end 2007.
Recent Accounting Pronouncements
Information regarding recent accounting pronouncements is provided in Item 8, Note 1 of the
Consolidated Financial Statements, Page 87. We have determined that recent accounting
pronouncements have not had nor are they expected to have any material impact on our
consolidated financial statements.
Results Of Operations
The consolidated results of operations reflect the operating results of each of our four
segments along with the parent company and other non-insurance activities. The four segments
are:
We measure profit or loss for our property casualty and life 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 lines and personal lines insurance segments. Our consolidated property casualty
insurance operations generated an unusually low percent of our total revenues in 2007 and
2006 due to sales of investment assets, which are included in the investments segment
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 commercial lines
and personal lines 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. We also use
statutory accounting data and ratios as key performance indicators for our life insurance
operations.
Investments held by the parent company and the investment portfolios for the property
casualty and life 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 Investments
Results of Operations.
The calculations of segment data are described in more detail in Item 8, Note 17 of the
Consolidated Financial Statements, Page 96. The following sections review results of
operations for each of the four segments. Commercial Lines Insurance Results of Operations
begins on Page 44, Personal Lines Insurance Results of Operations begins on Page 51,
Life Insurance Results of Operations begins on Page 56, and Investments Results of
Operations begins on Page 57. We begin with an overview of our consolidated property
casualty operations, which is the total of our commercial lines and personal lines segments.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 42
Consolidated Property Casualty Insurance Results Of Operations
In addition to the factors discussed in Commercial Lines and Personal Lines Insurance
Results of Operations, Page 44 and Page 51, growth and profitability for our consolidated
property casualty insurance operations were affected by:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 43
Catastrophe Losses Incurred
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