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Cincinnati Financial Corporation
The Cincinnati Insurance Companies
The Cincinnati Insurance Companies
|
Cincinnati Financial Corporation The Cincinnati Insurance Companies |
Cincinnati Financial Corporation 2008 Annual Report on Form 10-K March 11, 2009
In addition, you will find information about your company's strategies and initiatives in the Letter from the Chairman and the Chief
Executive Officer and our quarterly letters to shareholders, as they become available. Together with the detailed analysis of the 2008
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. Our main business is marketing property casualty insurance.
Our headquarters is in Fairfield, Ohio. At year-end 2008, we had 4,179 associates, with
2,984 headquarters associates providing support to 1,195 field associates.
At year-end 2008, Cincinnati Financial Corporation owned 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 other
insurance subsidiaries.
In addition to The Cincinnati Insurance Company, our standard market property casualty
insurance group includes two of those subsidiaries – The Cincinnati Casualty Company and The
Cincinnati Indemnity Company. This group markets a broad range of business, homeowner and
auto policies in 35 states. Other subsidiaries of The Cincinnati Insurance Company include
The Cincinnati Life Insurance Company, which markets life insurance, disability income
policies and annuities, and The Cincinnati Specialty Underwriters Insurance Company, which
began offering 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 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 provided asset management services to internal and
third-party clients. CinFin Capital Management will cease operations effective February 28,
2009.
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
The Cincinnati Insurance Company was founded almost 60 years ago by independent insurance
agents. They established the mission that continues to guide all of the companies in the
Cincinnati Financial family – to grow profitably and enhance the ability of local
independent insurance agents to deliver quality financial protection to the people and
businesses they serve by:
A select group of agencies in 35 states actively markets our property casualty insurance
within their communities. Standard market commercial lines policies are available in all of
those states, while personal lines policies are available in 27 and surplus commercial lines
policies are available in 33 of the same 35 states. Within this select group, we also seek
to become the life insurance carrier of choice and to help agents and their clients – our
policyholders – by offering leasing and financing services.
Three hallmarks distinguish this company, positioning us to build value and long-term
success:
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 1
Independent Insurance Agency Marketplace
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:
Standard market property casualty insurers generally offer insurance products through one or
more distribution channels:
For the most part, we compete with standard market insurance companies that market through
independent insurance agents.
We are committed to this channel. The independent agencies that we choose to market our
standard lines insurance products share our philosophies. They do business person to person;
offer broad, value-added services; maintain sound balance sheets; and manage their agencies
professionally. We develop our relationships with agencies that are active in their local
communities, providing important knowledge of local market trends, opportunities and
challenges.
In addition to the standard market for property casualty insurance, the surplus lines market
exists due to a regulatory distinction. Generally, surplus lines insurance carriers provide
insurance that is unavailable in the standard market due to market conditions or due to
characteristics of the insured person or organization that are caused by nature, the
insured’s claim history or the characteristics of their business. Insurers operating in the
surplus lines market are generally small specialty insurers or specialized divisions of
larger insurance organizations. Each markets through surplus lines insurance brokers.
We opened our own surplus line insurance brokerage firm so that we could offer surplus lines
products exclusively to the independent agents who market our other property casualty
insurance products. We also market life insurance products through the agencies that market
our property casualty products.
At year-end 2008, our 1,133 agency relationships had 1,387 reporting 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. The number of reporting agency locations
indicates our agents’ regional scope and the extent of our presence within our 35 active
states. At year-end 2007, our 1,092 agency relationships had 1,327 reporting locations. At
year-end 2006, our 1,066 agency relationships had 1,289 reporting locations.
On average, we have a 12.4 percent share of the property casualty insurance purchased
through our reporting agency locations. Our share is 18.1 percent in reporting agency
locations that have represented us for more than 10 years; 7.4 percent in agencies that have
represented us for five to 10 years; 4.4 percent in agencies that have represented us for
one to five years; and 0.6 percent in agencies that have represented us for less than one
year.
Our largest single agency relationship accounted for approximately 1.3 percent of our total
property casualty agency earned premiums in 2008. No aggregate of locations under a single
ownership structure accounted for more than 2.3 percent of our total agency earned premiums
in 2008.
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 that may share back office and other functions to enhance economies,
while maintaining their individual ownership structures.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 2 Financial Strength
We believe that our financial strength and strong surplus position, reflected in our insurer
financial strength ratings, are clear, competitive advantages in the segment of the
insurance marketplace that we serve. This strength supports the consistent, predictable
performance that our policyholders, agents, associates and shareholders have always expected
and received, and helps us withstand significant challenges.
While the prospect exists for volatility due to our exposures to potential catastrophes or
significant capital market losses, 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 being a consistent, stable market for our
agents’ business over short-term benefits that might accrue by quick reaction to changes in
market conditions.
At year-end 2008 and 2007, risk-based capital (RBC) for our standard and surplus lines
property casualty operations and life operations was exceptionally strong, far exceeding
regulatory requirements.
The consolidated property casualty insurance group’s ratio of investments in common stock to
statutory surplus at 53.4 percent at year-end 2008 compared with 84.5 percent at year-end
2007. The life insurance company’s ratio was 39.2 percent compared with 70.6 percent a year
ago.
Our parent company’s senior debt is rated by four independent ratings firms. In addition,
the 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 financial obligations to policyholders and do not necessarily
address all of the matters that may be important to shareholders. Ratings may be subject to
revision or withdrawal at any time by the rating agency, and each rating should be evaluated
independently of any other rating.
All of our insurance subsidiaries continue to be highly rated. Each of the four
organizations that rate our companies placed the ratings of our standard market property
casualty and life companies on watch or review in June and July 2008 and subsequently
lowered them. These actions followed our June announcement of significant catastrophe losses
and declines in value of our investment assets.
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As of February 26, 2009, our credit and financial strength ratings were:
Our debt ratings are discussed in Item 7, Additional Sources of Liquidity,
Page 71.
Operating Structure
We offer our broad array of insurance products through the independent agency channel. We
recognize that locally based independent agencies have relationships in their communities
that can lead to policyholder satisfaction, loyalty and profitable business. We seek to be a
consistent and predictable property casualty carrier that agencies can rely on to serve
their clients. For our standard market business, field and headquarters underwriters make
risk-specific decisions about both new business and renewals.
In our 10 highest volume states for consolidated property casualty premiums, 910 reporting
agency locations wrote 68.7 percent of our 2008 consolidated property casualty earned
premium volume compared with 69.1 percent in 2007.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 4 Property Casualty Insurance Earned Premiums by State
Field Focus
We rely on our field associates to provide service and be accountable to our agencies for
decisions we make at the local level. These associates live in the communities they serve
and work from offices in their homes, providing 24/7 availability to our agents.
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, strengthening the personal relationships we have with
these organizations. Agents have opportunities for direct, personal
conversations with our senior management team, and headquarters associates have
opportunities to refresh their knowledge of marketplace conditions and field activities.
The field team is coordinated by field marketing representatives responsible for new
commercial lines business underwriting. They are joined by field representatives
specializing in claims, loss control, personal lines, machinery and equipment, bond, premium
audit, life insurance and leasing. The field team provides many services for agencies and
policyholders; 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 work with us 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 means working on an individual case or customizing policy terms
and conditions that preserve flexibility, choice and other sales advantages. We seek to
develop long-term relationships by understanding the unique needs of their customers, our
policyholders.
We also are responsive to agent needs for well designed property casualty products. Our
commercial lines products are structured to allow flexible combinations of property and
liability coverages in a single package with a single expiration date. This approach brings
policyholders convenience, discounts and a reduced risk of coverage gaps or disputes. At the
same time, it increases account retention and saves time and expense for the agency and our
company.
We seek to employ technology solutions and business process improvements that:
Agencies access our systems and other electronic services via their agency management
systems or CinciLink®, our secure agency-only Web site. CinciLink provides an array of
Web-based services and content
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 5 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, accounting
services, and electronic libraries for property and casualty coverage forms and state rating
manuals.
Superior Claims Service
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.
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. We believe this same local approach to handling
claims is a competitive advantage for our agents providing surplus lines coverage in their
communities. Our field claims representatives handle these claims under the guidance of
headquarters-based surplus lines claims managers.
Our property casualty claims operation uses CMS, a claims management system, to streamline
processes and achieve operational efficiencies. CMS allows field and headquarters claims
associates to collaborate on reported claims through a virtual claim file. Our field claims
representatives use tablet computers to view and enter information into CMS from any
location, including an insured’s home or agent’s office, and to print claim checks using
portable printers. Agencies now can access selected CMS information such as activity notes
on workers’ compensation claims. Later in 2009, activity notes for other business lines will
be available to the agencies.
Catastrophe response teams are comprised of volunteers from our experienced field claims
staff. We take 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 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
and data between rotating storm teams, headquarters and local field claims representatives.
When hurricanes or other weather events are predicted, we can choose to have catastrophe
response team members 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.
Our claims associates work to control costs where appropriate. They use vendor resources
that provide negotiated pricing to our insureds and claimants. Our field claims
representatives also are educated continuously on new techniques and
repair trends. They can leverage their local knowledge and experience with area body shops,
which helps them negotiate the right price with any facility the policyholder chooses.
We staff a Special Investigations Unit with former law enforcement and claims professionals
whose qualifications make them uniquely suited to gathering 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 forensic lab, using sophisticated software to recover data and mitigate 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 losses. The costs we incur in
investigating, resolving and processing these claims are 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 (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.
Our annual review has led us to add to earnings in each of the past 20 years 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 41, we discuss
our process for analyzing potential losses and establishing reserves. In Item 7, Property
Casualty Loss and Loss Expense Obligations and Reserves,
Page 74, and Life Insurance
Policyholder Obligations and Reserves,
Page 80, we review reserve levels, including 10 year
development of our property casualty loss reserves.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 6 Insurance Products
We actively market property casualty insurance in 35 states through a select group of
independent insurance agencies. Our standard market commercial lines products are marketed
in all of those states while our standard market personal lines are marketed in 27. We
discuss our commercial lines and personal lines insurance operations and products in
Commercial Lines Property Casualty Insurance Segment,
Page 11, and Personal Lines Property
Casualty Insurance Segment,
Page 14. At year-end 2008, CSU Producer Resources marketed our
surplus lines products to agencies in 33 states that represent Cincinnati Insurance.
The Cincinnati Specialty Underwriters Insurance Company was formed in 2007. The company was
capitalized with $200 million from its parent company, The Cincinnati Insurance Company. It
began offering surplus lines insurance products in January 2008. We structured this
operation to exclusively serve the needs of the independent agencies that currently market
our standard market insurance policies. When all or a portion of a current or potential
client’s insurance program requires surplus lines coverages, those agencies now can write
the whole account with Cincinnati, gaining benefits not often found in the broader surplus
lines market. Agencies have access to The Cincinnati Specialty Underwriters Insurance
Company’s product line through CSU Producer Resources, the wholly owned insurance brokerage
subsidiary of parent-company Cincinnati Financial Corporation.
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.
We also 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, our life
operation increases diversification of revenue and profitability sources for both the agency
and our company.
Our property casualty agencies make up the main distribution system for our life insurance
products. To help build scale, we also develop life business from other independent life
insurance agencies in geographic markets 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.
Other Services to Agencies
We complement the insurance operations by providing products and services that help attract
and retain high-quality independent insurance agencies. When we appoint agencies, we look
for organizations with knowledgeable, professional staffs. In turn, we make an exceptionally
strong commitment to assist them in keeping their knowledge up to date and educating new
people they bring on board as they grow. Numerous activities fulfill this commitment at our
headquarters, in regional and agency locations, and online.
Except 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 non-insurance financial
services available through CFC Investment Company. 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. We believe that providing these services enhances agency
relationships with their clients, increasing loyalty while diversifying the agency’s
revenues.
Strategic Initiatives
Management has worked with the board of directors to identify the strategies that can
position us for long-term success. We broadly group these strategies into three areas of
focus – preserving capital, improving insurance profitability and driving premium growth –
correlating with the primary ways we measure our progress toward our long-term financial
objectives. Our strategies are intended to position us to compete successfully in the
markets we have targeted while minimizing risk. We believe successful implementation of the
initiatives that support our strategies will help us better serve our agent customers,
reduce volatility in our financial results and weather difficult economic, market or pricing
cycles. We describe our expectations for the results of these initiatives in Item 7,
Executive Summary of the Management’s Discussion and Analysis,
Page 37.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 7 Preserve Capital
Our first strategy is to preserve capital. Implementation of the initiatives below that
support this strategy is intended to preserve our capital and liquidity so that we can
successfully grow our insurance business. A strong capital position provides the capacity to
support premium growth and provides the liquidity to sustain our investment in the people
and infrastructure needed to implement our other strategic initiatives.
The four primary capital preservation initiatives are:
We measure the overall success of our strategy to preserve capital primarily by growing
investment income and by achieving over any five-year period a total return on our equity
investment portfolio that exceeds the Standard & Poor’s 500’s return. We also monitor other
measures. One of the most significant is our ratio of property casualty net written premiums
to statutory surplus, which was 0.9-to-1 at year-end 2008 compared with 0.7-to-1 at year-end
2007 and 2006. This ratio is a common measure of operating leverage used in the property
casualty industry; the lower the ratio the more capacity a company has for premium growth.
The estimated property casualty industry net written premium to statutory surplus ratio also
was 0.9-to-1 at year-end 2008, 0.8-to-1 at year-end 2007 and 0.9-to-1 at year-end 2006.
Our second means of verifying our capital preservation strategy is our financial strength
ratings as discussed in Our Business and Our Strategy,
Page 1. All of our insurance
subsidiaries continue to be highly rated. A third means is measurement of our risk-based
capital ratios, which currently indicate that our insurance subsidiaries are operating with
a level of capital far exceeding regulatory requirements.
Improve Insurance Profitability
Our second strategy is to improve insurance profitability. Implementation of the operational
initiatives below is intended to support improved cash flow and profitable growth for the
agencies that represent us and for our company. These initiatives primarily seek to
strengthen our relationships with agents, allowing them to serve clients faster and manage
expenses better. Others may streamline our internal processes so we can devote more time to
agent service.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 8 The three primary initiatives to improve insurance profitability are:
We measure the overall success of our strategy to improve insurance profitability primarily
through our GAAP combined ratio, which we believe can be consistently below 100 percent over
any five-year period.
In addition, we expect these initiatives to contribute to our rank as the No. 1 or No. 2
carrier based on premium volume in agencies that have represented us for at least five
years. In 2008, we again earned that rank in more than 75 percent of the agencies that have
represented Cincinnati Insurance for more than five years. We are working to improve that
rank again in 2009 and in each of the years that follow.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 9 Drive Premium Growth
Our third strategy is to drive premium growth. Implementation of the operational initiatives
below is intended to expand our geographic footprint and diversify our premium sources to
obtain profitable growth without significant infrastructure expense. Diversified growth also
may reduce our catastrophe exposure risk and temper negative changes that may occur in the
economic, judicial or regulatory environments in the territories we serve.
The four primary initiatives to drive premium growth are:
We measure the overall success of this strategy to drive premium growth primarily through
changes in net written premiums, which we believe can grow faster than the industry average
over any five-year period.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 10 Notably, many of our growth initiatives have been under way for a
year or more and helped us achieve 13 percent new business growth for 2008 although total
written premiums were down on weak market pricing, economic pressures and a reinsurance
restatement premium.
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, personal lines and surplus lines results.
Revenues, income before income taxes, and identifiable assets for each segment are shown in
a table in Item 8, Note 18 of the Consolidated Financial Statements,
Page 119. 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
Item 7, Management’s Discussion and Analysis of Financial Condition and Results of
Operations, which begins on
Page 37.
Commercial Lines Property Casualty Insurance Segment
The commercial lines property casualty insurance segment contributed net earned premiums of
$2.316 billion to total revenues, or 60.6 percent of that total, and $70 million to income
before income taxes in 2008. Commercial lines net earned premiums declined 3.9 percent in
2008 after growing 0.4 percent in 2007 and 6.6 percent in 2006.
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:
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 11
Our emphasis is on products that agents can market to small- to mid-size businesses in their
communities. Of our 1,387 reporting agency locations, eight market only our surety and
executive risk products and four market only our personal lines products. The remaining
1,375 locations, located in all states in which we actively market, offer some or all of our
standard market commercial insurance products.
In 2008, our 10 highest volume commercial lines states generated 65.9 percent of our earned
premiums compared with 66.7 percent in the prior year. Earned premiums in the 10 highest
volume states decreased 4.4 percent in 2008 and decreased 3.1 percent in the remaining 25
states. The number of reporting agency locations in our 10 highest volume states increased
to 905 in 2008 from 878 in 2007.
Commercial Lines Earned Premiums by State
For new commercial lines business, case-by-case underwriting and pricing is coordinated by
our locally based field marketing representatives. Our agents and our field marketing,
claims, loss control, premium audit, bond and machinery and equipment representatives get to
know the people and businesses in their communities and can make informed decisions about
each risk. These field marketing representatives also are responsible for selecting new
independent agencies, coordinating field teams of specialized company representatives and
promoting all of the company’s products within the agencies they serve.
Commercial lines policy renewals are managed by headquarters underwriters who are assigned
to specific agencies and consult with local field staff as needed. As part of our team
approach, the headquarters underwriter also helps oversee agency growth and profitability.
They are responsible for formal issuance of all new business and renewal policies as well as
policy endorsements. Further, the headquarters underwriters provide day-to-day customer
service to agencies and marketing representatives by providing product training, answering
underwriting questions, helping to determine underwriting eligibility and assisting with the
mechanics of premium determination.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 12 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 and other underwriting judgment factors. We estimate that
approximately 75 percent of 2008 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.
Staying abreast of evolving market conditions is a critical function, accomplished in both
an informal and a formal manner. Informally, our field marketing representatives and
underwriters are in constant receipt of market intelligence from the
agencies with which they work. Formally, our commercial lines product management group and
field marketing associates conduct periodic surveys to obtain competitive intelligence. This
market information helps identify the top competitors by line of business or specialty
program and also identifies our market strengths and weaknesses. The analysis encompasses
pricing, breadth of coverage and underwriting/eligibility issues.
In addition to reviewing our competitive position, our product management group and our
underwriting audit group review compliance with our underwriting standards as well as the
pricing adequacy of our commercial insurance programs and coverages. Further, our research
and development department analyzes opportunities and develops new products, new coverage
options and improvements to existing insurance products.
At year-end 2008, we supported our commercial lines operations with a variety of technology
tools. WinCPP® is our commercial lines premium quoting system. WinCPP is available in all of
our agency locations in which we actively market commercial lines insurance and provides
quoting capabilities for nearly 100 percent of our new and renewal commercial lines
business. WinCPP works with our real-time agency interface, CinciBridge™, which allows
automated movement of key underwriting data from an agency’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 easy and efficient for our agencies
to issue and service these policies. At year-end 2008, e-CLAS for BOP and DBOP was in use in
30 states representing 98 percent of our premiums for these products, which are included in
the specialty packages commercial line of business. e-CLAS also uses CinciBridge to provide
real-time data transfer with agency management systems.
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 2008, more than 92 percent of in-force
non-workers’ compensation commercial lines policy files were administered and stored
electronically in iView. Workers’ compensation policies are to be added to iView in 2009.
Commercial Lines Insurance Marketplace
Our competition for the types and sizes of commercial 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
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 13 market insurance carriers, including both national
and regional carriers, some of which may be mutual companies.
Overall, the softening commercial lines marketplace of the past several years continued to
intensify in 2008. Over this period, anecdotal reports of very aggressive pricing have grown
in frequency. Over the course of 2008, we saw many situations where underwriting discipline
appeared to slip as carriers sought to capture market share. Many carriers continued to
manage the soft market conditions by working aggressively to protect their renewal
portfolios. Renewal decreases in the mid-single digits were still prevalent in the fourth
quarter of 2008; however, we have worked to retain our best renewal business while
continuing to write new business and maintain underwriting discipline. In late 2008 and
early 2009, we have begun to see preliminary indications leading us to believe that market
pricing may be starting to level.
Personal Lines Property Casualty Insurance Segment
The personal lines property casualty insurance segment contributed net earned premiums of
$689 million to total revenues, or 18.0 percent of the total, and reported a loss before
income taxes of $82 million in 2008. Personal lines net earned premiums declined 3.4 percent
in 2008, 6.3 percent in 2007 and 5.3 percent in 2006.
We prefer to write personal lines coverage in accounts that include both auto and homeowner
coverages as well as coverages that are part of our other personal business line. 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:
At year-end, we marketed personal lines insurance products through 954 of our 1,387
reporting agency locations in 27 of the 35 states in which we offer standard market
commercial lines insurance. The remaining 433 locations primarily are in states where we do
not yet actively market these products; some are in locations where we have determined, in
conjunction with agency management, that our personal lines products were not appropriate
for their agencies at this time. As discussed in Strategic Initiatives,
Page 7, introducing
personal lines to these agencies is one of the ways we intend to grow profitably in the next
several years. The number of reporting agency locations in our 10 highest volume states
increased to 627 in 2008 from 604 in 2007.
In 2008, our 10 highest volume personal lines states generated 85.1 percent of our earned
premiums compared with 84.9 percent in the prior year. Earned premiums in the 10 highest
volume states declined 3.0 percent in 2008 and declined 6.4 percent in the remaining states.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 14 Personal Lines Earned Premiums by State
New and renewal personal lines business reflects our risk-specific underwriting philosophy.
Each agency selects personal lines business primarily from within the geographic territory
that it serves, based on the agent’s knowledge of the risks in those communities or
familiarity with the policyholder. Personal lines activities are supported by headquarters
associates assigned to individual agencies. We now have five full-time personal lines
marketing representatives, two headquarters based and three living in the field, and plan to
add two more in 2009. These marketing representatives have underwriting authority and visit
agencies on a regular basis. They reinforce the advantages of our personal lines products
and offer training in the use of our processing system.
Competitive advantages of our personal lines coverages include our claims service, credit
structure and customizable endorsements for both the personal auto and homeowner policies.
Most of our personal lines products are processed through Diamond, our real-time personal
lines policy processing system, which supports and allows 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 third-party data such as
insurance scores, motor vehicle reports and address verification. At year-end 2008, Diamond
was in use in 24 states representing approximately 99 percent of our personal lines premium
volume, all of which is on a one-year term.
In 2006, we introduced PL-efiles, a policy imaging system, to our personal lines operations.
Through year-end 2008, we had transitioned information on current Diamond personal lines
policies to PL-efiles and continue to work on imaging necessary older 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
online access to policy documents and data, enabling them to respond to agent requests and
inquiries quickly and efficiently.
Personal Lines Insurance Marketplace
The independent agencies that market our personal lines products typically represent four to
six standard personal lines carriers. 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.
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, including credit-based information, to
identify multiple relevant variables to segment the market.
We expect the overall market to remain competitive, with small pricing increases in personal
lines over the next 12 to 24 months. Carriers will continue to increase the sophistication
of their pricing to attract more
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 15 preferred customers and gain market share. Industry results
should continue to improve if catastrophe losses return to a normalized level.
Life Insurance Segment
The life insurance segment contributed $126 million, or 3.3 percent, of net earned premiums
and $4 million of income before income taxes in 2008. Life insurance segment profitability
is discussed in detail in Item 7, Life Insurance Results of Operations,
Page 64. Life
insurance net earned premiums grew 0.8 percent in 2008, 9.0 percent in 2007 and 7.9 percent
in 2006.
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 2008, almost 75 percent of our 1,387 property casualty reporting agency locations
offered Cincinnati Life’s products to their clients. We also develop life business from
approximately 500 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 83.7 percent of the life insurance
segment’s revenues:
In addition, Cincinnati Life markets:
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 16 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, 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 in combination with 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 (Excellent),
Fitch – AA- (Very Strong) and Standard & Poor’s – A+ (Strong), as discussed in Financial
Strength,
Page 3. 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. While these redundant
reserves have no effect on GAAP results, they 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.
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 $675 million, or 17.6 percent, of our total revenues in
2008, primarily from net investment income and from realized investment gains and losses
from investment portfolios managed for the holding company and each of the operating
subsidiaries. After deducting $63 million in interest credited to contract holders of the
life insurance segment, the investments segment contributed $612 million of income before
income taxes, or more than 100 percent of our 2008 total income before income taxes.
During 2008, our board and investment department adopted internal guidelines to place
additional parameters around our portfolio. These parameters address, among other issues,
the overall mix of the portfolio as well as security and sector concentrations. The
parameters came out of our risk management program, with the goal of more specifically
defining our risk tolerances, aligning our operating plan accordingly and improving
management’s ability to identify and respond to changing conditions. Going forward, we will
evaluate all of our fixed-maturity and equity investments using our investment parameters,
as appropriate.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 17 The fair value (market value) of our investment portfolio was $8.807 billion and $12.198
billion at year-end 2008 and 2007, respectively. Despite the market turmoil of 2008 and our
decision to realize $1.024 billion in gains on security sales during the year, the overall
portfolio remained in an unrealized gain position at year-end.
The cash we generate from insurance operations historically has been invested in three broad
categories of investments:
We actively determine the portion of new cash flow to be invested in fixed-maturity and
equity securities at the parent and insurance subsidiary levels. We consider internal
measures, as well as insurance department regulations and ratings agency guidance. We
monitor a variety of metrics, including after-tax yields, the ratio of investments in common
stocks to statutory surplus for the property casualty and life insurance operations and the
parent company’s ratio of investment assets to total assets.
At year-end 2008, 1.6 percent of the value of our investment portfolio was made up of
securities that do not actively trade on a public market and require management’s judgment
to develop pricing or valuation techniques (Level 3 assets). We obtain at least two outside
valuations for these assets and generally use the more conservative calculation. These
investments include private placements, small issues and various thinly traded securities.
See Item 7, Fair Value Measurements,
Page 45, and Item 8, Note 3 of the Consolidated
Financial Statements
Page 106, for additional discussion of our valuation techniques.
In addition to securities held in our investment portfolio, at year-end 2008, other invested
assets included $37 million of life policy loans, $32 million of venture capital fund
investments, $8 million of private equity investments and $6 million of investment in real
estate.
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.
During the third quarter of 2008, we terminated a securities lending program under which
certain fixed maturities from our investment portfolio were loaned to other institutions for
short periods of time. As a result, no securities were on loan at year-end 2008 compared
with $745 million at year-end 2007. We discuss the program in Item 8, Note 2 of the
Consolidated Financial Statements,
Page 104.
In conjunction with the program termination, we returned the collateral but chose to retain
a small portfolio of collateralized mortgage obligations (CMOs) rather than sell them at
what we felt were distressed prices in an illiquid market. The CMOs were an investment made
by one of the short-duration funds, which subsequently dissolved and distributed the assets
to its investors. All $30 million of the CMOs in the portfolio are collateralized by Alt-A mortgages that
originated between 2004 and 2006. Consequently, at December 31, 2008, we owned
investment-grade CMOs with a fair value and book value of $27 million and $39 million,
respectively. Of the $27 million investment-grade CMOs, $21 million were rated AAA by
Standard & Poor’s. We also owned non-investment grade CMOs that had a fair value and book
value of $3 million and $4 million, respectively. We do not intend to make additional
investments in this asset category.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 18 Fixed-maturity and Short-term Portfolio Ratings
As of year-end 2008, the portfolio was trading at 96.2 percent of its book value, in line
with general market conditions. The general level of interest rates decreased over the
course of 2008; however, credit spreads widened considerably due to a continued flight to
quality.
The downward shift in the higher portfolio ratings during 2008 primarily was driven by
significant calls of government sponsored entities (GSE) bonds, as well as rating
withdrawals that occurred in response to the difficulties experienced by certain municipal
bond insurers. 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:
We discuss the maturity of our fixed-maturity portfolio in Item 8, Note 2 of the
Consolidated Financial Statements,
Page 104. Attributes of the fixed-maturity portfolio
include:
Taxable Fixed Maturities
Our taxable fixed-maturity portfolio (at fair value) at year-end 2008 included:
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. With the exception of U.S. agency paper (government-sponsored
entities), no individual issuer’s securities accounted for more than 1.7 percent of the
taxable fixed-maturity portfolio at year-end 2008.
The investment-grade corporate bond portfolio is most heavily concentrated in the
financial-related sectors, including banks, brokerage, finance and investment and insurance
companies. The financial sectors represented 34.2 percent of fair value of this portfolio at
year-end 2008, compared with 42.1 percent, at year-end 2007. Although the financial-related
sectors make up our largest group of investment-grade corporate bonds, we believe our
concentration is below the average for the corporate bond market as a whole. Utilities are
the only other sector that exceeds 10 percent of our investment-grade corporate bond
portfolio, at 11.6 percent of fair value at year-end 2008.
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 0.6 percent of the tax-exempt municipal bond portfolio at year-end 2008, there
are higher concentrations within individual states. Holdings in Texas and Indiana accounted
for a total of 35.0 percent of the municipal bond portfolio at year-end 2008.
In recent years, we have purchased insured municipal bonds because of their excellent
credit-adjusted after-tax yields. At year-end 2008, bonds representing $2.290 billion, or
83.8 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,
over 90 percent of the insured municipal bonds have an underlying rating of at least A3 or
A-.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 19 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 2008, we had $84
million of short-term investments compared with $101 million at year-end 2007.
Equity Investments
After covering both our intermediate and long-range insurance obligations with
fixed-maturity investments, we historically used available cash flow to invest in equity
securities. Investment in equity securities has played an important role in achieving our
portfolio objectives and has contributed to portfolio appreciation. We remain committed to
our long-term equity focus, which we believe is key to our company’s long-term growth and
stability.
Common Stocks
Our common stock investments generally are dividend-paying securities. In this market, we
are seeking to maximize our potential return while minimizing dividend income risk by
selecting securities from a variety of dividend scenarios, including those with the
potential for dividend growth from a below-market current yield. Other criteria we evaluate
include increasing sales and earnings, proven management and a favorable outlook. We believe
our equity investment style is an appropriate long-term strategy after we have purchased
fixed maturity investments to cover our insurance reserves.
In mid-2008, we began applying new investment guidelines that increased portfolio
diversification, reducing single issue and sector concentrations. Our year-end 2008
portfolio has been positioned for reduced volatility going forward. As a result, despite
economic and market disruptions that led to unprecedented value declines, our equity
portfolio suffered less than the broader indices during 2008.
We view our diversifying actions to be consistent with our view of prudent risk management.
At year-end 2008, our financial sector holdings were 12.4 percent of our $2.7 billion
publicly traded common stock portfolio, below the Standard & Poor’s 500 weighting, and
significantly lower than our 56.2 percent financial sector weighting at year-end 2007. Among
other changes, we reduced our Fifth Third Bancorp (NASDAQ:FITB) holding to approximately 12
million shares at year-end 2008. Following Fifth Third’s further reduction of its dividend
payout in December 2008, we sold the remainder of our holding in January 2009 for an
additional capital gain. We expect to continue to make changes to the portfolio, as deemed
appropriate.
Proceeds of sales are being reinvested in both fixed income and equity securities with
yields that we believe are likely to be more secure. This may slow the return to growth in
investment income although we believe year-over-year comparisons may turn positive in the
second half of 2009.
Common Stock Portfolio Industry Sector Distribution
At year-end 2008, 29.7 percent of our common stock holdings (measured by fair value) were
held at the parent company level.
Until June 2008, we had held more than 10 percent of Fifth Third’s common stock for many
years. We continue to hold more than 5 percent of Piedmont Natural Gas Company (NYSE:PNY).
At year-end 2008, there were 12 holdings with a fair value equal to or greater than 2
percent of our publicly traded common stock portfolio compared with 15 similar holdings at
year-end 2007. No single issue accounted for more than 14.5 percent at year-end 2008.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 20 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, providing us with another layer of protection. We believe that careful
application of this strategy continues to have merit, although events of 2008 indicated that
preferred stocks will not receive preferential treatment in a government-sponsored
restructuring. 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 104.
Other
We report as “Other” the other income of our standard market property casualty insurance
subsidiary, as well as non-investment operations of the parent company and its subsidiaries,
CFC Investment Company and CinFin Capital Management Company (excluding client investment
activities). In 2008, we also included results of our surplus lines operations, The
Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources.
CFC Investment Company
CFC Investment Company offers commercial leasing and financing services to our agents, their
clients and other customers. As of year-end 2008, CFC Investment Company had 2,197 accounts
and $71 million in receivables, compared with 2,590 accounts and $92 million in receivables
at year-end 2007.
CinFin Capital Management
CinFin Capital Management provided asset management services to internal and third-party
clients. CinFin Capital advised clients in December 2008 that it would close on February 28,
2009. During the recent financial market downturn, this business performed satisfactorily
relative to the appropriate benchmarks, and it was profitable over its 10 years in
operation. We determined that sufficient future growth through agency referrals or other
routes would have required a substantial increase in resources even as we are seeking to
increase our focus on our core insurance business with new initiatives. Many of our agencies
did not see referrals for investment management services within the scope of their offerings
to their clients.
As of year-end 2008, CinFin Capital had 44 institutional, corporate and individual clients.
Assets under management were $817 million. We have given our unaffiliated clients ample
opportunity to arrange for another financial adviser and respond to any market changes in a
timely manner. We will continue to manage internally our pension plan and Cincinnati Life’s
separate accounts.
Surplus Lines Property Casualty Insurance
Agencies have access to The Cincinnati Specialty Underwriters Insurance Company’s product
line through CSU Producer Resources, the wholly owned insurance brokerage subsidiary of
parent-company Cincinnati Financial Corporation. CSU Producer Resources has binding
authority on all classes of business written through CSU and maintains appropriate agent and
surplus lines licenses to process non-admitted business.
Producers can submit risks to CSU Producer Resources, reflecting the mix of accounts
Cincinnati agencies currently write in their non-admitted surplus lines markets. CSU
Producer Resources currently markets and underwrites commercial general liability, property
and miscellaneous errors and omissions coverages in 33 states. It will continue to add lines
of business and coverages.
Agency producers have direct access through CSU Producer Resources to our dedicated surplus
lines 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 surplus lines 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.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 21 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 insurance
subsidiary is governed by the insurance laws and regulations in its respective state of
domicile. We also are subject to state regulatory authorities of all states in which we
write insurance. The state laws and regulations that have the most significant effect on our
insurance operations and financial reporting are discussed below.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 22
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 — 2008 Annual Report on 10-K — Page 23
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 24 Item 1A. Risk Factors
Our business involves various risks and uncertainties that may affect achievement of our
business objectives. Many of the risks could have ramifications across our organization. For
example, while risks related to setting insurance rates and establishing and adjusting loss
reserves are insurance activities, errors in these areas could have an impact on our
investment activities, growth and overall results. The following discussion should be viewed
as a starting point for understanding the significant risks we face. It is not a definitive
summary of their potential impacts or of our strategies to manage and control the risks.
Please see Item 7, Management’s Discussion and Analysis of Financial Condition and Results
of Operations,
Page 37, for a discussion of those strategies.
The risks and uncertainties discussed 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. We could lose premium if
a bank that owns appointed agencies changes its strategies.
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.
We could experience an unusually high level of losses due to catastrophic, pandemic 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
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 25 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. Our ability to appropriately manage catastrophe risk depends
partially on catastrophe models, the accuracy of which may be impacted by inaccurate or
incomplete data, the uncertainty of the frequency and severity of future events and the
uncertain impact of climate change.
The geographic regions in which we market insurance are exposed to numerous natural
catastrophes, such as:
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 35 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 experience
over a period of time exceeds our actuarially determined expectations. In addition, our
financial condition would be adversely affected if we were required to sell securities prior
to maturity or at unfavorable prices to pay an unusually high level of loss and loss
expenses. Securities pricing might be even less favorable if a number of insurance 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 products
in 35 states, but our business is concentrated in the Midwest and Southeast. We also have
exposure in states where we do not actively market insurance when clients of our independent
agencies have businesses or properties in multiple states.
The Cincinnati Insurance Company also participates in three assumed reinsurance treaties
with two reinsurers that spread the risk of very high catastrophe losses among many
insurers. In 2009, 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. We also may be exposed to state guaranty fund assessments if
other carriers in a state cannot meet their obligations to policyholders. A catastrophe or
epidemic event also could affect our operations by damaging our headquarters facility,
injuring associates and visitors at our Fairfield, Ohio, headquarters or disrupting our
associates’ ability to perform their assigned tasks.
Our ability to achieve our performance objectives could be affected by changes in the
financial, credit and capital markets or the general economy.
We invest premiums received from policyholders and other available cash to generate
investment income and capital appreciation, maintaining sufficient liquidity to pay covered
claims and operating expenses, service our debt obligations and pay dividends.
Investment income is an important component of our revenues and net income. The ability to
increase investment income and generate longer-term growth in book value is affected by
factors 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, market events leading to
credit constriction and other widespread unpredictable events. These events may adversely
affect the economy generally and could cause our investment income or the value of
securities we own to decrease. A significant decline in our investment income could have an
adverse effect on our net income, and thereby on our shareholders’ equity and our
policyholders’ surplus. For more detailed discussion of risks associated with our
investments, please refer to Item 7A, Qualitative and Quantitative Disclosures About Market
Risk,
Page 85.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 26 We issue
life contracts with guaranteed minimum returns, referred to as bank-owned life
insurance contracts (BOLIs). BOLI investment assets must meet certain criteria established
by the regulatory authorities in which 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. We could experience losses
if the assets in the accounts are less than liabilities at the time of maturity or
termination. We discuss other risks associated with our separate account BOLIs in Item 7,
Critical Accounting Estimates, Separate Accounts,
Page 47.
Further deterioration in the banking sector or in banks with which we have relationships
could affect our results of operations. Our ability to maintain or obtain short-term lines
of credit could be affected if the banks from which we obtain these lines are purchased,
fail or are otherwise negatively affected. The value of corporate bonds and common equities
we hold in the banking sector could further deteriorate. We may lose
premium if a bank that owns appointed agencies changes its strategies. We could experience increased
losses in our directors and officers liability line of business if claims are made against
insured financial institutions.
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 2008, common stock holdings made up 30.6 percent of our invested assets. Adverse
news or events affecting the global or U.S. economy or the equity markets could affect our
net income, book value and overall results as well as our ability to pay our common stock
dividend. See Item 7, Investments Results of Operations,
Page 66, and Item 7A, Qualitative
and Quantitative Disclosures About Market Risk,
Page 85, for discussion of our investment
activities.
Deteriorating credit and market conditions could also impair our ability to access credit
markets and could affect existing or future lending arrangements.
Our overall results could be affected if a significant portion of our commercial lines
policyholders, including those purchasing surety bonds, are adversely affected by marked or
prolonged economic downturns and events such as a downturn in construction and related
sectors, tightening credit markets and higher fuel costs. Such events could make it more
difficult for policyholders to finance new projects, complete projects or expand their
businesses, leading to lower premiums from reduced payrolls and sales and lower purchases of
equipment and vehicles. These events could also cause claims, including surety claims, to
increase due to a policyholder’s inability to secure necessary financing to complete
projects or to collect on underlying lines of credit in the claims process. Such economic
downturns and events could have a greater impact in the construction sector where we have a
concentration of risks and in geographic areas that are hardest hit by economic downturns.
Deteriorating economic conditions could also increase the degree of credit risk associated
with amounts due from independent agents who collect premiums for payment to us and could
hamper our ability to recover amounts due from reinsurers.
Our ability to properly underwrite and price risks and increased competition could adversely
affect our results.
Our financial condition, cash flow and results of operations depend on our ability to
underwrite and set rates accurately for a full spectrum of risks. We establish our pricing
based on assumptions about the level of losses that may occur within classes of business,
geographic regions and other criteria.
To properly price our products, we must collect and properly analyze data; the data must be
sufficient, reliable and accessible; we need to develop appropriate rating methodologies and
formulae; and we may need to identify and respond to trends quickly. 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:
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 27
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 the discussion of our Commercial Lines, Personal Lines and Life Insurance
Segments in Item 1,
Page 11,
Page 14 and
Page 16, for a discussion of our competitive
position in the insurance marketplace.
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 98, and Item 7, Critical
Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves and Life
Insurance Policy Reserves,
Page 41 and
Page 44. Our most critical accounting estimate is loss reserves. Loss reserves are the amounts we
expect to pay for covered claims and expenses we incur to settle those claims. The loss
reserves we establish in our financial statements represent an estimate of amounts needed to
pay and administer claims arising from insured events that have already occurred, including
events that have not yet been reported to us. Loss reserves are estimates and are inherently
uncertain; they do not and cannot represent an exact measure of liability. 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 about
individual claims develop, additional losses are reported and new information becomes known.
Adjustments due to loss development on prior periods 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 Insurance Loss and Loss Expense
Reserves and Life Insurance Policy Reserves,
Page 41 and
Page 44.
Unforeseen losses, the type and magnitude of which we cannot predict, may emerge in the
future. These additional losses could arise from changes in the legal environment, laws and
regulations, climate change, catastrophic events, increases in loss severity or frequency,
or other causes. Such future losses could be substantial.
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
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 28 believe we are entitled to receive under our reinsurance contracts. Reinsurers might refuse
or fail to pay losses that we cede to them, or they might delay payment. For long-tail
claims, the creditworthiness of our reinsurers may change before we can recover amounts to
which we are entitled. A reinsurer’s insolvency, inability or unwillingness to make payments
under the terms of its reinsurance agreement with our insurance subsidiaries could have a
material adverse effect on our financial position, results of operations and cash flows.
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 2008, 28.6 percent, or $217 million,
of our total reinsurance receivables were related to USAIG, primarily for September 11,
2001, events, offset by $226 million of amounts ceded to other pool
participants and reinsurers. If the pool participants and reinsurers are unable to fulfill
their financial obligations and all security collateral that supports the participants’
obligations becomes worthless, we could be liable for an additional pool liability of
$283 million and our financial position and results of operations could be materially
affected. Currently all pool participants and reinsurers are financially solvent.
We no longer participate in new business generated by USAIG and its members. Please see Item
7, 2009 Reinsurance Programs,
Page 81, for a discussion of our reinsurance treaties.
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. This risk is exacerbated because approximately 70 percent of our associates work
at our Fairfield, Ohio, headquarters.
The effects of changes in industry practices and regulations on our business are uncertain.
As industry practices and legal, judicial, legislative, regulatory, political, social and
other environmental conditions change, unexpected and unintended issues related to insurance
pricing, claims, and coverage, may emerge. These issues may adversely affect our business by
impeding our ability to obtain adequate rates for covered risks, extending coverage beyond
our underwriting intent 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), state insurance
regulators and state legislators are continually reexamining existing laws and regulations
governing insurance companies and insurance holding 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, regulation or NAIC
initiatives, if adopted, may be more restrictive on our ability to conduct business than
current regulatory requirements or may result in higher costs.
Additionally, laws and regulations may be enacted in the wake of the current financial and
credit crises that have adverse affects on our business, potentially including a change from
a state-based system of regulation to a system of federal regulation. While we do not
participate or intend to seek to participate in the Troubled Asset Relief Program, the
effect of it or any similar legislation on our industry and the economy in general is
uncertain.
The effects of such changes could adversely affect our results of operations. Please see
Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense
Reserves and Life Insurance Policy Reserves,
Page 41 and
Page 44, for a discussion of our
reserving practices.
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
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 29 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, Strategic Initiatives,
Page 7 for a discussion of our technology
initiatives.
Our status as an insurance holding company with no direct operations could affect our
ability to pay dividends in the future.
Cincinnati Financial Corporation is a holding company that transacts substantially all of
its business through its subsidiaries. Our primary assets are the stock in our operating
subsidiaries and our investments. Consequently, our cash flow to pay cash dividends and
interest on our long-term debt depends on dividends we receive from our operating
subsidiaries and income earned on investments held at the parent-company level.
Dividends paid to our parent company by our insurance subsidiary are restricted by the
insurance laws of Ohio, its domiciliary state. These laws establish minimum solvency and
liquidity thresholds and limits. 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 22, and Item 8, Note 9 of the Consolidated Financial
Statements,
Page 110, for discussion of insurance holding company dividend regulations.
Item 1B. Unresolved Staff Comments
None
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 30 Item 2. Properties
Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land
in Fairfield, Ohio. This building has approximately 1,508,200 total square feet of available
space. In 2008, we completed construction of a 425,400 square foot third office tower and
276,800 square foot underground garage. We expect this expansion to accommodate our business
needs for the foreseeable future. The property, including land, is carried in our financial
statements at $159 million as of December 31, 2008, and is classified as land, building and
equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party,
occupies approximately 6,750 square feet (less than 1 percent).
Cincinnati Financial Corporation also owns the Fairfield Executive Center, which is located on
the northwest corner of our headquarters property. This four-story office building has
approximately 124,000 square feet of available space. The property is carried in the
financial statements at $6 million as of December 31, 2008, and is classified as an other
invested asset. Unaffiliated tenants occupy approximately 8 percent. All unoccupied space is
currently available for lease.
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 48,000 square foot building to serve as a business continuity center.
The property, including land, is carried on our financial statements at $6 million as of
December 31, 2008, 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 2008.
Part II
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
Cincinnati Financial Corporation had approximately 12,000 shareholders of record and
approximately 37,000 beneficial shareholders as of December 31, 2008. Many of our
independent agent representatives and most of the 4,179 associates of our subsidiaries own
the company’s common stock. We are unable to quantify those holdings because many are
beneficially held.
Our common shares are traded under the symbol CINF on the Nasdaq Global Select Market.
We discuss the factors that affect our ability to pay cash dividends and repurchase shares
in Item 7, Liquidity and Capital Resources,
Page 70. One factor we address is regulatory
restrictions on the dividends our insurance subsidiary can pay to the parent company, which
also is discussed in Item 8, Note 9 of the Consolidated Financial Statements,
Page 110.
The following summarizes securities authorized for issuance under our equity compensation
plans as of December 31, 2008:
The number of securities remaining available for future issuance includes: 7,304,065 shares
available for issuance under the Cincinnati Financial Corporation 2006 Stock Compensation
Plan, which can be issued as stock options, service-based, or performance-based restricted
stock units, stock appreciation rights or other equity-based grants; 25,394 shares available
for issuance of full share grants under the Cincinnati Financial Corporation 2003
Non-Employee Directors’ Stock Plan; and 4,186 shares of stock options available for issuance
under the Cincinnati Financial Corporation Stock Option Plan VII. Additional information
about stock-based associate compensation granted under our equity compensation plans is
available in Item 8, Note 17 of the Consolidated Financial Statements,
Page 117.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 32 We did not sell any shares that were not registered under the Securities Act during 2008.
The board of directors has authorized share repurchases since 1996. In 2008, we repurchased
a total of 3.8 million shares. In January 2008, we acquired 71,003 shares to settle the
accelerated share repurchase program authorized in October 2007, when the board of directors
expanded an 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 publicly announced plan repurchases in the
table above were made under the expansion announced in October 2007 of our 2005 program.
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, 2003, assuming the reinvestment of all dividends, was a negative 9.0 percent
for Cincinnati Financial Corporation’s common stock compared with a negative 2.1 percent for
the Standard & Poor’s Composite 1500 Property & Casualty Insurance Index and a negative 10.5
percent for the Standard & Poor’s 500 Index.
The Standard & Poor’s Composite 1500 Property & Casualty Insurance Index includes 23
companies: Allstate Corporation, Berkley (W R) Corporation, Chubb Corporation, Cincinnati
Financial Corporation, Fidelity National Financial Inc., First American Corporation, Hanover
Insurance Group Inc., Infinity Property & Casualty Corporation, MBIA Inc., Mercury General
Corporation, Navigators Group Inc., Old Republic International Corporation, Proassurance
Corporation, Progressive Corporation, RLI Corporation, Safety Insurance Group 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 — 2008 Annual Report on 10-K — Page 33 Item 6. Selected Financial Data
Per share data adjusted to reflect all stock splits and dividends prior to December 31,
2008.
One-time Charges or Adjustments:
2008 — We changed the form of retirement benefit we offer certain associates to a 401(k)
plan with company match from a qualified defined benefit pension plan. We incurred a pretax
expense of $27 million to recognize a settlement loss associated with the partial
termination of the qualified pension plan. The expense reduced net income by $17 million, or
11 cents per share, and raised the combined ratio by 0.8 percentage points.
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 — We 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. We 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 — 2008 Annual Report on 10-K — Page 34
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 35 [This page intentionally blank]
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 36 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of
Operations
Introduction
The purpose of Management’s Discussion and Analysis is to provide an understanding of
Cincinnati Financial Corporation’s consolidated results of operations and financial
condition. Our Management’s Discussion and Analysis should be read in conjunction with Item
6, Selected Financial Data,
Page 34 and
Page 35, and Item 8, Consolidated Financial Statements
and related Notes, beginning on
Page 91. We present per share data on a diluted basis unless
otherwise noted, adjusting those amounts for all stock splits and stock dividends.
We begin with an executive summary of our results of operations and outlook, 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 within the context of 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, Cincinnati Financial Corporation is one of the 25
largest property casualty insurers in the nation, based on written premium volume for
approximately 2,000 U.S. stock and mutual insurer groups. We market our insurance products
through a select group of independent insurance agencies in 35 states as discussed in Item
1, Our Business and Our Strategy,
Page 1.
Although 2008 was a difficult year for our economy, our industry and our company, our
long-term perspective lets us address the immediate challenges while focusing on the major
decisions that best position the company for success through all market cycles. We believe
that this forward-looking view has consistently benefited our policyholders, agents,
shareholders and associates.
To measure our progress, we have defined a measure of value creation that we believe
captures the contribution of our insurance operations, the success of our investment
strategy and the importance we place on paying cash dividends to shareholders. Between 2010
and 2014, we expect the total of 1) our rate of growth in book value per share plus 2) the
ratio of dividends declared per share to beginning book value per
share to average 12 percent to 15
percent. With the current economic and market uncertainty, we believe this ratio is an
appropriate way to measure our long-term progress in creating value.
When looking at our longer-term objectives, we see three performance drivers:
The board of directors is committed to rewarding shareholders directly through cash
dividends and through share repurchase authorization. The board also has periodically
declared stock dividends and splits. Through
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 37 2008, the company has increased the indicated annual cash dividend rate for 48 consecutive
years, a record we believe is matched by only 11 other publicly traded companies. While
seeing merit in continuing that record, in February 2009, our board indicated its first
priority was assuring continued financial strength for the company and that its intention
was to consider the potential for a 49th year of increase over the course of
2009. We discuss our financial position in more detail in Liquidity and Capital Resources,
Page 70.
Strategic Initiatives Highlights
Management has worked with the board of directors to identify the strategies that can lead
to long-term success. Our strategies are intended to position us to compete successfully in
the markets we have targeted while minimizing risk. We believe successful implementation of
the initiatives that support our strategies will help us better serve our agent customers,
reduce volatility in our financial results and weather difficult economic, market or pricing
cycles.
We discuss each of these strategies, along with the metrics we use to assess their progress,
in Item 1, Strategic Initiatives,
Page 7.
Factors Influencing Our Future Performance
In January and February of 2009, storms affecting our policyholders largely in the Midwest
currently are estimated to have resulted in about $30 million of reported claims, which
will be included in first-quarter pretax catastrophe losses. This estimate does not take
into account development of these catastrophes, any further catastrophe activity that may
occur in the remainder of the first quarter of 2009 or potential development from events in
prior periods.
In 2008, the rate of growth in book value plus the rate of dividend contribution was below
our target, as discussed in the review of our financial highlights below. In 2009, we
believe our value creation ratio may also be below our long-term target for several reasons.
Our view of the value we can create over the next five years relies on two assumptions about
the external environment. First, we’re anticipating some firming of commercial insurance
pricing during 2009. Second, we believe that the economy and financial markets can resume a
growth track by the end of 2010. If those assumptions prove to be inaccurate, we may not be
able to achieve our performance targets even if we accomplish our strategic objectives.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 38 Other factors that could influence our ability to achieve our targets include:
We discuss in our Item 1A, Risk Factors,
Page 25, many potential risks to our business and
our ability to achieve our qualitative and quantitative objectives. These are real risks,
but their probability of occurring may not be high. We also believe that our risk management
programs generally can mitigate their potential effects, in the event they do occur.
We have formal risk management programs overseen by a senior officer and supported by a team
of representatives from business areas. The team reports to our chairman, our president and
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.
Below we review highlights of our financial results for the past three years. Detailed
discussion of these topics appears in Results of Operations,
Page 48, and Liquidity and
Capital Resources,
Page 70.
Corporate Financial Highlights
The value creation ratio discussed in the Executive Summary,
Page 37, was a negative 23.5
percent in 2008, a negative 5.7 percent in 2007 and a positive 16.7 percent in 2006. In both
2008 and 2007, a decline in unrealized gains on our investment portfolio was the most
significant factor in the decline in book value as discussed below. In 2008, net income also
was significantly below the level of the prior two years.
Cash dividends declared per share rose 9.9 percent in 2008, 6.0 percent in 2007 and 11.2
percent in 2006.
Balance Sheet Data and Performance Measures
Invested
assets declined because of lower fair values for portfolio investments, largely
due to economic factors. The downturn in the economy had a particularly adverse effect on
our financial sector equity holdings, which made up a significant portion of the portfolio
prior to mid-2008. By year-end 2008, the portfolio was substantially more diversified and
generally better positioned to withstand short-term fluctuations. We discuss our investment
strategy in Item 1, Investments Segment,
Page 17, and results for the segment in Investments
Results of Operations,
Page 66.
Our ratio of debt to total capital (debt plus shareholders’ equity) rose over the three
years due to the effect on shareholders’ equity of the declining value of our invested
assets. Long-term debt was unchanged over the period.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 39 Income Statement and Per Share Data
Net income declined in 2008 from the higher levels of the prior two years because of a
three-year decline in realized investment gains, a first-ever decline in investment income
and a lower aggregate contribution from our insurance segments. The pension plan settlement
reduced 2008 net income by $17 million, or 11 cents per share. The transition from a defined
benefit pension plan reduces company risk while providing flexible, company-sponsored 401(k)
benefit to associates.
Weighted average shares outstanding may fluctuate from period to period because we
repurchase shares under board authorizations and we issue shares when associates exercise
stock options. Weighted average shares outstanding on a diluted basis declined 9 million in
2008, 3 million in 2007 and 2 million in 2006.
As discussed in Investments Results of Operation,
Page 66, security sales led to realized
investment gains in all three years, although 2008 gains were tempered by $510 million in
other-than-temporary impairment charges. Realized investment gains and losses are integral
to our financial results over the long term. We have substantial discretion in the timing of
investment sales and, therefore, the gains or losses that are recognized in any period. That
discretion generally is independent of the insurance underwriting process. Also, applicable
accounting standards require us to recognize gains and losses from certain changes in fair
values of securities and for securities with embedded derivatives without actual realization
of those gains and losses.
Lower income from dividends led to an 11.6 percent decline in net investment income in 2008,
the first decline in this measure in company history. The primary reason for the decline was
dividend reductions by common and preferred holdings, including reductions during the year
on positions subsequently sold or reduced.
Contribution from Insurance Segments
The trend in overall written premium growth reflected the competitive and market factors
discussed in Item 1, Commercial Lines and Personal Lines Property Casualty Insurance
Segment,
Page 11 and
Page 14.
In 2008, our property casualty insurance operations reported an underwriting loss after
achieving record profitability in 2007. Underwriting profitability can be measured by the
combined ratio. (The combined ratio is the percentage of each earned premium dollar spent on
claims plus all expenses — the lower the ratio, the better the performance.) In 2008 and
2007, higher savings from favorable development on prior period reserves helped offset other
loss and loss expenses. Catastrophe losses fluctuated dramatically over the three-year
period, making an unusually high contribution of 6.8 percentage points to the combined ratio
in 2008 after an unusually low 0.8 points in 2007. The pension plan settlement increased the
2008 combined ratio by 0.8 percentage points.
Our new surplus lines operation contributed $14 million to net written premiums and $5
million to earned premiums, but had an immaterial effect on net income. The business
achieved its first-year strategic plan objectives.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 40 Our life insurance segment continued to provide a consistent source of profit. We discuss results for the segment in Life Insurance Results of
Operations,
Page 64. Income and gains from the life insurance investment portfolio are
included in Investment segment results.
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 98. In
conjunction with that discussion, material implications of uncertainties associated with the
methods, assumptions and estimates underlying the company’s critical accounting policies are
discussed below. The audit committee of the board of directors reviews the annual financial
statements with management and the independent registered public accounting firm. These
discussions cover the quality of earnings, review of reserves and accruals, reconsideration
of the suitability of accounting principles, review of highly judgmental areas including
critical accounting policies, audit adjustments and such other inquiries as may be
appropriate.
Property Casualty Insurance Loss And Loss Expense Reserves
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 $4.040 billion at year-end
2008 compared with $3.925 billion at year-end 2007.
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 about a loss becomes available. As part of the review process, we monitor
industry trends, cost trends, relevant court cases, legislative activity and other current
events in an effort to ascertain new or additional loss exposures.
We also establish incurred but not reported (IBNR) reserves to provide for all unpaid loss
and loss expenses not accounted for by case reserves:
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 41
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 IBNR reserve estimates for these losses primarily on the
indications of methods and models that analyze accident year data. Accident year is the year
in which an insured claim, loss, or loss expense occurred. The specific methods and models
that our actuaries have used for the past several years are:
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 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:
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 42
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 of the likelihood that statistically significant patterns in
historical data may extend into the future. The four most significant of the key assumptions
used by our actuarial staff and approved by management are:
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.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 43 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 90.6 percent of our 2008 loss and loss expense reserves as well as the potential
effects on our net income, assuming a 35 percent federal tax rate. Standard errors and
reserve ranges for assorted groupings of these lines of business cannot be computed by
simply adding the standard errors and reserve ranges of the component lines of business,
since such an approach would ignore the effects of product diversification. See Range of
Reasonable Reserves,
Page 74, 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 may fall, one or more lines’ actual unpaid loss and loss expenses could nonetheless
fall outside of the indicated ranges.
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 2008,
consolidated fixed maturity investments exceeded total insurance reserves (including life
policy reserves) by more than $190 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.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 44 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 fair 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
that reduced our income before income taxes by $510 million in 2008, $16 million in 2007 and
$1 million in 2006. 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 may be recouped within a designated recovery period. Other than-temporary
impairment losses represent non-cash charges to income.
Our portfolio managers monitor their assigned portfolios. 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 fair value, the extent of the
fair value decline and the length of time the value of the security has been depressed, as
well as qualitative measures such as pending events, credit ratings and issuer liquidity. We
are even more proactive when these declines in valuation are greater than might be
anticipated when viewed in the context of overall economic and market conditions. We provide
information about valuation of our invested assets in Item 8, Note 2 of the Consolidated
Financial Statements,
Page 104.
All securities valued below 100 percent of book value are reported to the asset impairment
committee for evaluation. A security valued between 95 percent and 100 percent of book value
is not monitored separately by the committee. These assets generally are at this value
because of interest rate-driven factors.
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 financial strength, management may not impair certain securities even when
they are trading below cost.
For fixed-maturity investments, we can make that determination based on our ability to hold
until their scheduled redemption securities that are meeting their debt obligations and have
the potential to recover value. For equity investments, we can make that determination based
on a thorough assessment of the potential for recovery over a longer-term horizon. 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. We provide detailed information about
securities trading in a continuous loss position at year-end 2008 in Item 7A, Application of
Asset Impairment Policy,
Page 87. An other-than-temporary decline in the fair value of a
security is recognized in net income as realized investment losses.
Other-than-temporary impairment charges 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 fair value, which may be at maturity. Under the same accounting
treatment as fair value gains, temporary declines (changes in the fair value of these securities) are
reflected in shareholders’ equity on our balance sheet in accumulated other comprehensive
income, net of tax, and have no impact on reported net income.
Fair Value Measurements
Valuation of Financial Instruments
Valuation of financial instruments, primarily securities held in our investment portfolio,
is a critical component of our interim financial statement preparation. We account for our
investment portfolio at fair value and apply fair value measurements as defined by SFAS No.
157, Fair Value Measurements, to financial instruments. Fair value is applicable to SFAS No.
115, Accounting for Certain Investments in Debt and Equity Securities, SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities, SFAS No. 155, Accounting for
Certain Hybrid Financial Instruments, and SFAS No. 107, Disclosures about Fair Value of
Financial Instruments.
We adopted the provisions of SFAS No. 157 on January 1, 2008. SFAS No. 157 defines fair
value as the exit price or the amount that would be 1) received to sell an asset or 2) paid
to transfer a liability in an orderly transaction between marketplace participants at the
measurement date. When determining an exit price, we
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 45 must, whenever possible, rely upon observable market data. Prior to the adoption of SFAS No.
157, we considered various factors such as liquidity and volatility but primarily obtained
pricing from various external services, including broker quotes.
The SFAS No. 157 exit price notion requires our valuation also to consider what a
marketplace participant would pay to buy an asset or receive to assume a liability.
Therefore, while we can consider pricing data from outside services, we ultimately determine
whether the data or inputs used by these outside services are observable or unobservable.
In accordance with SFAS No. 157, we have categorized our financial instruments, based on the
priority of the inputs to the valuation technique, into a three-level fair value hierarchy.
The fair value hierarchy gives the highest priority to quoted prices in active markets for
identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs
(Level 3). If the inputs used to measure the financial instruments fall within different
levels of the hierarchy, the categorization is based on the lowest level that is significant
to the fair value measurement of the instrument.
Financial assets and liabilities recorded on the Consolidated Balance Sheets are categorized
based on the inputs to the valuation techniques as described in Item 8, Note 3 of the
Consolidated Financial Statements,
Page 106.
Level 1 and Level 2 Valuation Techniques
Over 98 percent of our $8.8 billion invested assets measured at fair value are classified as
Level 1 or Level 2. Financial assets that fall within Level 1 and Level 2 are priced
according to observable data from identical or similar securities that have traded in the
marketplace. Also within Level 2 are securities that are valued by outside services or
brokers where we have evaluated the pricing methodology and determined that the inputs are
observable.
Included in the Level 2 hierarchy are a small portfolio of collateralized mortgage
obligations that represented less than 1 percent of the fair value of our investment
portfolio at December 31, 2008. We obtained the CMOs as part of the termination of our
securities lending program during 2008. The CMOs were an investment made by one of the
short-duration funds, which subsequently dissolved and distributed the assets to its
investors. When we terminated the securities lending program, we chose to retain the CMOs
rather than sell them at what we felt were distressed prices in an illiquid market.
All $30 million of the CMOs in our portfolio are collateralized by Alt-A mortgages that
originated between 2004 and 2006. We owned investment grade CMOs with a fair value and
book value of $27 million and $39 million, respectively, at December 31, 2008. Of the $27
million investment-grade CMOs, $21 million were rated AAA by Standard & Poor’s. We also
owned non-investment grade CMOs that had a fair value and book value of $3 million and $4
million, respectively. We do not intend to make additional investments in this asset
category.
Level 3 Valuation Techniques
Financial assets that fall within the Level 3 hierarchy are valued based upon unobservable
market inputs, normally because they are not actively traded on a public market. Level 3
taxable fixed maturities securities include certain private placements, small issues,
general corporate bonds and medium-term notes. Level 3 tax-exempt fixed maturities
securities include various thinly traded municipal bonds. Level 3 common equities include
private equity securities. Level 3 preferred equities include private and thinly traded
preferred securities.
Pricing for each Level 3 security is based upon inputs that are market driven, including
third-party reviews provided to the issuer or broker quotes. However, we placed in the Level
3 hierarchy securities for which we were unable to obtain the pricing methodology or we
could not consider the price provided as binding. Management ultimately determined the
pricing for each Level 3 security that we considered to be the best exit price valuation. As
of December 31, 2008, total Level 3 assets were 1.6 percent of our investment portfolio
measured at fair value, which was relatively stable throughout 2008. Broker
quotes are obtained for thinly traded securities that subsequently fall within the Level 3
hierarchy. We obtained two non-binding quotes from brokers and used the more conservative
price for fair value. At December 31, 2008, total fair value of assets priced by broker
quotes for the SFAS No. 157 disclosure was $83 million and consisted mostly of taxable fixed
maturities.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 46 Employee Benefit Pension Plan
As discussed in Item 8, Note 13 of the Consolidated Financial Statements,
Page 113, we
modified our qualified defined benefit pension during 2008, terminating participation in the
plan for certain participants in a transition to a sponsored 401(k) with company matching of
associate contributions. 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 2008 net pension obligation were a 6.00 percent
discount rate and rates of compensation increases ranging from 4 percent to 6 percent. Key
assumptions used in developing the 2008 net pension expense were a 6.25 percent discount
rate, an 8 percent expected return on plan assets and rates of compensation increases
ranging from 4 percent to 6 percent. See Note 13 for additional information on assumptions.
In 2008, the net pension expense was $47 million, including one-time charges of $27 million
for settlement and $3 million for curtailment related to the modifications to the qualified
pension plan. In 2009, we expect a net pension expense of $11 million.
Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate
would lower our 2009 net income before income taxes by $1 million. Likewise, a 0.5
percentage point decline in the expected return on plan assets would lower our 2009 income
before income taxes by $1 million.
The fair value of the plan assets was $52 million less than the accumulated benefit
obligation at year end 2008 and $4 million greater than the accumulated benefit obligation
at year-end 2007. The fair value of the plan assets was $88 million less than the projected
plan benefit obligation at year-end 2008 and $60 million less at year-end 2007. Market
conditions and interest rates significantly affect future assets and liabilities of the
pension plan. In 2009, we expect to contribute approximately $33 million to our qualified
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 $75
million in 2008 contributed 2.5 percentage points to the property casualty combined ratio.
If contingent commissions paid were to vary from that amount by 5 percent, it would affect
2009 net income by $2 million (after tax), or 1 cent per share, and the combined ratio by
approximately 0.1 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.
Separate account assets are carried at fair value. Separate account liabilities primarily
represent the contract holders’ claims to the related assets and are carried at an amount
equal to the contract holders account value. 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
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 47 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 2009, the account holder would pay a surrender charge equal
to 1 percent of the contract’s account value. The surrender charge falls to zero in 2010 and
beyond.
At year-end 2008, net unamortized realized losses amounted to $12 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 are approximately
$36 million before tax in the separate account portfolio, which had a book value of $521
million at year-end 2008.
Recent Accounting Pronouncements
Information about recent accounting pronouncements is provided in Item 8, Note 1 of the
Consolidated Financial Statements,
Page 98. 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
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 report as “Other” the non-investment operations of the parent company and its
subsidiaries CFC Investment Company and CinFin Capital Management Company (excluding client
investment activities), as well as other income of our standard market property casualty
insurance operations. CinFin Capital Management will terminate all operations effective
February 28, 2009. Beginning in 2008, we also include in Other the results of The Cincinnati
Specialty Underwriters Insurance Company and CSU Producer Resources.
We measure profit or loss for our commercial lines and personal lines property casualty and
life insurance segments based upon underwriting results (profit or loss), which represent
net earned premium less loss and loss expenses and underwriting expenses on a pretax basis.
We also frequently evaluate results for our consolidated property casualty insurance
operations, which is the total of our commercial, personal and surplus insurance results.
Underwriting results and segment pretax operating income are not substitutes for net income
determined in accordance with GAAP.
For our consolidated property casualty insurance operations as well as the insurance
segments, statutory accounting data and ratios are key performance indicators that we use to
assess business trends and to make comparisons to industry results, since GAAP-based
industry data generally is not as readily available.
Investments held by the parent company and the investment portfolios for the insurance
subsidiaries are managed and reported as the investments segment, separate from the
underwriting businesses. Net investment income and net realized investment gains and losses
for our investment portfolios are discussed in the Investments Results of Operations.
The calculations of segment data are described in more detail in Item 8, Note 18 of the
Consolidated Financial Statements,
Page 119. The following sections review results of
operations for each of the four segments. Commercial Lines Insurance Results of Operations
begins on
Page 51, Personal Lines Insurance Results of Operations begins on
Page 59, Life
Insurance Results of Operations begins on
Page 64, and Investments Results of Operations
begins on
Page 66. We begin with an overview of our consolidated property casualty
operations, which is the total of our commercial lines, personal lines and surplus lines
results.
Cincinnati Financial Corporation — 2008 Annual Report on 10-K — Page 48 Consolidated Property Casualty Insurance Results Of Operations
In addition to the factors discussed in Commercial Lines and Personal Lines Insurance
Results of Operations,
Page 51 and
Page 59, growth and profitability for our consolidated
property casualty insurance operations were affected by a number of common factors.
Changes in written and earned premiums over the past three years reflected growing price
competition partially offset by consistently high retention rates of renewal business. New
business written directly by agencies rose in 2008 after declining in 2007. The resurgence
in new business was largely due to the contribution of agencies appointed the past five
years, the contribution of our surplus lines business and more competitive personal lines
pricing. Other written premium is largely ceded reinsurance premiums.
Our combined ratio before catastrophe losses and savings from favorable prior period reserve
development rose substantially in 2008 due to lower pricing prompted by soft market
conditions and also due to normal loss cost inflation, a higher level of larger commercial
lines losses and the pension plan settlement cost. The pension plan settlement increased the
2008 combined ratio by 0.8 percentage points. Our 2007 combined ratio before catastrophe
losses and savings from favorable prior period reserve development rose largely due to the
effects of lower pricing, normal loss cost inflation and a higher level of larger commercial
lines losses.
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