Cincinnati Financial Corporation
The Cincinnati Insurance Companies
The Cincinnati Insurance Companies
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Cincinnati Financial Corporation The Cincinnati Insurance Companies |
Cincinnati Financial Corporation 2007 Annual Report on Form 10-K February 29, 2008
In addition, you will find information about your company's strategies and initiatives in The Cincinnati Experience,
the Chairman and President's Letter
and our quarterly letters to shareholders, as they become available. Together with the detailed analysis of the
2007 Annual Report on Form 10-K,
these documents comprise a package of information similar to what appeared in our previous annual reports.
 Part I
Item 1. Business
Cincinnati Financial Corporation — Introduction
We are an Ohio corporation formed in 1968. Our lead subsidiary, The Cincinnati Insurance
Company, was founded in 1950 to market property casualty insurance, which is our main
business. Our headquarters is in Fairfield, Ohio. At year-end 2007, we had 4,087 associates,
with 2,924 headquarters associates providing support to 1,163 field associates.
Cincinnati Financial Corporation owns 100 percent of four subsidiaries: The Cincinnati
Insurance Company, CSU Producer Resources Inc., CFC Investment Company and CinFin Capital
Management Company. In addition, the parent company has an investment portfolio, owns the
headquarters building and is responsible for corporate borrowings and shareholder dividends.
The Cincinnati Insurance Company owns 100 percent of our four insurance subsidiaries.
In addition to The Cincinnati Insurance Company, our standard market property casualty
insurance group includes subsidiaries The Cincinnati Casualty Company and The Cincinnati
Indemnity Company. This group markets a broad range of business, homeowner and auto policies
in 34 states. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati
Life Insurance Company, which markets life insurance policies, disability income policies
and annuities, and The Cincinnati Specialty Underwriters Insurance Company, which began
offering excess and surplus lines insurance products in January 2008.
The three other subsidiaries of Cincinnati Financial are CSU Producer Resources, which
offers insurance brokerage services to our independent agencies so their clients can access
our excess and surplus lines insurance products; CFC Investment Company, which offers
commercial leasing and financing services to our agents, their clients and other customers;
and CinFin Capital Management Company, which provides asset management services to
institutions, corporations and individuals.
Our filings with the Securities and Exchange Commission are available, free of charge, on
our Web site, www.cinfin.com, as soon as possible after they have been filed with the SEC.
These filings include our annual reports on Form 10-K, our quarterly reports on Form 10-Q,
current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934. In the following pages we
reference various Web sites. These Web sites, including our own, are not incorporated by
reference in this Annual Report on Form 10-K.
Periodically, we refer to estimated industry data so that we can give information about our
performance versus the overall insurance industry. Unless otherwise noted, the industry data
is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and
insurer financial strength and credit rating organization. Information from A.M. Best is
presented on a statutory basis. When we provide our results on a comparable statutory basis,
we label it as such; all other company data is presented in accordance with accounting
principles generally accepted in the United States of America (GAAP).
Our Business and Our Strategy
Introduction
Our company was founded more than 50 years ago by independent agents to support the ability
of local independent property casualty insurance agents to deliver quality financial
protection to people and businesses in their communities. Today, we operate much the same
way, actively marketing standard market commercial insurance policies in 34 states through a
select group of independent insurance agencies. We actively market all of our personal lines
insurance policies in 22 of those states and began in January 2008 to market excess and
surplus lines policies in five states through the same agencies that offer our standard
market property casualty insurance products. We also seek to become the life insurance
carrier of choice for the agencies that market our property casualty insurance products and
offer other financial services to help agents and their clients, the policyholders.
Our company distinguishes itself in three key ways:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 1 Cultivating Relationships with Independent Insurance Agents
The U.S. property casualty insurance industry is a highly competitive marketplace with over
2,000 stock and mutual companies operating independently or in groups. No single company or
group dominates across all product lines and states. Standard market insurance companies
(carriers) can market a broad array of products nationally or:
In addition to the widely known standard market for property casualty insurance, the excess
and surplus lines market exists due to a regulatory distinction. Generally, excess and
surplus lines insurance carriers provide insurance that is unavailable to businesses in the
standard market due to market conditions or due to characteristics of the insured that are
caused by nature, the insured’s history or the nature of their business. Insurers operating
in the surplus lines market are generally small, specialty insurers or specialized divisions
of larger insurance organizations. Each markets through surplus lines insurance brokers.
Standard market property casualty insurers generally offer their products through one or
more distribution channels:
Some carriers use more than one channel. For the most part, we compete with standard market
insurance companies that market through independent insurance agents.
Independent Agency Distribution System
We are committed to the independent agency distribution system, offering our broad array of
insurance products through this channel. We recognize that locally based independent
agencies have relationships in their communities that can lead to policyholder satisfaction,
loyalty and profitable business. Our field associates provide service and accountability to
the agencies, living in the communities they serve and working from offices in their homes,
providing 24/7 availability to our agents.
At year-end 2007, our 1,092 agency relationships had 1,327 reporting agency locations
marketing our standard market insurance products. An increasing number of agencies have
multiple, separately identifiable locations, reflecting their growth and consolidation of
ownership within the independent agency marketplace. Reporting agency locations describes
our agents’ scope of business and our presence within our 34 active states. At year-end
2006, our 1,066 agency relationships had 1,289 reporting agency locations marketing our
insurance products. At year-end 2005, we had 1,024 agency relationships with 1,252 reporting
agency locations. In addition to providing data on reporting agency locations, we continue
to give agency relationships metrics, such as our penetration within each agency
relationship.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 2 Property Casualty Earned Premiums by State
In our 10 highest volume states, 882 reporting agency locations wrote 69.1 percent of our
2007 total standard market property casualty earned premium volume compared with 70.0
percent in 2006.
In 2006, the most recent period for which data is available, Cincinnati Insurance was the
No. 1 or No. 2 carrier in approximately 75 percent of the reporting agency locations that
have represented us for more than five years. The independent agencies that we choose to
market our products share our philosophies. They do business person to person; offer broad,
value-added services; maintain sound balance sheets and manage their agencies
professionally. On average, we have a 14.9 percent share of the property casualty insurance
in our reporting agency locations. Our share is 20.5 percent in reporting agency locations
that have represented us for more than 10 years; 9.7 percent in agencies that have
represented us for five to 10 years; 4.6 percent in agencies that have represented us for
one to five years; and 0.8 percent in agencies that have represented us for less than one
year.
Over the next decade, industry analysts predict successful agencies will have opportunities
to increase their size on average almost three-fold. Agencies are expected to continue to
pursue consolidation opportunities, buying or merging with other agencies to create stronger
organizations and expand service. In addition to the growing networks of agency locations
owned by banks and brokers, other agencies are addressing the consolidation by forming
voluntary associations. These associations, or “clusters,” share back office and other
functions to enhance economies, while maintaining their individual ownership structures.
Our largest single
agency relationship accounted for approximately 1.2 percent of our total agency earned
premiums in 2007. No aggregate of locations under a single ownership structure accounted for
more than 2.5 percent of our total agency earned premiums in 2007.
Strengthening Our Agency Relationships
We follow a number of strategies to strengthen our relationships with the independent
property casualty insurance agencies that market our products.
Emphasis on Relationships and Local Decision-making
We continue to expand the services we provide that support agency opportunities. Accessible
field representatives are the first layer of support. Headquarters associates also provide
agencies with underwriting, accounting and technology assistance and training. Company
executives, headquarters underwriters and special teams regularly travel to visit agencies.
Agents have opportunities for direct, personal conversations with our senior management
team, and headquarters associates have opportunities to refresh their knowledge of
marketplace conditions and field activities.
The field marketing representatives are joined by field representatives specializing in
claims, loss control, machinery and equipment, bond, premium audit, life insurance and
leasing. For example, our field machinery and equipment and loss control representatives
perform inspections and recommend specific actions to improve the safety of the
policyholder’s operations and the quality of the agent’s account.
Agents tell us they agree with the need to carefully select risks and assure pricing
adequacy. They appreciate the time our associates invest in creating solutions for their
clients while protecting profitability, whether that
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means working on an individual case or developing modified policy terms and conditions that preserve flexibility, choice and other
sales advantages.
Risk-specific Underwriting
We seek to be a consistent, predictable and reasonable property casualty carrier that
agencies can rely on to serve their clients. Our field and headquarters underwriters make
risk-specific decisions about both new business and renewals. On a case-by-case basis, we
select risks we can cover on acceptable terms and at adequate prices rather than
underwriting solely by geographic location or business class.
For new commercial lines business, this case-by-case underwriting and pricing is coordinated
by the local field marketing representatives. Our agents and our field marketing, loss
control, premium audit, bond and machinery and equipment representatives get to know the
people and businesses in their communities and can make informed decisions about each risk.
These field marketing representatives also are responsible for selecting new independent
agencies, coordinating field teams of specialized company representatives and promoting all
of the company’s products within the agencies they serve. Commercial lines policy renewals
are managed by headquarters underwriters who are assigned to specific agencies and consult
with local field staff, as needed.
We apply our risk-specific underwriting philosophy to personal lines new and renewal
business in a different process. Each agency selects personal lines business from within the
geographic territory that it serves, based on the agent’s knowledge of the risks in those
communities or familiarity with the policyholder. New and renewal business activities are
supported by headquarters associates assigned to individual agencies.
Competitive Insurance Products
We are committed to offering the property casualty products and services local agents need
to serve their clients — the policyholders. Our products are structured to allow flexible
combinations of property and liability coverages in a single package with a single
expiration date. This approach brings policyholders convenience, discounts and a reduced
risk of coverage gaps or disputes. At the same time, it increases account retention and
saves time and expense for the agency and our company.
Our commercial lines packages are typically offered on a three-year policy term for most
insurance coverages, a key competitive advantage. Although we offer three-year policy terms,
premiums for some coverages within those policies are adjustable at anniversary for the next
annual period, and policies may be cancelled at any time at the discretion of the
policyholder. Contract terms often provide that rates for property, general liability,
inland marine and crime coverages, as well as policy terms and conditions, are fixed for the
term of the policy. The general liability exposure basis may be audited annually. Commercial
auto, workers’ compensation, professional liability and most umbrella liability coverages
within multi-year packages are rated at each of the policy’s annual anniversaries for the
next one-year period. The annual pricing could incorporate rate changes approved by state
insurance regulatory authorities between the date the policy was written and its annual
anniversary date, as well as changes in risk exposures and premium credits or debits
relating to loss experience, competition and other underwriting judgment factors. We
estimate that approximately 75 percent of 2007 commercial premiums were subject to annual
rating or were written on a one-year policy term.
In our experience, multi-year packages are somewhat less price sensitive for the
quality-conscious insurance buyers who we believe are typical clients of our independent
agents. Customized insurance programs on a three-year term complement the long-term
relationships these policyholders typically have with their agents and with the company. By
reducing annual administrative efforts, multi-year policies lower expenses for our company
and for our agents. The commitment we make to policyholders encourages long-term
relationships and reduces their need to annually re-evaluate their insurance carrier or
agency. We believe that the advantages of three-year policies in terms of improved
policyholder convenience, increased account retention and reduced administrative costs
outweigh the potential disadvantage of these policies, even in periods of rising rates.
Our personal lines policies are offered on a one-year term, except homeowner policies in
three states that represent less than one percent of total personal lines premium volume.
Competitive advantages of our personal lines coverages include our credit structure and
customizable endorsements for both the personal auto and homeowner policies. A newly
introduced personal auto policy endorsement is replacement cost coverage for newly purchased
vehicles. Popular homeowner endorsements include replacement cost for contents, inflation
guard, identity theft expense coverage and advocacy services, flexible water damage
coverages and enhanced replacement cost coverage for older homes.
Technology Solutions
We seek to employ technology solutions and business process improvements that complement our
core values of local underwriting decisions, strong relationships with our independent
agencies and superior claims service.
In recent years, we have made significant investments in state-of-the-art information
technology platforms, systems and Internet-based applications to:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 4
Agencies access our systems and other electronic services via CinciLink®, our secure
agency-only portal. CinciLink provides an array of Web-based services and content that make
it easier to do business with us, such as commercial and personal lines rating and
processing systems, policy loss information, sales and marketing materials, educational
courses on our products and services, and electronic libraries for property and casualty
coverage forms and state rating manuals.
Commercial Lines Technology — WinCPP® is our commercial lines premium quoting system.
WinCPP is available in all of our agency locations in 32 of the 34 states in which we
actively market insurance and provides quoting capabilities for nearly 100 percent of our
new and renewal commercial lines business. In 2008, we plan to introduce WinCPP in our
newest states — Washington and New Mexico. WinCPP provides a real-time agency interface,
CinciBridge™, which allows automated movement of key underwriting data from an agent’s
management system to WinCPP, reducing agents’ data entry and allowing seamless quoting and
rating capabilities.
Many small
business accounts written as Businessowners Policies (BOP) and Dentist’s Package
Policies (DBOP) are eligible to be issued at our agency locations through our Web-based
e-CLAS®
policy processing system. (A businessowners policy combines property, liability and
business interruption coverages for small businesses.) e-CLAS provides full policy lifecycle
transactions including: quoting, issuance, policy changes, renewal processing and policy
printing at the agency location. These features make it easier and more efficient for our
agencies to issue and service these policies. At year-end 2007, e-CLAS was in use in 17
states representing 85 percent of our BOP and DBOP premiums, which are included in the
specialty packages commercial line of business. We continue to roll out e-CLAS to additional
states for these policy types, including two new states since the beginning of 2008. e-CLAS
also utilizes CinciBridge to provide real-time agency interface. Our primary long-term
technology objective is to complete development of e-CLAS for all of our commercial lines of
business.
To respond to agency needs, a direct bill payment option is being made available for
commercial lines policyholders. Our first step is to make the direct bill option available
for policies issued through e-CLAS. We rolled out this capability to selected agencies in
2007 with full agency rollout in early 2008. Similar direct billing capability for selected
commercial policies not issued through e-CLAS is anticipated by the end of 2008 with the
intent to offer this capability for all policies as soon as practicable.
Since 2004, we have been streamlining internal processes and achieving operational
efficiencies in our headquarters commercial lines operations through deployment of iView™, a
policy imaging and workflow system. This system provides online access to electronic copies
of policy files, enabling our underwriters to respond to agent requests and inquiries more
quickly and efficiently. iView also automates internal workflows through electronic routing
of underwriting and processing work tasks. At year-end 2007, more than 74 percent of
in-force non-workers’ compensation commercial lines policy files were administered and
stored electronically in iView.
E&S Technology — Cincinnati Specialty Underwriters and CSU Producer Resources employ a
Web-based policy administration system to quote, bind, issue and deliver policies
electronically to agents. This system also provides integration to existing document
management and data management systems, allowing for straight-through processing of policies
and billing.
Personal Lines Technology — Diamond is a real-time personal lines policy processing system,
supporting all six of our personal lines of business and allowing once and done processing.
Diamond incorporates features frequently requested by our agencies such as direct bill and
monthly payment plans, local and headquarters policy printing options, data transfer to and
from popular agency management systems and real-time integration with data from third-party
sources needed to calculate final premiums such as insurance scores, MVR reports and address
verification. At year-end 2007, Diamond was in use in 17 states representing approximately
97.5 percent of our personal lines premium volume. In 2008, we expect to deploy Diamond to
agencies in eight additional states. Although we already market personal lines products in
Maryland, Montana, New Hampshire, North Carolina and Vermont, we expect agencies in these
states to respond favorably to Diamond’s advantages. We also expect to deploy Diamond to
agencies in Arizona, South Carolina and Utah, new markets for our personal lines products.
In 2006, we introduced PL-efiles, a policy imaging system, to our personal lines operations.
Through year-end 2007, we had transitioned information on current Diamond personal lines
policies to PL-efiles and continue to work on imaging older policy information. The transition replaces paper format with
electronic copies of policy documents. PL-efiles complements the Diamond system by giving
personal lines underwriters and support staff
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 5 online access to policy documents and data
that enable them to respond to agent requests and inquiries quickly and efficiently.
Claims Technology — Our property and casualty claims operation has streamlined processes
and achieved operational efficiencies through the use of CMS, our claims file management
system. Initially deployed in late 2003, CMS allows field and headquarters claims associates
to process all reported claims in a virtual claim file. We continue to refine the system to
add capabilities to make our associates more effective. During 2006, we issued tablet
computers to our field claims representatives. These units allow our claims representatives
to view and enter information into CMS from any location, including an insured’s home or
agent’s office, and to print claim checks using portable printers. Agency access to selected
CMS information was tested in the fourth quarter of 2007, with the full rollout due to be
completed in early 2008.
Life Insurance Offerings Strengthen Agency Relationships
We support the independent agencies affiliated with our property casualty operations in
their programs to sell life insurance. The products offered by our life insurance subsidiary
round out and protect accounts and improve account persistency. At the same time, the life
operation looks to increase diversification of revenue and profitability sources for both
the agency and our company.
Our property casualty agencies make up the main distribution system for our life insurance
products. We also develop life business from other independent life insurance agencies to
provide us with penetration in geographic markets not served through our property casualty
agencies. We are careful to solicit business from these other agencies in a manner that does
not conflict with or compete with the marketing and sales efforts of our property casualty
agencies. We emphasize up-to-date products, responsive underwriting, high quality service
and competitive pricing.
Excess and Surplus Lines Operation Further Enhances Agency Relationships
In January 2008, we began accepting excess and surplus lines business from Cincinnati’s
independent agencies in Georgia, Illinois, Indiana, Ohio and Wisconsin. These agencies have
access to The Cincinnati Specialty Underwriters Insurance Company’s product line through CSU
Producer Resources, the new, wholly owned insurance brokerage subsidiary of parent-company
Cincinnati Financial Corporation. CSU Producer Resources has binding authority on all
classes of business written through CSU and maintains appropriate agent and surplus lines
licenses to process non-admitted business. CSU and CSU Producer Resources plan to expand
into all states except Delaware on an excess and surplus lines basis as the new companies
obtain the necessary state regulatory approvals.
We structured our new E&S operations to exclusively serve the needs of the independent
agencies that currently market our standard market insurance policies. When all or a portion
of a current or potential client’s insurance program requires E&S coverages, those agencies
now can write the whole account with Cincinnati, gaining benefits not often found in the
broader E&S market.
Producers can submit risks to CSU Producer Resources from a variety of classes, reflecting
the mix of accounts Cincinnati agencies currently write in their non-admitted E&S markets.
CSU Producer Resources currently markets and underwrites general liability coverages and
plans to expand this to include commercial property, multi-peril insurance, miscellaneous
professional liability and excess casualty in coming months.
Agency producers have direct access through CSU Producer Resources to our dedicated E&S
underwriters, and they also can tap into their agencies’ broader Cincinnati relationships to
bring their policyholders services such as experienced and responsive loss control and
claims handling. Our new E&S policy administration system delivers electronic copies of
policies to producers within minutes of underwriting approval and policy issue. CSU Producer
Resources gives extra support to our producers by remitting surplus lines taxes and stamping
fees and retaining admitted market affadavits, where required.
CSU was capitalized with $200 million from its parent company, The Cincinnati Insurance
Company. That high level of funding underscores our commitment to help our independent
agencies. Everything we do to increase their competitive advantages and success also helps
us achieve our own long term growth and profitability goals.
Programs, Products and Services to Support Agency Growth
We complement the insurance operations by providing products and services that help attract
and retain high-quality independent insurance agencies. When we appoint agencies, we look
for organizations with knowledgeable, professional staffs. In turn, we make an exceptionally
strong commitment to assist them in keeping their knowledge up to date and educating new
people they bring on board as they grow. Numerous activities at our headquarters, in
regional and agency locations, and online fulfill this commitment:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 6
Except travel-related expenses for courses held at our headquarters, most programs are
offered at no cost to our agencies. While that approach may be extraordinary in our industry
today, the result is quality service for our policyholders and increased success for our
independent agencies.
In addition to broad education and training support, we make financial services available
through our non-insurance subsidiaries. We believe that providing these services enhances
agency relationships with their clients, increasing loyalty while diversifying the agency’s
revenues. CFC Investment Company offers equipment and vehicle leases and loans for
independent insurance agencies, their commercial clients and other businesses. It also
provides commercial real estate loans to help agencies operate and expand their businesses.
CinFin Capital Management markets asset management services to agencies and their clients,
as well as other institutions, corporations and individuals.
Superior Financial Strength Ratings
In addition to the ratings of our parent company senior debt, independent ratings firms
award our property casualty and life operations insurer financial strength ratings based on
their quantitative and qualitative analyses. These ratings assess an insurer’s ability to
meet its financial obligations to policyholders and do not necessarily address all of the
matters that may be important to shareholders.
We believe that our strong surplus position and superior insurer financial strength ratings
are clear, competitive advantages in the segment of the insurance marketplace that our
agents serve. Our financial strength supports the consistent, predictable performance that
our policyholders, agents, associates and shareholders have always expected and received,
and it must be able to withstand significant challenges. We seek to ensure that our
performance remains consistent and predictable by aligning agents’ interests with those of
the company, giving them outstanding service and compensation and earning their best
business by enhancing their ability to serve the businesses and individuals in their
communities.
As of February 29, 2008, financial strength ratings were unchanged from those reported for
our standard market property casualty and life operations in our 2006 Annual Report on Form
10-K. As of December 21, 2007, our new excess and surplus lines subsidiary was awarded its
first financial strength rating, an A (Excellent) with a stable outlook, from A.M. Best.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 7
Statutory surplus for our property casualty insurance group was $4.307 billion at year-end
2007, with the ratio of the group’s investments in common stock to statutory surplus at 84.5
percent, in line with our targeted sub-100 percent level. Statutory surplus for our property
casualty insurance subsidiary was $4.750 billion at year-end 2006, with the ratio of the
group’s investments in common stock to statutory surplus to statutory surplus at 96.7
percent. The life insurance company’s statutory surplus was $477 million at year-end 2007,
with the ratio of life insurance company’s investments in common stock to statutory adjusted
capital and surplus at 70.6 percent. Life statutory surplus was $479 million at year-end
2006, with the ratio at 88.8 percent.
Cincinnati Life’s statutory adjusted risk-based surplus decreased 8.9 percent to $506
million at year-end 2007, from $556 million a year earlier. Statutory adjusted risk-based
surplus as a percentage of liabilities, a key measure of life insurance company capital
strength, was 28.5 percent at year-end 2007 compared with an estimated industry average
ratio of 10.9 percent. A higher ratio indicates an insurer’s stronger security for
policyholders and capacity to support business growth.
At year-end 2007 and 2006, the risk-based capital (RBC) for our property casualty and life
operations was exceptionally strong and well above levels that would have required
regulatory action.
We continue to review the risk management and capital requirement changes that rating
agencies have suggested for our industry. Additionally, we began a formal implementation of
enterprise risk management in 2005. Responsibility for enterprise risk management has been
assigned at the officer level, supported by a team of representatives from business areas.
The team reports to our president, our chief executive officer and our board of directors,
as appropriate, on detailed and summary risk assessments, risk metrics and risk plans. Our
use of operational audits, strategic plans and departmental business plans, as well as our
culture of open communications and our fundamental respect for our code of conduct, continue
to help us manage risks on an ongoing basis.
While the potential for volatility exists due to our catastrophe exposures, investment
philosophy and bias toward incremental change, the ratings agencies consistently have
asserted that we have built appropriate financial strength and flexibility to manage that
volatility. We remain committed to strategies that emphasize long-term stability over
short-term benefits that might accrue by quick reaction to changes in market conditions.
For example, through all market and economic cycles we maintain strong insurance company
statutory surplus, a solid, conservative reinsurance program, sound reserving practices and
low interest rate risk, as well as low debt and strong capital at the parent-company level.
Investments at the parent company give us flexibility to support our capitalization policies
for the subsidiaries, improve the ability of the insurance companies to write additional
premiums and maintain high insurer financial strength ratings for the protection of
policyholders.
We believe that our property catastrophe reinsurance program provides adequate protection
for large loss events. Our strong capital position would allow the payment of claims if an
event exceeded our reinsurance program. Currently participating on our property per risk and
casualty per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance
America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation
and its subsidiaries, all of which have A.M. Best insurer financial strength
ratings of A (Excellent) or A+ (Superior). Over the past several
years, we also modified policyholder deductibles
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 8 for both commercial and personal lines property coverages to reduce our exposure
to a single significant catastrophic event.
Our ratio of property casualty net written premiums to statutory surplus was 0.7 at year-end
2007, 2006 and 2005. This ratio is a common measure of operating leverage used in the
property casualty industry. It serves as an indicator of the company’s premium growth
capacity. The estimated property casualty industry net written premium to statutory surplus
ratio was 0.8 at year-end 2007, 0.9 at year-end 2006 and 1.0 at year-end 2005.
Growing with Our Agencies
One of our primary objectives is to increase our written premiums more rapidly than the
industry. We believe our agencies are growing more rapidly than the industry, and we seek to
maintain or increase our share of each agency’s business as it grows.
To help us maintain or increase our share within each agency, we are further improving
service through the creation of smaller marketing territories that permit our local field
marketing representatives to devote more time to each agency relationship. At year-end 2007,
we had 106 field marketing territories, up from 102 at the end of 2006 and 100 at the end of
2005. In 2007, we also appointed our first agencies in eastern
Washington and New Mexico, our 33rd and 34th states of operation. While we continually study the
regulatory and competitive environment in states where we could decide to actively market
our property casualty products, we have not announced plans to enter any of those states in
the near future.
Another way we seek to increase overall premiums is to expand our agency plant within our
current marketing territories. Our objective is to appoint additional sales offices, or
points of distribution, each year. We are targeting 65 appointments in 2008.
In measuring progress towards this goal, we include appointment of new agency relationships
with Cincinnati (the primary focus of our goal). For those that we believe will produce a
meaningful amount of new business premiums, we also include appointment of agencies that
merge with a Cincinnati agency and new branch offices opened by existing Cincinnati
agencies. We made 66, 55 and 57 new appointments in 2007, 2006 and 2005, respectively. Of
these new appointments, 50, 42 and 41, respectively, were new relationships. These new
appointments and other changes in agency structures led to a net increase in reporting
agency locations of 38 in 2007, 37 in 2006 and 39 in 2005. We are very careful to protect
the franchise for current agencies when selecting and appointing new agencies.
Achieving Claims Excellence
Our claims philosophy reflects our belief that we will prosper as a company by responding to
claims person to person, paying covered claims promptly, preventing false claims from
unfairly adding to overall premiums and building financial strength to meet future
obligations. We also believe that our company should have the financial strength to pay
claims while also creating value for shareholders, leading to our emphasis on the
establishment of adequate loss reserves.
Superior Claims Service
Our 748 locally based field claims representatives work from their homes, assigned to
specific agencies. They respond personally to policyholders and claimants, typically within
24 hours of receiving an agency’s claim report. We believe we have a competitive advantage
because of the person-to-person approach and the resulting high level of service that our
field claims representatives provide. We also help our agencies provide prompt service to
policyholders by giving agencies authority to immediately pay most first-party claims under
standard market policies up to $2,500.
Catastrophe response teams are comprised of volunteers from our experienced field claims
staff. As hurricanes threaten, these associates travel to strategic locations near the
expected impact area. This puts them in position to quickly get to the affected area, set up
temporary offices and start calling on policyholders. Cincinnati takes pride in giving our
field personnel the tools and authority they need to do their jobs. In times of widespread
loss, our field claims representatives confidently and quickly resolve claims, often writing
checks for damages on the same day they inspect the loss. CMS introduced new efficiencies
that are especially evident during catastrophes. Electronic claim files allow for fast
initial contact of policyholders and easy sharing of information between rotating storm
teams, headquarters and local field claims representatives.
Cincinnati’s claims associates work hard to control costs where appropriate. They have
vendor resources that provide negotiated pricing to our insureds and claimants and that help
us determine appropriate pricing for medical cost-related claims. Our field claims
representatives also are educated continuously on new techniques and repair trends. They can
leverage their local knowledge and experience with area body shops, which helps them
negotiate the right price with any facility the policyholder chooses.
We staff a Special Investigations Unit with former law enforcement and claims professionals
who are available to gather facts to uncover potential fraud. While we believe it’s our job
to pay what is due under each policy, we also want to prevent false claims from unfairly
increasing overall premiums. Our SIU also operates a computer
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 9 forensic lab, using sophisticated software to recover data and mitigating the cost of
computer-related claims for business interruption and loss of records.
Loss and Loss Expense Reserves
When claims are made by or against policyholders, any amounts that our property casualty
operations pay or expect to pay for covered claims are termed losses. The costs we incur in
investigating, resolving and processing these claims are termed loss expenses. Our
consolidated financial statements include property casualty loss and loss expense reserves
that estimate the costs of not-yet-paid claims incurred through December 31 of each year.
The reserves include estimates for claims that have been reported to us plus our estimates
for claims that have been incurred but not yet reported called IBNR, along with our estimate
for loss expenses associated with processing and settling those claims. We develop the
various estimates based on individual claim evaluations and statistical projections. We
reduce the loss reserves by an estimate for the amount of salvage and subrogation we expect
to recover. For over 10 years, our annual review has led us to report savings from favorable
development of loss reserves on prior accident years.
We encourage you to review several sections of the Management’s Discussion and Analysis
where we discuss our loss reserves in greater depth. In Item 7, Critical Accounting
Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 37, we discuss
our process for analyzing potential losses and establishing reserves. In Item 7, Property
Casualty Insurance Reserves, Page 65, we review reserve levels, including 10-year
development of our property casualty loss reserves.
Investing For Long-Term Total-Return
While we seek to generate an underwriting profit in our insurance operations, our
investments historically have provided our primary source of net income and contributed to
our financial strength, driving long-term growth in shareholders’ equity and book value.
Under the direction of the investment committee of the board of directors, our investment
department portfolio managers seek to balance current investment income opportunities and
long-term appreciation so that current cash flows can be compounded to achieve above-average
long-term total return. We invest some portion of cash flow in tax-advantaged fixed-maturity
and equity securities to maximize after-tax earnings. Premium payments, generally received
before claims are made, particularly for casualty business lines, create substantial cash
flow for investment.
Insurance regulatory and statutory requirements established to protect policyholders from
investment risk have always influenced our investment decisions on an individual insurance
company basis. After covering both our intermediate and long-range insurance obligations
with fixed-maturity investments, we historically used available cash flow to invest in
equity securities. Investment in equity securities has played an important role in achieving
our portfolio objectives and has contributed significantly to total portfolio net unrealized
investment gains of $3.339 billion (pretax) at year-end 2007. We remain committed to our
long-term equity focus, which we believe is key to our company’s long-term growth and
stability.
Our Segments
Consolidated financial results primarily reflect the results of our four reporting segments.
These segments are defined based on financial information we use to evaluate performance and
to determine the allocation of assets.
We also evaluate results for our consolidated property casualty operations, which is the
total of our commercial lines and personal lines segments. Revenues generated by our
consolidated property casualty operations were a lower percent of the total in 2007 and 2006
due to sales of investment assets, which are included in the investments segment results.
Revenues, income before income taxes, and identifiable assets for each segment are shown in
a table in Item 8, Note 17 of the Consolidated Financial Statements, Page 105. Some of that
information also is discussed in this section of this report, where we explain the business
operations of each segment. The financial performance of each segment is discussed in the
Management’s Discussion and Analysis of Financial Condition and Results of Operations, which
begins on Page 32.
Commercial Lines Property Casualty Insurance Segment
The commercial lines property casualty insurance segment contributed $2.411 billion of net
earned premiums to total revenues and $261 million to income before income taxes in 2007.
Commercial lines net earned premiums grew 0.4 percent in 2007, 6.6 percent in 2006 and 6.0
percent in 2005.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 10 Approximately 95 percent of our commercial lines premiums are written to provide accounts
with coverages from more than one of our business lines. As a result, we believe that our
commercial lines business is best measured and evaluated on a segment basis. However, we
provide line of business data to summarize growth and profitability trends separately for
our business lines. The seven commercial business lines are:
Our emphasis is on products that agents can market to small- to mid-size businesses in their
communities. Of our 1,327 reporting agency locations, six market only our surety and
executive risk products and three market only our personal lines products. The remaining
1,318 locations, located in all 34 states in which we actively market, offer some or all of
our standard market commercial insurance products.
In 2007, our 10 highest volume commercial lines states generated 66.7 percent of our earned
premiums compared with 67.7 percent in the prior year. Earned premiums in the 10 highest
volume states decreased 1.1 percent in 2007 but rose 3.5 percent in the remaining 24 states.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 11 Commercial Lines Earned Premiums by State
Commercial Lines Insurance Marketplace
For commercial lines, our competition for the types and sizes of accounts we typically write
in the standard market, predominantly consists of those companies that also distribute
through independent agencies. The independent agencies that market our commercial lines
products typically represent six to 12 standard market insurance carriers, including both
national and regional carriers, some of which may be mutual companies.
Softening market conditions in recent years have blurred the distinctions between national
and regional carriers; however, we often observe certain characteristics as we compete
within each agency. National and many regional carriers are more likely to appoint a greater
number of agencies and focus on specific types of products or certain size accounts. They
often seek to take greatest advantage of tools that enhance their efficiency and the ease of
doing business with their organization. Time-intensive services may be offered only to
larger accounts. They may be less interested in the smaller accounts that require
significant attention. Regional carriers are more likely to utilize an agency strategy,
focusing on differentiating themselves through relationships and service. They often seek to
place decision-making closer to the local market level and have begun to target larger
accounts to develop or retain their position within agencies. In our experience, the level
of competition varies state by state and region by region, regardless of the mix of carriers
represented within a specific agency.
Overall, the softening commercial lines marketplace of the past several years continued to
intensify in 2007. Over this period, anecdotal reports of very aggressive pricing have grown
in frequency. Over the course of 2007, we saw more situations where underwriting discipline
appeared to slip as carriers sought to capture market share. Many carriers appear to be
managing the soft market conditions by working aggressively to protect their renewal
portfolios.
Personal Lines Property Casualty Insurance Segment
The personal lines property casualty insurance segment contributed $714 million of net
earned premiums to total revenues and $43 million to income before income taxes in 2007.
Personal lines net earned premiums declined 6.3 percent in 2007 and 5.3 percent in 2006
after rising 1.4 percent in 2005.
We prefer to write personal lines coverage on an account basis that includes both auto and
homeowner coverages as well as coverages that are part of our other personal business line.
As a result, we believe that our personal lines business is best measured and evaluated on a
segment basis. However, we provide line of business data to summarize growth and
profitability trends separately for three business lines:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 12
We market both homeowner and personal auto insurance products through 812 of our 1,327
reporting agency locations in 22 of the 34 states in which we offer standard market
commercial lines insurance. We market homeowner products through 21 locations in three
additional states (Maryland, North Carolina and West Virginia.) The remaining 494 locations
largely are in states where we do not yet actively market these products. A smaller number
are those where we have determined, in conjunction with agency management, that our personal
lines products are not appropriate for their agencies at this time.
In 2007, our 10 highest volume personal lines states generated 84.9 percent of our earned
premiums compared with 84.7 percent in the prior year. Earned premiums in the 10 highest
volume states declined 6.5 percent in 2007 and declined 5.2 percent in the remaining states.
Personal Lines Earned Premiums by State
Personal Lines Insurance Marketplace
In addition to carriers that market through independent agents, our personal lines
competition also includes carriers that market through captive agents and direct writers,
which our agencies’ clients may investigate independently. The independent agencies that
market our personal lines products typically represent four to six standard personal lines
carriers.
Over the past several years, we have seen increased competition in the personal lines
marketplace, driven by industrywide improvement in results and favorable frequency and
severity trends. The increased competition in the past several years also reflected
implementation of tiered rating systems by a growing number of carriers. Carriers that have
adopted these systems rely on increasingly more data to identify multiple relevant variables
to segment the market, including credit-based information.
We expect that competition in the personal auto and homeowner markets will continue to
increase over the next 12 to 24 months. Many personal lines carriers have reported strong
operating results in the past three years and continue to have healthy capital to support
business growth. We believe these carriers are focused on gaining market share through the
introduction of new products and services and increased advertising expenditures.
Life Insurance Segment
The life
insurance segment contributed $125 million of net earned premiums and $3 million in
income before income taxes in 2007. Life insurance segment profitability is discussed in
detail in Item 7, Life Insurance Results of Operations, Page 56. Life insurance net earned
premiums grew 9.0 percent in 2007, 7.9 percent in 2006 and
5.7 percent in 2005.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 13 The overall mission of our company is supported by The Cincinnati Life Insurance Company.
Cincinnati Life helps meet the needs of our agencies, including increasing and diversifying
agency revenues. We primarily focus on life products that produce revenue growth through a
steady stream of premium payments. By
diversifying revenue and profitability for both the agency and our company, this strategy
enhances the already strong relationship built by the combination of the property casualty
and life companies.
Cincinnati Life seeks to become the life insurance carrier of choice for the independent
agencies that work with our property casualty operations. We emphasize up-to-date products,
responsive underwriting and high quality service as well as competitive commissions. At
year-end 2007, approximately 82 percent of our 1,327 property casualty reporting agency
locations offered Cincinnati Life’s products to their clients. We also develop life business
from 545 other independent life insurance agencies. We are careful to solicit business from
these other agencies in a manner that does not conflict with or compete with the marketing
and sales efforts of our property casualty agencies.
Life Insurance Business Lines
Four lines of business — term insurance, universal life insurance, worksite products and
whole life insurance — account for approximately 91.5 percent of the life insurance
segment’s revenues:
In addition, Cincinnati Life markets:
Life Insurance Marketplace
Our property casualty agencies comprise the main distribution system for our life insurance
segment. While other life insurance carriers continue to expand the use of nontraditional
distribution channels, such as banks or direct sales as alternatives to the agency channel,
we intend to market solely through independent agencies,
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 14 with an emphasis on enhancing
relationships with agencies affiliated with our property casualty insurance operations.
When marketing through our property casualty agencies we have specific competitive
advantages:
We continue to emphasize the cross-serving opportunities of our life insurance, including
term and worksite products, for the property casualty agency’s personal and commercial
accounts. In both the property casualty and independent life agency distribution systems we
enjoy the advantages of offering competitive, up-to-date products, providing close personal
attention combining financial strength and stability.
Because of our strong capital position, we can offer a competitive product portfolio
including guaranteed products, giving our agents a marketing edge. Our life insurance
company maintains strong insurer financial strength ratings: A.M. Best — A+ (Superior),
Fitch — AA (Very Strong) and Standard & Poor’s — AA- (Very Strong). Our life insurance
company has not chosen to establish a Moody’s rating.
Current statutory laws and regulations require life insurance companies to hold redundant
reserves, particularly for preferred risk underwriting classes. These redundant reserves, in
turn, depress statutory earnings and require a large commitment of capital. Redundant
reserves are a significant issue, not just for our life insurance operations, but for all
writers of term insurance and universal life with secondary guarantees. However, larger
carriers may be able to better absorb or may be able to securitize the statutory reserve
strain associated with competitively priced term insurance and universal life with secondary
guarantees.
The National Association of Insurance Commissioners recognizes the problems caused by
redundant reserves and is considering a principles-based reserving system rather than the
current formulaic system. While still capturing all material risks, a principles-based
system would allow a company to use its own experience, subject to credibility standards and
appropriate margins for uncertainty. Also, under the proposed principles-based system, the
insurer would fully document and disclose all its assumptions and methods to regulatory
officials.
Investments Segment
The investment segment contributed $990 million of our total revenues in 2007, primarily
from net investment income and realized investment gains and losses from investment
portfolios managed for the holding company and each of the operating subsidiaries. After
deducting interest credited to contract holders of the life insurance segment, the
investments segment contributed $931 million of income before
income taxes, or 78.0 percent
of our total income before income taxes.
The fair value (market value) of our investment portfolio was $12.198 billion and $13.699
billion at year-end 2007 and 2006, respectively. The cash we generate from insurance
operations historically has been invested in three broad categories of investments:
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 15 During 2007 and 2006, sales and market value declines of equity securities more than offset
purchases and market value appreciation. Sales of, or reductions in, selected large holdings
are discussed below.
We consider insurance department regulations and ratings agency comments, as well as the
trend in certain ratios, to determine what portion of new cash flow should be invested in
equity securities at the parent and insurance subsidiary levels. Key among these ratios is
the property casualty group’s ratio of investments in common stocks to statutory surplus and
the parent company’s ratio of investment assets to total assets. At year-end 2007, the ratio
of common stock to statutory surplus was 84.5 percent compared with 96.7 percent at year-end
2006. The ratio of investment assets to total assets for the parent company was 28.4 percent
at year-end 2007 compared with 31.5 percent at year-end 2006.
Fixed-maturity and Short-term Investments
By maintaining a well diversified fixed-maturity portfolio, we attempt to reduce overall
risk. We invest new money in the bond market on a continuous basis, targeting what we
believe to be optimal risk-adjusted after-tax yields. Risk, in this context, includes
interest rate, call, reinvestment rate, credit and liquidity risk. We do not make a
concerted effort to alter duration on a portfolio basis in response to anticipated movements
in interest rates. By continuously investing in the bond market, we build a broad,
diversified portfolio that we believe mitigates the impact of adverse economic factors. We
place a strong emphasis on purchasing current income-producing securities for the insurance
companies’ portfolios. Within the fixed-maturity portfolio, we invest in a blend of taxable
and tax-exempt securities with an eye toward maximizing credit adjusted after-tax yields.
With the exception of U.S. agency paper (government-sponsored entities), no individual
issuer’s securities accounted for more than 0.6 percent of the fixed-maturity portfolio at
year-end 2007. Our investment portfolio contains no mortgage loans and our fixed-maturity
portfolio has no mortgage-backed securities.
Fixed-maturity and Short-term Portfolio Ratings
Our investments in U.S. agency paper and insured municipal bonds over the past several years
have led to a significant rise in the percentage of A and higher rated fixed-maturity
holdings, based on fair value. The majority of our non-rated securities are tax-exempt
municipal bonds from smaller municipalities that chose not to pursue a credit rating. Credit
ratings as of December 31 for the fixed-maturity and short-term portfolio were:
Attributes of the fixed-maturity portfolio include:
We discuss the maturity of our fixed-maturity portfolio in Item 8, Note 2 of the
Consolidated Financial Statements, Page 93.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 16 Taxable Fixed-maturities
Our taxable fixed-maturity portfolio (at fair value) includes:
Our strategy typically is to buy and hold fixed-maturity investments to maturity but we
monitor credit profiles and market value movements when determining holding periods for
individual securities.
Similar to the equity portfolio, the taxable fixed-maturity portfolio is most heavily
concentrated in the financial sector, including banks, brokerage, finance and investment and
insurance companies. The financial sector represented 27.5 percent and 27.3 percent,
respectively of book value and fair value of the taxable fixed-maturity portfolio at
year-end 2007, compared with 27.2 percent and 27.7 percent, at year-end 2006. Although it is
our largest concentration in a single sector, we believe our percentage in the financial
sector is below average for the corporate bond market as a whole. No other sector or
industry accounted for more than 10 percent of the taxable fixed-maturity portfolio.
Tax-exempt Fixed-maturities
We traditionally have purchased municipal bonds focusing on general obligation and essential
services bonds, such as sewer, water or others. While no single municipal issuer accounted
for more than 1 percent of the tax-exempt municipal bond portfolio at year-end 2007, there
are higher concentrations within individual states. Holdings in Illinois, Indiana, Michigan,
Ohio and Texas accounted for 62.5 percent of the municipal bond portfolio at year-end 2007.
In recent years, we have purchased insured municipal bonds because of their excellent
credit-adjusted after-tax yields. At year-end 2007, bonds representing $2.212 billion, or 87
percent, of the fair value of our municipal portfolio were insured with an average rating of
AAA. Because of our emphasis on general obligation and essential services bonds, the
underlying rating of our insured municipal bond portfolio is approximately A1. We believe
this portion of the portfolio would experience little, if any, fair value adjustment in the
event of a ratings downgrade of one or more of the major bond insurers.
Short-term Investments
Our short-term investments consist primarily of commercial paper, demand notes or bonds
purchased within one year of maturity. We make short-term investments primarily with funds
to be used to make upcoming cash payments, such as taxes. At year-end 2007, we had $101
million in short-term investments.
Equity Investments
Our equity investment portfolio includes both common stocks and nonredeemable preferred
stocks. Approximately 82.2 percent of the equity portfolio is made up of a core group of
common stocks that we monitor closely to gain an in-depth understanding of their
organizations and industries. The portfolio also includes a broader group of smaller
positions. The average dividend yield-to-cost for our equity investments was 10.2 percent at
year-end 2007 compared with 9.9 percent at year-end 2006.
Common Stocks
At year-end 2007, 32.4 percent of our common stock holdings (measured by fair value) were
held at the parent company level. Our common stock investments generally are securities with
annual dividend yields that meet or exceed that of the overall market and have the potential
for future dividend increases. Other criteria we evaluate include increasing sales and
earnings, proven management and a favorable outlook. When investing in common stock, we seek
to identify a limited group of companies in which we can become well versed. As a corollary,
we frequently accumulate sizeable holdings over a period of time. At year-end 2007, we held
more than 5 percent of two companies: Fifth Third Bancorp and Piedmont Natural Gas Company.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 17 At
year-end 2007, there were 15 holdings in which we held a fair value of at least $100
million:
Largest Common Stock Holdings
In 2007, the most significant changes in the common stock portfolio were:
We sold all of our holdings in Alltel Corporation common stock in 2006. Because of a
restructuring that Alltel announced in late 2005, we determined that it no longer met our
investment parameters.
Our buy-and-hold strategy, along with our emphasis on a small group of equities and
long-term investment horizon has resulted in significant concentrations within the
portfolio. These investments have built up substantial accumulated unrealized appreciation
over a number of years. At year-end 2007, the largest industry concentrations within our
common stock holdings were the financial sector at 56.7 percent of total fair value and the
healthcare sector at 10.1 percent.
Nonredeemable Preferred Stocks
We evaluate preferred stocks in a manner similar to the evaluation we make for
fixed-maturity investments, seeking attractive relative yields. We generally focus on
investment-grade preferred stocks issued by companies that have a strong history of paying
common dividends, which provides us with another layer of protection. When possible we seek
out preferred stocks that offer a dividend received deduction for income tax purposes.
Additional information regarding the composition of investments is included in Item 8, Note
2 of the Consolidated Financial Statements, Page 93.
Other
We report
as “Other” the operations of the parent company, CFC Investment Company, CinFin
Capital Management Company (excluding investment activities) and CSU
Producer Resources as well as other income of our
insurance subsidiary. As of year-end 2007, CFC Investment Company had 2,590 accounts and $92
million in receivables, compared with 2,897 accounts and $108 million in receivables at
year-end 2006. As of year-end 2007 and 2006, CinFin Capital had 64 institutional, corporate
and individual clients. Assets under management were $977 million at year-end 2007 compared
with $960 million at year-end 2006.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 18 Regulation
State Regulation
The business of insurance primarily is regulated by state law. All of our insurance company
subsidiaries are domiciled in the State of Ohio, except The Cincinnati Specialty
Underwriters Insurance Company, which is domiciled in the State of Delaware. Each subsidiary
is governed by the insurance laws and regulations in its respective state of domicile. We
also are subject to state regulatory authorities of all states in which we write insurance.
The state laws and regulations that have the most significant effect on our insurance
operations and financial reporting are discussed below.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 19
Federal Regulation
Although the federal government and its regulatory agencies generally do not directly
regulate the business of insurance, federal initiatives often have an impact. Some of the
current and proposed federal measures that may significantly affect our business are
discussed below.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 20 Item 1A. Risk Factors
Our business involves various risks and uncertainties that may affect achievement of our
business objectives. Many of the risks could have ramifications across our integrated
business activities. For example, while risks related to setting insurance rates and
establishing and adjusting loss reserves are insurance activities, errors in these areas
could have an impact on our investment activities, growth and overall results. The following
discussion should be viewed as a starting point for understanding the significant risks we
face. It is not a definitive summary of their potential impact or of our strategies to
manage and control the risks. Please see Item 7, Management’s Discussion and Analysis of
Financial Condition and Results of Operations, Page 32, for a discussion of those
strategies.
The risks and uncertainties below are not the only ones we face. There are additional risks
and uncertainties that we currently do not believe are material at this time. There also may
be risks and uncertainties of which we are not aware. If any risks or uncertainties
discussed here develop into actual events, they could have a material adverse effect on our
business, financial condition or results of operations. In that case, the market price of
our common stock could decline materially.
Readers should carefully consider this information together with the other information we
have provided in this report and in other reports and materials we file periodically with
the Securities and Exchange Commission as well as news releases and other information we
disseminate publicly.
We rely exclusively on independent insurance agents to distribute our products.
We market our products through independent, non-exclusive insurance agents. These agents are
not obligated to promote our products and can and do sell our competitors’ products. We must
offer insurance products that meet the needs of these agencies and their clients. We need to
maintain good relationships with the agencies that market our products. If we do not, these
agencies may market our competitors’ products instead of ours, which may lead to us having a
less desirable mix of business and could affect our results of operations.
Events or conditions that could diminish our agents’ desire to produce business for us and
the competitive advantage that our independent agencies enjoy:
A reduction in the number of independent agencies marketing our products, the failure of
agencies to successfully market our products or the choice of agencies to reduce their
writings of our products could affect our results of operations if we are unable to replace
them with agencies that produce adequate and profitable premiums.
Further, policyholders may choose a competitor’s product rather than our own because of real
or perceived differences in price, terms and conditions, coverage or service. If the quality
of the independent agencies with which we do business were to decline, that also might cause
policyholders to purchase their insurance through different agencies or channels. Consumers,
especially in the personal insurance segments, may increasingly choose to purchase insurance
from distribution channels other than independent insurance agents, such as direct
marketers.
Please see Item 1, Our Business and Our Strategy, Page 1, for a discussion of our
relationships with independent insurance agents.
Our ability to properly underwrite and price risks and increased competition could adversely
affect our results.
Our financial condition, cash flow and results of operations depend on our ability to
underwrite and set rates accurately for a full spectrum of risks. We establish our pricing
based on assumptions regarding the level of losses that will occur within classes of
business, geographic regions and other criteria.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 21 To properly price our products, we must collect and properly analyze data, the data must be
sufficient, reliable and accessible, we need to develop appropriate rating methodologies and
formulae, and identify and respond to trends quickly. If rates are not accurate, we may not
generate enough premiums to offset losses and expenses or we may not be competitive in the
marketplace.
Setting appropriate rates could be hampered if a state or states where we write business
refuses to allow rate increases that we believe are necessary to cover the risks insured. At
least one state requires us to purchase reinsurance from a mandatory reinsurance fund. Such
reinsurance funds can create a credit risk for insurers if not adequately funded by the
state and, in some cases, the existence of a reinsurance fund could affect the prices
charged for our policies. The effect of these and similar arrangements could reduce our
profitability in any given period or limit our ability to grow our business.
The insurance industry is cyclical and intensely competitive. From time to time, the
insurance industry goes through prolonged periods of intense competition during which it is
more difficult to attract new business, retain existing business and maintain profitability.
Competition in our insurance business is based on many factors, including:
If our pricing is incorrect or we are unable to compete effectively because of one or more
of these factors, our premium writings could decline and our results of operations and
financial condition could be materially adversely affected.
Please see Item 7, Commercial Lines, Personal Lines and Life Insurance Results of
Operations, Page 44, Page 51, and Page 56, for a discussion of our competitive position in
the insurance marketplace.
Managing technology initiatives and meeting new data security requirements are significant
challenges.
While technology can streamline many business processes and ultimately reduce the cost of
operations, technology initiatives present short-term cost, implementation and operational
risks. In addition, we may have inaccurate expense projections, implementation schedules or
expectations regarding the efficacy of the end product. These issues could escalate over
time. If we are unable to find and retain employees with key technical knowledge, our
ability to develop and deploy key technology solutions could be hampered.
We necessarily collect, use and hold data concerning individuals and businesses with whom we
have a relationship. Threats to data security rapidly emerge and change, exposing us to
rising costs and competing time constraints to secure our data in accordance with customer
expectations and statutory and regulatory requirements. A breach of our security that
results in unauthorized access to our data could expose us to data loss, litigation,
damages, fines and penalties, significant increases in compliance costs and reputational
damage.
Please see Item 1, Technology Solutions, Page 4 for a discussion of our technology
initiatives.
The effects of changes in industry practices and regulations on our business are uncertain.
As industry practices and legal, judicial, regulatory, social and other environmental
conditions change, unexpected and unintended issues related to insurance pricing, claims,
and coverage, may emerge. These issues may adversely affect our business by impeding our
ability to obtain adequate rates for covered risks, extending coverage beyond our
underwriting intent or by increasing the number or size of claims. In some instances,
unforeseeable emerging and latent claim and coverage issues may not become apparent until
some time after we have issued the insurance policies that could be affected by the changes.
As a result, the full extent of liability under our insurance contracts may not be known for
many years after a policy is issued.
Further, the National Association of Insurance Commissioners (NAIC) and state insurance
regulators are continually reexamining existing laws and regulations governing insurance
companies and insurance holding
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 22 companies, specifically focusing on modifications to statutory accounting principles,
interpretations of existing laws and the development of new laws and regulations that affect
a variety of financial and nonfinancial components of our business. Any proposed or future
legislation or NAIC initiatives, if adopted, may be more restrictive on our ability to
conduct business than current regulatory requirements or may result in higher costs.
The effects of such changes could adversely affect our results of operations.
Please see Item 7, Critical Accounting Estimates, Property Casualty and Life Insurance
Reserves, Page 37, for a discussion of our reserving practices.
Our loss reserves, our largest liability, are based on estimates and could be inadequate to
cover our actual losses.
Our
consolidated financial statements are prepared using GAAP. These principles require us to make
estimates and assumptions that affect the amounts reported in the Consolidated Financial
Statements and accompanying Notes. Actual results could differ materially from those
estimates. For a discussion of the significant accounting policies we use to prepare our
financial statements and the material implications of uncertainties associated with the
methods, assumptions and estimates underlying our critical accounting policies, please refer
to Item 8, Note 1 of the Consolidated Financial Statements, Page 87, and Item 7, Critical
Accounting Estimates, Property Casualty and Life Insurance Reserves, Page 37.
Our most critical accounting estimate is loss reserves. Loss reserves are the amounts we
expect to pay for covered claims and expenses we incur to settle those claims. The loss
reserves we establish in our financial statements represent an estimate of amounts needed to
pay and administer claims arising from insured events that have occurred, including events
that have not yet been reported to us. Loss reserves are estimates and are inherently
uncertain; they do not and cannot represent an exact measure of liability. Accordingly, our
loss reserves for past periods could prove to be inadequate to cover our actual losses and
related expenses. Any changes in these estimates are reflected in our results of operations
during the period in which the changes are made. An increase in our loss reserves would
decrease earnings, while a decrease in our loss reserves would increase earnings.
The estimation process for unpaid loss and loss expense obligations involves uncertainty by
its very nature. We continually review the estimates and adjust the reserves as facts
regarding individual claims develop, additional losses are reported and new information
becomes known. Adjustments due to loss development on prior years are reflected in the
calendar year in which they are identified. The process used to determine our loss reserves
is discussed in Item 7, Critical Accounting Estimates, Property Casualty and Life Insurance
Reserves, Page 37.
Unforeseen losses, the type and magnitude of which we cannot predict, may emerge in the
future. These additional losses could arise from changes in the legal environment,
catastrophic events, increases in loss severity or frequency, or other causes. Such future
losses could be substantial.
We could experience an unusually high level of losses due to catastrophic or terrorism
events or risk concentrations.
In the normal course of our business, we provide coverage against perils for which estimates
of losses are highly uncertain, in particular catastrophic and terrorism events.
Catastrophes can be caused by a number of events, including hurricanes, tornadoes,
windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Due to the
nature of these events, we are unable to predict precisely the frequency or potential cost
of catastrophe occurrences. The extent of losses from a catastrophe is a function of both
the total amount of insured exposure in the area affected by the event and the severity of
the event.
We have natural catastrophe exposure to:
The occurrence of terrorist attacks in the geographic areas we serve could result in
substantially higher claims under our insurance policies than we have anticipated. While we
do insure terrorism risk in all areas we serve, we have identified our major terrorism
exposure as general commercial risks in the metropolitan Chicago area as well as small co-op
utilities, small shopping malls and small colleges throughout our 34 active states.
Additionally, our life insurance subsidiary could be adversely affected in the event of a
terrorist event or an epidemic such as the avian flu, particularly if the epidemic were to
affect a broad range of the population beyond just the very young or the very old. Our
associate health plan is self-funded and could similarly be affected.
Our results of operations would be adversely affected if the level of losses we experienced
over a period of time exceeded our actuarially determined expectations. In addition, our
financial condition would be adversely
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 23 affected if we were required to sell securities prior to maturity or at unfavorable prices
to pay an unusually high level of loss and loss expenses. Securities pricing might be even
less favorable if a number of insurance companies needed to sell securities during a short
period of time because of unusually high losses from catastrophic events.
Our geographic concentration ties our performance to business, economic, environmental and
regulatory conditions in certain states. We market our property casualty insurance product
in 34 states, but our business is concentrated in the Midwest and Southeast. We also have
exposure in states where we do not actively market insurance when clients of our independent
agencies have business or properties in multiple states.
The Cincinnati Insurance Company also participates in three assumed reinsurance treaties
with two reinsurers that spread the risk of very high catastrophe losses among many
insurers. In 2008, we have exposure of up to $7 million of assumed losses in three layers,
from $1.0 billion to $1.7 billion, from a single event under an assumed reinsurance treaty
for Munich Re Group. The other two assumed reinsurance treaties are immaterial.
In the event of a severe catastrophic event or terrorist attack elsewhere in the world, our
insurance losses may be immaterial. However, the companies in which we invest might be
severely affected, which could affect our financial condition and results of operations. Our
reinsurers might experience significant losses, potentially jeopardizing their ability to
pay losses we cede to them. A catastrophe or epidemic event also could affect our operations
by damaging our headquarters facility or disrupting our associates’ ability to perform their
assigned tasks.
Please see Item 7, Critical Accounting Estimates, Property Casualty and Life Insurance
Reserves, Page 37, for a discussion of our reserving practices.
Our ability to obtain or collect on our reinsurance protection could affect our business,
financial condition, results of operations and cash flows.
We buy property casualty and life reinsurance coverage to mitigate the liquidity risk of an
unexpected rise in claims severity or frequency from catastrophic events or a single large
loss. The availability, amount and cost of reinsurance depend on market conditions and may
vary significantly. If we are unable to obtain reinsurance on acceptable terms and in
appropriate amounts, our business and financial condition may be adversely affected.
In addition, we are subject to credit risk with respect to our reinsurers. Although we
purchase reinsurance to manage our risks and exposures to losses, this reinsurance does not
discharge our direct obligations under the policies we write. We would remain liable to our
policyholders even if we were unable to recover what we believe we are entitled to receive
under our reinsurance contracts. Reinsurers might refuse or fail to pay losses that we cede
to them, or they might delay payment. For long-term cases, the creditworthiness of our
reinsurers may change before we can recover amounts to which we are entitled. A reinsurer’s
insolvency, inability or unwillingness to make payments under the terms of its reinsurance
agreement with our insurance subsidiaries could have a material adverse effect on our
financial position, results of operations and cash flows.
Prior to 2003, we participated in USAIG, a joint underwriting association of individual
insurance companies that collectively functions as a worldwide insurance market for all
types of aviation and aerospace accounts. At year-end 2007, 29.8 percent, or $225 million,
of our total reinsurance receivables were related to USAIG, primarily for September 11,
2001, events. Although more than 99 percent of the reinsurance recoverables associated with
USAIG are backed by securities on deposit, if we are unable to collect these receivables,
our financial position and results of operations could be materially affected. We no longer
participate in new business generated by USAIG and its members.
Please see Item 7, 2008 Reinsurance Programs, Page 70, for a discussion of our reinsurance
treaties.
Our ability to realize our investment objectives could affect our financial condition, our
results of operations or cash flows.
We invest premiums received from policyholders and other available cash to generate
investment income and capital appreciation, maintaining sufficient liquidity to pay covered
claims and operating expenses, service our debt obligations and pay dividends. At year-end
2007, our investment portfolio was $12.198 billion, or 73.3 percent of our total assets. In
2007, our investment segment contributed 21.8 percent of our
revenue and 78.0 percent of our
total income before income taxes.
Investment income is an important component of our revenues and net income. The ability to
achieve our investment objectives is affected by factors that are beyond our control, such
as inflation, economic growth, interest rates, world political conditions, terrorism attacks
or threats, adverse events affecting other companies in our industry or the industries in
which we invest and other widespread unpredictable events. These events may adversely affect
the economy generally and could cause our investment income or the value of securities we
own to decrease. A significant decline in our investment income could have an adverse effect
on our net income, and thereby on our shareholders’ equity and our policyholders’ surplus.
For more detailed discussion of risks associated with our investments, please refer to Item
7A, Qualitative and Quantitative Disclosures About Market Risk, Page 73.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 24 Our investment performance also could suffer because of the types or concentrations of
investments, industry groups and/or individual securities in which we choose to invest.
Market value changes related to these choices could cause a material change in our financial
condition or results of operations.
At year-end 2007, common stock holdings made up 49.4 percent of our investment portfolio. Of
those equities, 56.7 percent were in financial sector companies. Adverse news or events
affecting equities, and this sector specifically, such as unfavorable developments related
to subprime lending, could affect our net income, book value and overall results.
One of our financial sector investments, Fifth Third, accounted for 28.5 percent of our
shareholders’ equity at year-end 2007 and dividends earned from our Fifth Third investment
were 20.0 percent of our investment income in 2007. Based on 2007 results, a 10 percent
change in dividends earned from our Fifth Third holding would result in a $12 million change
in pretax investment income and an $11 million change in after-tax earnings. Every $1.00
change in the market price of Fifth Third’s common stock has approximately a 26 cent impact
on our book value per share. A 20 percent change in the market price of Fifth Third’s common
stock from its year-end 2007 closing price would result in a $338 million change in assets
and a $220 million change in after tax unrealized gains.
Because we currently own more than 10 percent of Fifth Third’s outstanding shares and
because our CEO serves as a director of Fifth Third, we are limited in the amount of Fifth
Third stock we could sell in any given period and the timing of any sale. This limitation
could lead us to hold a sizeable position in Fifth Third even if it would no longer meet our
investment parameters. This could result in a variety of adverse consequences depending on
the reason we had concluded Fifth Third no longer met our investment parameters. For
example, if Fifth Third were to stop paying dividends on its common stock, we would not be
able to quickly sell a part of our holdings to reinvest in other income-earning investments,
which would have a material effect on our results of operations. We also insure property,
liability, surety and life insurance exposures for Fifth Third and rely on the bank to
service many of our corporate accounts, associate payroll and 401(k) plan.
Please see Item 1, Investments Segment, Page 15, Item 7, Investments Results of
Operations, Page 57, and Liquidity and Capital Resources, Page 60, for discussion of our
investment activities.
Our status as an insurance holding company with no direct operations could affect our
ability to pay dividends in the future.
Cincinnati Financial Corporation is a holding company that transacts substantially all of
its business through its subsidiaries. Our primary assets are the stock in our operating
subsidiaries and our investments. Consequently, our cash flow to pay cash dividends and
interest on our long-term debt depends on dividends we receive from our operating
subsidiaries and income earned on investments held at the parent-company level.
Dividends paid to us by our insurance subsidiary are restricted by the insurance laws of
Ohio, its domiciliary state. These laws establish minimum solvency and liquidity thresholds
and limits. Currently, the maximum dividend that may be paid without prior regulatory
approval is limited to the greater of 10 percent of statutory surplus or 100 percent of
statutory net income for the prior calendar year, up to the amount of statutory unassigned
surplus as of the end of the prior calendar year. Dividends exceeding these limitations may
be paid only with prior approval of the Ohio Department of Insurance. Consequently, at
times, we might not be able to receive dividends from our insurance subsidiary or we might
not receive dividends in the amounts necessary to meet our debt obligations or to pay
dividends on our common stock. This could affect our financial position.
Please see Item 1, Regulation, Page 19, and Item 8, Note 8 of the Consolidated Financial
Statements, Page 96, for discussion of insurance holding company dividend regulations.
We could make investment decisions or experience market value fluctuations that trigger
restrictions applicable to the parent company under the Investment Company Act of 1940.
Compared with other insurance holding companies, we hold a significant level of investment
assets at the parent company level. If these investment assets grow to account for more than
40 percent of parent company’s total assets, excluding assets of our subsidiaries, we might
become subject to regulation under the Investment Company Act of 1940. Our operations are
limited by the constraint that investment securities held at the holding company level
should remain below the 40 percent threshold described above. Efforts to stay below the
threshold could result in:
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 25
If the parent company’s investment assets were to exceed the 40 percent ratio to its total
assets, excluding investment in its subsidiaries, and if it were determined that the holding
company was an unregistered investment company, the holding company might be unable to
enforce contracts with third parties, and third parties could seek rescission of
transactions with the holding company undertaken during the period that it was an
unregistered investment company, subject to equitable considerations set forth in the
Investment Company Act. In addition, the holding company could become subject to monetary
penalties or injunctive relief, or both, in an action brought by the SEC.
Our business depends on the uninterrupted operation of our facilities, systems and business
functions.
Our business depends on our associate’s ability to perform necessary business functions,
such as processing new and renewal policies and claims. We increasingly rely on technology
and systems to accomplish these business functions in an efficient and uninterrupted
fashion. Our inability to access our headquarters facilities or a failure of technology,
telecommunications or other systems could significantly impair our ability to perform such
functions on a timely basis or affect the accuracy of transactions. If sustained or
repeated, such a business interruption or system failure could result in a deterioration of
our ability to write and process new and renewal business, serve our agents and
policyholders, pay claims in a timely manner, collect receivables or perform other necessary
business functions. If our disaster recovery and business continuity plans did not
sufficiently consider, address or reverse the circumstances of an interruption or failure,
this could result in a materially adverse effect on our operating results and financial
condition.
Item 1B. Unresolved Staff Comments
None
Item 2. Properties
Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land
in Fairfield, Ohio. This building contains approximately 800,000 total square feet. The
property, including land, is carried in our financial statements at $68 million as of
December 31, 2007, and is classified as land, building and equipment, net, for company use.
John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square
feet (1 percent).
Construction of a 690,000 total square foot underground garage and third office tower at our
headquarters building began in early 2005. We estimate a completion date of July 2008 for
the project. We believe this estimated $100 million expansion will accommodate our business
needs for the foreseeable future. The construction project is on schedule and on budget. As
of December 31, 2007, construction costs totaled $86 million, which is classified as land,
building and equipment, net, for company use.
Cincinnati Financial Corporation owns the Fairfield Executive Center, which is located on
the northwest corner of our headquarters property. This is a four-story office building
containing approximately 124,000 square feet. The property is carried in the financial
statements at $7 million as of December 31, 2007, and is classified as land, building and
equipment, net, for company use. Our subsidiaries occupy approximately 90 percent of the
rentable square feet and unaffiliated tenants occupy approximately 10 percent. In 2008,
subsidiary operations in this building will relocate to the third officer tower at our
headquarters location. Portions of this space will be available for
lease during 2008.
In 2007, The Cincinnati Life Insurance Company sold a four-story office building in
Springdale, Ohio. The property was carried in the financial statements at $3 million as of
December 31, 2006, and was classified as other invested assets. A capital gain of $2 million
was realized on the sale of the property.
The Cincinnati Insurance Company owns an unoccupied building on 16 acres of land in
Springfield Township, Ohio, approximately six miles from our headquarters. We plan to
renovate the 51,000 square foot building to serve as a disaster recovery and backup data
processing center at an estimated cost of $26 million. The property, including land, is
carried on our financial statements at $3 million as of December 31, 2007, and is classified
as land, building and equipment, net, for company use.
Item 3. Legal Proceedings
Neither the company nor any of our subsidiaries is involved in any material litigation other
than ordinary, routine litigation incidental to the nature of its business.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders of Cincinnati Financial during the
fourth quarter of 2007.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 26 Part II
Cincinnati Financial Corporation had approximately 12,000 shareholders of record and
approximately 46,000 beneficial shareholders as of December 31, 2007. Many of our
independent agent representatives and most of the 4,087 associates of our subsidiaries own
the company’s common stock. We are unable to accurately quantify those holdings because many
are beneficially held.
Our common shares are traded under the symbol CINF on the Nasdaq Global Select Market.
Our ability to pay cash dividends may depend on the ability of our insurance subsidiary to
pay dividends to the parent company. The dividend restrictions of our insurance company
subsidiaries are discussed in Item 8, Note 8 of the Consolidated Financial Statements, Page
96.
The following summarizes securities authorized for issuance under our equity compensation
plans as of December 31, 2007:
Additional information about stock-based associate compensation granted under our equity
compensation plans is available in Item 8, Note 16 of the Consolidated Financial Statements,
Page 102.
The board of directors has authorized share repurchases since 1996. We discuss the board
authorization in Item 7, Liquidity and Capital Resources, Uses of Capital, Page 64. In 2007,
we repurchased a total of 7,454,637 shares.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 27
On October 24, 2007, we entered into an accelerated share repurchase agreement for 4 million shares. At the same time, the board of directors also expanded the existing repurchase
authorization to approximately 13 million shares. Purchases are expected to be made
generally through open market transactions. The board gives management discretion to
purchase shares at reasonable prices in light of circumstances at the time of purchase,
pursuant to SEC regulations.
The prior repurchase program for 10 million shares was announced in 2005, replacing a
program that had been in effect since 1999. No repurchase program has expired during the
period covered by the above table. All of the repurchases reported in the table above were
repurchased under our original 2005 program or the expansion announced in October 2007.
Neither the 2005 nor 1999 program had an expiration date, but no further repurchases will
occur under the 1999 program.
Cumulative Total Return
As depicted in the graph below, the five-year total return on a $100 investment made
December 31, 2002, assuming the reinvestment of all dividends, was 34.0 percent for
Cincinnati Financial Corporation’s common stock compared with 62.3 percent for the Standard
& Poor’s Composite 1500 Property & Casualty Insurance Index and 82.9 percent for the
Standard & Poor’s 500 Index.
The Standard & Poor’s Composite 1500 Property & Casualty Insurance Index includes 29
companies: Ace Ltd., Allstate Corporation, AMBAC Financial Group, Berkley (W R) Corporation,
Chubb Corporation, Cincinnati Financial Corporation, Commerce Group Inc., Fidelity National
Financial Inc., First American Corporation, Hanover Insurance Group Inc., Infinity Property
& Casualty Corporation, Landamerica Financial Group, MBIA Inc., Mercury General Corporation,
Old Republic International Corporation, Philadelphia Consolidated Holding Corporation,
Proassurance Corporation, Progressive Corporation, RLI Corporation, Safeco Corporation,
Safety Insurance Group Inc., SCPIE Holdings Inc., Selective Insurance Group Inc., Stewart
Information Services, Tower Group Inc., Travelers Companies Inc., United Fire & Casualty
Company, XL Capital Ltd. and Zenith National Insurance Corporation.
The Standard & Poor’s 500 Index includes a representative sample of 500 leading companies in
a cross section of industries of the U.S. economy. Although this index focuses on the large
capitalization segment of the market, it is widely viewed as a proxy for the total market.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 28
Item 6. Selected Financial Data
continued...
Per share data adjusted to reflect
all stock splits and dividends prior to December 31, 2007. Significant realized gains and one-time charges or adjustments:
2007 — The company sold 3.8 million shares of its holding in Exxon Mobil Corporation common
stock. The sale contributed $217 million (pretax) to realized investment gains and revenues
and $141 million (after tax), or 81 cents per share, to net income. The company divested the
majority of its real estate investment trust holdings. The sales contributed $73 million
(pretax) to realized investment gains and revenues and $47 million (after tax), or 27 cents
per share, to net income. The company sold 5.5 million shares of its holdings in Fifth Third
Bancorp common stock. The sale contributed $64 million (pretax) to realized investment gains
and revenues and $42 million (after tax), or 24 cents per share, to net income. The company
sold all of its holdings in FirstMerit Corporation common stock. The sale contributed $59
million (pretax) to realized investment gains and revenues and $38 million (after tax), or
22 cents per share, to net income.
2006 — The company sold all of its holdings in Alltel Corporation common stock. The sale
contributed $647 million (pretax) to realized investment gains and revenues and $412 million
(after tax), or $2.35 per share, to net income.
2003 — As the result of a settlement negotiated with a vendor, pretax results included the
recovery of $23 million of the $39 million one-time, pretax charge incurred in 2000.
2000 — The company recorded a one-time charge of $39 million, pretax, to write down
previously capitalized costs related to the development of software to process property
casualty policies. The company earned $5 million in interest in the first quarter from a
$303 million single-premium bank-owned life insurance (BOLI) policy booked at the end of
1999 that was segregated as a separate account effective April 1, 2000. Investment income
and realized investment gains and losses
from separate accounts generally accrue directly to the contract holder and, therefore, are
not included in the company’s consolidated financials.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 30 & 31
Introduction
The purpose of Management’s Discussion and Analysis is to provide an understanding of
Cincinnati Financial Corporation’s consolidated results of operations and financial
position. Management’s Discussion and Analysis should be read in conjunction with Item 6,
Selected Financial Data, Pages 30 and 31, and Item 8, Consolidated Financial Statements and
related Notes, beginning on Page 80. We present per share data on a diluted basis unless
otherwise noted, and we have adjusted those amounts for all stock splits and stock
dividends.
We begin with an executive summary of our results of operations and outlook, as well as
details on critical accounting policies and estimates. Periodically, we refer to estimated
industry data so that we can give information on our performance versus the overall
insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best, a
leading insurance industry statistical, analytical and financial strength rating
organization. Information from A.M. Best is presented on a statutory basis. When we provide
our results on a comparable statutory basis, we label it as such; all other company data is
presented in accordance with accounting principles generally accepted in the United States
of America (GAAP).
Executive Summary
Through The Cincinnati Insurance Company and its local independent agent representatives,
Cincinnati Financial Corporation has become one of the 25 largest property casualty insurer
groups in the nation, based on premium volume for the approximate 2,000 U.S. stock and
mutual insurer groups. We primarily market standard market property casualty insurance
products through a select group of independent insurance agencies in 34 states. As we
discussed in the business description in Item 1, we believe three key characteristics
distinguish our company and allow us to build shareholder value:
We provide additional detail on these subjects in the Results of Operations and Liquidity
and Capital Resources sections of this discussion.
Among the factors that influence the consolidated results of operations and financial
position of the company, we consider our relationships with independent insurance agents to
be the most significant. We seek to be an indispensable partner in each agency’s success. To
continue to achieve our performance targets, we must maintain these strong relationships,
write a significant portion of each agency’s business and attract new agencies that share
our business philosophy.
We believe consistently applying our long-term strategies rather than taking short-term
actions will allow us to address these challenges. We seek to meet our agents’ needs, with
an eye toward solutions and approaches that will give us an advantage for five, 10 or more
years. As we appoint new agencies, we are looking to build relationships that lead them to
award us a preferred position and a meaningful share of the business they write.
In 2007, we did not achieve some of our objectives for creating shareholder value. For the
year, we wrote less new property casualty business than the prior year and market pricing
trends led to slightly lower written premiums and put some pressure on our current accident
year margins. Nonetheless, we continued to build our company for the long term. Agencies
continued to successfully market our products to their better accounts. They gave us $325
million of new property casualty business and helped us maintain the persistency of renewals
at more than 90 percent of our accounts. Our equity-focused investment strategy led to
another year of record investment income even as declines in the market values of our
financial sector common stocks led to lower invested assets and book value.
We look beyond 2007, recognizing the challenges that will face us and with strategies in
place to address those challenges. We remain committed to providing a stable market for our
agents’ high quality business, underwriting this business carefully and producing steady
value for our shareholders, as represented by the board of directors’ recent decision to
increase our 2008 indicated annual cash dividend by 9.9 percent, which would mark the
48th consecutive year of increase in that measure. We believe we can achieve
above-industry-average growth in written premiums and industry-leading profitability over
the long term by building on our proven strategies: strong agency relationships, local
underwriting, quality claims service, solid reserves and total return investing.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 32
Over our 57 year history, our growth largely has been driven by increasing our share of the
business written by the agencies that market our products, growth of those agencies,
appointment of new agencies and our periodic entry into new states. During 2008, we are
targeting 65 new agency appointments.
Over the years, we have been able to increase our share of our agencies’ business by making
available insurance products that meet the needs of the individuals and businesses in their
communities. In recent years, our agents had indicated their interest in having Cincinnati
available as a market for commercial accounts that require the flexibility of excess and
surplus lines coverage. Preparations that began in early 2007 to initiate excess and surplus
lines operations concluded on schedule in December 2007. Our new subsidiary, The Cincinnati
Specialty Underwriters Insurance Company, received an A (Excellent) rating from A.M. Best,
an independent provider of insurer ratings. As noted in Item 1, Excess and Surplus Lines
Operation Further Enhances Agency Relationships, Page 6, our new wholly owned brokerage CSU
Producer Resources began marketing excess and surplus lines policies to selected agencies in
five states in January 2008.
Below we review highlights of our financial results for the past three years and measures of
the success of our efforts to create shareholder value. Detailed discussion of these topics
appears in Results of Operations, Page 42, and Liquidity and Capital Resources, Page 60.
Corporate Financial Highlights
Income Statement and Per Share Data
Revenues in 2007 and 2006 were significantly higher than in 2005. Both years reflected
significant net realized investment gains from sales of common stock holdings. In both
years, rising pretax investment income offset the slowing growth rate of consolidated
property casualty earned premiums.
Net income and net income per share declined slightly in 2007 from a record level in 2006.
The most significant factors contributing to net income are:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 33
Cash dividends declared per share rose 6.0 percent and 11.2 percent in 2007 and 2006.
Balance Sheet Data and Performance Measures
Invested assets and total assets declined in 2007, primarily due to lower market values of
financial sector equity holdings. Invested assets and total assets rose in 2006 on new
investments and appreciation in the equity portfolio.
Comprehensive income is net income plus the year-over-year difference in unrealized gains on
investments. Comprehensive income moved in concert with the changes in unrealized investment
gains over the three-year period. Unrealized investment gains declined in 2007 because of
lower market values of our financial sector holdings, after rising in 2006. Unrealized gains
were lower in 2005 primarily due to a decline in the market value of our Fifth Third
investment.
Return on equity in 2007 declined slightly due to lower realized gains on investments after
rising in 2006 due to higher realized gains on investments. Return on equity based on
comprehensive income declined in 2007 because of lower comprehensive income due to lower
unrealized investment gains. It rose in 2006 due to the increase in accumulated other
comprehensive income.
Our ratio of long-term debt to capital (long-term debt plus shareholders’ equity) rose in
2007 after declining in 2006. The increase in 2007 was due to share repurchase and lower
unrealized gains, which primarily reflected the lower market values of our financial sector
equity holdings.
Property Casualty Highlights
The trend in overall written premium growth reflected the competitive and market factors
discussed in Item 1, Commercial Lines and Personal Lines Insurance Results of Operations,
Page 44 and Page 51. Our consolidated property casualty insurance underwriting profit rose in
2007 after declining in 2006, matching the trend in our combined ratio. (The combined ratio
is the percentage of each premium dollar spent on claims plus all
expenses — the lower the ratio, the better the performance.) 2007 performance was bolstered
by lower catastrophe losses and higher savings from favorable development on prior period
reserves.
We also measure a variety of non-financial metrics for our property casualty operations. For
example, we monitor our rank within our reporting agency locations. In 2006, we ranked No. 1
or No. 2 by premium volume in 74.2 percent of the locations that have marketed our products
for more than five years. Other measures include subdivision of territories and new agency
appointments. We ended 2007 with 106 field territories, subdividing three new territories
and merging one into the surrounding regions. As discussed in Item 1, Growing with Our
Agencies, Page 9, we made 66 new agency appointments in 2007, 50 of which were new
relationships. These new appointments and other changes in agency structures led to a net
increase in reporting agency locations of 38 in 2007.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 34
Agent satisfaction with our technology solutions is, and will continue to be, a requirement
for maintaining our strong relationships with these agencies. In 2007, we made additional
progress in implementing technology solutions that we believe should make it easier for
agencies to do business with us. Among other 2007 milestones, we deployed our new commercial
lines policy processing system to agencies in 10 states for use in processing new and
renewal businessowners policies, bringing the year-end total to 17 states. We also deployed
our personal lines policy processing system in four states, bringing the year-end total to
17 states, and continued to make important upgrades and enhancements.
In each of the past three years, our results have compared satisfactorily to estimated
industry results. Industry net written premiums were estimated to decline 1.2 percent in
2007. In 2006, industry premiums were estimated to rise 3.9 percent after no change in 2005.
In the past three years, industry premium trends have been obscured by the reinsurance
sector, where premiums were estimated to have declined 8.5 percent in 2007, risen 28.1
percent in 2006 and declined 28.2 percent in 2005. The estimated industry average statutory
combined ratios were 95.6 percent in 2007, 92.4 percent in 2006 as well as 101.2 percent in
2005 when the 144.9 percent estimated reinsurance sector combined ratio obscured the
industry combined ratio.
Measuring Our Success In 2008 And Beyond
Looking into 2008 and beyond, we will continue to measure the success of our strategies:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 35
Factors supporting our outlook for 2008 are discussed in the Results of Operations for each
of the four business segments.
Critical Accounting Estimates
Cincinnati Financial Corporation’s financial statements are prepared using GAAP. These
principles require management to make estimates and assumptions that affect the amounts
reported in the Consolidated Financial Statements and accompanying Notes. Actual results
could differ materially from those estimates.
The significant accounting policies used in the preparation of the financial statements are
discussed in Item 8, Note 1 of the Consolidated Financial Statements, Page 87. In
conjunction with that discussion, material implications of uncertainties associated with the
methods, assumptions and estimates underlying the company’s critical accounting policies are
discussed below. The audit committee of the board of directors reviews the annual financial
statements with management and the independent registered public accounting firm. These
discussions cover the quality of earnings, review of reserves and accruals, reconsideration
of the suitability of accounting principles, review of highly judgmental areas including
critical accounting policies, audit adjustments and such other inquiries as may be
appropriate.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 36
Property Casualty Insurance Loss And Loss Expense Reserves
Overview
We establish loss and loss expense reserves for our property casualty insurance business as
balance sheet liabilities. These reserves account for unpaid loss and loss expenses as of a
financial statement date. Unpaid loss and loss expenses are the estimated amounts necessary
to pay for and settle all outstanding insured claims, including incurred but not reported
(IBNR) claims, as of that date.
For some lines of business that we write, a considerable and uncertain amount of time can
elapse between the occurrence, reporting and payment of insured claims. The amount we will
actually have to pay for such claims also can be highly uncertain. This uncertainty,
together with the size of our reserves, makes the loss and loss expense reserves our most
significant estimate. Gross loss and loss expense reserves were $3.925 billion, or
36.7 percent of total liabilities, at year-end 2007, compared with $3.860 billion, or 37.1
percent of total liabilities, at year-end 2006.
How Reserves Are Established
Our field claims representatives establish case reserves when claims are reported to the
company to provide for our unpaid loss and loss expense obligation associated with these
claims. Experienced headquarters claims supervisors review individual case reserves greater
than $35,000 that were established by field claims representatives. Headquarters claims
managers also review case reserves greater than $100,000.
Our claims representatives base their case reserve estimates primarily upon case-by-case
evaluations that consider:
Case reserves of all sizes are subject to review on a 90-day cycle or more frequently, if
new information regarding a loss becomes available. As part of the review process, we
monitor industry trends, cost trends, relevant court cases, legislative activity and other
current events in an effort to ascertain new or additional loss exposures.
We also establish incurred but not reported (IBNR) reserves to provide for all unpaid loss
and loss expenses not accounted for by case reserves. For other than asbestos and
environmental claims, we calculate IBNR reserves quarterly by first deriving an actuarially
based estimate of the ultimate cost of total loss and loss expenses incurred as of the
financial statement date. We then reduce the estimate by total loss and loss expense
payments and total case reserves carried as of the financial statement date.
We calculate IBNR reserves for asbestos and environmental claims by deriving an actuarially
based estimate of total unpaid loss and loss expenses as of the financial statement date. We
then reduce the estimate by total case reserves as of the financial statement date. We
discuss the reserve analysis that applies to claims other than asbestos and environmental
claims below. We discuss the reserve analysis that applies to asbestos and environmental
reserves in Asbestos and Environmental Reserves,
Page 66.
Our actuarial staff applies significant judgment in selecting models and estimating model
parameters when preparing reserve analyses. In addition, unpaid loss and loss expenses are
inherently uncertain as to timing and amount. Uncertainties relating to model
appropriateness, parameter estimates and actual loss and loss expense amounts are referred
to as model, parameter and process uncertainty, respectively. Our management and actuarial
staff control for these uncertainties in the reserving process in a variety of ways.
Our actuarial staff bases its estimates primarily on the indications of methods and models
that analyze accident year data. Accident year is the year in which an insured claim, loss,
or loss expense occurred. The specific methods and models that we have used for the past
several years are:
Our actuarial staff uses diagnostics provided by stochastic reserving software to evaluate
the appropriateness of the models and methods listed above. The software’s diagnostics have
indicated that the appropriateness of these models and methods for estimating IBNR reserves
for our lines of business tends to depend on a line’s tail. Tail refers to the time interval
between a typical claim’s occurrence and its settlement. For our long tail lines such as
workers’ compensation and commercial casualty, models from the probabilistic trend family
tend to provide superior fits and to validate well compared with models underlying the loss
development and Bornhuetter-Ferguson methods. The loss development and Bornhuetter-Ferguson
methods, particularly the reported loss variations, tend to produce the more appropriate
IBNR reserve estimates for our short-tail lines
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 37
such as homeowner and commercial property.
For our mid-tail lines such as personal and commercial auto liability, all models and
methods provide useful insights.
Our actuarial staff also devotes significant time and effort to the estimation of model and
method parameters. The loss development and Bornhuetter-Ferguson methods require the
estimation of numerous loss development factors. The Bornhuetter-Ferguson methods also
involve the estimation of numerous ultimate loss ratios by accident year. Models from the
probabilistic trend family require the estimation of development trends, calendar year
inflation trends and exposure levels. Consequently, our actuarial staff monitors a number of
trends and measures to gain key business insights necessary for exercising appropriate
judgment when estimating the parameters mentioned.
These trends and measures include:
These trends and measures also support the estimation of ultimate accident year loss ratios
needed for applying the Bornhuetter-Ferguson methods and for assessing the reasonability of
all IBNR reserve estimates computed. Our actuarial staff reviews these trends and measures
quarterly and updates them as necessary.
Quarterly, our actuarial staff summarizes its reserve analysis by preparing an actuarial
best estimate and a range of reasonable IBNR reserves intended to reflect the uncertainty of
the estimate. An inter-departmental committee that includes our actuarial management team
reviews the results of each quarterly reserve analysis. The committee establishes
management’s best estimate of IBNR reserves, which is the amount that is included in each
period’s financial statements. In addition to the information provided by actuarial staff,
the committee also considers factors such as the following:
The determination of management’s best estimate, like the preparation of the reserve
analysis that supports it, involves considerable judgment. Changes in reserving data or the
trends and factors that influence reserving data may signal fundamental shifts or may simply
reflect single-period anomalies. Even if a change reflects a fundamental shift, the full
extent of the change may not become evident until years later. Moreover, since our methods
and models do not explicitly relate many of the factors we consider directly to reserve
levels, we typically cannot quantify the precise impact of such factors on the adequacy of
reserves prospectively or retrospectively.
Due to the uncertainties described above, our ultimate loss experience could prove better or
worse than our carried reserves reflect. To the extent that reserves are inadequate and
increased, the amount of the increase is a charge in the period that the deficiency is
recognized, raising our loss and loss expense ratio and reducing earnings. To the extent
that reserves are redundant and released, the amount of the release is a credit in the
period that the redundancy is recognized, reducing our loss and loss expense ratio and
increasing earnings.
Key Assumptions — Loss Reserving
Our actuarial staff makes a number of key assumptions when using their methods and models to
derive IBNR reserve estimates. Appropriate reliance on these key assumptions essentially
entails determinations regarding the likelihood that statistically significant patterns in
historical data will extend into the future. The four most significant of the key
assumptions used by our actuarial staff and approved by management are:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 38
These key assumptions have not changed since 2005, when our actuarial staff began using
probabilistic trend family models to estimate IBNR reserves.
Paid losses, reported losses and paid allocated loss expenses are subject to random as well
as systematic influences. As a result, actual paid losses, reported losses and paid
allocated loss expenses are virtually certain to differ from projections. Such differences
are consistent with what specific models for our business lines predict and with the related
patterns in the historical data used to develop these models. As a result, management does
not closely monitor statistically insignificant differences between actual and projected
data.
Reserve Estimate Variability
Management believes that the standard error of a reserve estimate, a measure of the
estimate’s variability, provides the most appropriate measure of the estimate’s sensitivity.
The reserves we establish depend on the models we use and the related parameters we estimate
in the course of conducting reserve analyses. However, the actual amount required to settle
all outstanding insured claims, including IBNR claims, as of a financial statement date
depends on stochastic, or random, elements as well as the systematic elements captured by
our models and estimated model parameters. For the lines of business we write, process
uncertainty — the inherent variability of loss and loss expense payments — typically
contributes more to the imprecision of a reserve estimate than parameter uncertainty.
Consequently, a sensitivity measure that ignores process uncertainty would provide an
incomplete picture of the reserve estimate’s sensitivity. Since a reserve estimate’s
standard error accounts for both process and parameter uncertainty, it reflects the
estimate’s full sensitivity to a range of reasonably likely scenarios.
The table below provides standard errors and reserve ranges for lines of business that
account for 91.6 percent of our loss and loss expense reserves as well as the potential
effects on our net income assuming a 35 percent federal tax rate. Standard errors and
reserve ranges for assorted groupings of these lines of business cannot be computed by
simply adding the standard errors and reserve ranges of the component lines of business,
since such an approach would ignore the effects of product diversification. See Range of
Reasonable Reserves below for a total reserve range. While the table reflects our assessment
of the most likely range within which each line’s actual unpaid loss and loss expenses will
fall, one or more lines’ actual unpaid loss and loss expenses could nonetheless fall outside
of the indicated ranges.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 39
If actual unpaid loss and loss expenses fall within these ranges, our cash flow and fixed
maturity investments should provide sufficient liquidity to make the subsequent payments. To
date, our cash flow has covered our loss and loss expense payments, and we have never had to
sell investments to make these payments. If this were to become necessary, however, our
fixed maturity investments should provide us with ample liquidity. At year-end 2007, fixed
maturity investments exceeded total insurance reserves (including life policy reserves) by
more than $400 million.
Life Insurance Policy Reserves
We establish the reserves for traditional life insurance policies based on expected
expenses, mortality, morbidity, withdrawal rates and investment yields, including a
provision for uncertainty. Once these assumptions are established, they generally are
maintained throughout the lives of the contracts. We use both our own experience and
industry experience adjusted for historical trends in arriving at our assumptions for
expected mortality, morbidity and withdrawal rates. We use our own experience and historical
trends for setting our assumptions for expected expenses. We base our assumptions for
expected investment income on our own experience adjusted for current economic conditions.
We establish reserves for our universal life, deferred annuity and investment contracts
equal to the cumulative account balances, which include premium deposits plus credited
interest less charges and withdrawals. Some of our universal life insurance policies contain
no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the
account balance based on expected no-lapse guarantee benefits and expected policy
assessments.
Asset Impairment
Our fixed-maturity and equity investment portfolios are our largest assets. The company’s
asset impairment committee continually monitors the holdings in these portfolios and all
other assets for signs of other-than-temporary or permanent impairment. The committee
monitors significant decreases in the market value of invested assets, changes in legal
factors or in the business climate, an accumulation of costs in excess of the amount
originally expected to acquire or construct an asset, uncollectability of all receivable
assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure to
pay interest or dividends or signs indicating that the carrying amount may not be
recoverable.
The application of our impairment policy resulted in other-than-temporary impairment charges
and realized investment losses that reduced our income before income taxes by $16 million in
2007 and $1 million in both 2006 and 2005.
Our portfolio managers monitor the status of their assigned portfolios for
indications of potential problems that may be possible impairment issues. If a security is
trading below book value, the portfolio managers undertake additional reviews. Such declines
often occur in conjunction with events taking place in the overall economy and market,
combined with events specific to the industry or operations of the issuing organization.
Management reviews quantitative measurements such as a declining trend in market value, the
extent of the market value decline and the length of time the value of the security has been
depressed, as well as qualitative measures such as pending events and issuer liquidity.
Generally, these declines in valuation are
greater than might be anticipated when viewed in the context of overall economic and market
conditions. We provide information regarding valuation of our invested assets in Item 8,
Note 2 of the Consolidated Financial Statements, Page 93.
Impairment charges are recorded for other-than-temporary declines in value, if, in the asset
impairment committee’s judgment, there is little expectation that the value will be recouped
in the foreseeable future. A security valued between 95 percent and 100 percent of book
value will not be monitored separately by the committee. These assets generally are at this
value because of interest rate-driven factors. All securities valued below 95 percent of
book value are reported to the asset impairment committee for evaluation.
When evaluating for other-than-temporary impairments, the committee considers the company’s
intent and ability to retain a security for a period adequate to
recover its cost. Because of the company’s strong capitalization, management may not
impair certain securities even though they are trading below cost. The company can make that
determination based on its ability to hold until their scheduled redemption securities that
have the potential to recover value. In addition to evaluating the security’s current
valuation, the impairment committee reviews objective evidence that indicates the potential
for a recovery in value. Information is evaluated regarding the security, such as financial
performance, near-term prospects and the financial condition of the region and industry in
which the issuer operates.
Securities
that have previously been impaired are evaluated based on their adjusted book value
and written down further, if deemed appropriate. The decision to sell or write down a
security with impairment indications reflects, at least in part, management’s opinion that
the security no longer meets the company’s investment objectives. We provide detailed
information about securities trading in a continuous loss position at year-end 2007 in
Item 7A, Unrealized Investment Gains and Losses, Page 77. An other-than-temporary decline in
the fair value of a security is recognized in net income as realized investment losses.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 40
Permanent impairment charges (write-offs) are defined as those for which management believes
there is little potential for future recovery, for example, following the bankruptcy of the
issuer. A permanent decline in the fair value of a security is written off at the time when
facts and circumstances indicate such write-down is warranted, and is reflected in realized
investment losses.
Other-than-temporary and permanent impairments are distinct from the ordinary fluctuations
seen in the value of a security when considered in the context of overall economic and
market conditions. Securities considered to have a temporary decline would be expected to
recover their market value, which may be at maturity. Under the same accounting treatment as
market value gains, temporary declines (changes in the fair value of these securities) are
reflected on our balance sheet in accumulated other comprehensive income, net of tax, and
have no impact on reported net income.
Employee Benefit Pension Plan
We have a defined benefit pension plan covering substantially all employees. Contributions
and pension costs are developed from annual actuarial valuations. These valuations involve
key assumptions including discount rates and expected return on plan assets, which are
updated each year. Any adjustments to these assumptions are based on considerations of
current market conditions. Therefore, changes in the related pension costs or credits may
occur in the future due to changes in assumptions.
Key assumptions used in developing the 2007 net pension obligation were a 6.25 percent
discount rate and rates of compensation increases ranging from 4 percent to 6 percent. Key
assumptions used in developing the 2007 net pension expense were a 5.75 percent discount
rate, an 8 percent expected return on plan assets and rates of compensation increases
ranging from 4 percent to 6 percent.
In 2007, the net pension expense was $21 million. In 2008, we expect a net pension expense
of $19 million, primarily as a result of reduced service costs due to a 0.5 percentage point
increase in the discount rate.
Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate
would lower our 2008 net income before income taxes by $2 million. Likewise, a
0.5 percentage point decline in the expected return on plan assets would lower our 2008
income before income taxes by $1 million.
The fair value of the plan assets exceeded the accumulated benefit obligation by $9 million
at year-end 2007 and $8 million at year-end 2006. The fair value of the plan assets was less
than the projected plan benefit obligation by $54 million at year-end 2007 and $58 million
at year-end 2006. Market conditions and interest rates significantly affect future assets
and liabilities of the pension plan.
Deferred Acquisition Costs
We establish a deferred asset for costs that vary with, and are primarily related to,
acquiring property casualty and life insurance business. These costs are principally agent
commissions, premium taxes and certain underwriting costs, which are deferred and amortized
into income as premiums are earned. Deferred acquisition costs track with the change in
premiums. Underlying assumptions are updated periodically to reflect actual experience.
Changes in the amounts or timing of estimated future profits could result in adjustments to
the accumulated amortization of these costs.
For property casualty policies, deferred acquisition costs are amortized over the terms of
the policies. For life policies, acquisition costs are amortized into income either over the
premium-paying period of the policies or the life of the policy, depending on the policy
type.
Contingent Commission Accrual
Another significant estimate relates to our accrual for property casualty contingent
(profit-sharing) commissions. We base the contingent commission accrual estimates on
property casualty underwriting results and on supplemental information. Contingent
commissions are paid to agencies using a formula that takes into account agency
profitability, premium volume and other factors, such as prompt monthly payment of amounts
due to the company. Due to the complexity of the calculation and the variety of factors that
can affect contingent commissions for an individual agency, the amount accrued can differ
from the actual contingent commissions paid. The contingent commission accrual of
$102 million in 2007 contributed 3.3 percentage points to the property casualty combined
ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would
affect 2008 net income by $3 million (after tax), or 2 cents per share, and the combined
ratio by approximately 0.2 percentage points.
Separate Accounts
We issue life contracts, referred to as bank-owned life insurance policies (BOLI). Based on
the specific contract provisions, the assets and liabilities for some BOLIs are legally
segregated and recorded as assets and liabilities of the separate accounts. Other BOLIs are
included in the general account. For separate account BOLIs, minimum investment returns and
account values are guaranteed by the company and also include death benefits to
beneficiaries of the contract holders.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 41
Separate account assets are carried at fair value. Separate account liabilities primarily
represent the contract holders’ claims to the related assets and also are carried at the
fair value of the assets. Generally, investment income and realized investment gains and
losses of the separate accounts accrue directly to the contract holders and, therefore, are
not included in our Consolidated Statements of Income. However, each separate account
contract includes a negotiated realized gain and loss sharing arrangement with the company.
This share is transferred from the separate account to our general account and is recognized
as revenue or expense. In the event that the asset value of contract holders’ accounts is
projected below the value guaranteed by the company, a liability is established through a
charge to our earnings.
For our most significant separate account, written in 1999, realized gains and losses are
retained in the separate account and are deferred and amortized to the contract holder over
a five-year period, subject to certain limitations. Upon termination or maturity of this
separate account contract, any unamortized deferred gains and/or losses will revert to the
general account. In the event this separate account holder were to exchange the contract for
the policy of another carrier in 2008, the account holder would pay a surrender charge equal
to 2 percent of the contract’s account value. The surrender
charge will fall to 1 percent in 2009 and 0 percent in 2010 and beyond.
At year-end 2007, net unamortized realized gains amounted to $1 million. In accordance with
this separate account agreement, the investment assets must meet certain criteria
established by the regulatory authorities to whose jurisdiction the group contract holder is
subject. Therefore, sales of investments may be mandated to maintain compliance with these
regulations, possibly requiring gains or losses to be recorded, and charged to the general
account. Potentially, losses could be material; however, unrealized losses in the separate
account portfolio were less than $6 million at year-end 2007.
Recent Accounting Pronouncements
Information regarding recent accounting pronouncements is provided in Item 8, Note 1 of the
Consolidated Financial Statements, Page 87. We have determined that recent accounting
pronouncements have not had nor are they expected to have any material impact on our
consolidated financial statements.
Results Of Operations
The consolidated results of operations reflect the operating results of each of our four
segments along with the parent company and other non-insurance activities. The four segments
are:
We measure profit or loss for our property casualty and life segments based upon
underwriting results (profit or loss), which represent net earned premium less loss and loss
expenses and underwriting expenses on a pretax basis. We also frequently evaluate results
for our consolidated property casualty insurance operations, which is the total of our
commercial lines and personal lines insurance segments. Our consolidated property casualty
insurance operations generated an unusually low percent of our total revenues in 2007 and
2006 due to sales of investment assets, which are included in the investments segment
results. Underwriting results and segment pretax operating income are not substitutes for
net income determined in accordance with GAAP.
For our consolidated property casualty insurance operations as well as the commercial lines
and personal lines segments, statutory accounting data and ratios are key performance
indicators that we use to assess business trends and to make comparisons to industry
results, since GAAP-based industry data generally is not as readily available. We also use
statutory accounting data and ratios as key performance indicators for our life insurance
operations.
Investments held by the parent company and the investment portfolios for the property
casualty and life insurance subsidiaries are managed and reported as the investments
segment, separate from the underwriting businesses. Net investment income and net realized
investment gains and losses for our investment portfolios are discussed in the Investments
Results of Operations.
The calculations of segment data are described in more detail in Item 8, Note 17 of the
Consolidated Financial Statements, Page 96. The following sections review results of
operations for each of the four segments. Commercial Lines Insurance Results of Operations
begins on Page 44, Personal Lines Insurance Results of Operations begins on Page 51,
Life Insurance Results of Operations begins on Page 56, and Investments Results of
Operations begins on Page 57. We begin with an overview of our consolidated property
casualty operations, which is the total of our commercial lines and personal lines segments.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 42
Consolidated Property Casualty Insurance Results Of Operations
In addition to the factors discussed in Commercial Lines and Personal Lines Insurance
Results of Operations, Page 44 and Page 51, growth and profitability for our consolidated
property casualty insurance operations were affected by:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 43
Catastrophe Losses Incurred
The discussions of our property casualty insurance segments provide additional detail
regarding these factors.
Commercial Lines Insurance Results Of Operations
Overview — Three-year Highlights
Performance highlights for the commercial lines segment include:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 44
Commercial Lines Results
Growth and Profitability
As the commercial markets have grown more competitive over the past several years, we have
focused on leveraging our local relationships and the efforts of our agents and the teams
that work with them. We believe that we are maintaining appropriate pricing discipline for
both new and renewal business as we emphasize the importance of assessing account quality to
our agencies and underwriters.
For new business, our field associates are in our agents’ offices helping to judge the
quality of each account, emphasizing the Cincinnati value proposition, calling on prospects
with those agents, carefully evaluating risk
exposure and working up their best quotes. At year-end 2007, our field marketing
representatives reported pricing down about 15 percent to 20 percent on average to write the
same piece of new quality business we would have quoted in 2006, the second consecutive year
of significant declines in our new business pricing. We believe this reflects the importance
carriers are placing on protecting their renewal portfolios.
For renewal business, our headquarters underwriters talk regularly with agents. Our field
teams are available to assist the headquarters underwriters by conducting inspections and
holding renewal review meetings with agency staff. These activities can help verify that a
commercial account retains the characteristics that caused us to write the business
initially. For quality risks, our commercial underwriters are offering policyholders the
convenience of policy extensions of one and two additional years.
In these conditions, we have needed to use credits more frequently to retain renewals of
quality business — the larger the account, the higher the credits, with variations by
geographic region and class of business. At year-end 2007, rate declines of 4 percent to 6
percent seemed typical for our renewal business.
We intend to remain a stable market for our agencies’ best business and believe that our
case-by-case approach gives us a clear advantage. Our independent agents, field marketing
representatives and headquarters underwriters work together to select risks and respond
appropriately to local pricing trends. Historically, they have proven capable of balancing
risk and price to achieve profitable growth over the longer term.
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.
In 2007, competition in our markets continued to intensify, and we view this as the most
significant factor in the 1.2 percent decline in commercial lines written premiums. Our
largest four commercial lines of business reported lower written premiums, led by commercial
auto, which is one of the first lines to experience pricing pressure because it often
represents the largest portion of insurance costs for many commercial policyholders. In this
environment, we will continue to work with our agents to identify quality risks, lower
prices to keep our
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 45
best accounts and help our agencies protect their accounts from
competition. Agency emphasis on larger accounts, convenience and technology considerations
were the primary reasons for a slight decline in the number of our smallest policies.
Other
factors contributing to the year-over-year premium differences include the economic
slowdown in many regions and higher reinsurance premiums. For commercial accounts, we
typically calculate general liability premiums based on sales or payroll volume while we
calculate workers’ compensation premiums based on payroll volume. A change in sales or
payroll volume generally indicates a change in a business’s exposure to risk.
Economic factors, such as the housing market slowdown, can cause demand for our
policyholders’ business services to rise or fall. Changes in demand may cause our
policyholders’ sales and payroll volumes to fluctuate. Those fluctuations can have a modest
effect on our premium trends. Policyholders that experience sales or payroll volume changes
due to economic factors may be purchasers of other types of insurance, such as commercial
auto or commercial property, in addition to general liability and workers’ compensation.
Premium levels for these other types of policies generally are not linked directly to sales
or payroll volumes. In 2007, we estimated that policyholders with a contractor-related ISO
general liability code accounted for approximately 43 percent of our general liability
premiums, which are included in the commercial casualty line of business, and that
policyholders with a contractor-related NCCI workers’ compensation code accounted for
approximately 46 percent of our workers’ compensation premiums.
In 2006, strong new business activity, steady policy retention rates and higher premiums per
policy led to net written premium growth in all of our commercial lines of business, with
commercial auto showing the slowest rate of growth.
Primarily because of the heightened competition, new commercial lines business written
directly by agencies declined 11.5 percent to $287 million in 2007 after rising 14.9 percent
to a record $324 million in 2006.
We discuss growth by commercial line of business below. Over the past three years, we
continued to focus on seeking and maintaining adequate premium per exposure as well as
pursuing non-pricing means of enhancing longer-term profitability. Non-pricing means have
included deliberate reviews of each risk, seeking to ensure that we identified relevant
exposures and offered appropriate coverages, terms and conditions and limits of
insurance. We continue to adhere to our underwriting guidelines, to re-underwrite books of
business with selected agencies and to update policy terms and conditions, where necessary.
In addition, we continue to leverage our strong local presence. Our field marketing
representatives meet with local agencies to reaffirm agreements on the extent of frontline
renewal underwriting agents will perform. Loss control, machinery and equipment and field
claims representatives continue to conduct on-site inspections. Field claims representatives
prepare full risk reports on any account reporting a loss above $100,000 or on any risk of
concern.
We describe the significant cost components for the commercial lines segment below.
Loss and Loss Expenses (excluding catastrophe losses)
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as
well as the associated loss expenses. The trend in the loss and loss expense ratio excluding
catastrophe losses over the past three years reflected competitive market conditions and
softer pricing that began in 2005 and continued through 2007, as discussed above. This
resulted in a steady increase in the accident year loss and loss expense ratio excluding
catastrophe losses to 65.2 percent in 2007 from 61.4 percent in 2006 and 60.3 percent in
2005.
Savings from favorable development on prior period reserves reduced the ratio by 8.4, 4.1
and 5.6 percentage points in 2007, 2006 and 2005, respectively. Particularly for our
longer-tail lines, our ultimate loss ratio estimates continue to show the benefits of
re-classification and re-pricing initiatives undertaken early in this decade. During the
same period, we also made changes to our policy terms, conditions and coverages, to help
manage limits or exposures. Further, we also continue to see positive payment and reporting
pattern changes, attributable to the implementation of a claims management system and to the
use of a claims mediation process that promotes earlier liability settlement resolution.
The rise in the loss and loss expense ratio included a higher contribution from new losses
and case reserve increases greater than $250,000. In total, commercial lines new losses and
reserve increases greater than $250,000 rose to 23.3 percent of earned premium from 21.3
percent in 2006 and 16.8 percent in 2005. Our analysis indicated no unexpected concentration
of these losses and reserve increases by risk category, geographic region, policy inception,
agency or field marketing territory. We believe the increase was due to a number of factors,
including changes in retention levels for our per risk reinsurance programs, case reserve
practices for our workers’ compensation business line, natural volatility and general
inflationary trends in loss costs, which we continue to monitor. A single large loss in 2005
was insufficiently covered through our facultative reinsurance programs, which increased
that year’s loss and loss expenses by $22 million, net of reinsurance, or 1.0 percentage
points.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 46
Commercial Lines Losses by Size
Catastrophe Loss and Loss Expenses
Commercial lines catastrophe losses added just 0.7 percentage points to the loss and loss
expense ratio in 2007, down from the significantly higher levels of the prior two years.
Commission Expenses
Commercial lines commission expense as a percent of earned premium was relatively stable in
2007 after declining by 1.0 percentage points in 2006. Commission expenses include our
profit-sharing, or contingent, commissions, which are calculated on the profitability of an
agency’s aggregate property casualty book of Cincinnati business, taking into account
longer-term profit and premium volume, with a percentage for prompt payment of premiums and
other criteria, and reward the agency’s effort. These profit-based commissions generally
fluctuate with our loss and loss expense ratio. Our 2007 contingent commission accrual
reflected our estimate of the profit-sharing commissions to be paid to our agencies in early
2008 based largely on each agency’s performance in 2007.
Underwriting Expenses
Non-commission underwriting expenses rose to 11.9 percent of earned premiums in 2007 from
11.1 percent in 2006 and 10.1 percent in 2005. In 2007, slower earned premium growth led to
an unfavorable deferred acquisition expense comparison. Further, our excess and surplus
lines start-up activities contributed slightly to higher staffing and technology expenses.
Reallocation of expenses between our commercial lines and personal lines segments as we
refined our data also contributed to the increase in non-commission underwriting expenses.
In 2006, higher technology and staffing expenses contributed 1.2 percentage points to the
increase, with stock option expense accounting for 0.5 percentage points of that amount.
These increases were offset partially by savings in taxes, licenses and fees.
Policyholder Dividends
Policyholder dividend expense was 0.6 percent of earned premium in 2007 compared with 0.7
percent in 2006 and 0.2 percent in 2005.
Line of Business Analysis
Approximately 95 percent of our commercial lines premiums relate to accounts with coverages
from more than one of our business lines. As a result, we believe that the commercial lines
segment is best measured and evaluated on a segment basis. However, we provide line of
business data to summarize growth and profitability trends separately for each line. The
accompanying accident year loss data provides current estimates of incurred loss and loss
expenses and corresponding ratios over the most recent three accident years. Accident year
data classifies losses according to the year in which the corresponding loss event occurs,
regardless of when the losses are actually reported, recorded or paid.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 47
Commercial Casualty
Commercial casualty is our largest business line. Commercial casualty net written premiums
declined slightly in 2007 as competition intensified in the casualty market. In addition,
premiums for this business line can reflect economic trends, including changes in underlying
exposures.
The commercial casualty loss and loss expense ratio improved slightly in 2007 after rising
in 2006 and remains within the range we consider appropriate. In each of the last three
calendar years, the level of favorable development on prior period reserves has been the
primary reason for the fluctuations in the loss and loss expense ratio. Factors contributing
to the level of favorable development are discussed in Commercial Lines Insurance Segment
Reserves, Page 67. In addition to the level of favorable development, the ratio was affected
by the substantial rise in 2007 and 2006 of the level of $1 million plus general liability
losses compared with the level in 2005. These large losses contributed 6.9 percentage points
to the loss and loss expense ratio in 2007, 5.9 percentage points in 2006 and 2.4 percentage
points in 2005.
Pricing and normal loss cost inflation accounted for a portion of the deterioration in the
accident year loss ratio over the three-year period. In addition, the commercial casualty
business line includes some of our longest tail exposures, making initial estimates of
accident year loss and loss expenses incurred more uncertain, as we discuss in Critical
Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 37.
Commercial Property
Commercial property is our second largest business line. Commercial property net written
premiums declined slightly in 2007 in part due to higher reinsurance premiums. The 2006
growth rate benefited by 1.2 percentage points due to the effect of a $5 million reinsurance
reinstatement premium included in 2005 premiums.
The commercial property loss and loss expense ratio excluding catastrophe losses
deteriorated in 2007 after improving in 2006. The rise in 2007 reflected the growing impact
of softer pricing on our commercial property business line. The improvement in the ratio in
2006 largely was due to the large loss discussed above that added 5.0 percentage points to
the 2005 ratio.
Lower catastrophe losses were the primary factor in the decline in the accident year loss
ratio over the three-year period.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 48
Commercial Auto
The decline in commercial auto 2007 written premiums reflected the downward pressure exerted
by the market on the pricing of commercial accounts. Commercial auto is one of the business
lines that we renew and price annually, so market trends may be reflected here more quickly
than in other lines. Commercial auto also is generally one of the larger components of the
typical package.
The commercial auto loss and loss expense ratio remained within the range we consider
appropriate despite the increasing pricing pressures. New losses greater than $1 million
contributed 16.5 percentage points to the loss and loss expense ratio in 2007, 11.5
percentage points in 2006 and 8.5 percentage points in 2005. We believe the higher number of
commercial auto losses greater than $1 million was due to natural volatility and general
inflationary trends in loss costs.
Pricing and normal loss cost inflation were the primary drivers of the deterioration in the
accident year loss ratio over the past three years. In each calendar year, the loss and loss
expense ratio reflected an increase in the accident-year loss and loss expense ratio that
was moderated by favorable development on prior period reserves, a benefit of past
re-underwriting efforts, Ohio judicial decisions regarding underinsured/uninsured motorist
claims and a favorable frequency trend.
Workers’ Compensation
In 2007, workers’ compensation written premiums were essentially unchanged after rising
significantly in 2006. Workers’ compensation premiums partially reflect the general business
economy and related payroll levels. Premiums also benefited from initiatives to modestly
expand our workers’ compensation business in selected states. We cannot offer workers’
compensation coverage in Ohio, our highest total property casualty
premium volume state, because it is provided solely by
the state instead of private insurers.
In 2005, the workers’ compensation loss and loss expense ratio rose to 90.9 percent after
remaining steady for several years. The 2005 rise largely was due to reserve strengthening
on incurred but not yet reported claims for older accident years to reflect higher trends in medical cost inflation and
longer estimated payout periods than originally projected. Since we pay a lower commission
rate on workers’ compensation business, this line has a higher loss and loss expense
breakeven point than our other commercial business lines. Nonetheless, the ratio remained
above our target level over the three-year period.
In 2006, we also reviewed each of our established workers’ compensation case reserves above
$100,000 in light of current trends in medical cost inflation and estimated payout periods.
The review led to an approximate $60 million increase in case reserves held for specific
claims from accident years going back as many as 20 years and the identification of several
new losses greater than $1 million. Since we had raised
workers’ compensation IBNR reserves in 2005 to reflect trends in
medical cost inflation and estimated payout periods, we were able to offset $44 million of the case
reserve increases through IBNR reserve decreases.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 49
Pricing and normal loss cost inflation contributed to the increase in the accident year loss
and loss expense ratio in 2007. In addition, the workers’ compensation business line
includes our longest tail exposures, making initial estimates of accident year loss and loss
expenses incurred more uncertain. Favorable development on prior period reserves moderated
the effect of the increase in the 2007 accident year loss and loss expense ratio on the
corresponding calendar year ratio.
Due to the lengthy payout period of workers’ compensation claims, small shifts in medical
cost inflation and payout periods could have a significant effect on our potential future
liability compared with our current projections.
Specialty Packages
Specialty packages net written premiums rose in 2007 and 2006. The rollout of our commercial
lines policy processing system for Businessowners Policies, which are included in this
business line, should help us meet changing agency needs and address pricing, technology and
service innovations that other carriers have introduced for similar products in recent
years.
The loss and loss expense ratio excluding catastrophe losses and the accident year loss and
loss expense ratio remained within the ranges we consider appropriate.
Surety and Executive Risk
Surety and executive risk net written premiums rose in 2007 and 2006. Healthy economic
activity in some regions drove the 2006 growth.
Director and officer liability coverage accounted for 62.3 percent of surety and executive
risk premiums in 2007 compared with 60.5 percent in 2006 and 57.1 percent in 2005. Our
director and officer liability policies are offered primarily to nonprofit organizations,
reducing the risk associated with this line of business. Nonprofit organizations accounted
for approximately 80 percent of the director and officer liability policies we wrote in
2007. We manage our loss exposure to director and officer liability coverages by writing on
claims-made coverage forms, providing limits up to $10 million and purchasing reinsurance.
In addition, our independent agencies market our director and officer liability policies to
some clients that are for-profit organizations. At year-end 2007, our in-force director and
officer liability policies provided coverage to 30 non-financial publicly traded companies,
including two Fortune 1000 companies. We also provided this coverage to approximately 500
banks, savings and loans and other financial institutions. The majority of these financial
institution policyholders are smaller community banks, and we believe they have no unusual
exposure
to credit-market concerns, including subprime mortgages. Only 12 of our bank and savings and
loan policyholders have assets greater than $2 billion, including one Fortune 500 company;
only 23 have assets between $1 billion and $2 billion; and 52 have assets between $500
million and $1 billion.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 50
The loss and loss expense ratio and reserve development fluctuated significantly over the
three years. We do not believe the changes indicate any new trend or risk.
Machinery and Equipment
Machinery and equipment net written premiums rose slightly in 2007, building on an 8.7
percent increase in 2006. Marketing by machinery and equipment and field marketing
representatives contributed to the growth. Conditions in the machinery and equipment
insurance marketplace are similar to those of commercial lines overall.
Because of the relatively small size of this business line, the calendar year and accident
year loss and loss expense ratio fluctuates. In 2006, a single unusually large loss was
responsible for the higher ratio.
Commercial Lines Insurance Outlook
Industrywide commercial lines written premiums are expected to decline approximately 2.3
percent in 2008 with the industry combined ratio estimated at 97.5 percent. As discussed in
Item 1, Commercial Lines Insurance Marketplace, Page 12, over the past several years, agents
have reported that renewal and new business pricing have come under steadily increasing
pressure, reinforcing the need for more flexibility and careful risk selection. We
anticipate that commercial lines pricing trends observed in 2007 will persist into 2008.
We intend to continue to market our products to a broad range of business classes, price our
products adequately and take a package approach. We intend to maintain our underwriting
selectivity and carefully manage our rate levels as well as our programs that seek to
accurately match exposures with appropriate premiums. We will continue to evaluate each risk
individually and to make decisions regarding rates, the use of three-year commercial
policies, policy term extensions and other policy conditions on a case-by-case basis, even
in lines and classes of business that are under competitive pressure. We also expect new
marketing territories created over the past several years and new agency appointments will
make a growing contribution to commercial lines premiums and underwriting profit in 2008.
We believe our approach should allow us to continue to underwrite commercial lines business
profitably in 2008 although we anticipate another year of both lower premiums and a higher
commercial lines combined ratio, as ongoing soft market conditions lead to lower premium per
exposure. In addition, we do not believe favorable reserve development will continue to
contribute to underwriting profits to the extent seen over the past four years. Further,
underwriting expenses are rising. We discuss our overall outlook for our property casualty
insurance operations in Measuring Our Success in 2008 and Beyond, Page 35.
Personal Lines Insurance Results of Operations
Overview — Three-year Highlights
Performance highlights for the personal lines segment include:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 51
Our personal lines statutory combined ratio was 94.1 percent in 2007, 103.6 percent in
2006 and 94.3 percent in 2005. By comparison, the estimated industry personal lines
combined ratio was 97.0 percent in 2007, 92.3 percent in 2006 and 97.6 percent in 2005.
We believe our results are trending differently than the overall industry because of the
competitive and pricing factors discussed below. In addition, the industry experienced
unusually high catastrophe losses in 2005 and unusually low catastrophe losses in 2006.
Personal Lines Results
Growth and Profitability
Personal lines insurance is a strategic component of our overall relationship with many of
our agencies and an important component of agency relationships with their clients. We
believe agents recommend Cincinnati personal insurance products for their value-oriented
clients who seek to balance quality and price and are attracted by Cincinnati’s superior
claims service and the benefits of our package approach.
In late 2004, price competition returned to the personal lines market as insurers leveraged
the higher profitability and stronger financial positions that were the outcome of
industrywide increases in homeowner rates and of stricter enforcement of underwriting
standards. Through 2006, our growth and profitability were stymied by delays in implementing
rate changes needed to respond to the market and delays in deploying new technology
initiatives. During this time, other carriers began using segmented pricing models more
aggressively, allowing them to develop more accurate prices for each risk.
Policyholder retention and new business levels have remained at higher levels following our
July 2006 introduction of a limited program of policy credits for personal auto and
homeowner pricing in most of the states in which our Diamond system is in use. These credits
incorporate insurance scores and are intended to improve our ability to compete for our
agents’ highest quality personal lines accounts, increasing the opportunity for our agents
to market the advantages of our personal lines products and services to their clients. These
changes resulted in credits for eligible new and renewal policyholders identified as
above-average risks.
We also have deployed our technology solution, Diamond, to 17 states, which represent 97.5
percent of personal lines premiums. We continue to respond to agency requests for
enhancements as we prepare Diamond for additional states.
At year-end 2007, new business premiums had risen for six consecutive quarters after
declining for the 14 prior quarters. However, the increased new business did not fully
offset the impact of lost business and lower rates on above-average quality renewal
business. The number of in-force homeowner and personal auto policies has declined since
2003.
Premium trends by personal line of business and strategies to achieve growth in our personal
lines segment are discussed below.
Even though 2007 was a profitable year as a result of low catastrophe activity, the combined
ratio excluding catastrophes has risen in each of the past three years and remains above our
targeted range. We continue to address pricing, scale, growth and other issues to help
restore the financial health of this strategic business segment. In 2006, higher catastrophe
losses also contributed to a higher combined ratio.
We describe the significant cost components for the personal lines segment below.
Loss and Loss Expenses (excluding catastrophe losses)
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as
well as the associated loss expenses. The trend in the loss and loss expense ratio excluding
catastrophe losses over the past three years largely was due to the pricing factors
discussed above. This resulted in a steady increase in the accident year loss and loss
expense ratio excluding catastrophe losses to 64.2 percent in 2007 from
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 52
61.9 percent in 2006
and 61.5 percent in 2005. Savings from favorable development on prior period reserves
reduced the loss and loss expense ratio by 5.7, 2.4 and 4.3 percentage points in 2007, 2006
and 2005, respectively. We discuss the contribution of changes in prior period reserves by
personal line of business below.
The rise in the loss and loss expense ratio included a higher contribution from new losses
and case reserve increases greater than $250,000. In total, personal lines new losses and
reserve increases greater than $250,000 rose to 12.8 percent of earned premium from 11.0
percent in 2006 and 8.2 percent in 2005. Our analysis indicated no unexpected concentration
of these losses and reserve increases by risk category, geographic region, policy inception,
agency or field marketing territory. We believe the increase largely was due to general
inflationary trends in loss costs, which we continue to monitor, as well as natural
volatility. We also continue to analyze factors that could contribute to a rise in large
losses.
Personal Lines Losses by Size
Catastrophe Loss and Loss Expenses
Personal lines catastrophe losses, net of reinsurance and before taxes, contributed 10
percentage points less to the combined ratio in 2007 primarily because of the lower level of
catastrophe activity during the year. In 2006, catastrophe losses, net of reinsurance and
before taxes, contributed 5 percentage points more to the combined ratio than in 2005
because of an increase of $35 million in incurred catastrophe losses and lower earned
premium. The majority of these losses related to wind and hail from storms in Indiana and
Ohio.
Commission Expenses
Personal lines commission expense as a percent of earned premium rose by 0.4 and 0.7
percentage points in 2007 and 2006. The increases were primarily due to higher
profit-sharing commissions resulting from accrual and allocation adjustments. Commission
expenses include our profit-sharing, or contingent, commissions, which are calculated on the
profitability of an agency’s aggregate property casualty book of Cincinnati business, taking
into account longer-term profit and premium volume, with a percentage for prompt payment of
premiums and other criteria, and reward the agency’s effort. These profit-based commissions
generally fluctuate with our loss and loss expense ratio. Our 2007 contingent commission
accrual reflected our estimate of the profit-sharing commissions to be paid to our agencies
in early 2008 based largely on each agency’s performance in 2007.
Underwriting Expenses
Non-commission underwriting expenses moderated slightly in 2007 after a significant rise in
2006. We continue to invest in our associates and technology, which contributed to an
increase in non-commission underwriting expenses in 2006. In that year, higher technology
expense contributed 0.8 percentage points and higher staffing expense contributed 0.8
points, with stock option expense accounting for 0.5 percentage points of that amount.
Increases in those amounts were offset partially by savings in taxes, licenses and fees.
Reallocation of expenses between our commercial lines and personal lines segments as we
refined our data also contributed to the 2007 improvement.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 53
Line of Business Analysis
We prefer to write personal lines coverage on an account basis that includes both auto and
homeowner coverages as well as coverages from the other personal business line. As a result,
we believe that the personal lines segment is best measured and evaluated on a segment
basis. However, we provide the line of business data to summarize growth and profitability
trends separately for each line.
The corresponding accident year loss data provides current estimates of incurred loss and
loss expenses and corresponding ratios over the most recent three accident years. Accident
year data classifies losses according to the year in which the corresponding loss event
occurs, regardless of when the losses are actually reported, recorded or paid.
Personal Auto
Accident year loss and loss expenses incurred and ratios to earned premiums:
The decline in written and earned premiums over the past three years largely was due to
policy credits adopted in mid-2006 that improved our position in the market by lowering
premiums for eligible new and renewal policyholders. The new policy credits have had a
positive effect on policyholder retention and new business activity. New business, however,
has not yet returned to a level that would allow us to replace premiums lost due to price
reductions and normal attrition. We continue to monitor and modify selected rates and
credits to address our competitive position.
The personal auto loss and loss expense ratio excluding catastrophe losses deteriorated in
2007 after several years of stability. The higher ratio in 2007 largely reflected current
pricing and normal loss cost trends. In recent years, we have seen generally higher costs
for liability claims, including severe injuries, and we are seeking rate increases for
liability coverages that would partially offset price decreases we are seeking for physical
damage coverages. Pricing decreases and normal loss cost inflation also are the primary drivers in the
rise in the accident year loss and loss expense ratio over the past three years.
Homeowner
Accident year loss and loss expenses incurred and ratios to earned premiums:
Written and earned premium trends reflected improved new business levels in 2007 that were
not sufficient; however, to replace premiums lost due to price reductions, normal attrition
and higher reinsurance premiums. Policy credits adopted in mid-2006 improved our competitive
position, while lowering rates for eligible new and renewal policyholders. The new policy
credits have had a positive effect on policyholder retention and new business activity. We
continue to monitor and modify selected rates and credits to address our competitive
position. Higher 2007 reinsurance premiums contributed 2.7 percentage points to the decline
in written premiums.
The homeowner loss and loss expense ratio excluding catastrophes improved in 2007 after
deteriorating in 2006. Although the full benefit of pricing and underwriting actions taken
between 2004 and 2006 is reflected in homeowner results, this line has not yet achieved
breakeven performance if a normalized level of
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 54
catastrophe losses is assumed. Rate changes we made to keep our retention rate and new
business at acceptable levels, along with higher reinsurance costs, have interrupted our
progress toward consistent breakeven performance for the homeowner business line. Changes in
catastrophe loss levels were the primary reason for the fluctuations in the accident year
loss ratio over the past three years.
Two other factors also contribute to our ability to achieve satisfactory homeowner results:
Other Personal
Accident year loss and loss expenses incurred and ratios to earned premiums:
Other personal written premiums were essentially unchanged between 2005 and 2007. The
decline in the number of homeowner and personal auto policies over the past several years
hindered growth in this business line since most of our other personal coverages are
endorsed to homeowner or auto policies.
The loss and loss expense ratio for other personal improved in 2007 after deteriorating in
2006. Personal umbrella losses, which are a major component of other personal losses, can
fluctuate significantly, and we do not believe that the changes indicated any new trend.
Personal Lines Insurance Outlook
Industry analysts currently anticipate industrywide personal lines written premiums may rise
approximately 1.4 percent in 2008 with the combined ratio estimated at 99.5 percent. While
the improvement in our new business levels and policy retention rates over the past 18
months are positive indications for our personal lines business, we believe our growth rate
will be below that of the industry as we continue to address our pricing structure. We are
aware that our personal lines pricing and loss activity are at levels that could put
pressure on our future consolidated property casualty insurance combined ratio, if those
trends continue.
We plan to take steps in our personal lines insurance operations to enhance our response to
the changing marketplace. These strategies should help us achieve our long-term objectives
for this segment:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 55
We identify several other factors that may affect the personal lines combined ratio in 2008
and beyond. Personal lines underwriters continue to focus on insurance-to-value initiatives
to verify that policyholders are buying the correct level of coverage for the value of the
insured risk, and we are carefully maintaining underwriting standards. If earned premiums
decline more than we expect, the personal lines expense ratio may be higher than the 2007
level because some of our costs are relatively fixed, such as our planned investments in
technology. We discuss our overall outlook for our property casualty insurance operations in
Measuring Our Success in 2008 and Beyond, Page 35.
Life Insurance Results of Operations
Overview — Three-year Highlights
Performance highlights for the life insurance segment include:
At the same time, we recognize that assets under management, capital appreciation and
investment income are integral to evaluation of the success of the life insurance segment
because of the long duration of life products. For that reason, we also evaluate GAAP data,
including all investment activities on life insurance-related assets. Including investment
income and realized gains on investments, GAAP net income for the life insurance segment
grew 3.8 percent in 2007 to $65 million, 32.6 percent in 2006 to $63 million and
23.8 percent in 2005 to $47 million. The life insurance company portfolio had after tax
realized investment gains of $26 million in 2007 compared with $29 million in 2006 and
$11 million in 2005.
Life Insurance Results
Growth
We market term, whole and universal life products, fixed annuities and disability income
products. In addition, we offer term, whole and universal life and disability insurance to
employees at their worksite. These products provide our property casualty agency force with
excellent cross-serving opportunities for both commercial and personal accounts.
Total statutory life insurance net written premiums were $167 million in 2007 compared with
$161 million in 2006 and $205 million in 2005. Total statutory written premiums for life
insurance operations for all periods include life insurance, annuity and accident and health
premiums. The change primarily was due to:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 56
Fee income from universal life products increased 35.1 percent in 2007 to $31 million after
declining 14.9 percent to $23 million in 2006. Our new universal life product with secondary
guarantees contributed to the increase in fee income in 2007. Separate account investment
management fee income contributed $4 million, $3 million and $4 million to total revenues in
2007, 2006 and 2005.
Over the past several years, we have worked to maintain a portfolio of simple, yet
competitive products, primarily under the LifeHorizons banner. Our product development
efforts emphasize death benefit protection and guarantees. Distribution expansion within our
property casualty insurance agencies remains a high priority. In the past several years, we
have added life field marketing representatives for the western, southeastern and
northeastern states. Our 29 life field marketing representatives work in partnership with
our 106 property casualty field marketing representatives. Approximately 71 percent of our
term and other life insurance product premiums were generated through our property casualty
insurance agency relationships.
Profitability
Life segment expenses consist principally of:
Life segment profitability depends largely on premium levels, the adequacy of product
pricing, underwriting skill and operating efficiencies. Life segment results include only
investment interest credited to contract holders (interest assumed in life insurance policy
reserve calculations). The remaining investment income is reported in the investment segment
results. The life investment portfolio is managed to earn target spreads between earned
investment rates on general account assets and rates credited to policyholders. We consider
the value of assets under management and investment income for the life investment portfolio
as key performance indicators for the life insurance segment.
We seek to maintain a competitive advantage with respect to benefits paid and reserve
increases by consistently achieving better than average claims experience due to skilled
underwriting. Commissions paid by the life insurance operation are on par with industry
averages. During the past several years, we have invested in imaging and workflow technology
and have significantly improved application processing. We have achieved process
efficiencies while improving our service.
Life Insurance Outlook
Our overall objective is to increase premiums and contain expenses as the life insurance
company seeks to improve penetration of our property casualty agencies. Term insurance is
our largest life insurance product line. We continue to introduce new term products with
features our agents and their clients indicate are important. We also continue to improve
our worksite portfolio to help in our cross-selling initiatives.
The life insurance business is considered mature. In our experience, it is not mature within
the property casualty distribution system where cross-sell opportunities abound — both to
personal lines and commercial lines clients. In particular, there are approximately 41
million under- and uninsured employees of small business in the United States, making the
cross-selling of voluntary, worksite products a huge opportunity for Cincinnati Life’s
worksite marketing and sales strategies.
In 2008 we plan to redesign all our term insurance products. In addition to redesigning our
worksite term insurance, we will be updating all of the other products in our worksite life
insurance portfolio. These improvements support opportunities to cross-sell life insurance
products to clients of the independent agencies that sell Cincinnati’s property casualty
insurance policies.
Investments Results of Operations
Overview — Three-year Highlights
The investment segment contributes investment income and realized gains and losses to
results of operations. Investments provide our primary source of pretax and after-tax
profits.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 57
Investment Results
Investment Income
Growth of investment income reflected new investments, higher interest income from the
growing fixed-maturity portfolio and increased cash dividend income from the common stock
portfolio. The advantages of strong cash flow in the past three years for new investments
have been somewhat offset by the challenge of investing in a low interest rate environment.
In 2006, proceeds from the sale of the Alltel holding that were later used to make the
applicable tax payments during the year were invested in short-term instruments that
generated approximately $5 million in interest income.
Overall, common stock dividends contributed 44.6 percent of pretax investment income
compared with 42.4 percent in 2006 and 43.7 percent in 2005. Fifth Third, our largest equity
holding, contributed 41.3 percent of total dividend income in 2007. We discuss our Fifth
Third investment in Item 7A, Quantitative and Qualitative Disclosures About Market Risk,
Page 73. In 2007, 35 of the 42 common stock holdings in the portfolio raised their indicated
annual dividend payout, as did 38 of the 50 in 2006 and 36 of 49 in 2005.
Net Realized Investment Gains and Losses
Net realized investment gains and losses are made up of realized investment gains and losses
on the sale of securities, changes in the valuation of embedded derivatives within certain
convertible securities and other-than-temporary impairment charges. These three areas are
discussed below.
Realized Investment Gains and Losses
Pretax realized investment gains in the past three years largely were due to the sale of
equity holdings. We discuss these sales in Item 1, Investments Segment, Page 15.
As appropriate, we buy, hold or sell both fixed-maturity and equity securities on an ongoing
basis to help achieve our portfolio objectives.
During the past three years, fixed maturity securities were divested as a result of calls or
as outright sales executed to either improve yield prospects or in response to adverse
credit concerns. Although we prefer to hold fixed-maturity investments until they mature, a
decision to sell reflects our perception of a change in the underlying fundamentals of the
security and preference to allocate those funds to investments that more
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 58
closely meet our
established parameters for long-term stability and growth. Our
opinion that a security fundamentally no longer meets our investment parameters may reflect a loss of confidence in
the issuer’s management, a change in underlying risk factors (such as political risk,
regulatory risk, sector risk or credit risk), or a strategic shift in business strategy that
is not consistent with our long-term outlook.
Realized gains in the past three years also have included gains from the sale of previously
impaired securities.
Change in the Valuation of Securities with Embedded Derivatives
In 2007, we recorded $11 million in fair value declines compared with $7 million in fair
value increases in 2006 and $7 million in fair value declines in 2005. In 2007, these
changes in fair value were due to the application of SFAS No. 155, which allows us to
account for the entire hybrid financial instrument at fair value, with changes recognized in
realized investment gains and losses. In 2006 and 2005, these changes in fair value were due
to the application of SFAS No. 133, which required measurement of the fluctuations in the
value of the embedded derivative features in selected convertible securities. The changes in
fair values are recognized in net income in the period they occur. See the discussion of
Derivative Financial Instruments and Hedging Activities in Item 8, Note 1 of the
Consolidated Financial Statements, Page 87, for details on the accounting for convertible
security embedded options.
Other-than-temporary Impairment Charges
In 2007, we recorded $16 million in write-downs of investments that we deemed had
experienced an other-than-temporary decline in market value versus $1 million in both 2006
and 2005. The factors we consider when evaluating impairments are discussed in Critical
Accounting Estimates, Asset Impairment, Page 40. The other-than-temporary impairment charges
represented less than 0.1 percent of our total invested assets at year-end 2007.
Other-than-temporary impairment charges also include unrealized losses of holdings that we
have identified for sale but not yet completed a transaction.
The increase in other-than-temporary impairment in 2007 from the negligible level of the
prior two years was due to market value declines for 20 securities. Those declines reflected
general credit concerns that began in the subprime mortgage market and spread to other areas
in the homebuilding and related industries over the course of 2007. While we do not directly
own mortgages or mortgage backed securities in our investment portfolio, we do own
investments in industries directly affected by this credit environment.
Other-than-temporary impairment charges from the investment portfolio by industry are
summarized as follows:
Other-than-temporary impairment charges from the investment portfolio by the asset class we
described in Item 1, Investments Segment, Page 15, are summarized below:
Investments Outlook
We believe investment income growth may slow in 2008 as managements of our financial sector
holdings evaluate their dividend levels. Our buy-and-hold equity investing strategy has been
key to the long-term growth
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 59
of our assets and shareholders’ equity. Our common stock
investments generally are securities with annual dividend yields that meet or exceed that of
the overall market and have the potential for future dividend increases. Other criteria we
evaluate include increasing sales and earnings, proven management and a favorable outlook.
Over the years, these equities have generally offered a steadily increasing flow of dividend
income along with the potential for capital appreciation.
We continue to focus on portfolio strategies to balance near-term income generation and
long-term book value growth. In 2008, we expect to continue to allocate a proportion of cash
available for investment to equity securities, taking into consideration insurance
department regulations and ratings agency comments.
We believe a continuation of the current credit environment, if exacerbated by recessionary
economic conditions, could lead to further declines in portfolio values and a resulting
increase in other-than-temporary impairment charges in 2008. All but three securities in the
portfolio were trading at or above 70 percent of book value at year-end 2007. Our asset
impairment committee continues to monitor the investment portfolio. The current asset
impairment policy is described in Critical Accounting Estimates, Asset Impairment, Page 40.
Other
In 2007, other income of the insurance subsidiaries, parent company operations and
non-investment operations of CFC Investment Company and CinFin Capital Management Company
resulted in $15 million in revenues compared with $14 million in 2006 and $12 million in
2005. Losses before income taxes of $46 million in 2007 were primarily due to $49 million in
interest expense from debt of the parent company. Losses before income taxes were $51
million and $50 million in 2006 and 2005, when interest expense was $51 million and $52
million, respectively. An immaterial level of expenses for CSU
Producer Resources was included in 2007.
Taxes
Income tax expense was $337 million in 2007 compared with $399 million in 2006 and $221
million in 2005. The effective tax rate for 2007 was 28.3 percent compared with 30.0 percent
in 2006 and 26.8 percent in 2005.
The primary reason for the change in the effective tax rate was the level and timing of
realized gains as discussed in Investments Results of Operations, Page 57. In 2007, we had
pretax realized gains of $382 million compared with pretax gains of $684 million in 2006 and
$61 million in 2005. Growth in the tax-exempt municipal bond portfolio, higher investment
income from dividends and changes in operating earnings over the periods also contributed to
the change in the effective tax rate for 2007.
We pursue a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity
and equity securities to minimize our overall tax liability and maximize after-tax earnings.
For our insurance subsidiaries, approximately 85 percent of income from tax-advantaged
fixed-maturity investments is exempt from federal tax. Our non-insurance companies own no
tax-advantaged fixed-maturity investments. For our insurance subsidiaries, the dividend
received deduction, after the dividend proration of the 1986 Tax Reform Act, exempts
approximately 60 percent of dividends from qualified equities from federal tax. The dividend
received deduction exempts 70 percent of dividends from qualified equities for our
non-insurance companies. Details regarding our effective tax rate are found in Item 8, Note
10 of the Consolidated Financial Statements, Page 98.
Liquidity and Capital Resources
Liquidity and capital resources represent the overall financial strength of our company and
our ability to generate cash flows to meet the short- and long-term cash requirements of
business obligations and growth needs. We seek to maintain prudent levels of liquidity and
financial strength for the protection of our
policyholders, creditors and shareholders. We manage liquidity at two levels. The first is
the liquidity of the parent company. The second is the liquidity of our insurance
subsidiary. The management of liquidity at both levels is essential because each has
different funding needs and sources and each is subject to certain regulatory guidelines and
requirements.
The parent company’s primary means of meeting liquidity requirements are dividends from our
insurance subsidiary and income from investments held at the parent-company level supported
by our capital resources. At year-end 2007, we had shareholders’ equity of $5.929 billion
and total debt of $860 million. Our ability to access the capital markets and short-term
bank borrowing provide other potential sources of liquidity. One way we seek to maintain
financial strength is by keeping our ratio of debt to capital below 15 percent. Our parent
company’s cash requirements include dividends to shareholders, interest payments on our
long-term debt, common stock repurchases and general operating expenses.
Our insurance subsidiary’s primary sources of liquidity are collection of premiums and
investment income. Its cash needs primarily consist of paying property casualty and life
insurance loss and loss expenses as well as
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 60
ongoing operating expenses and payments of
dividends to the parent company. Although we have never sold investments to pay claims, the
sale of investments would provide an additional source of liquidity, if required.
After
satisfying operating cash requirements, cash flows are invested in fixed-maturity and equity
securities, leading to the potential for increases in future investment income and
unrealized appreciation.
Sources of Liquidity and Capital Resources
Subsidiary Dividends
Our insurance subsidiary declared dividends to the parent company of $420 million in 2007
and $275 million in both 2006 and 2005. State of Ohio regulatory requirements restrict the
dividends insurance subsidiaries can pay. During 2008, total dividends that our insurance
subsidiary can pay to our parent company without regulatory approval are approximately $658
million.
Insurance Underwriting
Our property casualty and life insurance operations provide liquidity because premiums
generally are received before losses are paid under the policies purchased with those
premiums. After satisfying our cash requirements, we invest excess cash flows, increasing
future investment income.
This table shows a summary of operating cash flow of the insurance subsidiary (direct
method):
Historically, cash receipts from property casualty and life insurance premiums, along with
investment income, have been more than sufficient to pay claims, operating expenses and
dividends to the parent company. While first-year life insurance expenses normally exceed
the premiums, subsequent premiums are used to generate investment income until the time the
policy benefits are paid.
We believe that our insurance operations maintain sufficient liquidity to pay claims and
operating expenses, as well as meet commitments in the event of unforeseen circumstances
such as catastrophe losses, reinsurer insolvencies, changes in the timing of claims
payments, increases in claims severity, reserve deficiencies or inadequate premium rates. We
believe catastrophic events are the most likely cause of an unexpected rise in claims
severity or frequency.
After payment of claims and operating expenses, cash flows from underwriting declined in
2007 and 2006, tracking with the changes in underwriting income discussed in Commercial
Lines and Personal Lines Insurance Results of Operations, Pages 44 and 51. We discuss our
future obligations for claims payments in Contractual Obligations, Page 63, and our future
obligations for underwriting expenses in Other Commitments, Page 64. Insurance subsidiary
operating cash flow remained relatively stable over the three years, however, due to rising
investment income.
Based on our outlook for commercial lines, personal lines and life insurance, we believe
that cash flows from underwriting could continue to decline in 2008. A lower level of cash
flow available for investment could lead to lower investment income and reduced potential
for future capital gains.
Investing Activities
Investment income is a primary source of liquidity for both the parent company and insurance
subsidiary. As we discuss under Investments Results of Operations, Page 57, investment
income rose in each of the past three years. We anticipate slower growth in investment
income in 2008 as our financial sector holdings evaluate their dividend
levels. We continue to focus on portfolio strategies to balance near-term income generation
and long-term book value growth.
Realized gains also can provide liquidity, although we follow a buy-and-hold investment
philosophy seeking to compound cash flows over the long-term. When we dispose of
investments, we generally reinvest the gains in new investment securities. Disposition of
investments may occur for a number of reasons:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 61
We generally have substantial discretion in the timing of investment sales and, therefore,
the resulting gains or losses to be recognized in any period. That discretion generally is
independent of the insurance underwriting process. In 2008, we expect to continue to limit
the disposition of investments to those that no longer meet our investment parameters or
those that reach maturity or are called by the issuer. The sale of equity investments that
no longer meet our investment criteria can provide cash for investment in common stocks that
we perceive to have greater potential for dividend growth and capital appreciation.
Sources of Capital
As a long-term investor, we historically have followed a buy-and-hold investing strategy.
This policy has generated a significant amount of unrealized appreciation on equity
investments. Total unrealized appreciation in the investment portfolio, before deferred
income taxes, declined to $3.339 billion from $5.244 billion at year-end 2007 and 2006,
respectively, because of market value declines of our equity holdings. On an after-tax
basis, it constituted 36.6 percent of total shareholders’ equity at year-end 2007.
At year-end 2007, our debt-to-capital ratio was 12.7 percent. Based on our present capital
requirements, we do not anticipate a material increase in debt levels during 2008. As a
result, we believe that changes in our debt-to-capital ratio will be a function of the
contribution of unrealized investment gains or losses to shareholders’ equity. We estimate
that changes in that measure would not be sufficient to increase the debt-to-capital ratio
above our target cap of 15 percent.
We had $791 million of long-term debt and $69 million in borrowings on our short-term lines
of credit at year-end 2007. We generally have minimized our reliance on debt financing
although we may utilize lines of credit to fund short-term cash needs.
We provide details of our three long-term notes in Item 8, Note 7 of the Consolidated
Financial Statements, Page 96. None of the notes are encumbered by rating triggers.
Four independent credit rating organizations affirmed Cincinnati Financial Corporation’s
debt ratings in 2007, maintaining stable outlooks on the ratings. On May 21, 2007, A.M. Best
affirmed its aa- senior debt ratings and issuer credit rating. On July 26, 2007, Standard &
Poor’s Ratings Services affirmed its A counterparty credit rating. On September 18, 2007,
Moody’s Investors Service affirmed its A2 senior debt rating. On October 8, 2007, Fitch
Ratings affirmed its AA- issuer default rating and A+ senior debt ratings.
At year-end 2007, we had two lines of credit with commercial banks amounting to $225 million
with an outstanding balance of $69 million. One line of credit for $75 million was
established more than five years ago and has no financial covenants. This line of credit
matures on June 30, 2008, and we expect to renew it under terms and conditions that are
essentially unchanged.
The second line of credit is an unsecured $150 million line of credit from Huntington
Bancshares established in 2007 that will mature in 2012. It is available for general
corporate purposes and contains customary financial covenants.
Off-balance Sheet Arrangements
We do not utilize any special-purpose financing vehicles or have any undisclosed off-balance
sheet arrangements (as that term is defined in applicable SEC rules) that are reasonably
likely to have a current or
future material effect on the company’s financial condition, results of operation,
liquidity, capital expenditures or capital resources. Similarly, the company holds no
fair-value contracts for which a lack of marketplace quotations would necessitate the use of
fair-value techniques.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 62
Uses of Liquidity and Capital Resources
Our parent company and insurance subsidiary have contractual obligations and other
commitments. In addition, one of our primary uses of cash is to enhance shareholder return.
Contractual Obligations
At December 31, 2007, we estimated our future contractual obligations as follows:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 63
Factors contributing to our estimation of other future contractual obligations include:
Other Commitments
In addition to our contractual obligations, we have other operational commitments.
Investing Activities
After fulfilling operating requirements, we invest cash flows from underwriting, investment
and other corporate activities in fixed maturity and equity securities on an ongoing basis
to help achieve our portfolio objectives. See Item 1, Investments Segment, Page 15, for a
discussion of our investment strategy, portfolio allocation and quality.
Uses of Capital
Uses of cash to enhance shareholder return include:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 64
Property Casualty Insurance Reserves
Range of Reasonable Reserves
The company established a reasonably likely range for net loss and loss expense reserves of
$3.132 billion to $3.427 billion at year-end 2007, carrying net reserves of $3.397 billion. The likely range was $3.097 billion to $3.380 billion at
year-end 2006, with the company carrying net reserves
of $3.356 billion. Our loss and loss expense reserves are not discounted, but we have
reduced the reserves by an estimate of the amount of salvage and subrogation payments we
expect to recover. We provide a reconciliation of the property casualty reserves with the
loss and loss expense reserve as shown on the balance sheet in Item 8, Note 4 of the
Consolidated Financial Statements, Page 95.
The low point of each year’s range corresponds to approximately one standard error below
each year’s mean reserve estimate, while the high point corresponds to approximately one
standard error above each year’s mean reserve estimate. We discussed management’s reasons
for basing reasonably likely reserve ranges on standard errors in Reserve Estimate
Variability above.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at
year-end 2007 and 2006. However, actual unpaid loss and loss expenses could nonetheless fall
outside of the indicated ranges.
Management’s
best estimate of total loss reserves as of year-end 2007 was consistent with the corresponding actuarial
best estimate. Management’s best estimate as of year-end 2006 was above the corresponding
actuarial best estimate. Our inter-departmental committee, which
includes our actuarial management team, chose a higher estimate for two reasons. First, we
incurred three unusually large workers’ compensation claims in accident year 2006 that
totaled $12 million. The historical reserving data used to derive the actuarial best
estimate for this line of business did not fully reflect those three losses. Second,
management recognized the potential for a higher level of loss expense inflation for the
commercial casualty line than was reflected in the actuarial best estimate. Management chose
the higher level because of a rise in loss expense inflation between 2004 and 2006.
Development of Loss and Loss Expenses
We reconcile the beginning and ending balances of our reserves for loss and loss expenses at
December 31, 2007, 2006 and 2005, in Item 8, Note 4 of the Consolidated Financial
Statements, Page 95. The reconciliation of our year-end 2006 reserve balance to net incurred
losses one year later recognizes approximately $244 million of redundant reserves.
The table below shows the development of the estimated reserves for loss and loss expenses
the past 10 years.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 65
In evaluating the development of our estimated reserves for loss and loss expenses for the
past 10 years, note that each amount includes the effects of all changes in amounts for
prior periods. For example, payments or reserve adjustments related to losses settled in
2007 but incurred in 2001 are included in the cumulative deficiency or redundancy amount for
2001 and each subsequent year. In addition, this table presents calendar year data, not
accident or policy year development data, which readers may be more accustomed to analyzing.
Conditions and trends that affected development of the reserves in the past may not
necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate
future redundancies or deficiencies based on this data.
Differences between the property casualty reserves reported in the accompanying consolidated
balance sheets (prepared in accordance with GAAP) and those same reserves reported in the
annual statements (filed with state insurance departments in accordance with statutory
accounting practices — SAP), relate principally to the reporting of reinsurance
recoverables, which are recognized as receivables for GAAP and as an offset to reserves for
SAP.
Asbestos and Environmental Reserves
We carried $123 million of net loss and loss expense reserves for asbestos and environmental
claims as of year-end 2007, compared with $131 million for such claims as of year-end 2006.
These amounts constitute 3.6 percent and 3.9 percent of total loss and loss expense reserves
as of these year-end dates.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 66
We believe our exposure to asbestos and environmental claims is limited, largely because our
reinsurance retention was $500,000 or below prior to 1987. We also predominantly were a
personal lines company in the 1960s and 1970s when asbestos and pollution exclusions were
not widely used. During the 1980s and early 1990s, commercial lines grew as a percentage of
our overall business and our exposure to asbestos and environmental claims grew accordingly.
Over that period, we endorsed to or included in most policies an asbestos and environmental
exclusion.
Additionally, since 2002, we have revised policy terms where permitted by state regulation
to limit our exposure to mold claims prospectively and further reduce our exposure to other
environmental claims generally. Finally, we have not engaged in any mergers or acquisitions
through which such a liability could have been assumed. We continue to monitor our claims
for evidence of material exposure to other mass tort classes such as silicosis, but we have
found no such credible evidence to date.
Reserving data for asbestos and environmental claims has characteristics that limit the
usefulness of the methods and models used to analyze loss and loss expense reserves for
other claims. Specifically, asbestos and environmental loss and loss expenses for different
accident years do not emerge independently of one another as loss development and
Bornhuetter-Ferguson methods assume. In addition, asbestos and environmental loss and loss
expense data available to date does not reflect a well-defined tail, greatly complicating
the identification of an appropriate probabilistic trend family model.
Due to these considerations, our actuarial staff elected to use a paid survival ratio method
to estimate reserves for incurred but not yet reported asbestos and environmental claims.
Although highly uncertain, reserve estimates obtained via this method have held up
reasonably well since 2004. Between 2005 and 2007, total asbestos and environmental reserves
decreased 1.3 percent. Our exposure to such claims is limited, therefore, we do not believe
that a more detailed reserve analysis would be an appropriate use of resources.
Commercial Lines Insurance Segment Reserves
For the business lines in the commercial lines insurance segment, the following table shows
the breakout of gross reserves among case, IBNR and loss expense reserves. The rise in total
gross reserves for our commercial business lines is partially due to normal loss cost
inflation and exposure growth in our commercial casualty and workers’ compensation business
lines. The increase also reflected higher loss expense reserves due to a claims mediation
process that promoted earlier liability settlement resolution and to increased legal fees.
In addition, commercial casualty gross reserves rose because of the increase in large losses
as we discussed in Commercial Lines Insurance Results of Operations, Page 44.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 67
The
following table shows net reserve changes at year-end 2007, 2006 and
2005 by commercial line of business and accident year:
The overall favorable development recorded for the commercial lines reserves illustrates the
potential for revisions inherent in estimating reserves, especially for long-tail lines such
as commercial casualty. Commercial lines reserve development over the past three years was
consistent with:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 68
Personal Lines Insurance Segment Reserves
For the business lines in the personal lines insurance segment, the following table shows
the breakout of gross reserves among case, IBNR and loss expense reserves. Total gross
reserves were down slightly from year-end 2006 due to the decline in premiums and exposures
for this segment. Homeowner gross reserves also reflected a lower level of catastrophe
losses in 2007 as we discussed in Personal Lines Insurance Results of Operations, Page 51.
The following table shows net reserve changes at year-end 2007, 2006 and 2005 by personal line of business and accident year:
The overall favorable development recorded for the personal lines segment reserves
illustrates the potential for revisions inherent in estimating reserves. Personal lines
reserve development over the past three years was consistent with:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 69
Life Insurance Reserves
Gross life policy reserves were $1.478 billion at year-end 2007, compared with $1.409
billion at year-end 2006. We establish 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.
We regularly review our life insurance business to ensure that any deferred acquisition cost
associated with the business is recoverable and that our actuarial liabilities (life
insurance segment reserves) make sufficient provision for future benefits and related
expenses.
2008 Reinsurance Programs
A single large loss or an unexpected rise in claims severity or frequency due to a
catastrophic event could present us with a liquidity risk. In an effort to control such
losses, we forego marketing property casualty insurance in specific geographic areas,
monitor our exposure in certain coastal regions, review aggregate exposures to huge
disasters and purchase reinsurance. We use the Risk Management Solutions (RMS) and Applied
Insurance Research (AIR) models to evaluate exposures to a once-in-a-100 year and a
once-in-a-250 year event to help determine appropriate reinsurance coverage programs. In
conjunction with these activities, we also continue to evaluate information provided by our
reinsurance broker. These various sources explore and analyze credible scientific evidence,
including the impact of global climate change, which may affect our exposure under insurance
policies.
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss
that can arise from large risks or risks concentrated in areas of exposure. Management’s
decisions regarding the appropriate level of risk retention are affected by various factors,
including changes in our underwriting practices, capacity to retain risks and reinsurance
market conditions. Reinsurance does not relieve us of our obligation to pay covered claims.
The financial strength of our reinsurers is important because our ability to recover for
losses covered under any reinsurance agreement depends on the financial viability of the
reinsurer.
Currently participating on our standard market property and casualty per-risk and
per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance America,
Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of
which have A.M. Best insurer financial strength ratings of A (Excellent) or A+ (Superior).
Our property catastrophe program is subscribed through a broker by reinsurers from the
United States, Bermuda, London and the European markets.
Primary components of the 2008 property and casualty reinsurance program include:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 70
Individual risks with insured values in excess of $25 million, as identified in the policy,
are handled through a different reinsurance mechanism. We typically reinsure property
coverage for individual risks with insured values between $25 million and $60 million under
an automatic facultative treaty. For risks with property values exceeding $60 million, we
negotiate the purchase of facultative coverage on an individual certificate basis.
For casualty coverage on individual risks with limits exceeding $25 million, facultative
reinsurance coverage is placed on an individual certificate basis.
Terrorism coverage at various levels has been secured in all of our reinsurance agreements.
The broadest coverage for this peril is found in the property and casualty working treaties,
which provide coverage for commercial and personal risks. Our property catastrophe treaty
provides coverage for personal risks, and the majority of its reinsurers provide limited
coverage for commercial risks with total insured values of $10 million or less. For insured
values between $10 million and $25 million, there also may be coverage in the property
working treaty.
Reinsurance protection for the company’s surety business is covered under separate treaties
with many of the same reinsurers that write the property casualty working treaties.
The company’s newly formed excess and surplus lines subsidiary has purchased a property and
casualty reinsurance treaty for 2008 through Swiss Reinsurance America Corporation. Primary
components of the treaty include:
For property or casualty risks with limits exceeding $5 million, underwriters place
facultative reinsurance coverage on an individual certificate basis. The combined property
and casualty treaty provides protection on a participating basis for extra contractual
obligations, as well as exposure to losses in excess of policy limits. The limit is $5
million for both property and casualty.
Reinsurance protection for our life insurance business is covered under separate treaties
with many of the same reinsurers that write the property casualty working treaties. In 2005,
we modified our reinsurance protection for our term life insurance business due to changes
in the marketplace that affected the cost and availability of reinsurance for term life
insurance. We are retaining no more than a $500,000 exposure, ceding
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 71
the balance using excess over retention mortality coverage, and retaining the policy
reserve. Retaining the policy reserve has no direct impact on GAAP results. However, because
of the conservative nature of statutory reserving principles, retaining the policy reserve
unduly depresses our statutory earnings and requires a large commitment of our capital. We
also have catastrophe reinsurance coverage on our life insurance operations that reimburses
us up to $40 million for covered net losses in excess of $10 million. The treaty contains a
reinstatement provision, provided the covered losses were not due to terrorism, and contains
protection for extra-contractual liability coverage losses. For term life insurance business
written prior to 2005, we retain 10 percent to 25 percent of each term policy, not to exceed
$500,000, ceding the balance of mortality risk and policy reserve.
The NAIC has asked for industry comments on proposals to modify statutory accounting
procedures to reduce the negative effect on statutory life insurance income. We expect the
NAIC proposals will be adopted. If they are not, we believe we will be able to structure a
reinsurance program to provide the life insurance company with the ability to continue to
grow in the term life insurance marketplace while appropriately managing risk, at a cost
that allows us to achieve our life insurance company profit targets.
Safe Harbor Statement
This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of
1995. Our business is subject to certain risks and uncertainties that may cause actual
results to differ materially from those suggested by the forward-looking statements in this
report. Some of those risks and uncertainties are discussed in our Item 1A, Risk Factors,
Page 21. Although we often review or update our forward-looking statements when events
warrant, we caution our readers that we undertake no obligation to do so.
Factors that could cause or contribute to such differences include, but are not limited to:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 72
Further, the company’s insurance businesses are subject to the effects of changing social,
economic and regulatory environments. Public and regulatory initiatives have included
efforts to adversely influence and restrict premium rates, restrict the ability to cancel
policies, impose underwriting standards and expand overall regulation. The company also is
subject to public and regulatory initiatives that can affect the market value for its common
stock, such as recent measures affecting corporate financial reporting and governance.
The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Introduction
Market risk is the potential for a decrease in securities value resulting from broad yet
uncontrollable forces such as: inflation, economic growth, interest rates, world political
conditions or other widespread unpredictable events. It is comprised of many individual
risks that, when combined, create a macroeconomic impact. The company accepts and manages
risks in the investment portfolio as part of the means of achieving portfolio objectives.
Some of the risks are:
Company-specific risk is the potential for a particular issuer to experience a decline in
valuation due to the impact of sector or market risk on the holding or because of issues
specific to the firm:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 73
The investment committee of the board of directors monitors the investment risk management
process primarily through its executive oversight of our investment activities. We take an
active approach to managing market and other investment risks, including the
accountabilities and controls over these activities. Actively managing these market risks is
integral to our operations and could require us to change the character of future
investments purchased or sold or require us to shift the existing asset portfolios to manage
exposure to market risk within acceptable ranges.
Sector risk is the potential for a negative impact on a particular industry due to its
sensitivity to factors that make up market risk. Market risk affects general supply/demand
factors for an industry and will affect companies within that industry to varying degrees.
Risks associated with the five asset classes described in Item 1, Investments Segment, Page
15, can be summarized as follows (H — high, A — average, L — low):
Fixed-maturity Investments
For investment-grade corporate bonds, the inverse relationship between interest rates and
bond prices leads to falling bond values during periods of increasing interest rates.
Although the potential for a worsening financial condition, and ultimately default, does
exist with investment-grade corporate bonds, their higher-quality financial profiles make
credit risk less of a concern than for lower-quality investments. We address this risk by
consistently investing within a particular maturity range, which has, over the years,
provided the portfolio with a laddered maturity schedule, which we believe is less subject
to large swings in value due to interest rate changes. While a single maturity range may see
values drop due to general interest rate levels, other maturity ranges would typically be
less affected by those changes. Additionally, purchases are spread across a wide spectrum of
industries and companies, diversifying our holdings and minimizing the impact of specific
industries or companies with greater sensitivities to interest rate fluctuations.
The primary risk related to high-yield corporate bonds is credit risk or the potential for a
deteriorating financial structure. A weak financial profile can lead to rating downgrades
from the credit rating agencies, which can put further downward pressure on bond prices.
Interest rate risk, while significant, is less of a factor with high-yield corporate bonds,
as valuation is related more directly to underlying operating performance than to general
interest rates. This puts more emphasis on the financial results achieved by the issuer
rather than on general economic trends or statistics within the marketplace. We address this
concern by analyzing issuer- and industry-specific financial results and by closely
monitoring holdings within this asset class.
The primary risks related to tax-exempt bonds are interest rate risk and political risk
associated with the specific economic environment within the political boundaries of the
issuing municipal entity. We address these concerns by focusing on municipalities’
general-obligation debt and on essential-service bonds. Essential-service bonds derive a
revenue stream from the services provided by the municipality, which are vital to the people
living in the area (water service, sewer service, etc.). Another risk related to tax-exempt
bonds is regulatory risk or the potential for legislative changes that would negate the
benefit of owning tax-exempt bonds. We monitor regulatory activity for situations that may
negatively affect current holdings and our ongoing strategy for investing in these
securities.
The final, less significant risk is our exposure to credit risk for a portion of the
tax-exempt portfolio that has support from corporate entities. Examples are bonds insured by
corporate bond insurers or bonds with interest payments made by a corporate entity through a
municipal conduit/authority. Our decisions regarding these investments primarily consider
the underlying municipal situation. The existence of third-party insurance is intended to
reduce risk in the event of default. In circumstances in which the municipality is unable to
meet its obligations, risk would be increased if the insuring entity were experiencing
financial duress. Because of our diverse exposure and selection of higher-rated entities
with strong financial profiles, we do not believe this is a material concern as we discuss
in Item 1, Investments Segment, Page 15.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 74
Interest Rate Sensitivity Analysis
Because of our strong surplus, long-term investment horizon and ability to hold most
fixed-maturity investments until maturity, we believe the company is well positioned if
interest rates were to rise. A higher rate environment would provide the opportunity to
invest cash flow in higher-yielding securities, while reducing the likelihood of untimely
redemptions of currently callable securities. While higher interest rates would be expected
to continue to increase the number of fixed-maturity holdings trading below 100 percent of
book value, we believe lower fixed-maturity security values due solely to interest rate
changes would not signal a decline in credit quality.
A dynamic financial planning model developed during 2002 uses analytical tools to assess
market risks. As part of this model, the effective duration of the fixed-maturity portfolio
is continually monitored by our investment department to evaluate the theoretical impact of
interest rate movements.
The table below summarizes the effect of hypothetical changes in interest rates on the
fixed-maturity portfolio:
The effective duration of the fixed maturity portfolio is currently 4.84 years, down
slightly from year-end 2006. A 100 basis point movement in interest rates would result in an
approximately 4.8 percent change in the market value of the fixed maturity portfolio.
Generally speaking, the higher a bond is rated, the more directly correlated movements in
its market value will be to changes in the general level of interest rates, exclusive of
call features. The market values of average- to lower-rated corporate bonds are additionally
influenced by the expansion or contraction of credit spreads.
In the dynamic financial planning model, the selected interest rate change of 100 basis
points represents our views of a shift in rates that is quite possible over a one-year
period. The rates modeled should not be considered a prediction of future events as interest
rates may be much more volatile in the future. The analysis is not intended to provide a
precise forecast of the effect of changes in rates on our results or financial condition,
nor does it take into account any actions that we might take to reduce exposure to such
risks.
Short-Term Investments
Our short-term investments present minimal risk as we generally purchase the highest quality
commercial paper.
Equity Investments
Common stocks are subject to a variety of risk factors encompassed under the umbrella of
market risk. General economic swings influence the performance of the underlying industries
and companies within those industries. A downturn in the economy can have a negative impact
on an equity portfolio. Industry- and company-specific risks have the potential to
substantially affect the market value of the company’s equity portfolio. We address these
risks by maintaining investments in a small group of holdings that we can analyze closely,
better understanding their business and the related risk factors.
At year-end 2007, we held 15 individual equity positions valued at approximately
$100 million or above, see Item 1, Investments Segment, Page 15, for additional details on
these holdings. These equity positions accounted for approximately 93.0 percent of the
unrealized appreciation of the entire portfolio.
Our common stock investments generally are securities with annual dividend yields that meet
or exceed that of the overall market and have the potential for future dividend increases.
Other criteria we evaluate include increasing sales and earnings, proven management and a
favorable outlook. We believe our equity investment style is an appropriate long-term
strategy. While our long-term financial position would be affected by prolonged changes in
the market valuation of our investments, we believe our strong surplus position and cash
flow provide a cushion against short-term fluctuations in valuation. We believe that the
continued payment of cash dividends by the issuers of the common equities we hold also
should provide a floor to their valuation.
Our investments are heavily weighted toward the financial sector, which represented
56.7 percent of the total fair value of the common stock portfolio at year-end 2007.
Financial sector investments typically underperform the overall market during periods when
interest rates are expected to rise. We historically have seen these types of short-term
fluctuations in market value of our holdings as potential buying opportunities but are aware
that a prolonged downturn in this sector could create a long-term negative effect on the
portfolio.
Over the longer term, our objective is for the performance of our equity portfolio to exceed
that of the broader market. Over the five years ended December 31, 2007, our compound annual
equity portfolio return was flat compared with a compound annual total return of
12.8 percent for the Standard & Poor’s 500 Index,
Cincinnati Financial Corporation – 2007 Annual Report on 10-K – Page 75
a common benchmark of market performance. In 2007, our annual equity portfolio return was a
negative 16.3 percent, compared with an annual total return of 5.5 percent for that Index.
Our equity portfolio underperformed the market for the five-year period primarily because of
the decline in the market value of our holdings of Fifth Third common stock between 2003 and
2007.
The primary risks related to preferred stocks are similar to those related to investment
grade corporate bonds. Falling interest rates adversely affect market values due to the
normal inverse relationship between rates and yields. Credit risk exists due to the
subordinate position of preferred stocks in the capital structure. We minimize this risk by
primarily purchasing investment grade preferred stocks of issuers with a strong history of
paying a common stock dividend.
In 2007, we purchased residual shares in two auction rate pass-through trusts, otherwise
known as auction rate securities. Each of the two trusts we purchased contain a single
investment grade preferred security (rated A3/A- and Aa3/A+) that provides for the cash flow
to be divided between the two types of shares within the Trust.
We own both the primary (“A”) and residual (“B”)
shares in one of these investments. Due to
recent disruptions within the auction process that sets the rate for payment to the primary
shares, there have been no residual cash flows available for payout
to our residual shares although the primary shares have performed as
expected. We have both the ability and intent to hold these securities. We will continue to monitor
the auction process until such time as it normalizes. However, if the auction process fails
to normalize in a reasonable period of time, we may deem it necessary to impair these
securities. As of year-end 2007, these investments had a fair value of $13 million and
represented unrealized losses of $4.2 million.
Fifth Third Bancorp Holding
One of our common stock holdings, Fifth Third, accounted for 28.5 percent of our
shareholders’ equity at year-end 2007 and dividends earned from our Fifth Third investment
were 20.0 percent of our investment income in 2007. In October 2007, we sold 5.5 million
shares of our Fifth Third holding to fund an ASR agreement.
Based on 2007 results, a 10 percent change in dividends earned from our Fifth Third holding
would result in a $12 million change in pretax investment income and a $11 million change in
after-tax earnings.
Every $1.00 change in the market price of Fifth Third’s common stock has approximately a 26
cent impact on our book value per share. A 20 percent change in the market price of Fifth
Third’s common stock from its year-end 2007 closing price would result in a $338 million
change in assets and a $220 million change in after tax unrealized gains.
The market value of Fifth Third, our largest holding, has been affected in recent years by
the residual effects of a regulatory review concluded in 2004, and, more recently by a
difficult interest rate environment and by challenging economic conditions in certain of its
geographic markets. We maintain confidence in its management team’s ability to
successfully execute its long-term strategic plan. During this challenging period for the
bank, we have continued to benefit from its superior dividend growth. Fifth Third paid
dividends of $1.66 per share in 2007 compared with $1.56 per share in 2006.
Securities Lending Collateral Invested
We participate in a securities lending program under which certain fixed maturities from our
investment portfolio are loaned to other institutions for short periods of time. At year-end
2007, we had fixed maturities with a market value of $745 million on loan. The $760 million
in offsetting collateral is shown on our balance sheets as securities lending collateral
invested.
Cincinnati Financial Corporation – 2007 Annual Report on 10-K – Page 76
A portion of the securities lending collateral invested was placed in asset-backed
commercial paper (ABCP) programs during 2007 by our lending agent. Due to the ABCP market
disruption, maturities on two of our investments were extended beyond
their original stated maturity dates. Only one of these investments remains outstanding.
That ABCP had an amortized cost
of $73 million at February 22, 2008, compared with $74 million at year-end 2007. The ABCP
manager is continuing to work with investors to allow for an orderly liquidation of the fund.
Excluding this remaining ABCP investment, all investments within our securities lending
program now are in overnight securities.
We are potentially at risk if our ability to return the collateral is compromised because of
a material decline in the market value of the securities in which we have invested the
collateral. We discuss the program in Item 8, Note 1 of the Consolidated Financial
Statements, Page 87.
Unrealized Investment Gains And Losses
At year-end 2007, unrealized investment gains before taxes totaled $3.527 billion and
unrealized investment losses in the investment portfolio amounted to $188 million.
Unrealized Investment Gains
The unrealized gains at year-end 2007 largely were due to long-term gains from our holdings
of Fifth Third common stock, which contributed 42.7 percent of those gains, and from our
other common stock holdings, including AllianceBernstein Holding L.P. (NYSE:AB), ExxonMobil
(NYSE:XOM), PNC Financial Services Group, Inc. (NYSE:PNC) and The Procter & Gamble Company
(NYSE:PG), which each contributed at least 5 percent of those gains.
Unrealized Investment Losses – Potential Other-than-temporary Impairments
During 2007, a total of 20 securities were written down as other-than-temporarily impaired
because of credit concerns that began with the pressure that the fallout from the subprime
mortgage crisis has placed on securities in the housing and related industries. Those
declines reflected general credit concerns that began in the subprime mortgage market and
spread to other areas in the homebuilding and related industries over the course of 2007.
During 2006, one security was written down.
We expect the number of securities trading below 100 percent of book value to fluctuate as
interest rates rise or fall and credit spreads expand or contract due to prevailing economic
conditions. Further, book values for some securities have been revised due to impairment
charges recognized in prior periods. At year-end 2007, 373 of the 2,053 securities we owned
were trading below 100 percent of book value compared with 679 of the 1,973 securities we
owned at year-end 2006 and 732 of the 1,814 securities we owned at year-end 2005.
The 373 holdings trading below book value at year-end 2007 represented 18.2 percent of
invested assets and $188 million in unrealized losses. We deem the risk related to
securities trading between 70 percent and 100 percent of book value to be relatively minor
and at least partially offset by the earned income potential of these investments.
As discussed in Critical Accounting Estimates, Asset Impairment, Page 40, when evaluating
other-than-temporary impairments, we consider our intent and ability to retain a security
for a period adequate to recover a substantial portion of its cost. Because of our investment philosophy and
strong capitalization, we can hold securities until their scheduled redemption that might
otherwise be deemed impaired as we evaluate their potential for recovery based on economic,
industry or company factors.
Cincinnati Financial Corporation – 2007 Annual Report on 10-K – Page 77
The following table summarizes the length of time securities in the investment portfolio have been in a continuous unrealized gain or loss position.
Cincinnati Financial Corporation – 2007 Annual Report on 10-K – Page 78
The following table summarizes the investment portfolio:
Cincinnati Financial Corporation – 2007 Annual Report on 10-K – Page 79
Item 8. Financial Statements and Supplementary Data
Responsibility for Financial Statements
We have prepared the consolidated financial statements of Cincinnati Financial Corporation
and our subsidiaries for the year ended December 31, 2007, in accordance with accounting
principles generally accepted in the United States of America (GAAP).
We are responsible for the integrity and objectivity of these financial statements. The
amounts, presented on an accrual basis, reflect our best estimates and judgment. These
statements are consistent in all material aspects with other financial information in the
Annual Report on Form 10-K. Our accounting system and related internal controls are designed
to assure that our books and records accurately reflect the company’s transactions in
accordance with established policies and procedures as implemented by qualified personnel.
Our board of directors has established an audit committee of independent outside directors.
We believe these directors are free from any relationships that could interfere with their
independent judgment as audit committee members.
The audit committee meets periodically with management, our independent registered public
accounting firm and our internal auditors to discuss how each is handling responsibilities.
The audit committee reports their findings to the board of directors. The audit committee
recommends to the board the annual appointment of the independent registered public
accounting firm. The audit committee reviews with this firm the scope of the audit
assignment and the adequacy of internal controls and procedures.
Deloitte & Touche LLP, our independent registered public accounting firm, audited the
consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for
the year ended December 31, 2007. Their report is on Page 82. Deloitte’s auditors met with
our audit committee to discuss the results of their examination. They have the opportunity
to present their opinions about the adequacy of internal controls and the quality of
financial reporting without management present.
Cincinnati Financial Corporation – 2007 Annual Report on 10-K – Page 80
Management’s Annual Report on Internal Control Over Financial Reporting
The management of Cincinnati Financial Corporation and its subsidiaries is responsible for
establishing and maintaining adequate internal controls, designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with accounting principles generally accepted
in the United States of America (GAAP). The company’s internal control over financial
reporting includes those policies and procedures that:
All internal control systems, no matter how well designed, have inherent limitations,
including the possibility of human error and the circumvention of overriding controls.
Accordingly, even effective internal control can provide only reasonable assurance with
respect to financial statement preparation and presentation. Further, because of changes in
conditions, the effectiveness of internal control may vary over time.
The company’s management assessed the effectiveness of the company’s internal control over
financial reporting as of December 31, 2007, as required by Section 404 of the Sarbanes
Oxley Act of 2002. Management’s assessment is based on the criteria established in the
Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission and was designed to provide reasonable assurance that the company
maintained effective internal control over financial reporting as of December 31, 2007. The
assessment led management to conclude that, as of December 31, 2007, the company’s internal
control over financial reporting was effective based on those criteria.
The company’s independent registered public accounting firm has issued an attestation report
on our internal control over financial reporting as of December 31, 2007. This report
appears below.
February 28, 2008
Cincinnati Financial Corporation – 2007 Annual Report on 10-K – Page 81
Report Of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors of Cincinnati Financial Corporation
Fairfield, Ohio We have
audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and
subsidiaries (the company) as of December 31, 2007 and 2006, and the related consolidated
statements of income, shareholders’ equity, and cash flows for each of the three years in
the period ended December 31, 2007. Our audits also included the financial statement
schedules listed in the Index at Item 15(c). We also have audited the company’s internal
control over financial reporting as of December 31, 2007, based on criteria established in
the Internal Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. The company’s management is responsible for these
financial statements and financial schedules, for maintaining effective internal control
over financial reporting, and for its assessment of the effectiveness of internal control
over financial reporting, included in Management’s Annual Report on Internal Control Over
Financial Reporting report. Our responsibility is to express an opinion on these financial
statements and financial statement schedules and an opinion on the company’s internal
control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free of material
misstatement and whether effective internal control over financial reporting was maintained
in all material respects. Our audit of financial statements included examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. Our audit of internal control over
financial reporting included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures
as we considered necessary in the circumstances. We believe that our audits provide a
reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the
supervision of, the company’s principal executive and principal financial officers, or
persons performing similar functions, and effected by the company’s board of directors,
management, and other personnel to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that: (1) pertain to the
maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (2) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles and that receipts and expenditures
of the company are being made only in accordance with authorizations of management and
directors of the company; and (3) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the company’s assets
that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including
the possibility of collusion or improper management override of controls, material
misstatements due to error or fraud may not be prevented or detected on a timely basis.
Also, projections of any evaluation of the effectiveness of the internal control over
financial reporting to future periods are subject to the risk that the controls may become
inadequate because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in
all material respects, the financial position of the company as of December 31, 2007 and
2006, and the results of its operations and its cash flows for each of the three years in
the period ended December 31, 2007, in conformity with accounting principles generally
accepted in the United States of America. Also, in our opinion, such financial statement
schedules, when considered in relation to the basic consolidated financial statements taken
as a whole, present fairly, in all material respects, the information set forth therein.
Also, in our opinion, the company maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2007, based on the criteria established
in Internal Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
As discussed in Note 1 of the Consolidated Financial Statements, the company adopted the
provisions of Statement of Financial Accounting Standards (SFAS) No. 123(R), Share Based
Payment, on January 1, 2006; the recognition and related disclosure provisions of SFAS No.
158, Employers’ Accounting for Defined Benefit Pension Plans and Other Postretirement
Benefit Plans, on December 31, 2006; the provisions of SFAS No. 155, Accounting for Certain
Hybrid Financial Instruments, an amendment of SFAS No. 133 and 140, on January 1, 2007; and
the provisions of Financial Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, an Interpretation of SFAS No. 109, on January 1, 2007.
Cincinnati, Ohio
February 28, 2008
Cincinnati Financial Corporation – 2007 Annual Report on 10-K – Page 82
Cincinnati Financial Corporation and Subsidiaries
Consolidated Balance Sheets
Accompanying notes are an integral part of these statements.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 83
Cincinnati Financial Corporation and Subsidiaries
Consolidated Statements of Income
Accompanying notes are an integral part of these statements.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 84
Cincinnati Financial Corporation and Subsidiaries
Consolidated Statements of Shareholders’ Equity
Accompanying notes are an integral part of these statements.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 85
Cincinnati Financial Corporation and Subsidiaries
Consolidated Statements of Cash Flows
Accompanying notes are an integral part of these statements.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 86
Notes to Consolidated Financial Statements
1. Summary of Significant Accounting Policies
Nature of Operations
Cincinnati Financial operates through our insurance group and three complementary subsidiary
companies: The Cincinnati Insurance Company leads our standard market property casualty insurance group
that also includes subsidiaries The Cincinnati Casualty Company and The Cincinnati Indemnity
Company. This group markets a broad range of standard market business, homeowner and auto
policies in 34 states. The group provides quality customer service to our select group of
1,092 local insurance agencies with 1,327 reporting locations. Other subsidiaries of The
Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life
insurance policies, disability income policies and annuities, and The Cincinnati Specialty
Underwriters Insurance Company, which began offering excess and surplus lines insurance
products in 2008.
The three complementary subsidiaries are CSU Producer Resources Inc. which offers insurance
brokerage services to our independent agencies so their clients can access our excess and
surplus lines insurance products; CFC Investment Company, which offers commercial leasing and
financing services to our agents, their clients and other customers; and CinFin Capital
Management Company, which provides asset management services to institutions, corporations and
individuals.
Basis of Presentation
Our consolidated financial statements include the accounts of the parent company and our
wholly owned subsidiaries. We present our statements in accordance with accounting principles
generally accepted in the United States of America (GAAP). In consolidating our accounts, we
have eliminated significant intercompany balances and transactions.
In accordance with GAAP, we have made estimates and assumptions that affect the amounts we
report and discuss in the consolidated financial statements and accompanying notes. Actual
results could differ from our estimates.
Earnings per Share
Net income per common share is based on the weighted average number of common shares
outstanding during each of the respective years. We calculate net income per common share
(diluted) assuming the exercise of stock options. We have adjusted shares and earnings per
share to reflect all stock splits and dividends prior to December 31, 2007.
Share-based Compensation
We grant qualified and non-qualified share-based compensation under authorized plans. Until
2007, all stock-based awards were in the form of stock options that had an exercise price
equal to the market value of the underlying common stock on the date of grant, vested in equal
amounts over the three years following the date of grant and were exercisable over 10 year
periods.
The 2006 Stock Compensation Plan, approved in 2006 by shareholders, provides the compensation
committee of the board of directors flexibility in the types of available stock-based awards
including stock options along with restricted stock, restricted stock units, stock
appreciation rights and other stock-based awards. The 2006 Stock Compensation Plan also
allowed the grant of performance-based awards.
In 2007, the committee approved a mix of stock options and restricted stock units for
stock-based awards. Service-based stock options awarded had similar terms but generally were
awarded for fewer shares compared with previous years to accommodate new awards of restricted
stock units while keeping the overall cost of stock-based compensation in line with previous
years.
Prior to January 1, 2006, we accounted for our stock option plans using the recognition and
measurement provisions pursuant to Accounting Principles Board Opinion No. 25, “Accounting for
Stock Issued to Employees” and related interpretations (APB 25), as permitted by the Statement
of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS
No. 123). No stock-based employee compensation cost was recognized in the Statements of Income
for the year ended December 31, 2005.
Effective January 1, 2006, we adopted the fair value recognition provisions of the SFAS No.
123(R), “Share-Based Payment,” using the modified-prospective-transition method. We elected to
use the alternative method for determining the beginning balance of the additional paid-in
capital pool, as described in the Financial Accounting Standards Board (FASB) Staff Position
123(R)-3. Refer to Note 16, Stock-based Associate Compensation Plans, Page 102 for more
information regarding our share-based compensation.
Employee Benefit Pension Plan
We sponsor a defined benefit pension
plan covering substantially all employees. Our pension expense is
based on certain acturial assumptions and also is composed of several
components that are determined using the projected unit credit
actuarial cost method.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 87
Property Casualty Insurance
Property casualty policy written premiums are deferred and recorded as earned premiums on a
pro rata basis over the terms of the policies. We record as unearned premium the portion of
written premiums that apply to unexpired policy terms. The expenses associated with issuing
insurance policies – primarily commissions, premium taxes and underwriting costs – are
deferred and amortized over the terms of policies. We update our acquisition cost assumptions periodically to reflect actual experience
and we evaluate our deferred acquisition cost for recoverability.
Certain property casualty policies are not booked before the effective date. An actuarial
estimate is made to determine the amount of unbooked written premiums. The majority of the
estimate is unearned and does not have a material impact on earned premium.
We establish reserves to cover the expected cost of claims – or losses – and our expenses
related to investigating, processing and resolving claims. Although determining the
appropriate amount of reserves is inherently uncertain, we base our decisions on past
experience and current facts. Reserves are based on claims reported prior to the end of the
year and estimates of unreported claims. We take into account the fact that we may recover
some of our costs through salvage and subrogation. We regularly review and update reserves
using the most current information available. Any resulting adjustments are reflected in
current year insurance losses and policyholder benefits.
The Cincinnati Insurance Companies actively market property casualty insurance policies in 34
states. Our 10 largest states generated 69.1 percent and 70.0 percent of total property
casualty premiums in 2007 and 2006. Ohio, our largest state, accounted for 21.2 percent and
22.0 percent of total earned premiums in 2007 and 2006. Agencies in Georgia, Illinois,
Indiana, Michigan, North Carolina, Pennsylvania and Virginia each contributed between 4
percent and 9 percent of premium volume in 2007. The largest single agency relationship
accounted for approximately 1.2 percent of the company’s total agency direct earned premiums in 2007.
Policyholder Dividends
Certain workers’ compensation policies include the possibility of an insured earning a return
of a portion of their premium, called a policyholder dividend. The dividend is generally
calculated by determining the profitability of a policy year along with the associated
premium. We reserve for all probable future policyholder dividend payments.
Life and Health Insurance
We offer several types of life and health insurance and we account for each according to the
duration of the contract. Short-duration contracts are written to cover claims that arise
during a short, fixed term of coverage. We generally have the right to change the amount of
premium charged or cancel the coverage at the end of each contract term. Group life insurance
is an example. We record premiums for short-duration contracts similarly to property casualty
contracts.
Long-duration contracts are written to provide coverage for an extended period of time.
Traditional long-duration contracts require policyholders to pay scheduled gross premiums,
generally not less frequently than annually, over the term of the coverage. Premiums for these
contracts are recognized as revenue when due. Whole life insurance and disability income
insurance are examples. Some traditional long-duration contracts have premium payment periods
shorter than the period over which coverage is provided. For these contracts the excess of
premium over the amount required to pay expenses and benefits is recognized over the term of
the coverage rather than over the premium payment period. Ten-pay whole life insurance is an
example.
We establish a liability for traditional long-duration contracts as we receive premiums. The
amount of this liability is the present value of future expenses and benefits less the present
value of future net premiums. Net premium is the portion of gross premium required to provide
for all expenses and benefits. We estimate future expenses and benefits and net premium using
assumptions for expected expenses, mortality, morbidity, withdrawal rates and investment
income. We include a provision for adverse deviation, meaning we allow for some uncertainty in
making our assumptions. We establish our assumptions when the contract is issued and we
generally maintain those assumptions for the life of the contract. 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 assumption for expected expenses. We base our assumption
for expected investment income on our own experience, adjusted for current economic
conditions.
When we issue a traditional long-duration contract, we capitalize acquisition costs.
Acquisition costs are costs which vary with, and are primarily related to, the production of
new business. We then charge these deferred policy acquisition costs to expenses over the
premium paying period of the contract and we use the same assumptions that we use when we
establish the liability for the contract. We update our acquisition cost assumptions periodically to reflect actual experience
and we evaluate our deferred acquisition cost for recoverability.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 88
Universal life contracts are long-duration contracts for which contractual provisions are not
fixed, unlike whole life insurance. Universal life contracts allow policyholders to vary the
amount of premium, within limits, without our consent. However we may vary the mortality and
expense charges, within limits, and the interest crediting rate used to accumulate policy
values. We do not record universal life premiums as revenue. Instead we recognize as revenue
the mortality charges, administration charges and surrender charges when received. Some of our
universal life contracts assess administration charges in the early years of the contract that
are compensation for services we will provide in the later years of the contract.
These administration charges are deferred and are recognized over the period when we provide those
future services.
For universal life long-duration contracts we maintain a liability equal to the policyholder
account value. There is no provision for adverse deviation. Some of our universal life
policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in
addition to the account balance, based on expected no-lapse guarantee benefits and expected
policy assessments.
When we issue a universal life long-duration contract we capitalize acquisition costs. We then
charge these capitalized costs to expenses over the term of coverage of the contract. When we
charge deferred policy acquisition costs to expenses, we use assumptions based on our best
estimates of long-term experience. We review and modify these assumptions on a regular basis.
Separate Accounts
We issue life contracts with guaranteed minimum returns, referred to as bank-owned life
insurance contracts (BOLIs). We legally segregate and record as separate accounts the assets
and liabilities for some of our BOLIs, based on the specific contract provisions. We guarantee
minimum investment returns, account values and death benefits for our separate account BOLIs.
Our other BOLIs are general account products.
We carry the assets of separate account BOLIs at fair value. The liabilities on separate
account BOLIs primarily are the contract holders’ claims to the related assets and are carried
at the fair value of the assets. If the BOLI asset value is projected below the value we
guaranteed, a liability is established by a charge to the company’s earnings.
Generally, investment income and realized investment gains and losses of the separate accounts
accrue directly to the contract holder and we do not include them in the Consolidated
Statements of Income. Revenues and expenses related to separate accounts consist of
contractual fees and mortality, surrender and expense risk charges. Also, each separate
account BOLI includes a negotiated gain and loss sharing arrangement with the company. A
percentage of each separate account’s realized gain and loss representing contract fees and
assessments accrues to us and is transferred from the separate account to our general account
and is recognized as revenue or expense.
Reinsurance
We reduce risk and uncertainty by buying property casualty and life reinsurance. Reinsurance
contracts do not relieve us from our duty to policyholders, but rather help protect our
financial strength to perform that duty all of our reinsurer
contracts transfer the economic risk of loss. All of our reinsurance
contracts transfer the economic risk of loss.
We also serve in a limited way as a reinsurer for other insurance companies, reinsurers and
involuntary state pools. We record our transactions for such assumed reinsurance based on
reports provided to us by the ceding reinsurer.
Reinsurance
assumed and ceded premiums are deferred and recorded as earned
premiums on a pro rata basis over the terms of the contract. We estimate loss amounts recoverable from our
reinsurers based on the reinsurance policy terms. Historically, our claims with reinsurers
have been paid. We do not have an allowance for uncollectible reinsurance.
Cash and Cash Equivalents
Cash and cash equivalents include commercial paper, money market funds, invested cash and
other overnight investments purchased with original maturities of less than three months, which are carried at fair value.
Investments
Our portfolio investments are primarily in publicly traded fixed-maturity, equity and
short-term investments, classified as available for sale at fair value in the consolidated
financial statements. Fixed-maturity investments (taxable bonds, tax-exempt bonds and
redeemable preferred stocks) and equity investments (common and non-redeemable preferred
stocks) are classified as available for sale and recorded at fair value in the consolidated
financial statements. The number of fixed-maturity securities trading below 100 percent of
book value can be expected to fluctuate as interest rates rise or fall. Because of our strong
surplus and long-term investment horizon, our intent is to hold fixed-maturity investments
until maturity, regardless of short-term fluctuations in fair values.
We include unrealized gains and losses on investments, net of taxes, in shareholders’ equity
as accumulated other comprehensive income. Realized gains and losses on investments are
recognized in net income on a specific identification basis.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 89
Investment income consists mainly of interest and dividends. We record interest on an accrual
basis and record dividends at the ex-dividend date. We amortize premiums and discounts on
fixed-maturity securities using the effective interest method over
the expected life of the security.
Facts and circumstances sometimes warrant investment write-downs. We record such
other-than-temporary declines as realized investment losses. 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.
Fair Value Disclosures
We primarily base fair value for investments in equity and fixed-maturity securities
(including redeemable preferred stock and assets held in separate accounts) on quoted market
prices or on prices from
FT Interactive Data, an outside resource that supplies global
securities pricing, dividend, corporate action and descriptive information to support fund
pricing, securities operations, research and portfolio management. When a price is not
available from these sources, as the case of securities that are not publicly traded, we
determine the fair value using cash flow projection models or using quotes from independent brokers. The fair value of investments
priced by independent brokers is less than 1 percent of the fair value of our total investment
portfolio.
We estimate fair value for liabilities under investment-type insurance contracts (annuities)
using discounted cash flow calculations. We base the calculations on interest rates offered on
contracts of similar nature and maturity. We base fair value for long-term senior notes and
notes payable on the quoted market prices for such notes.
Derivative Financial Instruments and Hedging Activities
We account for derivative financial instruments as defined by SFAS No. 133, “Accounting for Derivative
Instruments and Hedging Activities,” as amended by SFAS No. 137, “Deferral of the Effective
Date of FASB Statement No. 133” and SFAS No. 138, “Accounting for Certain Derivative
Instruments and Certain Hedging Activities” (collectively referred to as SFAS No. 133).
The hedging definitions included in SFAS No. 133 guide our recognition of the changes in the fair value of derivative financial
instruments as realized gains or losses in the consolidated statements of income or as a
component of accumulated other comprehensive income in shareholder’s equity in the period for
which they occur.
In 2006, CFC Investment Company (CFC-I) replaced $49 million of intercompany debt owed to CFC
with a short-term line of credit issued by PNC bank. CFC-I entered into an interest-rate swap
contract to hedge against fluctuations of interest payments for certain variable-rate debt
obligations ($49 million notional amount). Under the interest-rate swap contract, CFC-I agreed
to pay a fixed rate of interest of 5.66 percent for a three-year period ending August 29,
2009. In October 2006, we completed necessary requirements for the interest-rate swap to
qualify for hedge accounting treatment under the provisions of SFAS No. 133. At December 31,
2007 and 2006, the fair value of the interest rate swap was $1.2 million and $430,000,
respectively. We do not expect any significant reclassification into consolidated net income
for the year ending December 31, 2008.
Securities Lending Program
In 2006, we began actively participating in a securities lending program under which certain
fixed-maturity securities from our investment portfolio are loaned to other institutions for
short periods of time. We require cash collateral in excess of the market value of the loaned
securities. The collateral received is invested in accordance with our guidelines in
high-quality, short-duration instruments to generate additional investment income. The market
value of the loaned securities is monitored on a daily basis and additional collateral is
added or refunded as the market value of the loaned securities changes. As this program is
accounted for as a secured borrowing, the collateral is recognized as an asset, and classified
as securities lending collateral invested, with a corresponding liability for the obligation
to return the collateral.
We maintain the right and ability to redeem the securities loaned on short notice and continue
to earn interest on the collateral securities. Although the securities loaned have been
pledged and effectively secure the cash collateral we receive, we maintain effective control
over our securities, which we continue to classify as invested assets on our consolidated
balance sheets. At year-end 2007, we had $745 million in securities on loan and $760 million
of collateral. At year-end 2006, we had no securities on loan and held no collateral because
we recalled our securities on loan prior to year-end. Interest income on collateral, net of
fees, was $1.5 million in 2007 and $697,000 in 2006.
A portion of the securities
lending collateral invested was placed in asset-backed commercial paper (ABCP)
programs during 2007 by our lending agent. Due to the ABCP market disruption,
maturities on two of our investments were extended beyond their original stated
maturity dates. Only one of these investments remains outstanding. That ABCP had an amortized cost of $73 million at
February 22, 2008, compared with $74 million at year-end 2007. The ABCP manager
is continuing to work with investors to allow for an orderly liquidation of the
fund. Excluding this remaining ABCP investment, all investments within our securities
lending program now are in overnight securities.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 90
Lease/Finance
Our CFC Investment Company subsidiary provides auto and equipment direct financing (leases and
loans) to commercial and individual clients. We generally transfer ownership of the property
to the client as the terms of the leases expire. Our lease contracts contain bargain purchase
options. We record income over the financing term using the effective interest method.
We capitalize and amortize lease or loan origination costs over the life of the financing
using the effective interest method. These costs may include, but are not limited to: finder fees,
broker fees, filing fees and the cost of credit reports. We account
for these leases and loans as direct financing-type leases.
Asset Management
Our CinFin Capital Management subsidiary generates revenue from management fees. We set those
fees based on the market value of assets under management, and we record our revenue as it is
earned.
Land, Building and Equipment
We record building and equipment at cost less accumulated depreciation. Certain equipment held
under capital leases also is classified as property and equipment with the related lease
obligations recorded as liabilities. Our depreciation is based on estimated useful lives
(ranging from three years to 391/2 years) using straight-line and accelerated methods.
Depreciation expense was $38 million in both 2007 and 2006 and $33 million in 2005. We monitor
land, building and equipment for potential impairments. Potential
impairments may include a
significant decrease in the market values of the assets, considerable cost overruns on
projects or a change in legal factors or business climate, or other factors that indicate that
the carrying amount may not be recoverable.
We capitalize costs for internally developed computer software during the application
development stage. These costs generally consist of external consulting, payroll and
payroll-related costs.
Income Taxes
We calculate deferred income tax liabilities and assets using tax rates in effect for the time
when temporary differences in book and taxable income are estimated to reverse. We recognize
deferred income taxes for numerous temporary differences between our taxable income and
book-basis income and other changes in shareholders’ equity. Such temporary differences relate
primarily to unrealized gains on investments and differences in the recognition of deferred
acquisition costs and insurance reserves. We charge deferred income taxes associated with
unrealized appreciation (except the amounts related to the effect of income tax rate changes)
to shareholders’ equity in accumulated other comprehensive income. We charge deferred taxes
associated with other differences to income.
Pending Accounting Standards
Adopted Accounting Standards
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 91
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 92
2. Investments
The following table analyzes investment income, realized investment gains and losses and the
change in unrealized investment gains and losses:
At December 31, 2007, contractual maturity dates for fixed-maturity and short-term investments were:
Actual maturities may differ from contractual maturities when there is a right to call or
prepay obligations with or without call or prepayment penalties.
At December 31, 2007, investments with book value of $52 million and fair value of $53
million were on deposit with various states in compliance with regulatory requirements.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 93 The following table analyzes cost or amortized cost, gross unrealized gains, gross
unrealized losses and fair value for our investments:
At year-end 2007, our Fifth Third Bancorp common stock holding, with fair value of $1.691
billion and a cost of $185 million, was our only investment for which the fair value
exceeded 10 percent of shareholders’ equity. At year-end 2006, our Fifth Third common stock
holding, with fair value of $2.979 billion and a cost of $283 million, and our Exxon Mobil
Corporation common stock holding, with a fair value of $687 million and a cost of $133
million, exceeded 10 percent of shareholders’ equity.
We sold 5.5 million shares of our holdings of Fifth Third common stock in 2007. The sale
contributed $64 million to our 2007 pretax realized gains and $42 million to net income. We
sold 3.8 million shares of our holdings of ExxonMobil common stock in 2007. The sale
contributed $217 million to our 2007 pretax realized gains and $141 million to net income.
We sold 12.7 million shares of our holdings of Alltel Corporation common stock in 2006. The
sale contributed $647 million to our 2006 pretax realized gains and $412 million to net
income.
This table reviews unrealized losses and fair values by investment category and by the
duration of the securities’ continuous unrealized loss position:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 94 When
evaluating for other-than temporary impairments, our asset impairment committee considers
the company’s intent and ability to retain a security for a period
adequate to remain its cost.
At December 31, 2007, 184 fixed-maturity investments with a total unrealized loss of $20
million had been in an unrealized position for 12 months or more. Three securities were trading below
70 percent of book value with a total unrealized loss of $6 million. The remainder were
trading between 70 percent to less than 100 percent of book value.
At December 31, 2006, 482 fixed-maturity investments with a total unrealized loss of $53
million and three equity securities with a total unrealized loss of $1 million had been in
an unrealized position for 12 months or more. All were trading between 70 percent to less than 100
percent of book value.
3. Deferred Acquisition Costs
This table summarizes components of our deferred policy acquisition costs asset:
4. Property Casualty Loss and Loss Expenses
This table summarizes activity loss and loss expense reserves:
We use actuarial methods, models, and judgment to estimate, as of a financial statement date, the property casualty loss and loss expense reserves required to pay for and settle
all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date. The actuarial estimate is subject to review
and adjustment by an inter-departmental committee that includes actuarial management and is familiar with relevant company and industry business, claims, and underwriting
trends, as well as general economic and legal trends, that could effect future loss and loss expense payments.
Because of changes in estimates of insured events in prior years, we decreased the provision
for loss and loss expenses by $244 million, $116 million and $160 million in calendar years
2007, 2006 and 2005. These decreases are partly due to the effects of settling reported
(case) and unreported (IBNR) reserves established in prior years for amounts less than
expected. The reserve for loss and loss expenses in the consolidated balance sheets also includes $42
million, $36 million and $32 million at December 31, 2007, 2006 and 2005, respectively, for
certain life and health losses.
5. Life 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 as well as for expected expenses. We base
our assumptions for expected investment income on our own experience adjusted for current
economic conditions.
We establish reserves for the company’s universal life, deferred annuity and investment
contracts equal to the cumulative account balances, which include premium deposits plus
credited interest less charges and withdrawals. Some of our universal life policies contain
no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the
account balance, based on expected no-lapse guarantee benefits and expected policy
assessments.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 95 Here is a summary of our life policy reserves:
At both December 31, 2007 and 2006, the fair value associated with the annuities shown above
was approximately $564 million and $563 million, respectively.
6. Notes Payable
At December 31, 2007, we had two lines of credit with commercial banks amounting to $225
million with an outstanding balance of $69 million. We had two lines of credit with
commercial banks amounting to $125 million with an outstanding balance of $49 million at
year-end 2006. The company had no compensating balance requirement on short-term debt for
either 2007 or 2006. Interest rates charged on borrowings ranged from 5.4 percent to 8.3
percent during 2007.
The company’s subsidiary, CFC Investment Company, entered into an interest-rate swap
agreement during 2006, which expires August 29, 2009. The purpose of the interest-rate swap
contract is to hedge against fluctuations of interest payments for certain variable-rate
debt obligations ($49 million notional amount). Under the interest-rate swap contract, CFC-I
agreed to pay a fixed rate of interest of 5.66 percent. This swap is reflected at fair value
in the consolidated balance sheets as a component of shareholders’ equity in accumulated
other comprehensive income. The unrealized loss, net of tax, was $594,000 at year-end 2007
compared with $69,000 at year-end 2006. Management does not expect any significant amounts
to be reclassified into earnings as a result of interest rate changes in the next 12 months.
7. Senior Debt
This table summarizes the principal amounts of our long-term debt excluding unamortized
discounts:
The fair value of our senior debt approximated $802 million at year-end 2007 and $850
million at year-end 2006. None of the notes are encumbered by rating triggers.
8. Shareholders’ Equity and Dividend Restrictions
Our insurance subsidiary declared dividends to the parent company of $420 million in 2007
and $275 million in both 2006 and 2005. State regulatory requirements restrict the dividends
insurance subsidiaries can pay. Generally, the most our insurance subsidiaries can pay
without prior regulatory approval is the greater of 10 percent of policyholder surplus or
100 percent of statutory net income for the prior calendar year. Dividends exceeding these
limitations may be paid only with approval of the insurance department of the domiciliary
state. During 2008, the total dividends that our lead insurance subsidiary may pay to our
parent company without regulatory approval will be approximately $658 million.
As of December 31, 2007, 10.6 million shares of common stock were available for future stock
option grants.
Declared cash dividends per share were $1.42, $1.34 and $1.21 for the years ended December
31, 2007, 2006 and 2005, respectively.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 96 Accumulated Other Comprehensive Income
The change
in unrealized gains and losses on investments, pension obligations and derivatives included:
9. Reinsurance
Our statements of income include earned property casualty insurance premiums on assumed and
ceded business:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 97 Our statements of income include incurred property casualty insurance loss and loss expenses
on assumed and ceded business:
Our statements of income include earned life insurance premiums on assumed and ceded
business:
Our statements of income include life insurance contract holder benefits incurred on assumed
and ceded business:
10. Income Taxes
Deferred tax assets and liabilities reflect temporary differences between the carrying
amounts of assets and liabilities for financial reporting purposes and the amount recognized
for tax purposes. The significant components of deferred tax assets and liabilities included
in the balance sheet at December 31 were as follows:
The provision for federal income taxes is based upon filing a consolidated income tax return
for the company and subsidiaries. As of December 31, 2007, we had no operating or capital
loss carry forwards.
The differences between the 35 percent statutory income tax rate and our effective income
tax rate were as follows:
Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS
No. 109
We adopted the provisions of FIN 48 on January 1, 2007. As a result of the adoption, we
recorded a charge of approximately $300,000 to retained earnings. As of the adoption date,
we had a gross unrecognized tax benefit (FIN 48 liability) of $25 million.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 98 We reconcile the unrecognized tax benefit between January 1, 2007, and December 31, 2007, as follows:
The FIN 48 liability is carried in other liabilities in the condensed consolidated balance
sheets as of December 31, 2007. Included in the FIN 48 liability is an immaterial amount
that would change the effective tax rate, if recognized. Although no penalties currently are
accrued, if incurred, they would be recognized as a component of income tax expense. Accrued
interest expense is recognized as other operating expense in the condensed consolidated
statements of income. The accrued interest liability was $2.5 million and $1.8 million as of
January 1, 2007, and December 31, 2007, respectively. The consolidated
statements of income for the current year reflected net Internal Revenue Service interest
income of $1.5 million from a reduction in the accrued interest liability and
interest received on refund claims.
The IRS has concluded the examination phase of its audit of our 2002
through 2004 tax years. In November 2007, we met with IRS
appeals personnel in an attempt to settle the unresolved
issues related to those tax years. As a result of the appeals process, we reached a
preliminary agreement with the IRS settling those unresolved issues. Until an IRS
administrative review for the appeals settlement has been performed, the issues for which
preliminary agreement have been reached cannot be considered effectively settled under FIN
48. However, as a result of the preliminary agreement, the FIN 48 liability associated with
the 2002 to 2004 tax years have been adjusted and certain assumptions made for our FIN 48
liability associated with the tax years 2005 through 2007 tax years have been adjusted. We
anticipate that the 2002 through 2004 tax years will be effectively settled in the next 12
months, resulting in a settlement of the FIN 48 liability of approximately $2 million,
primarily related to the valuation of our loss reserves.
The IRS has begun the examination phase of its audit for our 2005 and 2006 tax years. It is
reasonably possible that a change in the unrecognized tax benefits may occur once the
examination phase has concluded. At this time, we can neither estimate the settlement date
of, nor quantify an estimated range for any potential change to, the unrecognized tax
benefits relating to these years.
In addition to our Internal Revenue Service filings, we file income tax returns in various
state jurisdictions. Material amounts of income tax are paid to Ohio, Illinois and Florida.
Of the state jurisdictions, Illinois has concluded an audit of tax years 2004 and 2005
resulting in an immaterial change to tax. No other audits are currently under way, nor is
the company aware of any pending audits.
11. Net Income Per Common Share
Basic earnings per share are computed based on the weighted average number of shares
outstanding. Diluted earnings per share are computed based on the weighted average number of
common and dilutive potential common shares outstanding. We have adjusted shares and
earnings per share to reflect all stock splits and dividends prior to December 31, 2007.
Here are calculations for basic and diluted earnings per share:
The only current sources of dilution of our common shares are outstanding stock options to
purchase shares of common stock and non-vested shares. The above table shows the number of
anti-dilutive options shares at year-end 2007, 2006 and 2005. We did not include these
options in the computation of net income per common share (diluted) because their exercise
would have an anti-dilutive effect.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 99 12. Employee Benefit Pension Plan
We sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension
plan covering substantially all employees. We do not contribute to the 401(k) plan but we do
pay all operating expenses. Benefits for the defined benefit pension plan are based on years
of credited service and compensation level. Contributions are based on the frozen entry age
actuarial cost method. We also maintain a supplemental retirement plan (SERP) with
liabilities of approximately $6 million and $5 million at year-end 2007 and 2006. The SERP
is included in the obligation and expense amounts. Our pension expense is based on certain actuarial assumptions and also is composed of
several components that are determined using the projected unit credit actuarial cost method.
Key assumptions used in developing the 2007 net pension obligation were a 6.25 percent
discount rate and rates of compensation increases ranging from 4 percent to 6 percent. To
determine the discount rate, the plan’s particular liability characteristics — the amounts,
timing and interest sensitivity of expected benefit payments — were evaluated and then
matched to a yield curve based on actual high-quality corporate bonds across a full maturity
spectrum. Once the plan’s projected cash flows matched the yield curve, a present value was
developed, which was then calibrated to a single-equivalent discount rate. That discount
rate, when applied to a single sum, would generate the necessary cash flows to pay benefits
when due. We increased the rate by 0.5 percentage points in 2007 due to market interest
rates conditions. We based the rates of compensation increase on the company’s historical
data, which led us to lower the range from the 5 percent to 7 percent used in previous
years.
Key assumptions used in developing the 2007 net pension expense were a 5.75 percent discount
rate, an 8 percent expected return on plan assets and rates of compensation increases
ranging from 4 percent to 6 percent. The 8 percent return on plan assets assumption is based
partially on the fact that substantially all of the investments held by the pension plan are
common stocks that pay dividends. We believe this rate is representative of the expected
long-term rate of return on these assets. These assumptions were consistent with the prior
year, except that the discount rate was increased by 0.25 percentage points due to market
interest rate conditions.
Benefit obligation activity using an actuarial measurement date at December 31 follows:
The accumulated benefit obligation was $206 million and $204 million at December 31, 2007
and 2006, respectively. The fair value of our stock comprised $25 million (12 percent of
total plan assets) at December 31, 2007, and $29 million (14 percent of total plan assets)
at December 31, 2006.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 100 A reconciliation follows of the funded status at the end of the measurement period to the
amounts recognized in the balance sheet at December 31, 2007:
The projected benefit obligation and fair value of plan assets for pension plans with a
projected benefit obligation in excess of plan assets at December 31 follows:
The projected benefit obligation, accumulated benefit obligation and fair value of plan
assets for pension plans with an accumulated benefit obligation in excess of plan assets at
December 31 follows:
The weighted-average assumptions used to determine benefit obligations at December 31 follows:
We evaluate our pension plan assumptions annually and update them as necessary. The discount
rate assumptions for our benefit obligation track with Moody’s Aa bond yield and yearly
adjustments reflect any changes to those bond yields. Compensation increase assumptions
reflect historical calendar year compensation increases.
Here are the components of our net periodic benefit cost at December 31:
Here is a summary of the weighted-average assumptions we use to determine our net expense for the plan:
Our pension plan asset allocations by category are:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 101 We expect to contribute approximately $10 million to our pension plan in 2008 with a target
allocation of 90 percent equity securities and 10 percent fixed maturities and cash.
We expect to make the following benefit payments, which reflect expected future service:
The estimated costs to be amortized from accumulated other comprehensive income into net periodic benefit cost over the next year are as follows:
13. Statutory Accounting Information (Unaudited)
Insurance companies use statutory accounting practices (SAP) as prescribed by regulatory
authorities. The three primary differences between SAP and GAAP are:
Statutory net income and capital and surplus as determined in accordance with SAP prescribed
or permitted by insurance regulatory authorities for four legal entities, our insurance
subsidiary and its three insurance subsidiaries, are as follows:
Statutory capital and surplus for our insurance subsidiary, The Cincinnati Insurance
Company, includes capital and surplus of its four insurance subsidiaries.
14. Transactions with Affiliated Parties
We paid certain officers and directors, or insurance agencies of which they are
shareholders, commissions of approximately $7 million, $7 million and $6 million on premium
volume of approximately $37 million, $40 million and $41 million for 2007, 2006 and 2005,
respectively.
15. Commitments and Contingent Liabilities
Legal issues are part of the normal course of business for all companies. As such, we have
various litigation and claims against us in process and pending. Having analyzed those
claims with our legal counsel, we believe the outcomes of normal insurance matters will not
have a material effect on our consolidated financial position, results of operations or cash
flows. We further believe that the outcomes of non insurance matters will be covered by
insurance coverage or will not have a material effect on our consolidated financial
position, results of operations or cash flows.
16. Stock-based Associate Compensation Plans
The adoption of SFAS No. 123(R) on January 1, 2006, reduced our income before income taxes
by $14 million and $17 million in the years ended December 31, 2007 and 2006, and reduced
our net income by $11 million and $14 million in the years ended December 31, 2007 and 2006.
The weighted-average grant-date fair value of options granted during 2007 and 2006 was $9.43
and $10.09 per share, respectively. The total intrinsic value of options exercised during
the years ended December 31, 2007, 2006 and 2005, was $8 million, $22 million and $9
million, respectively. In total, options vested during the year ended December 31, 2007, had
no intrinsic value. The total intrinsic value of options vested during the years ended
December 31, 2006 and 2005, was $10 million and $12 million. (Intrinsic value is the market
price less the exercise price.)
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 102 Under the modified-prospective-transition method, we recognized:
Results for prior periods have not been retrospectively adjusted for SFAS No. 123(R). As of
December 31, 2007, we had $13 million of unrecognized total compensation cost related to
non-vested stock options. That cost will be recognized over a weighted-average period of 1.7
years. SFAS No. 123(R) also requires us to classify certain tax benefits related to
share-based compensation deductions as cash from financing
activities. For the year ended December 31,
2007, these tax benefits totaled $2 million.
In determining the share-based compensation amounts for 2007, the fair value of each option
granted in 2007 was estimated on the date of grant using the binomial option-pricing model
with the following weighted average assumptions used for grants in 2007: dividend yield of
3.33 percent; expected volatility ranging from 18.29 percent to 24.14 percent; risk-free
interest rates ranging from 4.80 percent to 4.81 percent; and expected lives of five to
seven years.
In determining the share-based compensation amounts for 2006, the fair value of each option
granted in 2006 was estimated on the date of grant using the binomial option-pricing model
with the following weighted average assumptions used for grants in 2006: dividend yield of
3.22 percent; expected volatility ranging from 20.25 to 27.12 percent; risk-free interest
rates ranging from 4.5 to 4.61 percent; and expected lives of five to seven years.
The following table illustrates the effect on net income and earnings per share if we had
applied the fair value recognition provisions of SFAS No. 123 to options granted under our
stock option plans prior to our adoption of SFAS No. 123(R) on January 1, 2006. For purposes
of this pro forma disclosure, the fair value of each option was estimated on the date of
grant using the binomial option-pricing model. In 2005, the weighted-average assumptions
used for grants were a dividend yield of 2.66 percent; expected volatility of 25.61 percent;
risk-free interest rate of 4.62 percent; and expected lives of 10 years.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 103 Here is a summary of options information:
Cash received from the exercise of options was $19 million, $27 million and $11 million for
the years ended December 31, 2007, 2006 and 2005, respectively. The tax benefit realized on
options exercised was $2 million for the year ended December 31, 2007, $3 million for
the year ended December 31, 2006, and $1 million for the year
ended December 31, 2005.
Options outstanding and exercisable consisted of the following at December 31, 2007:
The weighted-average remaining contractual life for exercisable awards as of December 31,
2007, was 4.20 years. As of December 31, 2007, 10.6 million shares of common stock were
available for future stock option grants. We currently issue new shares for option
exercises.
Restricted Stock Units
In January 2007, the compensation committee granted service-based and performance-based
restricted stock units. The service-based restricted stock units vest at the end of a
three-year vesting period. The performance based restricted stock units granted in 2007 will
vest on March 1, 2010, if certain performance targets are attained. As of December 31, 2007,
management assumed for accounting purposes that performance targets used for the 2007 awards
would be met, which resulted in the inclusion of costs for these awards in share-based
compensation for 2007.
The fair value of the restricted stock unit awards was determined based on the fair value on
the date of grant less the present value of the dividends that holders of restricted stock
units do not receive on the restricted stock units during the vesting period.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 104 Restricted stock unit awards in 2007 were:
17. Segment Information
We operate primarily in two industries, property casualty insurance and life insurance. We
regularly review four different reporting segments to make decisions about allocating
resources and assessing performance:
We report as “Other” the non-investment operations of the parent company, CFC Investment
Company and CinFin Capital Management Company (excluding client investment activities), as
well as other income of our insurance subsidiary. In 2007, an immaterial level of expenses
from The Cincinnati Specialty Underwriters Insurance Company was included in the commercial
lines property casualty insurance segment while an immaterial level of expenses for CSU
Producer Resources was included in Other.
Revenues come primarily from unaffiliated customers:
Income or loss before income taxes for each segment is reported based on the nature of that
business area’s operations:
Identifiable assets are used by each segment in its operations. We do not separately report
the identifiable assets for the commercial or personal lines segments because we do not use
that measure to analyze the segments. We include all fixed-maturity and equity security
investment assets, regardless of ownership, in the investment operations segment.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 105 This table summarizes segment information:
18. Quarterly Supplementary Data (Unaudited)
This table includes unaudited quarterly financial information for the years ended December 31, 2007 and 2006:
Note: The sum of the quarterly reported amounts may not equal the full year as each is computed independently.
Significant realized gains:
Over the course of 2007, we sold 3.8 million shares of Exxon Mobil Corporation, 5.5 million
shares of Fifth Third Bancorp common stock, all of our FirstMerit Corporation common stock
holdings and disposed of the majority of our real estate investment trust holdings.
In the first quarter of 2006, we sold our Alltel Corporation common stock holding.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 106 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure
We had no disagreements with the independent registered public accounting firm on accounting
and financial disclosure during the last two fiscal years.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures — The company maintains disclosure
controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (Exchange Act)).
Any controls and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives. The company’s management,
with the participation of the company’s chief executive officer and chief financial officer,
has evaluated the effectiveness of the design and operation of the company’s disclosure
controls and procedures as of December 31, 2007. Based upon that evaluation, the company’s
chief executive officer and chief financial officer concluded that the design and operation
of the company’s disclosure controls and procedures provided reasonable assurance that the
disclosure controls and procedures are effective to ensure that:
Changes in Internal Control over Financial Reporting — During the three months ended
December 31, 2007, there were no changes in our internal controls over financial reporting
that have materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting. Management’s Annual Report on Internal Control Over
Financial Reporting and the Attestation Report of the Independent Registered Public
Accounting Firm are set forth in Item 8, Pages 81 and 82.
Item 9B. Other Information
None
Part III
Our Proxy Statement will be filed with the SEC in preparation for the 2008 Annual Meeting of
Shareholders no later than April 4, 2008. As permitted in Paragraph G(3) of the General
Instructions for Form 10-K, we are incorporating by reference to that statement portions of
the information required by Part III as noted in Item 10 through Item 14 below.
Item 10. Directors and Executive Officers of the Registrant
Item 11. Executive Compensation
Information on executive compensation appears in the Proxy Statement under
“Compensation of Named Executive Officers and Directors,”
which includes the
“Report of the Compensation Committee” and the
“Compensation Discussion and Analysis.”
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 107 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters
Item 13. Certain Relationships and Related Transactions
Information about certain relationships and related transactions appears in the Proxy
Statement under
“Certain Relationships and Transactions”
and
“Compensation Committee Interlocks and Insider Participation.”
Item 14. Principal Accountant Fees and Services
Information about independent registered public accounting firm fees and services and audit
committee pre-approval policies and procedures appears in the Proxy Statement under
“Audit-related Matters,” which includes the
“Report of the Audit Committee,”
“Fees Billed by the Independent Registered Public Accounting Firm” and
“Services Provided by the Independent Registered Public Accounting Firm.”
Part IV
Item 15. Exhibits and Financial Statement Schedules
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 108 SCHEDULE I
Cincinnati Financial Corporation and Subsidiaries
Summary of Investments — Other than Investments in Related Parties
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 109
SCHEDULE I (Continued)
Cincinnati Financial Corporation and Subsidiaries
Summary of Investments — Other than Investments in Related Parties
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 110
SCHEDULE II
Cincinnati Financial Corporation (parent company only)
Condensed Balance Sheets
This condensed financial information should be read in conjunction with the Consolidated Financial
Statements and Notes included in Part II, Item 8, Page 80.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 111
SCHEDULE II (Continued)
Cincinnati Financial Corporation (parent company only)
Condensed Statements of Income
This condensed financial information should be read in conjunction with the Consolidated Financial Statements and Notes included
in Part II, Item 8, Page 80.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 112
SCHEDULE II (Continued)
Cincinnati Financial Corporation (parent company only)
Condensed Statements of Cash Flows
This condensed financial information should be read in conjunction with the Consolidated Financial Statements and Notes included
in Part II, Item 8, Page 80.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 113
SCHEDULE III
Cincinnati Financial Corporation and Subsidiaries
Supplementary Insurance Information
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 114
SCHEDULE III (Continued)
Cincinnati Financial Corporation and Subsidiaries
Supplementary Insurance Information
Notes to Schedule III:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 115
SCHEDULE IV
Cincinnati Financial Corporation and Subsidiaries
Reinsurance
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 116
SCHEDULE V
Cincinnati Financial Corporation and Subsidiaries
Valuation and Qualifying Accounts
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 117
SCHEDULE VI
Cincinnati Financial Corporation and Subsidiaries
Supplementary Information Concerning Property Casualty Insurance Operations
Note to Schedule VI:
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 118
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
Cincinnati Financial Corporation
/S/ Kenneth W. Stecher
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been duly
signed below by the following persons on behalf of the registrant and in the capacities and on
the dates indicated.
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 119
Index of Exhibits
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 120
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 121
Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 122
EXHIBIT 23
Consent of Independent Registered Public Accounting Firm
We consent to the incorporation by reference in Registration Statement No. 333-85953 (on
Form S-8), No. 333-24815 (on Form S-8), No. 333-24817 (on Form S-8), No. 333-49981 (on Form
S-8), No. 333-103509 (on Form S-8), No. 333-103511 (on Form S-8), No. 333-121429 (on Form
S-4), No. 333-123471 (on Form S-4), and No. 333-126714 (on Form S-8), as amended, of
Cincinnati Financial Corporation of our report dated February 29, 2008, relating to the
consolidated financial statements and financial statement schedules of Cincinnati Financial
Corporation and subsidiaries and the effectiveness of internal
control over financial reporting (which report expresses an unqualified opinion and includes
an explanatory paragraph relating to the company’s adoption of Statement of Financial
Accounting Standards (SFAS) No. 123(R), Share Based Payment, on January 1, 2006; the
recognition and related disclosure provisions of SFAS No. 158, Employers’ Accounting for
Defined Benefit Pension Plans and Other Postretirement Benefit Plans, on December 31, 2006;
the provisions of SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an
amendment of SFAS No. 133 and 140, on January 1, 2007; and the provisions of Financial
Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS
No. 109, on January 1, 2007) appearing in this Annual Report on Form 10-K of Cincinnati
Financial Corporation for the year ended December 31, 2007.
/S/ Deloitte & Touche LLP
Cincinnati, Ohio
February 28, 2008 Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 123
EXHIBIT 31A
Certification pursuant to Section 302 of the Sarbanes Oxley Act of 2002
I, John J. Schiff, Jr., certify that:
Date: February 29, 2008
/S/ John J. Schiff, Jr.
John J. Schiff, Jr., CPCU
Chairman and Chief Executive Officer Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 124
EXHIBIT 31B
Certification pursuant to Section 302 of the Sarbanes Oxley Act of 2002
I, Kenneth W. Stecher, certify that:
Date: February 29, 2008
/S/ Kenneth W. Stecher
Kenneth W. Stecher
Chief Financial Officer, Executive Vice President, Secretary and Treasurer (Principal Accounting Officer) Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 125
EXHIBIT 32
Certification pursuant to Section 906 of the Sarbanes Oxley Act of 2002
The certification set forth below is being submitted in connection with this report on Form
10-K for the purpose of complying with Rule 13a-14(b) or Rule 15d-14(b) of the Securities
Exchange Act of 1934 and Section 1350 of Chapter 63 of Title 18 of the United States Code.
John J. Schiff, Jr., the chief executive officer, and Kenneth W. Stecher, the chief
financial officer, of Cincinnati Financial Corporation each certifies that, to the best of
his knowledge:
Date: February 29, 2008
/S/ John J. Schiff, Jr.
John J. Schiff, Jr., CPCU
Chairman and Chief Executive Officer /S/ Kenneth W. Stecher
Kenneth W. Stecher
Chief Financial Officer, Executive Vice President, Secretary and Treasurer (Principal Accounting Officer) Cincinnati Financial Corporation — 2007 Annual Report on 10-K — Page 126
Cincinnati Financial Corporation (as of February 28, 2008)
This report contains forward-looking statements that involve potential risks and uncertainties. For factors that
could cause results to differ materially from those discussed, please see the most recent edition of our safe
harbor statement under the Private Securities Litigation Reform Act of 1995. To view or print the edition in
effect as of this report's initial publication date, please view this document as a printable PDF.
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