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Cincinnati Financial Corporation The Cincinnati Insurance Companies |
Cincinnati Financial Corporation Chairman and CEO's Letter
In addition, you will find information about your company in the 2009 Proxy Statement and our quarterly letters to shareholders, as they become available. Together with the detailed analysis of the 2008 Annual Report on Form 10-K, these documents comprise a package of information similar to what appeared in our previous annual reports.
March 16, 2009
To Our Shareholders, Friends and Associates:
Your company broke some records in 2008. Uncharacteristically, this was not good news. Policyholders of The Cincinnati Insurance Companies suffered record storm damages in the first half of the year. Then, winds from Hurricane Ike came through the Midwest in September, causing our largest gross loss ever from a single catastrophe, $129 million, reduced by reinsurance to a net loss of $58 million.
The property casualty insurance industry our main business endured a fifth year of pricing pressure. As disciplined underwriters, we experienced a decline of 3.4 percent in net written premiums in 2008 compared with a decline of 0.8 percent industrywide. For the first time, earnings on our investment portfolio were less than the year before. Our $537 million of pretax investment income was off 11.6 percent from the 2007 total on lower dividends paid by holdings in our equity portfolio. This shortfall is one reflection of the forces buffeting the investment markets over the past months. Because of our low cost basis, we were able to lock in gains on sales of many holdings, leading to $686 million of net gains from investment transactions. Those gains were partially offset by unprecedented non-cash write-downs of $510 million, arising from our judgment that securities we continue to hold in our portfolio may not recover lost market value within a reasonable period of time. Our capital remained at high levels despite this multitude of pressures, but volatility in our equity portfolio caused ratings agencies to place our ratings on negative review and then lower them. By year-end 2008, A.M. Best Co. and Moody's Investors Service had Stable outlooks on our ratings. Our property casualty group rating from A.M. Best remains in the Superior category, but at A+ it is a notch down from the A++ we enjoyed for many years. This rating of our financial strength continues in the top 10 percent of the more than 1,000 insurer groups A.M. Best rates. Our insurance companies are capitalized at levels far exceeding regulatory requirements, increasing our flexibility through all periods to invest in and expand our insurance operations. When all was said and done, net income totaled $429 million, about half of 2007 earnings. Year-end book value was $25.75 compared with $35.70 at year-end 2007. We take little consolation in knowing that we were not alone in these disappointments and that broader economic and natural forces were at work. And we cannot say the worst is over. The first two months of the year have made it clear that we need to brace for another difficult year in 2009. What we will say is that our agent-centered business model is sound and gives a solid foundation for our next steps. We were not sufficiently prepared for all that happened in 2008. We cannot change the past, but we certainly have learned from it. We took major steps in response to the current extreme conditions, and we are confident we are building a more competitive and agile company.
We have the resources, the plans and the people to create long-term value for shareholders, policyholders, agents and associates. Our efforts in 2008, to be multiplied in 2009 and beyond, will firm up our position of strength and we will emerge a stronger competitor than ever over the next five years. Strong Financial Resources We are going forward with strong liquidity and capital.
Cash on hand was more than $1 billion at year-end. Implementing revised portfolio guidelines, we sold selected equity investments in 2008 and early 2009, locking in gains and reducing volatility by increasing sector and company diversification. In particular, we took our financial sector holdings to 12.4 percent of the equity portfolio at year-end 2008 from 56.2 percent at year-end 2007. We ended the year with no single stock accounting for more than 14.5 percent of the equity portfolio, which remained in an overall unrealized gain position at year-end. Reducing our financial sector holdings included taking gains on our position in Fifth Third Bancorp, reducing it to 12 million shares at year-end 2008. During January 2009, we sold most of our remaining financial sector equity holdings, including the last shares from our Fifth Third holding. Ample reserves and an effective reinsurance program have protected our liquidity, allowing fixed income investments to mature and equity investments to appreciate over time. Even in a tough year like 2008, cash flow provided adequate funds to pay claims. We have never been forced to prematurely sell securities to pay claims. At its year-end value of $5.8 billion, our diversified, highly rated fixed income portfolio more than covers our total insurance reserves. The parent company has healthy capital and flexibility, with $1.3 billion of cash and invested assets at year-end 2008. In the current environment, we intend to preserve capital and did not repurchase shares in the second half of 2008. Low debt leverage also increases our flexibility. We had access at year-end 2008 to $176 million on our lines of credit, and our three issues of long-term debt are not due until 2028 and 2032. Through 2008, your Cincinnati Financial cash dividends increased annually for 48 consecutive years, a record that fewer than a dozen U.S. companies can claim. Generally, our directors declared the increases during the first quarter. In February 2009, the board maintained the quarterly dividend at 39 cents, postponing discussion of a 2009 increase to later in the year. Many other companies have cut dividends in recent months, including some that contributed to our investment income. As we make quarterly 2009 dividend decisions, we'll carefully weigh our dividend record, responsibly considering our resources and our initiatives to preserve capital and grow profitably over the long term.
With $3.360 billion of property casualty statutory surplus and a ratio of written premiums to surplus of only 0.9 to 1, we are deploying capital and resources where they will help us expand and succeed. Strategic Operating Plans We are working toward improved efficiencies to benefit agency and company profitability.
We will achieve a good return, over time, on staffing expense for new territories and states and on new technology to improve ease, efficiency and profitability for our agencies and our company. We have shortened timelines for delivery of our next generation processing systems. We now expect our new system for commercial packages and commercial auto to go live in 10 states in 2009 and most other states in 2010. Our personal lines system now is scheduled to move to a faster, friendlier format in early 2010. Other business data initiatives will improve our underwriting and pricing by assuring quality data for use in models for rate-making, forecasting, risk management and other decisions. Accurate exposure, loss and expense data will help us address weaker property casualty underwriting profitability, partially masked in 2008 by reserve releases. Years of ongoing underwriting efforts, as well as allocation refinements, have built a trend of lower than expected losses from previous years, helping current calendar year profitability. This favorable reserve development more than offset our unusually high catastrophe losses in 2008, allowing a statutory combined ratio near breakeven at 100.4 percent versus an industrywide ratio of 104.7 percent. We continue in 2009 to apply the same prudent reserving philosophies and practices that have consistently benefited our results. Our growth initiatives are succeeding.
Prices continue to be low across the property casualty industry on both new and renewal business. The independent insurance agents who market our policies are helping their clients weigh value and service in addition to price, and they continue to award us a generous portion of their carefully selected new business. Agents are using our three-year policy term as a distinct sales advantage to attract and retain commercial accounts. Agents find that many businesses will pay slightly more to get stable costs on selected coverages, allowing them to budget a known amount.
We wrote $368 million of new business premiums, up 13.1 percent in 2008. The $43 million increase is about the same amount as the sum of contributions from agencies appointed since 2004 and from our new surplus lines operations. Production generally ramps up over the first 10 years as agency relationships mature. We continue to expand to new agencies and states, opening central Texas in 2008 and making plans to open Colorado and Wyoming in 2009. Over time, our westward movement is improving our spread of risk and potentially mitigating catastrophe volatility.
We offer the full range of products our property casualty agencies need to diversify their revenues and meet the needs of people in their local communities. We will see growing contributions from our surplus lines operation which wrote $14 million in 2008, its first year of operation and from sales of personal lines by agencies that previously marketed only our commercial policies. By steadily improving our processing systems and pricing accuracy, we are helping agencies see the value of selling our personal lines. Approximately 80 percent of our property casualty agencies sell our life insurance products, which feature simplicity, guarantees and service supported by our investment in imaging and workflow technology. Committed People, Clear Priorities We are setting the stage for continuity of leadership, values and commitments.
Our own jobs changed in 2008. As Vice Chairman Jim Benoski was preparing to retire in early 2009 from active employment, we moved ahead with executive transitions. Jack and Jim continue to lead our board as chairman and vice chairman, respectively. As of July 1, 2008, Jim passed the presidential torch to Ken, who stepped up from his post as chief financial officer; and Jack likewise turned over chief executive officer duties to Ken. Steve Johnston joined the company to be our new chief financial officer, bringing 25 years of experience in insurance accounting, finance, investments, actuarial and technology. This is the first time your company's president and CEO came from outside our insurance underwriting and marketing ranks. With his 40+ years with the company, Ken is the right leader as we sharpen our focus on our efficiency, enterprise risk management, data quality, modeling and technology initiatives to support smart growth and benefit agents, policyholders and shareholders. His selection was timely; together he and Steve brought their seasoned financial perspectives and a measured, analytic approach to our decisions as events of the second half of 2008 unfolded.
At the same time, responsibilities for several other executive officers broadened or changed, allowing all to round out their experience and qualifications to advance in our next generation of leadership. J.F. Scherer, head of our Sales & Marketing area, now is executive vice president. Tom Joseph now is president of The Cincinnati Casualty Company, heading up our personal lines operation. Bud Stoneburner has taken the reins in our largest business area, commercial lines. There also were director transitions in 2008. Ken joined the board, and Dirk Debbink departed after he was recalled to active military duty and appointed Vice Admiral and Chief of Navy Reserve, U.S. Navy. We thank him, both for his service to your company and for his service to our country. All of our directors and members of our executive team share a firm commitment to perpetuate our agent-centered values. Agents and policyholders can rely on our board and executive team to continue differentiating Cincinnati in the marketplace making decisions at the local level, providing superior claims service and managing the company to preserve and build financial strength. We made it a priority to honor relationships and act with integrity as we carried out change.
Some difficult and necessary actions better positioned your company for the future. Foremost among those hard decisions was the one relating to our 2009 dividend, discussed earlier in this letter. We also moved most of our associates out of our defined benefit pension plan and into 401(k) accounts with matching contributions. Our goal was to make our benefits program more attractive to many current and prospective associates while reducing potential volatility on our company balance sheets.
Finally, in February 2009, we chose to close CinFin Capital Management, our asset management subsidiary, suspending fees and facilitating smooth transitions to other money managers. Over its 10 years, CinFin Capital had been profitable, but further growth would have required resources we believe we can use more strategically to advance our core insurance business.
Lasting Shareholder Value We are committed to building long-term rewards for
you, our shareholders.
Near-term indicators for the U.S. economy continue negative, although our agents and field representatives are reporting some positive signs that insurance pricing is flattening and may firm. Your company, like most American companies, has never before operated through a period of comparable uncertainty and volatility in the financial markets. In 2008, our total shareholder return was a negative 22.5 percent compared with negative 36.9 percent for the S&P 500 Index. The many unknowns we all face include details and impacts of government programs affecting everything from banking, insurance and taxes to energy policy, public construction and entitlements. Even healthy companies like ours that are not recipients of government funds cannot predict how TARP, the stimulus package or other programs may change the environment for our industry or for the businesses and people we insure. Any specific 2009 performance targets we could suggest would be heavily conditioned by assumptions. In line with the long-term perspective we use to set decisions and initiatives, we believe guidance that looks beyond 2009 will prove more helpful to those who study the outlook for our future success.
Better Data > Better Tools > Better Decisions
While our business model and operating discipline are the foundation of our risk management program, we also use financial and actuarial models to help quantify risks, understand how they correlate and identify the impact of various business choices. Financial models help us estimate the impact of our business plans and identify operational targets. Actuarial models simulate various events, giving us a distributional snapshot of their probability, which we consider in making business decisions. Models rely on historical data and assumptions. Although they cannot predict the future with certainty, they are helpful tools to analyze and understand choices to improve long-term results. For example, we use models to estimate claims reserve needs and catastrophe exposures, applying results as we formulate underwriting and pricing guidelines and plans for geographical expansion. We also use dynamic financial analysis to help understand our capital needs in making reinsurance choices and comparing outcomes of various business strategies. Economic capital models quantify the risks a company faces and calculate both the capital needed to cover them and their risk-adjusted returns. Our resources, plans and people give us the flexibility we need to assure resilience through all underwriting cycles and economic markets. We are confident that for the five-year period spanning 2010 to 2014, we can achieve an average of 12 to 15 percent for a measure we are calling our value creation ratio. This ratio is the sum of the growth rate of book value per share plus the ratio of dividends declared per share to beginning book value per share. It captures the drivers of our progress in building shareholder value the contribution of our insurance operations, the success of our investment strategy and the high priority we place on paying cash dividends to you. We believe this target is achievable as long as there is some firming of commercial insurance prices this year, and by the end of 2010, a turn toward recovery in the economy and financial markets. Will we achieve this level of value creation in 2009 or in every year of the five-year span? This is unlikely. Our five-year target represents an average, recognizing that the inevitable ups and downs of markets and business cycles, catastrophes and, yes, looming economic uncertainties may take a toll in some years. Our focus is not on timing, but on plans that build success over time. Short-term pressures cannot alter our focus on achieving success over time through our flexible, relationship-based and agent-centered business model. We are more determined and convinced than ever that we will recover our stride and step up to higher levels of performance over the coming years. Respectfully,
March 16, 2009
Cincinnati Resilience
Managing risk to increase stability and agility
Your company's first defense against risk and uncertainty is its structure and simplicity. Since 1950, when independent insurance agents founded The Cincinnati Insurance Company, we have emphasized disciplined underwriting, low-debt tolerance and a simple, long-term investment strategy. These ideals continue to serve us well in uncertain times. At our parent company level, financial flexibility comes from our strong liquidity and low debt. Our investment portfolio reflects our belief that we should undertake only those risks that we understand.
At the insurance company level, our defenses include firsthand knowledge of local markets served by our large force of empowered field representatives, as well as conservative reinsurance and reserving practices. Our reinsurance program, backed by highly rated reinsurers, helps assure our stability. We carefully select retentions that allow us to effectively balance costs with benefits. We hold a highly rated, diversified bond portfolio with a total market value that exceeds our insurance reserve liabilities. Our consistently adequate policy reserve levels fully reflect underwriting and loss trends as they occur. We effectively mitigate the risks associated with our large insurance reserves by following sound claims and actuarial practices. We establish case reserves at the local level, based on local market knowledge, and use a claims mediation process to resolve many claims quickly. Key reserving decisions are subject to reviews at multiple levels and to annual review by our appointed actuary, an important check to ensure the long-term integrity of our reserve position. We continue our conservative approach by not discounting reserves. The recent and ongoing cascade of events in the economy and financial markets has viscerally demonstrated that it is not enough to study and manage financial and operational risks in isolation by case, by region, by agency, by business line or segment, or by any single factor. Rather, we are wiser to stress test our readiness to withstand risk by developing solutions for scenarios where risks emerge, converge and compound. Your company's management and board believe that we can strengthen the inherent stability and agility of our business model by applying enterprise risk management techniques. Understanding the risks we take and their potential impacts under harder-to-imagine scenarios can increase our resilience, allowing us to adapt and thrive through the worst of times.
For the past few years, we have been identifying, quantifying and defining our tolerances, mitigating risks, and managing intersecting risks across our operations. Nonetheless, ratings agencies rightfully faulted our efforts at mid-2008 for failing to reduce investment concentrations early enough to avoid losing surplus as market values declined. Just a few months later, ratings analysts who reviewed our progress gave us more favorable marks, approving of our mitigation efforts and concluding that our enterprise risk management program now is more advanced than those of many other insurers. We are integrating our enterprise risk management framework into our business planning at the corporate and department levels. Four examples below show how the framework drives risk-based decisions, keeping us on track, helping us bounce back, and giving us the confidence in our ability to balance risk and reward: EXAMPLE
Relationship risk: We rely exclusively on independent insurance agencies to distribute our products. Because each agency represents multiple insurers, we must demonstrate our value to our agents and contribute to their success. To win an increasing share of their business, we need to deploy policy processing systems that streamline their workflow, increase their productivity and reduce their expenses. Risk-based decision: In 2008, we significantly accelerated our two major technology projects, focusing resources and communicating this priority to all associates. We are on track for agencies in 10 of our larger states to begin using our e-CLAS system for commercial package and auto policies in 2009, and for most other states to go live in 2010. Our personal lines system now is slated to move to an updated, user-friendlier platform at the beginning of 2010, improving the experience of agents who sell our homeowner and personal auto products. Agents who have reviewed and tested prototypes of these systems believe their introductions will add to the advantages we already enjoy.
Intersections: In addressing this risk, we improve our management of other risks. For example, these new systems will improve the data we collect, supporting more precise underwriting and pricing. Additionally, their operation will improve the speed and efficiency of booking premium, reducing the need for time-consuming reconciliations. Further, the new systems allow agents the choice on commercial as well as personal policies to have us bill their clients directly, letting us prepare to offer services to policyholders, such as convenient online and telephone payment options. EXAMPLE
Catastrophe risk: Our property casualty insurance business started in Ohio, extending today to 35 states for commercial lines and 29 for personal lines. Our most established, penetrated marketing territories are in the Midwest, followed by states in the Southeast. This geographical concentration especially on the personal lines side, where more than 35 percent of premiums are written in Ohio makes us vulnerable to large catastrophe losses. Risk-based decision: We have always addressed catastrophe risk in our underwriting and pricing guidelines; now we also are shaping our growth strategy around mitigation of this risk through geographic diversification. For example, expansions are setting the stage to develop a sizeable presence in the West. As new agency relationships mature and our share of agency business ramps up, our exposures are spreading over a larger premium base, decreasing overall catastrophe vulnerability. We also are working to boost the premium base by leveraging our personal lines technology in agencies and states where we previously wrote only commercial lines business. Growth through our new surplus lines operation also is increasing our premium base. Intersections: These actions not only spread our exposures and increase our premiums; they also support a more diversified stream of revenues for your company and our agencies. When economic pressures, market forces and timing diverge across geographic markets and lines of business, diversified revenues help stabilize performance. EXAMPLE
Investment portfolio risk: In mid-2007, our equity investment portfolio was more than 50 percent concentrated in the financial sector, including 73 million shares of a single common stock, Fifth Third Bancorp. Beginning to be stressed by the mortgage crisis, financials were losing value. Over the ensuing months, many of these companies reduced or eliminated their dividends, which had previously boosted our profits. Risk-based decision: We developed, adopted and implemented revised investment guidelines. For the fixed-income portfolio, we limited exposures in a single issuer or within a credit rating category and placed a limit on the amount of municipal bonds that may come from a single state. For the equity portfolio, we established tolerances for company or sector concentration and for our overall equity ownership as a percent of total invested assets and statutory surplus. We moved quickly to bring the portfolio in line with the new tolerances, achieving some mitigation by year-end. As a result, we owned no shares of Fifth Third as of January 2009, and the financial sector, at only 12 percent, is no longer the largest in our equity portfolio. Intersections: We identified and measured potential impacts from multiple relationships with Fifth Third, including insurance, banking and 401(k) plan administration. Added to the investment relationship, these dependencies entailed more correlated risk than we found acceptable. Aside from eliminating the investment relationship, we established controls to fully evaluate and monitor the potential impact of entities with which we have multiple relationships.
Measuring and Monitoring Ethics
Perhaps our most important defense against risk is your company's culture and the values embedded in it. Training programs and internal communications convey ethical standards and guidelines, and we assess consistency of corporate business decisions and individual actions in many ways:
EXAMPLE
Location risk: By design, approximately 70 percent of our staff works at a single headquarters facility, supporting a dispersed field force that is unencumbered by branch offices. Instead, we give our field representatives who work out of their homes wide decision-making authority. The downside to our centralized headquarters support is higher business continuity risk. A natural or manmade disaster, epidemic or major power disruption, for instance, could seriously curtail or cut off our support of field representatives and agents across the country. Risk-based decision: We began improving our emergency backup arrangements for data and critical systems, including relocation of that capability to a different off-site, third-party facility. We expanded secure electronic access to files and systems from outside headquarters. We began converting a property to serve as an emergency operating base for selected headquarters associates. We stepped up health and wellness programs, including first responder training, and coordinated with authorities to become a point of distribution for emergency vaccines or antidotes. Intersections: Plans to assure disaster recovery and business continuity also mitigate financial risk related to employee benefits health, life and disability insurance, as well as workers' compensation. We mapped the aggregated risk to help us weigh potential losses and financial impacts and reduced risk by taking mitigation and transfer actions. Condensed Balance Sheets and Income Statements (unaudited)
Six-year Summary Financial Information
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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