In addition, you will find information about your company's strategies and initiatives in the Letter from the Chairman and the Chief
Executive Officer and our quarterly letters to shareholders, as they become available. Together with the detailed analysis of the 2009 Annual Report on Form 10-K, these documents comprise a package of information similar to what appeared in our previous annual reports.
February 26, 2010
Part I
Item 1. Business
Cincinnati Financial Corporation Introduction
We are an
Ohio corporation formed in 1968. Our lead subsidiary, The Cincinnati Insurance
Company, was founded in 1950. Our main business is property casualty insurance
marketed through independent insurance agents in 37 states. Our headquarters is
in Fairfield, Ohio. At year-end 2009, we employed 4,170 associates,
with 2,965 headquarters associates providing support to 1,205 field
associates.
At
year-end 2009, Cincinnati Financial Corporation owned 100 percent of three
subsidiaries: The Cincinnati Insurance Company, CSU Producer Resources Inc., and
CFC Investment Company. In addition, the parent company has an investment
portfolio, owns the headquarters property and is responsible for corporate
borrowings and shareholder dividends.
The
Cincinnati Insurance Company owns 100 percent of our four additional
insurance subsidiaries. Our standard market property casualty insurance group
includes two of those subsidiaries – The Cincinnati Casualty Company and The
Cincinnati Indemnity Company. This group writes a broad range of business,
homeowner and auto policies. Other subsidiaries of The Cincinnati Insurance
Company include The Cincinnati Life Insurance Company, which provides life
insurance, 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 two
non-insurance 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; and CFC
Investment Company, which offers commercial leasing and financing services to
our agents, their clients and other customers.
Our
filings with the Securities and Exchange Commission are available, free of
charge, on our Web site, www.cinfin.com/investors, as
soon as possible after they have been filed with the SEC. These filings include
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K and amendments to those reports filed or furnished pursuant to Section
13(a) or 15(d) of the Securities Exchange Act of 1934. In the following
pages we reference various Web sites. These Web sites, including our own, are
not incorporated by reference in this Annual Report on Form 10-K.
Periodically,
we refer to estimated industry data so that we can give information about our
performance versus the overall insurance industry. Unless otherwise noted, the
industry data is prepared by A.M. Best Co., a leading insurance
industry statistical, analytical and insurer financial strength and credit
rating organization. Information from A.M. Best is presented on a statutory
basis. When we provide our results on a comparable statutory basis, we label it
as such; all other company data is presented in accordance with accounting
principles generally accepted in the United States of America
(GAAP).
Our Business And Our Strategy
Introduction
The
Cincinnati Insurance Company was founded 60 years ago by four independent
insurance agents. They established the mission that continues to guide all of
the companies in the Cincinnati Financial family – to grow profitably and
enhance the ability of local independent insurance agents to deliver quality
financial protection to the people and businesses they serve by:
A select
group of agencies in 37 states actively markets our property casualty insurance
within their communities. Standard market commercial lines policies
are marketed in all of those states, while personal lines policies are
marketed in 29 of those states. Excess and surplus lines policies are available
in 36 of those states. Within this select group, we also seek to become the life
insurance carrier of choice and to help agents and their clients – our
policyholders – by offering leasing and financing services.
Three
competitive advantages distinguish our company, positioning us to build
shareholder value and overall long-term success:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 1 Independent
Insurance Agency Marketplace
The U.S.
property casualty insurance industry is a highly competitive marketplace with
over 2,000 stock and mutual companies operating independently or in groups. No
single company or group dominates across all product lines and states.
Standard market insurance companies (carriers) can market a broad array of
products nationally or:
Standard
market property casualty insurers generally offer insurance products through one
or more distribution channels:
For the
most part, we compete with standard market insurance companies that market
through independent insurance agents. Agencies marketing our commercial lines
products typically represent six to 12 standard market insurance carriers for
commercial lines products, including both national and regional carriers, some
of which may be mutual companies. Our agencies typically represent four to six
standard personal lines carriers, and we also compete with carriers that market
personal lines products through captive agents and direct writers. Distribution
though independent insurance agents or brokers represents nearly 60 percent of
overall U.S. property casualty insurance premiums and approximately 80 percent
of commercial property casualty insurance premiums, according to studies by the
Independent Insurance Agents and Brokers of America.
We are
committed exclusively to the independent agency channel. The independent
agencies that we choose to market our standard lines insurance products share
our philosophies. They do business person to person; offer broad, value-added
services; maintain sound balance sheets; and manage their agencies
professionally. We develop our relationships with agencies that are active in
their local communities, providing important knowledge of local market trends,
opportunities and challenges.
In
addition to the standard market for property casualty insurance, the excess and
surplus lines market exists due to a regulatory distinction. Generally, excess
and surplus lines insurance carriers provide insurance that is unavailable in
the standard market due to market conditions or due to characteristics of the
insured person or organization that are caused by nature, the insured's claim
history or the characteristics of their business. Insurers operating in the
excess and surplus lines market generally market business through excess and
surplus lines insurance brokers, whether they are small specialty insurers or
specialized divisions of larger insurance organizations.
We opened
our own excess and surplus lines insurance brokerage firm so that we could offer
excess and surplus lines products exclusively to the independent agents who
market our other property casualty insurance products. We also market life
insurance products through the agencies that market our property casualty
products, and through other independent agencies that represent The Cincinnati
Life Insurance Company without also representing our other
subsidiaries.
At
year-end 2009, our 1,180 property casualty agency relationships were marketing
our standard market insurance products out of 1,463 reporting locations. An
increasing number of agencies have multiple, separately identifiable locations,
reflecting their growth and consolidation of ownership within the independent
agency marketplace. The number of reporting agency locations indicates our
agents’ regional scope and the extent of our presence within our 37 active
states. At year-end 2008, our 1,133 agency relationships had 1,387
reporting locations. At year-end 2007, our 1,092 agency relationships had
1,327 reporting locations.
On
average, we have an 11.1 percent share of the property casualty insurance
purchased through our reporting agency locations. Our share is 16.7 percent in
reporting agency locations that have represented us for more than 10 years;
5.9 percent in agencies that have represented us for five to 10 years;
3.9 percent in agencies that have represented us for one to five years; and
0.6 percent in agencies that have represented us for less than one
year.
Our
largest single agency relationship accounted for approximately 1.2 percent
of our total property casualty earned premiums in 2009. No aggregate locations
under a single ownership structure accounted for more than 2.2 percent of
our earned premiums in 2009.
Financial Strength
We
believe that our financial strength and strong surplus position, reflected in
our insurer financial strength ratings, are clear, competitive advantages in the
segments of the insurance marketplace that we serve. This strength supports the
consistent, predictable performance that our policyholders, agents, associates
and shareholders have always expected and received, helping us withstand
significant challenges.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 2 While the
prospect exists for short-term financial performance volatility due to our
exposures to potential catastrophes or significant capital market losses, the
ratings agencies consistently have asserted that we have built appropriate
financial strength and flexibility to manage that volatility. We remain
committed to strategies that emphasize being a consistent, stable market for our
agents’ business over short-term benefits that might accrue by quick,
opportunistic reaction to changes in market conditions.
At
year-end 2009 and 2008, risk-based capital (RBC) for our standard and excess and
surplus lines property casualty operations and life operations was very strong,
far exceeding regulatory requirements.
The
consolidated property casualty insurance group’s ratio of investments in common
stock to statutory surplus was 58.4 percent at year-end 2009 compared with
53.4 percent at year-end 2008. The life insurance company’s ratio was 32.2
percent compared with 39.2 percent a year ago.
Cincinnati
Financial Corporation’s senior debt is rated by four independent ratings firms.
In addition, the ratings firms award our property casualty and life operations
insurer financial strength ratings based on their quantitative and qualitative
analyses. These ratings assess an insurer’s ability to meet financial
obligations to policyholders and do not necessarily address all of the matters
that may be important to shareholders. Ratings may be subject to revision or
withdrawal at any time by the rating agency, and each rating should be evaluated
independently of any other rating.
All of
our insurance subsidiaries continue to be highly rated. During 2009, Fitch
Ratings lowered our ratings as described below. No other ratings agency actions
occurred during 2009.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 3 |
As of
February 26, 2010, our credit and financial strength ratings were:
On August
6, 2009, Fitch Ratings lowered our ratings and changed the rating outlook to
stable. Our parent company senior debt rating was lowered from A- to BBB+ and
our standard market property casualty subsidiaries’ insurance and life insurance
subsidiary financial strength ratings were lowered from AA- to A+. Fitch said
the rating action was primarily driven by our unfavorable property casualty
underwriting performance during 2008 and the first half of 2009. Fitch said it
viewed favorably our steps taken with our investment portfolio. Fitch also noted
our strong capitalization and low operating leverage. No other ratings
agency actions occurred during 2009.
On
February 18, 2010, A.M. Best affirmed our ratings that it had assigned in
December 2008, continuing its stable outlook. A.M. Best cited our superior
risk-adjusted capitalization, strong five-year average operating performance,
historically redundant reserves and successful distribution within our targeted
regional markets. A.M. Best noted that common stock leverage was approximately
50 percent of statutory surplus at year-end 2009, a concern offset by our
conservative underwriting and reserving philosophies, with loss reserves more
than fully covered by a highly rated, diversified bond portfolio.
Our debt ratings are discussed in Item 7, Liquidity and Capital Resources, Additional Sources of Liquidity,
Page 69.
Operating Structure
We offer
our broad array of insurance products through the independent agency channel. We
recognize that locally based independent agencies have relationships in their
communities and local marketplace intelligence that can lead to policyholder
satisfaction, loyalty and profitable business. We seek to be a consistent and
predictable property casualty carrier that agencies can rely on to serve their
clients. For our standard market business, field and headquarters underwriters
make risk-specific decisions about both new business and renewals.
In our 10
highest volume states for consolidated property casualty premiums, 933 reporting
agency locations wrote 68.1 percent of our 2009 consolidated property
casualty earned premium volume compared with 910 locations and 68.7 percent
in 2008.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 4 Property Casualty Insurance Earned Premiums by State
Field Focus
We rely
on our field associates to provide service and be accountable to our agencies
for decisions we make at the local level. These associates live in the
communities our agents serve, working from offices in their homes and providing
24/7 availability to our agents. Headquarters associates also provide agencies
with underwriting, accounting and technology assistance and training. Company
executives, headquarters underwriters and special teams regularly travel to
visit agencies, strengthening the personal relationships we have with these
organizations. Agents have opportunities for direct, personal conversations with
our senior management team, and headquarters associates have opportunities to
refresh their knowledge of marketplace conditions and field
activities.
The field
team is coordinated by field marketing representatives responsible for
underwriting new commercial lines business. They are joined by field
representatives specializing in claims, loss control, personal lines, machinery
and equipment, bond, premium audit, life insurance and leasing. The field team
provides many services for agencies and policyholders; for example, our field
loss control representatives and others specializing in machinery and equipment
risks perform inspections and recommend specific actions to improve the safety
of the policyholder’s operations and the quality of the agent’s
account.
Agents
work with us to carefully select risks and assure pricing adequacy. They
appreciate the time our associates invest in creating solutions for their
clients while protecting profitability, whether that means working on an
individual case or customizing policy terms and conditions that preserve
flexibility, choice and other sales advantages. We seek to develop long-term
relationships by understanding the unique needs of their clients, who are also
our policyholders.
We also
are responsive to agent needs for well designed property casualty products. Our
commercial lines products are structured to allow flexible combinations of
property and liability coverages in a single package with a single expiration
date and several payment options. This approach brings policyholders
convenience, discounts and a reduced risk of coverage gaps or disputes. At the
same time, it increases account retention and saves time and expense for the
agency and our company.
We seek
to employ technology solutions and business process improvements
that:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 5 Agencies
access our systems and other electronic services via their agency management
systems or CinciLink®, our
secure agency-only Web site. CinciLink provides an array of Web-based services
and content that makes doing business with us easier, such as commercial and
personal lines rating and processing systems, policy loss information, sales and
marketing materials, educational courses about our products and services,
accounting services, and electronic libraries for property and casualty coverage
forms and state rating manuals.
Superior Claims Service
Our
claims philosophy reflects our belief that we will prosper as a company by
responding to claims person to person, paying covered claims promptly,
preventing false claims from unfairly adding to overall premiums and building
financial strength to meet future obligations.
Our 771
locally based field claims representatives work from their homes, assigned to
specific agencies. They respond personally to policyholders and claimants,
typically within 24 hours of receiving an agency’s claim report. We believe we
have a competitive advantage because of the person-to-person approach and the
resulting high level of service that our field claims representatives provide.
We also help our agencies provide prompt service to policyholders by giving
agencies authority to immediately pay most first-party claims under standard
market policies up to $2,500. We believe this same local approach to handling
claims is a competitive advantage for our agents providing excess and surplus
lines coverage in their communities. Handling of these claims includes guidance
from headquarters-based excess and surplus lines claims managers.
Our
property casualty claims operation uses CMS, our claims management system, to
streamline processes and achieve operational efficiencies. CMS allows field and
headquarters claims associates to collaborate on reported claims through a
virtual claim file. Our field claims representatives use tablet computers to
view and enter information into CMS from any location, including an insured’s
home or agent’s office, and to print claim checks using portable printers.
Agencies can also access selected CMS information such as activity notes on open
claims.
Catastrophe
response teams are comprised of volunteers from our experienced field claims
staff, and we give them the tools and authority they need to do their jobs. In
times of widespread loss, our field claims representatives confidently and
quickly resolve claims, often writing checks on the same day they inspect the
loss. CMS introduced new efficiencies that are especially evident during
catastrophes. Electronic claim files allow for fast initial contact of
policyholders and easy sharing of information and data by rotating storm teams,
headquarters and local field claims representatives. When hurricanes or other
weather events are predicted, we can choose to have catastrophe response team
members travel to strategic locations near the expected impact area. They are in
position to quickly get to the affected area, set up temporary offices and start
calling on policyholders.
Our
claims associates work to control costs where appropriate. They use vendor
resources that provide negotiated pricing to our insureds and claimants. Our
field claims representatives also are educated continuously on new techniques
and repair trends. They can leverage their local knowledge and experience with
area body shops, which helps them negotiate the right price with any facility
the policyholder chooses.
We staff
a Special Investigations Unit (SIU) with former law enforcement and claims
professionals whose qualifications make them uniquely suited to gathering facts
to uncover potential fraud. While we believe our job is to pay what is due under
each policy contract, we also want to prevent false claims from unfairly
increasing overall premiums. Our SIU also operates a computer forensic lab,
using sophisticated software to recover data and mitigate the cost of
computer-related claims for business interruption and loss of
records.
Loss and Loss Expense Reserves
When
claims are made by or against policyholders, any amounts that our property
casualty operations pay or expect to pay for covered claims are losses. The
costs we incur in investigating, resolving and processing these claims are loss
expenses. Our consolidated financial statements include property casualty loss
and loss expense reserves that estimate the costs of not-yet-paid claims
incurred through December 31 of each year. The reserves include estimates for
claims that have been reported to us plus our estimates for claims that have
been incurred but not yet reported (IBNR), along with our estimate for loss
expenses associated with processing and settling those claims. We develop the
various estimates based on individual claim evaluations and statistical
projections. We reduce the loss reserves by an estimate for the amount of
salvage and subrogation we expect to recover. 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 38, we discuss our
process for analyzing potential losses and establishing reserves. In Item 7,
Property Casualty Loss and Loss Expense Obligations and Reserves, Page 71, and
Life Insurance Policyholder Obligations and Reserves, Page 78, we review reserve
levels, including 10-year development of our property casualty
loss reserves.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 6 Insurance Products
We
actively market property casualty insurance in 37 states through a select group
of independent insurance agencies. Our standard market commercial lines products
are marketed in all of those states while our standard market personal lines
products are marketed in 29. We discuss our commercial lines and personal lines
insurance operations and products in Commercial Lines Property Casualty
Insurance Segment, Page 12, and Personal Lines Property Casualty Insurance
Segment, Page 15. At year-end 2009, CSU Producer Resources marketed our
excess and surplus lines products to agencies in 36 states that represent
Cincinnati Insurance.
The
Cincinnati Specialty Underwriters Insurance Company began excess and surplus
lines insurance operations in January 2008. We structured this operation to
exclusively serve the needs of the independent agencies that currently market
our standard market insurance policies. When all or a portion of a current or
potential client’s insurance program requires excess and surplus lines
coverages, those agencies can write the whole account with Cincinnati, gaining
benefits not often found in the broader excess and surplus lines market.
Agencies have access to The Cincinnati Specialty Underwriters Insurance
Company’s product line through CSU Producer Resources Inc., the wholly owned
insurance brokerage subsidiary of parent-company Cincinnati Financial
Corporation.
Cincinnati
Specialty Underwriters and CSU Producer Resources employ a Web-based policy
administration system to quote, bind, issue and deliver policies electronically
to agents. This system also provides integration to existing document management
and data management systems, allowing for straight-through processing of
policies and billing.
We also
support the independent agencies affiliated with our property casualty
operations in their programs to sell life insurance. The products offered by our
life insurance subsidiary round out and protect accounts and improve account
persistency. At the same time, our life operation increases diversification of
revenue and profitability sources for both the agency and our
company.
Our
property casualty agencies make up the main distribution system for our life
insurance products. To help build scale, we also develop life business from
other independent life insurance agencies in geographic markets underserved
through our property casualty agencies. We are careful to solicit business from
these other agencies in a manner that does not compete with the life insurance
marketing and sales efforts of our property casualty agencies. Our life
insurance operation emphasizes up-to-date products, responsive underwriting,
high quality service and competitive pricing.
Other Services to Agencies
We
complement the insurance operations by providing products and services that help
attract and retain high-quality independent insurance agencies. When we appoint
agencies, we look for organizations with knowledgeable, professional staffs. In
turn, we make an exceptionally strong commitment to assist them in keeping their
knowledge up to date and educating new people they bring on board as they grow.
Numerous activities fulfill this commitment at our headquarters, in regional and
agency locations and online.
Except
travel-related expenses for classes held at our headquarters, most programs are
offered at no cost to our agencies. While that approach may be extraordinary in
our industry today, the result is quality service for our policyholders and
increased success for our independent agencies.
In
addition to broad education and training support, we make non-insurance
financial services available through CFC Investment Company. CFC Investment
Company offers equipment and vehicle leases and loans for independent insurance
agencies, their commercial clients and other businesses. It also provides
commercial real estate loans to help agencies operate and expand their
businesses. We believe that providing these services enhances agency
relationships with the company and their clients, increasing loyalty while
diversifying the agency’s revenues.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 7 Strategic Initiatives
Management
has identified strategies that can position us for long-term success. The board
of directors and management believe that execution of our strategic plan will
create significant value for shareholders over time. We broadly group these
strategies into three areas of focus – managing capital effectively, improving
insurance profitability and driving premium growth – correlating with the
primary ways we measure our progress toward our long-term financial objectives.
Our strategies are intended to position us to compete successfully in the
markets we have targeted while seeking to optimize the balance of risk and
returns. We believe successful implementation of the initiatives that support
our strategies will help us better serve our agent customers, reduce volatility
in our financial results and achieve our long-term objectives despite
shorter-term effects of difficult economic, market or pricing cycles. We
describe our expectations for the results of these initiatives in Item 7,
Executive Summary of the Management’s Discussion and Analysis,
Page 34.
Manage Capital Effectively
Our first
strategy is a continuing focus on managing capital effectively. This strategy
serves as a foundation supporting other strategies focused on profitably growing
our insurance business, with the overall objective of building capital for the
long-term benefit of shareholders. Implementation of the initiatives below that
support our capital management strategy is intended to preserve our capital
while maintaining appropriate liquidity. A strong capital position provides the
capacity to support premium growth and liquidity provides for our investment in
the people and infrastructure needed to implement our other strategic
initiatives. Our strong capital and liquidity also provide financial flexibility
for shareholder dividends or other capital management actions.
The
primary capital management initiatives are:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 8
We
measure the overall success of our strategy to effectively manage capital
primarily by growing investment income and by achieving over any five-year
period a total return on our equity investment portfolio that exceeds the
Standard & Poor’s 500’s return. Investment income grew at a compound annual
rate of 0.3 percent over the five years ended December 31, 2009. It grew during
2005 through 2007, then declined during 2008 and 2009 when we experienced a
dramatic reduction in dividends from financial services companies held in our
equity portfolio, a risk we addressed aggressively during 2008 and early 2009.
Over the five years ended December 31, 2009, our compound annual equity
portfolio return was negative 5.8 percent compared with a compound annual total
return of 0.4 percent for the S&P 500 Index. Our equity portfolio
underperformed the market for the five-year period primarily because of the
decline in the market value of Fifth Third Bancorp (NASDAQ: FITB), our largest
holding for most of the period. We have not owned any shares of Fifth Third
common stock since early 2009.
We also
monitor other measures. One of the most significant is our ratio of property
casualty net written premiums to statutory surplus, which was 0.8-to-1 at
year-end 2009 compared with 0.9-to-1 at year-end 2008 and 0.7-to-1 at year-end
2007. This ratio is a common measure of operating leverage used in the property
casualty industry; the lower the ratio the more capacity a company has for
premium growth. The estimated property casualty industry net written premium to
statutory surplus ratio also was 0.8-to-1 at year-end 2009, 0.9-to-1 at year-end
2008 and 0.8-to-1 at year-end 2007.
Our
second means of verifying our capital preservation strategy is our financial
strength ratings as discussed in Our Business and Our Strategy, Page 1. All of
our insurance subsidiaries continue to be highly rated. A third means is
measurement of our risk-based capital ratios, which currently indicate that our
insurance subsidiaries are operating with a level of capital far exceeding
regulatory requirements.
Improve Insurance Profitability
Our
second strategy is to improve insurance profitability. Implementation of the
operational initiatives below is intended to improve pricing capabilities for
our property casualty business and improve our efficiency. Improved pricing
helps us manage profit margins and greater efficiency helps control costs,
together improving overall profitability. These initiatives also seek to help
the agencies that represent us to grow profitably by allowing them to serve
clients faster and manage expenses better. The primary initiatives to improve
insurance profitability are:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 9
We
measure the overall success of our strategy to improve insurance profitability
primarily through our GAAP combined ratio, which we believe can be
consistently below 100 percent over any five-year period.
In
addition, we expect these initiatives to contribute to our rank as the No. 1 or
No. 2 carrier based on premium volume in agencies that have represented us for
at least five years. In 2009, we again earned that rank in more than 75 percent
of the agencies that have represented Cincinnati Insurance for more than
five years, based on 2008 premiums. We are working to increase the
percentage of agencies where we have achieved that rank.
Drive Premium Growth
Our third
strategy is to drive premium growth. Implementation of the operational
initiatives below is intended to expand our geographic footprint and diversify
our premium sources to obtain profitable growth without significant
infrastructure expense. Diversified growth may also reduce our catastrophe
exposure risk and temper negative changes that may occur in the economic,
judicial or regulatory environments in the territories we serve.
The
primary initiatives to drive premium growth are:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 10
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 11 We
measure the overall success of this strategy to drive premium growth primarily
through changes in net written premiums, which we believe can grow faster than
the industry average over any five-year period. For 2009, our property casualty
net written premiums declined by 3.3 percent, comparing favorably with the
estimated 4.2 percent decline for the industry.
Our Segments
Consolidated
financial results primarily reflect the results of our four reporting segments.
These segments are defined based on financial information we use to evaluate
performance and to determine the allocation of assets.
We also
evaluate results for our consolidated property casualty operations, which is the
total of our commercial lines, personal lines and excess and surplus lines
results.
Revenues,
income before income taxes and identifiable assets for each segment are shown in
a table in Item 8, Note 18 of the Consolidated Financial Statements,
Page 115. Some of that information also is discussed in this section of
this report, where we explain the business operations of each segment.
The financial performance of each segment is discussed in the Item 7,
Management’s Discussion and Analysis of Financial Condition and Results of
Operations, which begins on Page 34.
Commercial
Lines Property Casualty Insurance Segment
The
commercial lines property casualty insurance segment contributed net earned
premiums of $2.199 billion to total revenues, or 56.3 percent of that
total, and reported a loss before income taxes of $35 million in 2009.
Commercial lines net earned premiums declined 5.1 percent and 3.9 percent in
2009 and 2008 after growing 0.4 percent in 2007.
Approximately
95 percent of our commercial lines premiums are written to provide accounts with
coverages from more than one of our business lines. As a result, we believe that
our commercial lines business is best measured and evaluated on a segment basis.
However, we provide line of business data to summarize growth and profitability
trends separately for our business lines. The seven commercial business lines
are:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 12
Our
emphasis is on products that agents can market to small- to mid-size businesses
in their communities. Of our 1,463 reporting agency locations, nine market
only our surety and executive risk products and five market only our
personal lines products. The remaining 1,449 locations, located in
all states in which we actively market, offer some or all of our standard
market commercial insurance products.
In 2009,
our 10 highest volume commercial lines states generated 65.3 percent of our
earned premiums compared with 65.9 percent in the prior year as we
continued efforts to geographically diversify our property casualty risks.
Earned premiums in the 10 highest volume states decreased 5.2 percent in
2009 and decreased 4.8 percent in the remaining 27 states. The number of
reporting agency locations in our 10 highest volume states increased to 933 in
2009 from 905 in 2008.
Commercial Lines Earned Premiums by State
For new
commercial lines business, case-by-case underwriting and pricing is coordinated
by our locally based field marketing representatives. Our agents and our field
marketing, claims, loss control, premium audit, bond and machinery and equipment
representatives get to know the people and businesses in their communities and
can make informed decisions about each risk. These field marketing
representatives also are responsible for selecting new independent agencies,
coordinating field teams of specialized company representatives and promoting
all of the company's products within the agencies they serve.
Commercial
lines policy renewals are managed by headquarters underwriters who are assigned
to specific agencies and consult with local field staff as needed. As part of
our team approach, the headquarters underwriter also helps oversee agency growth
and profitability. They are responsible for formal issuance of all new business
and renewal policies as well as policy endorsements. Further, the headquarters
underwriters provide day-to-day customer service to agencies and marketing
representatives by offering product training, answering
underwriting questions, helping to determine underwriting eligibility and
assisting with the mechanics of premium determination.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 13 Our
commercial lines packages are typically offered on a three-year policy term for
most insurance coverages, a key competitive advantage. In our experience,
multi-year packages appeal to 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.
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 canceled at any time at the discretion of the policyholder. Contract
terms often provide that rates for property, general liability, inland marine
and crime coverages, as well as policy terms and conditions, are fixed for the
term of the policy. The general liability exposure basis may be audited
annually. Commercial auto, workers’ compensation, professional liability and
most umbrella liability coverages within multi-year packages are rated at each
of the policy's annual anniversaries for the next one-year period. The annual
pricing could incorporate rate changes approved by state insurance regulatory
authorities between the date the policy was written and its annual anniversary
date, as well as changes in risk exposures and premium credits or debits
relating to loss experience and other underwriting judgment factors. We
estimate that approximately 75 percent of 2009 commercial premiums were
subject to annual rating or were written on a one-year policy 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 group analyzes opportunities
and develops new products, new coverage options and improvements to existing
insurance products.
At
year-end 2009, we supported our commercial lines operations with a variety of
technology tools. e-CLAS for commercial package business was rolled out to 11
states by year end 2009 with an additional 19 states planned for 2010. This
system allows our agencies to quote and print commercial package policies in
their offices, increasing their ease of doing business with us. The e-CLAS
platform also makes use of our real-time agency interface, CinciBridge®,
which allows the automated movement of key underwriting data from an
agency’s management system to e-CLAS. This reduces agents’ data entry and allows
seamless quoting, rating, and issuance capability. WinCPP® is our
commercial lines premium quoting system. WinCPP is available in all of our
agency locations where we actively market commercial lines insurance
and provides quoting capabilities for nearly 100 percent of our
new and renewal commercial lines business. WinCPP also works with
CinciBridge.
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 e-CLAS system as well. e-CLAS provides full policy lifecycle
transactions, including quoting, issuance, policy changes, renewal processing
and policy printing, at the agency location. These features make it easy and
efficient for our agencies to issue and service these policies. At year-end
2009, e-CLAS for BOP and DBOP was in use in 30 states representing
98 percent of our premiums for these products, which are included in the
specialty packages commercial line of business. e-CLAS also uses CinciBridge to
provide real-time data transfer with agency management systems.
We have
been streamlining internal processes and achieving operational efficiencies in
our headquarters commercial lines operations through deployment of iView™, a
policy imaging and workflow system. This system provides online access to
electronic copies of policy files, enabling our underwriters to respond to agent
requests and inquiries more quickly and efficiently. iView also automates
internal workflows through electronic routing of underwriting and processing
work tasks. At year-end 2009, more than 99 percent of in-force non-workers’
compensation commercial lines policy files were administered and stored
electronically in iView. In 2010, we plan to add our workers’ compensation
policies to i-View.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 14 Personal Lines Property Casualty Insurance Segment
The
personal lines property casualty insurance segment contributed net earned
premiums of $685 million to total revenues, or 17.6 percent of the total,
and reported a loss before income taxes of $81 million in 2009. Personal
lines net earned premiums declined 0.6 percent in 2009, 3.4 percent in 2008 and
6.3 percent in 2007.
We prefer
to write personal lines coverage in accounts that include both auto and
homeowner coverages as well as coverages that are part of our other personal
business line. As a result, we believe that our personal lines business is best
measured and evaluated on a segment basis. However, we provide line of business
data to summarize growth and profitability trends separately for three
business lines:
At
year-end, we marketed personal lines insurance products through 1,059 of our
1,463 reporting agency locations in 29 of the 37 states in which we offer
standard market commercial lines insurance. As discussed in Strategic
Initiatives, Page8, introducing personal lines to these agencies is one of
the ways we intend to grow profitably in the next several years. The number of
reporting agency locations in our 10 highest volume states increased more
than 5 percent to 660 in 2009 from 627 in 2008.
In 2009,
our 10 highest volume personal lines states generated 84.1 percent of our earned
premiums compared with 85.1 percent in the prior year. Earned premiums in the
10 highest volume states declined 1.7 percent in 2009 while
increasing 5.9 percent in the remaining states.
Personal Lines Earned Premiums by State
New and
renewal personal lines business reflects our risk-specific underwriting
philosophy. Each agency selects personal lines business primarily from within
the geographic territory that it serves, based on the agent’s knowledge of the
risks in those communities or familiarity with the policyholder. Personal lines
activities are supported by headquarters associates assigned to individual
agencies. We now have seven full-time personal lines marketing
representatives, who have underwriting authority and visit agencies on a regular
basis. They reinforce the advantages of our personal lines products and offer
training in the use of our processing system.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 15 Competitive
advantages of our personal lines operation include broad coverage forms,
flexible underwriting, superior claims service, generous credit structure and
customizable endorsements for both the personal auto and homeowner policies. Our
personal lines products are processed through Diamond, our real-time personal
lines policy processing system that supports and allows once-and-done
processing. Diamond incorporates features frequently requested by our agencies
such as direct bill and monthly payment plans, local and headquarters policy
printing options, data transfer to and from popular agency management systems
and real-time integration with third-party data such as insurance scores, motor
vehicle reports and address verification. The new web-based version of Diamond
that was released to our agents in the first quarter of 2010 provides
significant improvements, including more user-friendly screens and workflow plus
other features such as a pre-fill option to reduce key strokes for improved
efficiency.
In 2006,
we introduced PL-efiles, a policy imaging system, to our personal lines
operations. The transition was completed in 2009 and replaces paper format
with electronic copies of policy documents. PL-efiles complements the Diamond
system by giving personal lines underwriters and support staff online access to
policy documents and data, enabling them to respond to agent requests and
inquiries quickly and efficiently. The underlying technology is updated and
permits us to offer access to policy documents directly to policyholders in
2010. We intend to focus on nonrevenue bearing services that allow our agencies
to concentrate on more important services and sales. In early 2009 the
convenience of paying premiums online or over the phone was introduced to our
directly-billed personal lines policyholders.
Life Insurance Segment
The life
insurance segment contributed $143 million of net earned premiums,
representing 3.7 percent of total revenues, and $2 million of income before
income taxes in 2009. Life insurance segment profitability is discussed in
detail in Item 7, Life Insurance Results of Operations, Page 62.
Life insurance net earned premiums grew 13.0 percent in 2009,
0.8 percent in 2008 and 9.0 percent in 2007.
The
Cincinnati Life Insurance Company supports our agency-centered business model.
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 2009, almost 85 percent of our
1,463 property casualty reporting agency locations offered Cincinnati
Life’s products to their clients. We also develop life business from
approximately 500 other independent life insurance agencies. We are careful to
solicit business from these other agencies in a manner that does not conflict
with or compete with the marketing and sales efforts of our property casualty
agencies.
When
marketing through our property casualty agencies, we have specific competitive
advantages:
We
continue to emphasize the cross-serving opportunities of our life insurance,
including term and worksite products, for the property casualty agency’s
personal and commercial accounts. In both the property casualty and independent
life agency distribution systems, we enjoy the advantages of offering
competitive, up-to-date products, providing close personal attention in
combination with financial strength and stability.
Because
of our strong capital position, we can offer a competitive product portfolio
including guaranteed products, giving our agents a marketing edge. Our life
insurance company maintains strong insurer financial strength ratings: A.M. Best
– A (Excellent), Fitch – A+ (Strong) and Standard & Poor's –
A+ (Strong), as discussed in Financial Strength, Page 3. Our life insurance
company has chosen not to establish a Moody’s rating.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 16 Life
Insurance Business Lines
Four
lines of business – term insurance, universal life insurance, worksite products
and whole life insurance – account for approximately 96.4 percent of the
life insurance segment’s revenues:
In
addition, Cincinnati Life markets:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 17 Investment Segment
Revenues
of the investment segment are primarily from net investment income and from
realized investment gains and losses from investment portfolios managed for the
holding company and each of the operating subsidiaries. After adding back $69
million in interest credited to contract holders of the life insurance segment,
the investment segment contributed $837 million, or 21.5 percent, of our total
revenues in 2009. After deducting $69 million in interest credited to
contract holders of the life insurance segment, the investment segment
contributed $768 million of income before income taxes.
In 2008,
our investment department adopted internal guidelines to place additional
parameters around our portfolio, with the approval of the investment committee
of the board of directors. These parameters address, among other issues, the
overall mix of the portfolio as well as security and sector concentrations. The
parameters came out of our risk management program, with the goal of more
specifically defining our risk tolerances, aligning our operating plan
accordingly and improving management’s ability to identify and respond to
changing conditions. Going forward, we will evaluate all of our fixed-maturity
and equity investments using our investment parameters, as
appropriate.
The fair
value of our investment portfolio was $10.562 billion and $8.807 billion at
year-end 2009 and 2008, respectively. The overall portfolio remained in an
unrealized gain position as gains harvested from equity rebalancing efforts were
more than offset by the strong performance of the bond portfolio.
The cash
we generate from insurance operations historically has been invested in three
broad categories of investments:
We
actively determine the portion of new cash flow to be invested in fixed-maturity
and equity securities at the parent and insurance subsidiary levels. We consider
internal measures, as well as insurance department regulations and ratings
agency guidance. We monitor a variety of metrics, including after-tax yields,
the ratio of investments in common stocks to statutory surplus for the property
casualty and life insurance operations, and the parent company's ratio of
investment assets to total assets.
At
year-end 2009, less than 1 percent of the value of our investment portfolio was
made up of securities that do not actively trade on a public market and require
management’s judgment to develop pricing or valuation techniques (Level 3
assets). We generally obtain at least two outside valuations for these assets
and generally use the more conservative estimate. These investments include
private placements, small issues and various thinly traded securities. See Item
7, Fair Value Measurements, Page 43, and Item 8, Note 3 of the Consolidated
Financial Statements Page 103, for additional discussion of our valuation techniques.
In
addition to securities held in our investment portfolio, at year-end 2009, other
invested assets included $40 million of life policy loans, $24 million of
venture capital fund investments, $6 million of investment in real estate and
$11 million of other invested assets.
Fixed-maturity
and Short-term Investments
By
maintaining a well diversified fixed-maturity portfolio, we attempt to manage
overall interest rate, reinvestment, credit and liquidity risk. We pursue a buy
and hold strategy and do not attempt to make large scale changes to the
portfolio in anticipation of rate movements. By investing new money on a regular
basis and analyzing risk-adjusted after-tax yields, we work to achieve a
laddering effect to our portfolio that may mitigate some of the effects of
adverse interest rate movements.
Fixed-maturity
and Short-term Portfolio Ratings
As of
year-end 2009, the portfolio was trading at 104.5 percent of its book value, up
from last year as credit spreads tightened considerably.
The
portfolio grew significantly in 2009 due to a large volume of purchases. These
purchases were most concentrated in the investment grade corporate bond market,
particularly in the Baa/BBB ratings range.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 18 This
had the effect of increasing our year-end percentage of investment grade
bonds, those rated Baa/BBB or higher, by one percentage point to 92.5
percent. The majority of our non-rated securities are tax-exempt municipal
bonds from smaller municipalities that chose not to pursue a credit rating.
Credit ratings as of December 31 for the fixed-maturity and short-term portfolio
were:
We
discuss the maturity of our fixed-maturity portfolio in Item 8, Note 2 of the
Consolidated Financial Statements, Page 100. Attributes of the fixed-maturity
portfolio include:
Taxable Fixed Maturities
Our
taxable fixed-maturity portfolio (at fair value) at year-end 2009
included:
While our
strategy typically is to buy and hold fixed-maturity investments to maturity, we
monitor credit profiles and fair value movements when determining holding
periods for individual securities. With the exception of U.S. agency paper
(government-sponsored entities), no individual issuer's securities
accounted for more than 1.3 percent of the taxable fixed-maturity portfolio
at year-end 2009.
The
investment-grade corporate bond portfolio is most heavily concentrated in the
financial-related sectors, including banks, brokerage, finance and investment
and insurance companies. The financial sectors represented 25.3 percent of fair
value of this portfolio at year-end 2009, compared with 30.7 percent,
at year-end 2008. Although the financial-related sectors make up our
largest group of investment-grade corporate bonds, we believe our concentration
is below the average for the corporate bond market as a whole. Energy and
utilities are the only other sectors that exceed 10 percent of our
investment-grade corporate bond portfolio, at 11.9 and 10.4 percent of fair
value respectively at year end 2009.
Tax-exempt
Fixed Maturities
We
traditionally have purchased municipal bonds focusing on general obligation and
essential services, such as sewer, water or others. While no single municipal
issuer accounted for more than 0.6 percent of the tax-exempt municipal bond
portfolio at year-end 2009, there are higher concentrations within individual
states. Holdings in Texas and Indiana accounted for a total of 31.9 percent
of the municipal bond portfolio at year-end 2009.
At
year-end 2009, bonds representing $2.295 billion, or 76.7 percent, of the fair
value of our municipal portfolio were insured with an average rating of AAA.
Because of our emphasis on general obligation and essential services bonds, over
90 percent of the insured municipal bonds have an underlying rating of at least
A3 or A-.
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 2009, we had $6 million of short-term investments compared with
$84 million at year-end 2008.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 19 Equity Investments
After
covering both our intermediate and long-range insurance obligations with
fixed-maturity investments, we historically used available cash flow to
invest in equity securities. Investment in equity securities has
played an important role in achieving our portfolio objectives and has
contributed to portfolio appreciation. We remain committed to our
long-term equity focus, which we believe is key to our company’s long-term
growth and stability.
At
December 31, 2009, two holdings had a fair value equal to or greater than 5
percent of our publicly-traded common stock portfolio compared with four similar
holdings at year-end 2008. Procter & Gamble (NYSE:PG) is our largest single
common stock investment, comprising 5.8 percent of the publicly traded common
stock portfolio and 1.4 percent of the investment portfolio. The other stock
with a fair value greater than 5 percent of our publicly-traded common stock
portfolio is Johnson & Johnson (NYSE:JNJ).
Common Stocks
Our
common stock investments generally are dividend-paying securities that vary from
those with high current yield to others with lower yields but better growth
prospects. Other criteria we evaluate include increasing sales and earnings,
proven management and a favorable outlook. We believe our equity investment
style is an appropriate long-term strategy after we have purchased
fixed-maturity investments to cover our insurance reserves.
In
mid-2008, we began applying new investment guidelines that increased portfolio
diversification, reducing single issue and sector concentrations. Our year-end
2009 portfolio has been positioned for reduced volatility going forward. We view
our diversifying actions to be consistent with our view of prudent risk
management. We expect to continue to make changes to the portfolio, as
deemed appropriate.
Common
Stock Portfolio Industry Sector Distribution
At
year-end 2009, 26.2 percent of our common stock holdings (measured by fair
value) were held at the parent company level. For the publicly-traded
common stock portfolio on a consolidated basis, no single issue accounted for
more than 5.8 percent at year-end 2009. Until June 2008, we had held
more than 10 percent of Fifth Third’s common stock for many years, and it
represented over 25 percent of our common stock holdings as recently as December
31, 2007.
Preferred Stocks
We
evaluate preferred stocks in a manner similar to the evaluation we make for
fixed-maturity investments, seeking attractive relative yields. We generally
focus on investment-grade preferred stocks issued by companies that have a
strong history of paying common dividends, providing us with another layer of
protection. When possible, we seek out preferred stocks that offer a dividend
received deduction for income tax purposes. Events in the fall of 2008 and into
early 2009 led us to reevaluate the riskiness of all preferred securities,
particularly those of banking institutions. As a result, we downsized this
portfolio by $82 million of fair value to $93 million.
Additional
information regarding the composition of investments is included in Item 8, Note
2 of the Consolidated Financial Statements, Page 100.
Other
We report
as Other the other income of our standard market property casualty insurance
subsidiary, as well as non-investment operations of the parent company and its
subsidiary CFC Investment Company. Beginning 2008, we also included results
of our excess and surplus lines operations, The Cincinnati Specialty
Underwriters Insurance Company and CSU Producer Resources.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 20 CFC Investment Company
CFC
Investment Company offers commercial leasing and financing services to our
agents, their clients and other customers. As of year-end 2009,
CFC Investment Company had 2,286 accounts and $76 million in receivables,
compared with 2,197 accounts and $71 million in receivables at
year-end 2008.
Excess
and Surplus Lines Property Casualty Insurance
Agencies
have access to The Cincinnati Specialty Underwriters Insurance Company’s product
line through CSU Producer Resources, the wholly owned insurance brokerage
subsidiary of parent-company Cincinnati Financial Corporation. CSU Producer
Resources has binding authority on all classes of business written through CSU
and maintains appropriate agent and excess and surplus lines licenses to process
non-admitted business.
Agents
can submit risks to CSU Producer Resources, reflecting the mix of accounts
Cincinnati agencies currently write in their non-admitted excess and surplus
lines markets. CSU Producer Resources currently markets and underwrites
commercial general liability, property, excess liability and miscellaneous
errors and omissions coverages in 37 states.
Agency
producers have direct access through CSU Producer Resources to a group of our
underwriters who focus exclusively on excess and surplus lines business. Those
underwriters can tap into their agencies’ broader Cincinnati relationships to
bring their policyholders services such as experienced and responsive loss
control and claims handling. Our excess and surplus lines policy administration
system delivers electronic copies of policies to producers within minutes of
underwriting approval and policy issue. CSU Producer Resources gives extra
support to our producers by remitting excess and surplus lines taxes and
stamping fees and retaining admitted market affidavits,
where required.
Regulation
The
business of insurance primarily is regulated by state law. All of our insurance
company subsidiaries are domiciled in the State of Ohio, except The Cincinnati
Specialty Underwriters Insurance Company, which is domiciled in the State of
Delaware. Each insurance subsidiary is governed by the insurance laws and
regulations in its respective state of domicile. We also are subject to state
regulatory authorities of all states in which we write insurance. The state laws
and regulations that have the most significant effect on our insurance
operations and financial reporting are discussed below.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 21
Although
the federal government and its regulatory agencies generally do not directly
regulate the business of insurance, federal initiatives can affect our business.
We do not expect to have any material effects on our expenditures, earnings or
competitive position as a result of compliance with any federal, state, or local
provisions enacted or regulated relating to the protection of the environment.
We currently do not have any material estimated capital expenditures for
environmental control facilities.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 22 Item 1A. Risk Factors
Our
business involves various risks and uncertainties that may affect achievement of
our business objectives. Many of the risks could have ramifications across our
organization. For example, while risks related to setting insurance rates and
establishing and adjusting loss reserves are insurance activities, errors in
these areas could have an impact on our investment activities, growth and
overall results.
The
following discussion should be viewed as a starting point for understanding the
significant risks we face. It is not a definitive summary of their potential
impacts or of our strategies to manage and control the risks. Please see Item 7,
Management’s Discussion and Analysis of Financial Condition and Results of
Operations, Page 34, for a discussion of those strategies.
The risks
and uncertainties discussed below are not the only ones we face. There are
additional risks and uncertainties that we 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.
Certain
events or conditions 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, changes in the strategy
or operations of agencies or the choice of agencies to reduce their writings of
our products could affect our results of operations if we were 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.
We
could experience an unusually high level of losses due to catastrophic, pandemic
or terrorism events or risk concentrations.
In the
normal course of our business, we provide coverage against perils for which
estimates of losses are highly uncertain, in particular catastrophic and
terrorism events. Catastrophes can be caused by a number of events, including
hurricanes, tornadoes, windstorms, earthquakes, hailstorms, explosions, severe
winter weather and fires. Due to the nature of these events, we are unable to
predict precisely the frequency or potential cost of catastrophe occurrences.
The extent of losses from a catastrophe is a function of both the total amount
of insured exposure in the area affected by the event and the severity of the
event. Our ability
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 23 to
appropriately manage catastrophe risk depends partially on catastrophe models,
the accuracy of which may be affected by inaccurate or incomplete data, the
uncertainty of the frequency and severity of future events and the uncertain
impact of climate change.
The
geographic regions in which we market insurance are exposed to numerous natural
catastrophes, such as:
The
occurrence of terrorist attacks in the geographic areas we serve could result in
substantially higher claims under our insurance policies than we have
anticipated. While we do insure terrorism risk in all areas we serve, we have
identified our major terrorism exposure as general commercial risks in the
metropolitan Chicago area, small co-op utilities, small shopping malls and small
colleges throughout our 37 active states, and, because of the number of
associates located there, our Fairfield headquarters. Additionally, our life
insurance subsidiary could be adversely affected in the event of a terrorist
event or an epidemic such as the avian or swine flu, particularly if the
epidemic were to affect a broad range of the population beyond just the very
young or the very old. Our associate health plan is self-funded and could
similarly be affected.
Our
results of operations would be adversely affected if the level of losses we
experience over a period of time were to exceed our actuarially determined
expectations. In addition, our financial condition would be adversely affected
if we were required to sell securities prior to maturity or at unfavorable
prices to pay an unusually high level of loss and loss expenses. Securities
pricing might be even less favorable if a number of insurance companies needed
to sell securities during a short period of time because of unusually high
losses from catastrophic events.
Our
geographic concentration ties our performance to business, economic,
environmental and regulatory conditions in certain states. We market our
property casualty insurance products in 37 states, but our business is
concentrated in the Midwest and Southeast. We also have exposure in states where
we do not actively market insurance when clients of our independent agencies
have businesses or properties in multiple states.
The
Cincinnati Insurance Company also participates in three assumed reinsurance
treaties with two reinsurers that spread the risk of very high catastrophe
losses among many insurers. In 2009, the largest treaty had 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.
In the
event of a severe catastrophic event or terrorist attack elsewhere in the world,
our insurance losses may be immaterial. However, the companies in which we
invest might be severely affected, which could affect our financial condition
and results of operations. Our reinsurers might experience significant losses,
potentially jeopardizing their ability to pay losses we cede to them. We also
may be exposed to state guaranty fund assessments if other carriers in a state
cannot meet their obligations to policyholders. A catastrophe or epidemic event
also could affect our operations by damaging our headquarters facility, injuring
associates and visitors at our Fairfield, Ohio, headquarters or disrupting our
associates’ ability to perform their assigned tasks.
Our
ability to achieve our performance objectives could be affected by changes in
the financial, credit and capital markets or the general economy.
We invest
premiums received from policyholders and other available cash to generate
investment income and capital appreciation, maintaining sufficient liquidity to
pay covered claims and operating expenses, service our debt obligations and pay
dividends.
Investment
income is an important component of our revenues and net income. The ability to
increase investment income and generate longer-term growth in book value is
affected by factors that are beyond our control, such as inflation, economic
growth, interest rates, world political conditions, changes in laws and
regulations, terrorism attacks or threats, adverse events affecting other
companies in our industry or the industries in which we invest, market events
leading to credit constriction and other widespread unpredictable events. These
events may adversely affect the economy generally and could cause our investment
income or the value of securities we own to decrease. A significant decline in
our investment income could have an adverse effect on our net income, and
thereby on our shareholders’ equity and our policyholders’ surplus. For more
detailed discussion of risks associated with our investments, please refer to
Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 82.
We issue
life contracts with guaranteed minimum returns, referred to as bank-owned life
insurance contracts (BOLIs). BOLI investment assets must meet certain criteria
established by the regulatory authorities in which jurisdiction the group
contract holder is subject. Therefore, sales of investments may be mandated to
maintain compliance with these regulations, possibly requiring gains or losses
to be recorded.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 24 We could
experience losses if the assets in the accounts were less than liabilities at
the time of maturity or termination. We discuss other risks associated with our
separate account BOLIs in Item 7, Critical Accounting Estimates, Separate
Accounts, Page 45.
Deterioration
in the banking sector or in banks with which we have relationships could affect
our results of operations. Our ability to maintain or obtain short-term lines of
credit could be affected if the banks from which we obtain these lines are
purchased, fail or are otherwise negatively affected. We may lose premium if a
bank that owns appointed agencies were to change its strategies. We could
experience increased losses in our director and officer liability line of
business if claims were made against insured
financial institutions.
Our
investment performance also could suffer because of the types 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 2009, common stock holdings made up 24.5 percent of our invested
assets. Adverse news or events affecting the global or U.S. economy or the
equity markets could affect our net income, book value and overall results as
well as our ability to pay our common stock dividend. See Item 7, Investments
Results of Operations, Page 64, and Item 7A, Quantitative and Qualitative
Disclosures About Market Risk, Page 82, for discussion of our investment
activities.
Deteriorating
credit and market conditions could also impair our ability to access credit
markets and could affect existing or future lending arrangements.
Our
overall results could be affected if a significant portion of our commercial
lines policyholders, including those purchasing surety bonds, are adversely
affected by marked or prolonged economic downturns and events such as a downturn
in construction and related sectors, tightening credit markets and higher fuel
costs. Such events could make it more difficult for policyholders to finance new
projects, complete projects or expand their businesses, leading to lower
premiums from reduced payrolls and sales and lower purchases of equipment and
vehicles. These events could also cause claims, including surety claims, to
increase due to a policyholder’s inability to secure necessary financing to
complete projects or to collect on underlying lines of credit in the claims
process. Such economic downturns and events could have a greater impact in the
construction sector where we have a concentration of risks and in geographic
areas that are hardest hit by economic downturns.
Deteriorating
economic conditions could also increase the degree of credit risk associated
with amounts due from independent agents who collect premiums for payment to us
and could hamper our ability to recover amounts due from
reinsurers.
Our
ability to properly underwrite and price risks and increased competition could
adversely affect our results.
Our
financial condition, cash flow and results of operations depend on our ability
to underwrite and set rates accurately for a full spectrum of risks. We
establish our pricing based on assumptions about the level of losses that may
occur within classes of business, geographic regions and other
criteria.
To
properly price our products, we must collect and properly analyze data; the data
must be sufficient, reliable and accessible; we need to develop appropriate
rating methodologies and formulae; and we may need to identify and respond to
trends quickly. Inflation trends, especially outside of historical norms, may
make it more difficult to determine adequate pricing. 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.
Our
ability to set appropriate rates could be hampered if a state or states where we
write business refuses to allow rate increases that we believe are necessary to
cover the risks insured. At least one state requires us to purchase reinsurance
from a mandatory reinsurance fund. Such reinsurance funds can create a credit
risk for insurers if not adequately funded by the state and, in some cases, the
existence of a reinsurance fund could affect the prices charged for our
policies. The effect of these and similar arrangements could reduce our
profitability in any given period or limit our ability to grow our
business.
The
insurance industry is cyclical and intensely competitive. From time to time, the
insurance industry goes through prolonged periods of intense competition during
which it is more difficult to attract new business, retain existing
business and maintain profitability. Competition in our insurance business is
based on many factors, including:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 25
If our
pricing were incorrect or we were unable to compete effectively because of one
or more of these factors, our premium writings could decline and our results of
operations and financial condition could be materially
adversely affected.
Please
see the discussion of our Commercial Lines, Personal Lines and Life Insurance
Segments in Item 1, Page 12, Page 15 and Page 16, for a discussion of our
competitive position in the insurance marketplace.
Our
loss reserves, our largest liability, are based on estimates and could be
inadequate to cover our actual losses.
Our
consolidated financial statements are prepared using GAAP. These principles
require us to make estimates and assumptions that affect the amounts reported in
the Consolidated Financial Statements and accompanying Notes. Actual results
could differ materially from those estimates. For a discussion of the
significant accounting policies we use to prepare our financial statements and
the material implications of uncertainties associated with the methods,
assumptions and estimates underlying our critical accounting policies, please
refer to Item 8, Note 1 of the Consolidated Financial Statements,
Page 94, and Item 7, Critical Accounting Estimates, Property Casualty
Insurance Loss and Loss Expense Reserves and Life Insurance Policy Reserves,
Page 38 and
Page 42. Our most
critical accounting estimate is loss reserves. Loss reserves are the amounts we
expect to pay for covered claims and expenses we incur to settle those claims.
The loss reserves we establish in our financial statements represent an estimate
of amounts needed to pay and administer claims arising from insured events that
have already occurred, including events that have not yet been reported to us.
Loss reserves are estimates and are inherently uncertain; they do not and
cannot represent an exact measure of liability. Inflationary scenarios,
especially scenarios outside of historical norms, may make it more
difficult to estimate loss reserves. Accordingly, our loss reserves for past
periods could prove to be inadequate to cover our actual losses and related
expenses. Any changes in these estimates are reflected in our results of
operations during the period in which the changes are made. An increase
in our loss reserves would decrease earnings, while a decrease in our loss
reserves would increase earnings.
The
estimation process for unpaid loss and loss expense obligations involves
uncertainty by its very nature. We continually review the estimates and adjust
the reserves as facts about individual claims develop, additional losses are
reported and new information becomes known. Adjustments due to loss development
on prior periods are reflected in the calendar year in which they are
identified. The process used to determine our loss reserves is discussed in
Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and
Loss Expense Reserves and Life Insurance Policy Reserves, Page 38 and Page 42.
Unforeseen
losses, the type and magnitude of which we cannot predict, may emerge in the
future. These additional losses could arise from changes in the legal
environment, laws and regulations, climate change, catastrophic events,
increases in loss severity or frequency, or other causes. Such future losses
could be substantial.
Our
ability to obtain or collect on our reinsurance protection could affect our
business, financial condition, results of operations and cash
flows.
We buy
property casualty and life reinsurance coverage to mitigate the liquidity risk
of an unexpected rise in claims severity or frequency from catastrophic events
or a single large loss. The availability, amount and cost of reinsurance depend
on market conditions and may vary significantly. If we were unable to obtain
reinsurance on acceptable terms and in appropriate amounts, our business and
financial condition could 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-tail claims, the creditworthiness of our
reinsurers may change before we can recover amounts to which we are entitled. A
reinsurer’s insolvency, inability or unwillingness to make payments under the
terms of its reinsurance agreement with our insurance subsidiaries could have a
material adverse effect on our financial position, results of operations and
cash flows.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 26 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. Our participation was terminated after
policy year 2002. At year-end 2009, 31 percent, or $212 million, of
our total reinsurance receivables were related to USAIG, primarily for events of
September 11, 2001, offset by $221 million of amounts ceded to other pool
participants and reinsurers. If the pool participants and reinsurers were unable
to fulfill their financial obligations and all security collateral that supports
the participants’ obligations became worthless, we could be liable for an
additional pool liability of $288 million and our financial position and
results of operations could be materially affected. Currently all pool
participants and reinsurers are financially solvent.
Please
see Item 7, 2010 Reinsurance Programs, Page 79, for a discussion of our
reinsurance treaties.
Our
business depends on the uninterrupted operation of our facilities, systems and
business functions.
Our
business depends on our associates’ ability to perform necessary business
functions, such as processing new and renewal policies and claims. We
increasingly rely on technology and systems to accomplish these business
functions in an efficient and uninterrupted fashion. Our inability to access our
headquarters facilities or a failure of technology, telecommunications or other
systems could significantly impair our ability to perform such functions on a
timely basis or affect the accuracy of transactions. If sustained or repeated,
such a business interruption or system failure could result in a deterioration
of our ability to write and process new and renewal business, serve our agents
and policyholders, pay claims in a timely manner, collect receivables or perform
other necessary business functions. If our disaster recovery and business
continuity plans did not sufficiently consider, address or reverse the
circumstances of an interruption or failure, this could result in a materially
adverse effect on our operating results and financial condition. This risk is
exacerbated because approximately 70 percent of our associates work at our
Fairfield, Ohio, headquarters.
The
effects of changes in industry practices and regulations on our business are
uncertain.
As
industry practices and legal, judicial, legislative, regulatory, political,
social and other environmental conditions change, unexpected and unintended
issues related to insurance pricing, claims and coverage, may emerge. These
issues may adversely affect our business by impeding our ability to obtain
adequate rates for covered risks, extending coverage beyond our underwriting
intent or by increasing the number or size of claims. In some instances,
unforeseeable emerging and latent claim and coverage issues may not become
apparent until some time after we have issued the insurance policies that could
be affected by the changes. As a result, the full extent of liability under our
insurance contracts may not be known for many years after a policy is
issued.
Further,
the National Association of Insurance Commissioners (NAIC), state insurance
regulators and state legislators continually re-examine existing laws and
regulations governing insurance companies and insurance holding companies,
specifically focusing on modifications to statutory accounting principles,
interpretations of existing laws, regulations relating to product forms and
pricing methodologies and the development of new laws and regulations that
affect a variety of financial and nonfinancial components of our business.
Any proposed or future legislation, regulation or NAIC initiatives, if adopted,
may be more restrictive on our ability to conduct business than current
regulatory requirements or may result in higher costs.
Federal
laws and regulations, including those that may be enacted in the wake of the
financial and credit crises, may have adverse affects on our business,
potentially including a change from a state-based system of regulation to a
system of federal regulation, the repeal of the McCarran Ferguson Act and/or the
establishment of an insurance office in Department of Treasury. While we do not
participate or intend to seek to participate in the Troubled Asset Relief
Program, the effect of it or any similar legislation on our industry,
particularly competition from insurers that do participate, and the economy in
general is uncertain.
The
effects of such changes could adversely affect our results of operations. Please
see Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and
Loss Expense Reserves and Life Insurance Policy Reserves, Page 38 and Page 42, for a discussion of our reserving practices.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 27 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 effectiveness and user
acceptance of the end product. These issues could escalate over time. If we were
unable to find and retain employees with key technical knowledge, our ability to
develop and deploy key technology solutions could be hampered.
We
necessarily collect, use and hold data concerning individuals and businesses
with whom we have a relationship. Threats to data security rapidly emerge and
change, exposing us to rising costs and competing time constraints to secure our
data in accordance with customer expectations and statutory and regulatory
requirements. A breach of our security that results in unauthorized access to
our data could expose us to data loss, litigation, damages, fines and penalties,
significant increases in compliance costs and reputational damage.
Please
see Item 1, Strategic Initiatives, Page 8 for a discussion of our technology
initiatives.
Our
status as an insurance holding company with no direct operations could affect
our ability to pay dividends in the future.
Cincinnati
Financial Corporation is a holding company that transacts substantially all of
its business through its subsidiaries. Our primary assets are the stock in
our operating subsidiaries and our investments. Consequently, our cash flow
to pay cash dividends and interest on our long-term debt depends on dividends we
receive from our operating subsidiaries and income earned on investments held at
the parent-company level.
Dividends
paid to our parent company by our insurance subsidiary are restricted by the
insurance laws of Ohio, its domiciliary state. These laws establish minimum
solvency and liquidity thresholds and limits. Currently, the maximum dividend
that may be paid without prior regulatory approval is limited to the greater of
10 percent of statutory surplus or 100 percent of statutory net income for
the prior calendar year, up to the amount of statutory unassigned surplus as of
the end of the prior calendar year. Dividends exceeding these limitations may be
paid only with prior approval of the Ohio Department of Insurance. Consequently,
at times, we might not be able to receive dividends from our insurance
subsidiary, or we might not receive dividends in the amounts necessary to meet
our debt obligations or to pay dividends on our common stock without liquidating
securities. This could affect our financial position.
Please
see Item 1, Regulation, Page 21, and Item 8, Note 9 of the Consolidated
Financial Statements, Page 106, for discussion of insurance holding company
dividend regulations.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 28 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 has approximately 1,508,200 total
square feet of available space. The property, including land, is carried in our
financial statements at $165 million as of December 31, 2009, and
is classified as land, building and equipment, net, for company use.
John J. & Thomas R. Schiff & Co. Inc.,
a related party, occupies approximately 6,750 square feet (less than
1 percent).
Cincinnati
Financial Corporation also owns the Fairfield Executive Center, which is located
on the northwest corner of our headquarters property. This four-story office
building has approximately 124,000 square feet of available space. The
property is carried in the financial statements at $6 million as of
December 31, 2009, and is classified as an other invested asset.
Unaffiliated tenants occupy approximately 8 percent. All unoccupied space
is currently available for lease.
The
Cincinnati Insurance Company owns a building used for business continuity, with
approximately 48,000 square feet of available space, located approximately
six miles from our headquarters. The property, including land, is carried
on our financial statements at $10 million as of
December 31, 2009, 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 2009.
Part II
Item 5. Market
for the Registrant’s Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity
Securities
Cincinnati
Financial Corporation had approximately 13,000 shareholders of record and
approximately 36,000 beneficial shareholders as of
December 31, 2009. Many of our independent agent representatives and
most of the 4,170 associates of our subsidiaries own the company’s common stock.
We are unable to quantify those holdings because many are beneficially
held.
Our
common shares are traded under the symbol CINF on the Nasdaq Global Select
Market.
We
discuss the factors that affect our ability to pay cash dividends and repurchase
shares in Item 7, Liquidity and Capital Resources, Page 68. One factor we
address is regulatory restrictions on the dividends our insurance subsidiary can
pay to the parent company, which also is discussed in Item 8, Note 9
of the Consolidated Financial Statements, Page 106.
The
following summarizes securities authorized for issuance under our equity
compensation plans as of December 31, 2009:
The
number of securities remaining available for future issuance includes: 7,354,695
shares available for issuance under the Cincinnati Financial Corporation 2006
Stock Compensation Plan, which can be issued as stock options, service-based, or
performance-based restricted stock units, stock appreciation rights or other
equity-based grants; 72,158 shares of stock options available for issuance under
the Cincinnati Financial Corporation Stock Option Plan VII and
300,000 shares available for issuance of share grants under the Director’s Stock
Plan of 2009, which was approved by shareholders during 2009. Additional
information about stock-based associate compensation granted under our equity
compensation plans is available in Item 8, Note 17 of the Consolidated Financial
Statements, Page 113.
We did
not sell any of our shares that were not registered under the Securities Act
during 2009. The board of directors has authorized share repurchases since
1996. Purchases are expected to be made generally
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 30 through
open market transactions. The board gives management discretion to
purchase shares at reasonable prices in light of circumstances at the time
of purchase, subject to SEC regulations.
On
October 24, 2007, the board of directors expanded the existing repurchase
authorization to approximately 13 million shares. The prior repurchase
program for 10 million shares was announced in 2005, replacing a program that
had been in effect since 1999. No repurchase program has expired during the
period covered by the above table. All of the publicly announced plan
repurchases in the table above were made under the expansion announced in
October 2007 of our 2005 program. Neither the 2005 nor 1999 program had an
expiration date, but no further repurchases will occur under the
1999 program.
Cumulative Total Return
As
depicted in the graph below, the five–year total return on a $100 investment
made December 31, 2004, assuming the reinvestment of all dividends,
was a negative 23.3 percent for Cincinnati Financial Corporation’s common stock
compared with a negative 7.3 percent for the Standard & Poor’s Composite
1500 Property & Casualty Insurance Index and a 2.1 percent return for the
Standard & Poor’s 500 Index.
The
Standard & Poor’s Composite 1500 Property & Casualty Insurance Index
includes 25 companies: Allstate Corporation, American Physicians Capital,
Amerisafe Inc., Berkley (W R) Corporation, Chubb Corporation, Cincinnati
Financial Corporation, Employers Holdings Inc., Fidelity National Financial
Inc., First American Corporation, Hanover Insurance Group Inc.,
Infinity Property & Casualty Corporation, Mercury General Corporation,
Navigators Group Inc., Old Republic International Corporation, Proassurance
Corporation, Progressive Corporation, RLI Corporation, Safety Insurance Group
Inc., Selective Insurance Group Inc., Stewart Information Services, Tower Group
Inc., Travelers Companies Inc., United Fire & Casualty Company, XL
Capital Ltd. and Zenith National Insurance Corporation.
The
Standard & Poor’s 500 Index includes a representative sample of 500 leading
companies in a cross section of industries of the U.S. economy. Although this
index focuses on the large capitalization segment of the market, it is widely
viewed as a proxy for the total market.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 31 Item 6. Selected Financial Data
Per share
data adjusted to reflect all stock splits and dividends prior to December 31,
2009.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 32
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 33 Item 7. Managements Discussion and Analysis of Financial Condition and Results of
Operations
Introduction
The
purpose of Management’s Discussion and Analysis is to provide an understanding
of Cincinnati Financial Corporation’s consolidated results of operations and
financial condition. Our Management’s Discussion and Analysis should be read in
conjunction with Item 6, Selected Financial Data, Pages 32 and
Page 33 and Item
8, Consolidated Financial Statements and related Notes, beginning on Page 87. We
present per share data on a diluted basis unless otherwise noted, adjusting
those amounts for all stock splits and stock dividends.
We begin
with an executive summary of our results of operations and outlook, as well as
details on critical accounting policies and estimates. Periodically, we
refer to estimated industry data so that we can give information on our
performance within the context of the overall insurance industry. Unless
otherwise noted, the industry data is prepared by A.M. Best, a leading
insurance industry statistical, analytical and financial strength rating
organization. Information from A.M. Best is presented on a statutory basis.
When we provide our results on a comparable statutory basis, we label it as
such; all other company data is presented in accordance with
accounting principles generally accepted in the United States of America
(GAAP).
Executive Summary
Through
The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the
25 largest property casualty insurers in the nation, based on written
premium volume for approximately 2,000 U.S. stock and mutual insurer groups. We
market our insurance products through a select group of independent insurance
agencies in 37 states as discussed in Item 1, Our Business and Our
Strategy, Page 1.
Although
2009 and 2008 were difficult years for our economy, our industry and our
company, our long-term perspective lets us address the immediate challenges
while focusing on the major decisions that best position the company for success
through all market cycles. We believe that this forward-looking view has
consistently benefited our shareholders, agents, policyholders and
associates.
To
measure our progress, we have defined a measure of value creation that we
believe captures the contribution of our insurance operations, the success of
our investment strategy and the importance we place on paying cash
dividends to shareholders. We refer to this measure as our value creation ratio,
or VCR, and it is made up of two primary components: (1) our rate of growth
in book value per share plus (2) the ratio of dividends declared per
share to beginning book value per share. For the period 2010 through 2014,
an annual value creation ratio averaging 12 percent to 15 percent is our primary
performance target. Management believes this non-GAAP measure is a useful
supplement to GAAP information. With heightened economic and
market uncertainty since 2008, we believe the long-term nature of this
ratio is an appropriate way to measure our long-term progress in creating
shareholder value.
When
looking at our longer-term objectives, we see three performance
drivers:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 34
The board
of directors is committed to rewarding shareholders directly through cash
dividends and through authorizing share repurchases. The board also has
periodically declared stock dividends and splits. Through 2009, the company has
increased the indicated annual cash dividend rate for 49 consecutive years, a
record we believe is matched by only 11 other publicly traded companies. The
board regularly evaluates relevant factors in dividend-related decisions, and
the increase reflects confidence in our strong capital, liquidity and financial
flexibility, as well as progress through our initiatives to improve earnings
performance. We discuss our financial position in more detail in Liquidity and
Capital Resources, Page 68.
Strategic
Initiatives Highlights
Management
has worked to identify the strategies that can lead to long-term success, with
concurrence by the board of directors. Our strategies are intended to position
us to compete successfully in the markets we have targeted while appropriately
managing risk. We believe successful implementation of the initiatives that
support our strategies will help us better serve our agent customers, reduce
volatility in our financial results and weather difficult economic, market or
industry pricing cycles.
We
discuss each of these strategies, along with the metrics we use to assess their
progress, in Item 1, Strategic Initiatives, Page 8,
Factors
Influencing Our Future Performance
In 2009,
our value creation ratio result exceeded our target annual average of 12 percent
to 15 percent for the period 2010 through 2014, and in 2008, it was below our
target, as discussed in the review of our financial highlights below. For the
year 2010, we believe our value creation ratio may be below our long-term target
for several reasons.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 35
Our view
of the value we can create over the next five years relies on two assumptions
about the external environment. First, we anticipate some firming of commercial
insurance pricing by the end of 2010. Second, we believe that the economy and
financial markets can resume a growth track by the end of 2010. If those
assumptions prove to be inaccurate, we may not be able to achieve our
performance targets even if we accomplish our strategic objectives.
Other
factors that could influence our ability to achieve our targets
include:
We
discuss in our Item 1A, Risk Factors, Page 23, many potential risks to our
business and our ability to achieve our qualitative and quantitative objectives.
These are real risks, but their probability of occurring may not be high. We
also believe that our risk management programs generally could mitigate their
potential effects, in the event they would occur. We continue to study emerging
risks, including climate change risk and its potential financial effects on our
results of operation and those we insure. These effects include deterioration in
credit quality of our municipal or corporate bond portfolios and increased
losses without sufficient corresponding increases in premiums. As with any risk,
we seek to identify the extent of the risk exposure and possible actions to
mitigate potential negative effects of risk, at an enterprise
level.
We have
formal risk management programs overseen by a senior officer and supported
by a team of representatives from business areas. The team makes
reports to our chairman, our president and chief executive officer and our
board of directors, as appropriate, on risk assessments, risk metrics and
risk plans. Our use of operational audits, strategic plans and departmental
business plans, as well as our culture of open communications and our
fundamental respect for our Code of Conduct, continue to help us manage risks on
an ongoing basis.
Below we
review highlights of our financial results for the past three years. Detailed
discussion of these topics appears in Results of Operations, Page 46, and
Liquidity and Capital Resources, Page 68.
Corporate Financial Highlights
The value
creation ratio discussed in the Executive Summary, Page 34, was 19.7 percent in
2009, negative 23.5 percent in 2008 and negative 5.7 percent in 2007.
The book value per share growth component of the value creation ratio was 13.6
percent during 2009, largely reflecting improved valuation of our investment
portfolio in addition to earnings. In both 2008 and 2007, a decline in
unrealized gains on our investment portfolio was the most significant factor in
the decline in book value as discussed below. In 2009 and 2008, net income also
was significantly below the level of 2007.
Cash
dividends declared per share rose 0.6 percent in 2009, 9.9 percent in 2008 and
6.0 percent in 2007.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 36 Balance Sheet Data
Invested
assets increased significantly for the year 2009 primarily due to a strong rally
in the financial markets, reversing the trend of 2008 from lower fair values for
portfolio investments, largely due to economic factors. Entering 2009, the
portfolio was substantially more diversified and generally better positioned to
withstand short-term fluctuations compared with recent years. The downturn in
the economy during 2008 had a particularly adverse effect on our financial
sector equity holdings, which made up a significant portion of the portfolio
prior to mid-2008. We discuss our investment strategy in Item 1, Investments
Segment, Page 18, and results for the segment in Investment Results of
Operations, Page 64.
Our ratio
of debt to total capital (debt plus shareholders’ equity) decreased during 2009
after rising in 2008. The increase during 2008 was due to the effect on
shareholders’ equity from the declining value of our invested
assets.
Income Statement and Per Share Data
Net
income increased $3 million during 2009, reflecting the after-tax net effect of
three major contributing items: a $132 million increase from net realized
investment gains, partially offset by a $48 million decrease from investment
income and a $74 million decrease from property casualty underwriting results.
Net income declined in 2008 because of a decline in realized investment gains, a
first-ever decline in investment income and a lower aggregate contribution from
our insurance segments. A 2008 pension plan settlement reduced 2008 net
income by $17 million, or 11 cents per share. The transition from a defined
benefit pension plan reduced company risk while providing a company-sponsored
401(k) match to associates.
Weighted
average shares outstanding may fluctuate from period to period due to
repurchases of shares under board authorizations or issuance of shares when
associates exercise stock options. Weighted average shares outstanding on a
diluted basis declined by less than 1 million in 2009, after declining 9 million
in 2008 and 3 million in 2007.
As
discussed in Investment Results of Operation, Page 64, security sales led to
realized investment gains in all three years, although 2008 gains were tempered
by $510 million in other-than-temporary impairment charges. Realized investment
gains and losses are integral to our financial results over the long term. We
have substantial discretion in the timing of investment sales and, therefore,
the gains or losses that are recognized in any period. That discretion generally
is independent of the insurance underwriting process. Also, applicable
accounting standards require us to recognize gains and losses from certain
changes in fair values of securities and for securities with embedded
derivatives without actual realization of those gains and losses.
Lower
income from common stock dividends led to a 6.8 percent decline in pretax net
investment income in 2009, improving on an 11.6 percent decline for 2008, which
was the first decline for this measure in company history. The primary reason
for the decline was dividend reductions by common and preferred holdings,
including reductions during the year on positions subsequently sold or
reduced.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 37 Contribution
from Insurance Operations
The
decline in property casualty written premium growth reflected the competitive
and market factors discussed in Item 1, Commercial Lines and Personal Lines
Property Casualty Insurance Segment, Page 12 and
Page 15.
In both
2009 and 2008, our property casualty insurance operations reported an
underwriting loss after achieving record profitability in 2007. We measure
property casualty underwriting profitability primarily by the combined ratio.
Our combined ratio measures the percentage of each earned premium dollar spent
on claims plus all expenses related to our property casualty operations. A
lower ratio indicates more favorable results and better underlying performance.
In 2009, 2008 and 2007, favorable development on reserves for claims that
occurred in prior accident years helped offset incurred loss and loss expenses.
Reserve development is discussed further in Property Casualty Loss and Loss
Expense Obligations and Reserves, Pages 71 and Page 72. Catastrophe losses
fluctuated dramatically over the three-year period, with higher than
average contributions to the combined ratio of 5.7 and 6.8 percentage points in
2009 and 2008, respectively, following an unusually low 0.8 points in 2007.
Our 10-year historical annual average contribution of catastrophe losses to the
combined ratio was 4.2 percentage points as of December 31, 2009. The
pension plan settlement increased the 2008 combined ratio by
0.8 percentage points.
During
2009, our excess and surplus lines operations contributed $39 million to net
written premiums and $27 million to earned premiums. We began excess and surplus
lines operations in 2008, and performance is consistent with expectations,
including a modest underwriting loss primarily due to start-up expenses related
to technology for processing business.
Our life
insurance segment continued to provide a consistent source of profit. We discuss
results for the segment in Life Insurance Results of Operations, Page 62.
Investment income and realized investment gains from the life insurance
investment portfolio are included in Investments segment results.
Critical Accounting Estimates
Cincinnati
Financial Corporation’s financial statements are prepared using GAAP. These
principles require management to make estimates and assumptions that affect the
amounts reported in the Consolidated Financial Statements and accompanying
Notes. Actual results could differ materially from those estimates.
The
significant accounting policies used in the preparation of the financial
statements are discussed in Item 8, Note 1 of the Consolidated
Financial Statements, Page 94. In conjunction with that discussion, material
implications of uncertainties associated with the methods, assumptions and
estimates underlying the company’s critical accounting policies are discussed
below. The audit committee of the board of directors reviews the annual
financial statements with management and the independent registered public
accounting firm. These discussions cover the quality of earnings, review of
reserves and accruals, reconsideration of the suitability of accounting
principles, review of highly judgmental areas including critical accounting
policies, audit adjustments and such other inquiries as may
be appropriate.
Property
Casualty Insurance Loss And Loss Expense Reserves
We
establish loss and loss expense reserves for our property casualty insurance
business as balance sheet liabilities. These reserves account for unpaid loss
and loss expenses as of a financial statement date. Unpaid loss and loss
expenses are the estimated amounts necessary to pay for and settle all
outstanding insured claims, including incurred but not reported (IBNR) claims,
as of that date.
For some
lines of business that we write, a considerable and uncertain amount of time can
elapse between the occurrence, reporting and payment of insured claims. The
amount we will actually have to pay for such claims also can be highly
uncertain. This uncertainty, together with the size of our reserves, makes the
loss and loss expense reserves our most significant estimate. Gross loss and
loss expense reserves were $4.096 billion at year-end 2009 compared with
$4.040 billion at year-end 2008.
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 individual claims. Experienced
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 38 headquarters
claims supervisors review individual case reserves greater than $35,000 that
were established by field claims representatives. Headquarters claims managers
also review case reserves greater than $100,000.
Our
claims representatives base their case reserve estimates primarily upon
case-by-case evaluations that consider:
Case
reserves of all sizes are subject to review on a 90-day cycle, or more
frequently if new information about a loss becomes available. As part of the
review process, we monitor industry trends, cost trends, relevant court cases,
legislative activity and other current events in an effort to ascertain new or
additional loss exposures.
We also
establish incurred but not reported (IBNR) reserves to provide for all unpaid
loss and loss expenses not accounted for by case reserves:
Our
actuarial staff applies significant judgment in selecting models and estimating
model parameters when preparing reserve analyses. In addition, unpaid loss
and loss expenses are inherently uncertain as to timing and amount.
Uncertainties relating to model appropriateness, parameter estimates and actual
loss and loss expense amounts are referred to as model, parameter and process
uncertainty, respectively. Our management and actuarial staff control for these
uncertainties in the reserving process in a variety of ways.
Our
actuarial staff bases its IBNR reserve estimates for these losses primarily on
the indications of methods and models that analyze accident year data. Accident
year is the year in which an insured claim, loss, or loss expense occurred. The
specific methods and models that our actuaries have used for the past several
years are:
Our
actuarial staff uses diagnostics provided by stochastic reserving software to
evaluate the appropriateness of the models and methods listed above. The
software’s diagnostics have indicated that the appropriateness of these models
and methods for estimating IBNR reserves for our lines of business tends to
depend on a line's tail. Tail refers to the time interval between a typical
claim's occurrence and its settlement. For our long-tail lines such as workers’
compensation and commercial casualty, models from the probabilistic trend family
tend to provide superior fits and to validate well compared with models
underlying the loss development and Bornhuetter-Ferguson methods. The loss
development and Bornhuetter-Ferguson methods, particularly the reported loss
variations, tend to produce the more appropriate IBNR reserve estimates for our
short-tail lines such as homeowner and commercial property. For our mid-tail
lines such as personal and commercial auto liability, all models and methods
provide useful insights.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 39 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, updating parameters
derived from 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 of the likelihood that
statistically significant patterns in historical data may extend into the
future. The four most significant of the key assumptions used by our actuarial
staff and approved by management are:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 40
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 just over 90 percent of our 2009 loss and loss expense reserves
as well as the potential effects on our net income, assuming a 35 percent
federal tax rate. Standard errors and reserve ranges for assorted groupings of
these lines of business cannot be computed by simply adding the standard errors
and reserve ranges of the component lines of business, since such an approach
would ignore the effects of product diversification. See Range of Reasonable
Reserves, Page 72, for more details on our total reserve range. While the table
reflects our assessment of the most likely range within which each line's actual
unpaid loss and loss expenses may fall, one or more lines' actual unpaid loss
and loss expenses could nonetheless fall outside of the indicated
ranges.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 41
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 2009, consolidated fixed maturity investments
exceeded total insurance reserves (including life policy reserves) by more than
$1.930 billion.
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 fair value of
invested assets, changes in legal factors or in the business climate, an
accumulation of costs in excess of the amount originally expected to acquire or
construct an asset, uncollectability of all receivable assets, or other factors
such as bankruptcy, deterioration of creditworthiness, failure to pay interest
or dividends or signs indicating that the carrying amount may not be
recoverable.
The
application of our impairment policy resulted in other-than-temporary impairment
charges that reduced our income before income taxes by $131 million in 2009,
$510 million in 2008 and $16 million in 2007. Impairment charges are recorded
for other-than-temporary declines in value, if, in the asset impairment
committee’s judgment, there is little expectation that the value may be recouped
within a designated recovery period. Other than-temporary impairment losses
represent non-cash charges to income and are reported as realized
investment losses.
Our
portfolio managers monitor their assigned portfolios. If a security is trading
below book value, the portfolio managers undertake additional reviews. Such
declines often occur in conjunction with events taking place in the overall
economy and market, combined with events specific to the industry or operations
of the issuing organization. Management reviews quantitative measurements such
as a declining trend in fair value, the extent of the fair value decline and the
length of time the value of the security has been depressed, as well as
qualitative measures such as pending events, credit ratings and issuer
liquidity. We are even more proactive when these declines in valuation are
greater than might be anticipated when viewed in the context of overall economic
and market conditions. We provide information
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 42 about valuation
of our invested assets in Item 8, Note 2 of the Consolidated Financial
Statements, Page 100.
All
securities valued below 100 percent of book value are reported to the asset
impairment committee for evaluation. Securities valued between 95 percent and
100 percent of book value are reviewed but not monitored separately by the
committee. These assets generally are at this value because of interest
rate-driven factors.
When
evaluating for other-than-temporary impairments, the committee considers the
company’s intent and ability to retain a security for a period adequate to
recover its cost. Because of the company's financial strength, management may
not impair certain securities even when they are trading below book
value.
When
determining OTTI charges for our fixed-maturity portfolio, management places
significant emphasis on whether issuers of debt are current on contractual
payments and whether future contractual amounts are likely to be paid. Our fixed
maturity invested asset impairment policy states that OTTI is considered to have
occurred (1) if we intend to sell the impaired fixed maturity security; (2) if
it is more likely than not we will be required to sell the fixed maturity
security before recovery of its amortized cost basis; or (3) the present value
of the expected cash flows is not sufficient to recover the entire amortized
cost basis. If we intend to sell or it is more likely than not we will be
required to sell, the book value of any such securities is reduced to fair value
as the new cost basis, and a realized loss is recorded in the quarter in which
it is recognized. When we believe that full collection of interest and/or
principal is not likely, we determine the net present value of future cash flows
by using the effective interest rate implicit in the security at the date of
acquisition as the discount rate and compare that amount to the amortized cost
and fair value of the security. The difference between the net present value of
the expected future cash flows and amortized cost of the security is considered
a credit loss and recognized as a realized loss in the quarter in which it
occurred. The difference between the fair value and the net present value of the
cash flows of the security, the non-credit loss, is recognized in other
comprehensive income as an unrealized loss.
When
determining OTTI charges for our equity portfolio, our invested asset impairment
policy considers qualitative and quantitative factors, including facts and
circumstances specific to individual securities, asset classes, the financial
condition of the issuer, changes in dividend payment, the length of time fair
value had been less than book value, the severity of the decline in fair value
below book value, the volatility of the security and our ability and intent to
hold each position until its forecasted recovery.
For each
of our equity securities in an unrealized loss position at December 31, 2009, we
applied the objective quantitative and qualitative criteria of our invested
asset impairment policy for OTTI. Our long-term equity investment philosophy,
emphasizing companies with strong indications of paying and growing dividends,
combined with our strong surplus, liquidity and cash flow, provide us the
ability to hold these investments through what we believe to be slightly longer
recovery periods occasioned by the recession and historic levels of market
volatility. We review the expected recovery period by individual security. Based
on the individual qualitative and quantitative factors, as discussed above, we
evaluate and determine an expected recovery period for each security. A change
in the condition of a security can warrant impairment before the expected
recovery period. If the security has not recovered cost within the expected
recovery period, the security is impaired.
Securities
that have previously been impaired are evaluated based on their adjusted book
value and written down further, if deemed appropriate. We provide detailed
information about securities trading in a continuous loss position at year-end
2009 in Item 7A, Application of Asset Impairment Policy, Page 85.
An other-than-temporary decline in the fair value of a security is
recognized in net income as a realized investment loss.
Securities
considered to have a temporary decline would be expected to recover their book
value, which may be at maturity. Under the same accounting treatment as fair
value gains, temporary declines (changes in the fair value of these securities)
are reflected in shareholders’ equity on our balance sheet in accumulated other
comprehensive income, net of tax, and have no impact on net income.
Fair Value Measurements
Valuation of Financial Instruments
Valuation
of financial instruments, primarily securities held in our investment portfolio,
is a critical component of our year-end financial statement preparation. Fair
Value Measurements and Disclosures, ASC 820-10, defines fair value as the
exit price or the amount that would be (1) received to sell an asset or
(2) paid to transfer a liability in an orderly transaction between
marketplace participants at the measurement date. When determining an exit
price, we must, whenever possible, rely upon observable market data. Prior to
the adoption of ASC 820-10, we considered various factors such as liquidity and
volatility but primarily obtained pricing from various external services,
including broker quotes.
The fair
value measurement and disclosure exit price notion requires our valuation also
to consider what a marketplace participant would pay to buy an asset or receive
to assume a liability. Therefore, while we can
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 43 consider
pricing data from outside services, we ultimately determine whether the data or
inputs used by these outside services are observable or
unobservable.
In
accordance with ASC 820-10, we have categorized our financial instruments, based
on the priority of the inputs to the valuation technique, into a three-level
fair value hierarchy. The fair value hierarchy gives the highest priority to
quoted prices in active markets for identical assets or liabilities (Level 1)
and the lowest priority to unobservable inputs (Level 3). If the inputs used to
measure the financial instruments fall within different levels of the hierarchy,
the categorization is based on the lowest level that is significant to the fair
value measurement of the instrument.
Financial
assets and liabilities recorded on the Consolidated Balance Sheets are
categorized based on the inputs to the valuation techniques as described in Item
8, Note 3, Fair Value Measurements, Page 103.
Level 1 and Level 2 Valuation Techniques
Over 99
percent of the $10.562 billion of securities in our investment portfolio
measured at fair value are classified as Level 1 or Level 2. Financial
assets that fall within Level 1 and Level 2 are priced according to observable
data from identical or similar securities that have traded in the marketplace.
Also within Level 2 are securities that are valued by outside services or
brokers where we have evaluated the pricing methodology and determined that the
inputs are observable.
Included
in the Level 2 hierarchy is a small portfolio of collateralized mortgage
obligations (CMOs) that represented less than 1 percent of the fair value of our
investment portfolio at December 31, 2009. We obtained the CMOs as part of the
termination of our securities lending program during 2008.
Level 3 Valuation Techniques
Financial
assets that fall within the Level 3 hierarchy are valued based upon unobservable
market inputs, normally because they are not actively traded on a public market.
Level 3 corporate fixed-maturity securities include certain private placements,
small issues, general corporate bonds and medium-term notes.
Level 3 state, municipal and political subdivisions fixed-maturity
securities include various thinly traded municipal bonds. Level 3 common
equities include private equity securities. Level 3 preferred equities include
private and thinly traded preferred securities.
Pricing
for each Level 3 security is based upon inputs that are market driven, including
third-party reviews provided to the issuer or broker quotes. However, we placed
in the Level 3 hierarchy securities for which we were unable to obtain the
pricing methodology or we could not consider the price provided as binding.
Pricing for securities classified as Level 3 could not be corroborated by
similar securities priced using observable inputs.
Management
ultimately determined the pricing for each Level 3 security that we considered
to be the best exit price valuation. As of December 31, 2009, total Level 3
assets were less than 1 percent of our investment portfolio measured at fair
value. Broker quotes are obtained for thinly traded securities that subsequently
fall within the Level 3 hierarchy. We obtained two non-binding quotes
from brokers and, after evaluating, our investment professionals typically
selected the lower quote as the fair value.
Employee Benefit Pension Plan
We have a
defined benefit pension plan which was modified during 2008; refer to Item 8,
Note 13 of the Consolidated Financial Statements, Page 109, for additional
information. 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 annually. 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 2009 net pension obligation were a 6.10
percent discount rate and rates of compensation increases ranging from 4.00
percent to 6.00 percent. Key assumptions used in developing the 2009 net pension
expense were a 6.00 percent discount rate, an 8.00 percent expected return on
plan assets and rates of compensation increases ranging from 4.00 percent to
6.00 percent. See Note 13, Page 109 for additional information
on assumptions.
In 2009,
the net pension expense was $11 million. In 2010, we expect the net pension
expense to be $12 million.
Holding
all other assumptions constant, a 0.5 percentage-point change in the discount
rate would affect our 2010 income before income taxes by $1 million.
Likewise, a 0.5 percentage point change in the expected return on plan assets
would affect our 2010 income before income taxes by $1 million.
The fair
value of the plan assets was $42 million less than the accumulated benefit
obligation at year-end 2009 and $52 million less at year-end 2008. The fair
value of the plan assets was $77 million less than the projected plan benefit
obligation at year-end 2009 and $88 million less at year-end 2008. Market
conditions and interest rates significantly affect future assets and liabilities
of the pension plan. In 2010, we expect to contribute approximately
$25 million to our qualified plan.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 44 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 net 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. We assess recoverability of deferred acquisition costs at
the segment level, consistent with the ways we acquire service, manage and
measure profitability. Our standard market insurance operations consist of two
segments, commercial lines and personal lines. We also have deferred acquisition
costs in our excess and surplus lines operation, which is reported in Other. 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. We analyze our acquisition cost assumptions periodically to
reflect actual experience; we evaluate our deferred acquisition cost for
recoverability; and we regularly conduct reviews for potential premium
deficiencies or loss recognition.
Contingent Commission Accrual
Another
significant estimate relates to our accrual for property casualty contingent
(profit-sharing) commissions. We base the contingent commission accrual estimate
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
$81 million in 2009 contributed 2.8 percentage points to the
property casualty combined ratio. If contingent commissions paid were to vary
from that amount by 5 percent, it would affect 2010 net income by $3
million (after tax), or 2 cents per share, and the combined ratio by
approximately 0.1 percentage points.
Separate Accounts
We issue
life contracts referred to as bank-owned life insurance policies (BOLI). Based
on the specific contract provisions, the assets and liabilities for some BOLIs
are legally segregated and recorded as assets and liabilities of the separate
accounts. Other BOLIs are included in the general account. For separate account
BOLIs, minimum investment returns and account values are guaranteed by the
company and also include death benefits to beneficiaries of the contract
holders.
Separate
account assets are carried at fair value. Separate account liabilities primarily
represent the contract holders' claims to the related assets and are carried at
an amount equal to the contract holders’ account value. Generally, investment
income and realized investment gains and losses of the separate accounts accrue
directly to the contract holders and, therefore, are not included in our
Consolidated Statements of Income. However, each separate account contract
includes a negotiated realized gain and loss sharing arrangement with the
company. This share is transferred from the separate account to our general
account 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 2010, the account holder would not pay a surrender charge.
The surrender charge is zero in 2010 and beyond.
At year-end
2009, net unamortized realized losses amounted to $7 million. In accordance
with this separate account agreement, the investment assets must meet certain
criteria established by the regulatory authorities to whose jurisdiction the
group contract holder is subject. Therefore, sales of investments may be
mandated to maintain compliance with these regulations, possibly requiring gains
or losses to be recorded and charged to the general account. Potentially, losses
could be material; however, unrealized losses are approximately $6 million
before tax in the separate account portfolio, which had a book value of
$541 million at year-end 2009.
Recent Accounting Pronouncements
Information
about recent accounting pronouncements is provided in Item 8, Note 1 of the
Consolidated Financial Statements, Page 94. We have determined that recent
accounting pronouncements have not had nor are they expected to have any
material impact on our consolidated financial statements.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 45 Results Of Operations
Consolidated
financial results primarily reflect the results of our four reporting segments.
These segments are defined based on financial information we use to evaluate
performance and to determine the allocation of assets.
We report
as Other the non-investment operations of the parent company and its non-insurer
subsidiaries, CFC Investment Company and CSU Producers Resources Inc. We
also report as Other the results of The Cincinnati Specialty Underwriters
Insurance Company, as well as other income of our standard market property
casualty insurance subsidiary.
We
measure profit or loss for our commercial lines and personal lines property
casualty and life insurance segments based upon underwriting results (profit or
loss), which represent net earned premium less loss and loss expenses and
underwriting expenses on a pretax basis. We also frequently evaluate results for
our consolidated property casualty insurance operations, which is the total of
our commercial, personal plus our excess and surplus insurance results.
Underwriting results and segment pretax operating income are not substitutes for
net income determined in accordance with GAAP.
For our
consolidated property casualty insurance operations as well as the insurance
segments, statutory accounting data and ratios are key performance indicators
that we use to assess business trends and to make comparisons to industry
results, since GAAP-based industry data generally is not as readily
available.
Investments
held by the parent company and the investment portfolios for the insurance
subsidiaries are managed and reported as the investments segment, separate from
the underwriting businesses. Net investment income and net realized investment
gains and losses for our investment portfolios are discussed in the Investment
Results of Operations.
The
calculations of segment data are described in more detail in Item 8, Note 18 of
the Consolidated Financial Statements, Page 115. The following sections review
results of operations for each of the four segments. Commercial Lines Insurance
Results of Operations begins on Page 49, Personal Lines Insurance Results of
Operations begins on Page 57, Life Insurance Results of Operations begins
on Page 62, and Investment Results of Operations begins on Page 64. We begin
with an overview of our consolidated property casualty operations, which is the
total of our commercial lines, personal lines plus excess and surplus lines
results.
Consolidated
Property Casualty Insurance Results Of Operations
In
addition to the factors discussed in Commercial Lines and Personal Lines
Insurance Results of Operations, Page 49 and Page 57, overall growth and
profitability for our consolidated property casualty insurance operations were
affected by a number of common factors. The table below summarizes results of
operations for our property casualty operations.
Our 2009
and 2008 combined ratios before catastrophe losses and reserve development on
prior accident years were substantially higher than 2007 primarily due to lower
pricing prompted by soft market conditions and also due to normal loss cost
inflation. During 2008, we also experienced a higher level of larger commercial
lines losses and the impact of a pension plan settlement cost. The pension plan
settlement increased the 2008 combined ratio by 0.8 percentage points. We
have taken actions to manage expenses, increasing spending in some areas
such as technology to pursue long-term benefits and decreasing in other
areas of our operation. However, lower pricing continues to put upward pressure
on the underwriting expense ratio. This is consistent with industry trends as
A.M. Best estimates that the industry’s 2009 statutory underwriting expense
ratio increased by 1.4 percentage points compared with the year
2006 level.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 46
Changes
in written and earned premiums over the past three years reflected growing price
competition partially offset by fairly stable policy retention rates of renewal
business and increases in new business. New business written directly by
agencies rose in both 2009 and 2008 after declining in 2007. The resurgence in
new business was largely due to the contribution of new agency appointments – in
both new and existing states of operation; the contribution of our excess and
surplus lines business; and more competitive personal lines pricing. Other
written premiums primarily include premiums ceded to our reinsurers as part of
our reinsurance program.
Catastrophe
losses contributed 5.7 percentage points to the combined ratio in 2009, down
somewhat from the 2008 contribution of 6.8 percentage points, the highest
catastrophe loss ratio for our company since 1991. In 2007, catastrophe losses
added just 0.8 percentage points, the lowest ratio over the same period. Our
10-year historical annual average contribution of catastrophe losses to the
combined ratio was 4.2 percentage points as of December 31, 2009. The
following table shows catastrophe losses incurred, net of reinsurance, for
the past three years, as well as the effect of loss development on prior period
catastrophe reserves.
Hurricane
Ike, which reached the Gulf Coast on September 12, 2008, moved into the Midwest
on September 14, causing unusually high winds in Ohio, Indiana and
Kentucky. At December 31, 2009, our gross losses from Hurricane Ike were
estimated at $145 million, making it the single largest catastrophe in the
company’s history. Net of reinsurance, the loss was estimated at $59 million.
Virtually all of the losses reported by our policyholders occurred in the
Midwest.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 47 Catastrophe Losses Incurred
The rise
in the total underwriting expense ratio since 2007 largely was due to the rise
in non-commission underwriting expenses, reflecting our continued investment in
the people and systems necessary for our future growth, and also reflecting
lower premiums. Commission expenses include our profit-sharing, or contingent
commissions, which are primarily based on the profitability of an agency’s
aggregate property casualty book of Cincinnati business. The commission ratio
has declined from the 2007 level. These profit-based commissions generally
fluctuate with our loss and loss expense ratio, with the expense ratio generally
increasing when our loss and loss expense ratio declines. The change in our
pension plan added 0.5 percentage points to the 2008 non-commission underwriting
expense ratio.
The
discussions of our property casualty insurance segments provide additional
detail about these factors.
Commercial Lines Insurance Results Of Operations
Overview Three-year Highlights
Performance highlights for the commercial lines segment include:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 49 Commercial Lines Insurance Premiums
As
commercial lines markets have grown more competitive over the past several
years, we have focused on leveraging our local relationships as well as the
efforts of our agents and the teams that work with them. In this environment, we
have been careful to maintain appropriate pricing discipline for both new and
renewal business as we emphasize the importance of assessing account quality to
our agencies and underwriters. We continue to make case-by-case decisions
not to write or renew certain business. We continue to use rate credits to
retain renewals of quality business and earn new business, but do so selectively
in order to avoid commercial accounts that we believe have insufficient profit
margins. Our experience remains that the larger the account, the higher the
credits needed to write or retain the account, with variations by geographic
region and class of business.
Over the
past three years, we continued to focus on seeking and maintaining adequate
premium per risk exposure as well as pursuing non-pricing means of enhancing
longer-term profitability. Non-pricing means have included deliberate reviews of
each risk, 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. 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
the frontline renewal underwriting that agents will perform. Loss control,
machinery and equipment and field claims representatives continue to conduct
on-site inspections. To assist underwriters, field claims representatives
prepare full reports on their first-hand observations of risk
quality.
Both
renewal and new business reflected the effects of the economic slowdown in many
regions, as exposures declined and policyholders became increasingly focused on
reducing expenses. 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 demand for a business’s goods or
services, as well as a change in its exposure to risk. Policyholders
who 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 2009,
we estimated that policyholders with a contractor-related ISO general liability
code accounted for approximately 34 percent of our general liability
premiums, which are included in the commercial casualty line of business, and
that policyholders with a contractor-related National Council on Compensation
Insurance Inc. (NCCI) workers’ compensation code accounted for approximately
46 percent of our workers’ compensation premiums. The market seeking to
insure contractors has been more adversely affected by the economic slowdown
than some other markets.
The
decline in 2009 agency renewal written premiums was largely driven by pricing
and exposure declines while policy retention rates declined slightly. For
renewal business, our headquarters underwriters talk regularly with agents. Our
field teams are available to assist 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. We measure average changes in
commercial lines renewal pricing as the rate of change in renewal premium for
the new policy period compared with the premium for the expiring policy
period, assuming no change in the level of insured exposures or policy coverage
between those periods for respective policies. For policies renewed during 2009,
the typical pricing decline on average was in the low-single-digit range. For
larger accounts we typically experienced more significant premium declines and
for smaller accounts we sometimes saw little if any premium change at renewal.
The 2009 average represented an improvement from the mid-single-digit range
average pricing decline experienced in 2008. In addition to pricing pressures,
premiums confirmed by audits of policyholder sales and payrolls declined
significantly in 2009. Written and earned premiums from audits decreased $38
million and $52 million, respectively, for the year 2009 compared with
2008.
For new
business, our field associates are frequently in our agents’ offices helping to
judge the quality of each account, emphasizing the Cincinnati value proposition,
calling on sales prospects with those agents, carefully evaluating risk exposure
and providing their best quotes. In 2009, new business premium growth largely
was driven by agencies appointed in recent years, which includes Texas agents
appointed since late 2008 when we entered that state. Texas agencies generated
new business growth of $11 million during
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 50 2009
while other agencies appointed during 2008 and 2009 contributed $23 million of
our new commercial lines business. During 2009 we wrote fewer policies with
annual premiums above $100,000, reflecting significant competition for larger
accounts as many carriers continued to protect their renewal portfolio of
business during the soft pricing environment. Some of our 2009 new business came
from accounts that were not new to the agent. We believe these seasoned accounts
tend to be priced more accurately than business that is less familiar to our
agent because it was recently obtained from a competing agent. As we appoint new
agencies who choose to move accounts to us, we report these accounts as new
business to us.
In 2009,
other written premiums had less of a downward impact on commercial lines net
written premiums than in 2008, primarily due to a lower overall cost for
reinsurance and a smaller adjustment for estimated premiums of policies in
effect but not yet processed. The adjustment for estimated premiums had an
immaterial effect on earned premiums. Higher ceded reinsurance costs were the
primary driver of the larger negative effect in 2008, including $5 million for
ceded premium to reinstate coverage for our catastrophe reinsurance
treaty.
Commercial Lines Insurance Loss and Loss Expenses
Loss and
loss expenses include both net paid losses and reserve changes for unpaid losses
as well as the associated loss expenses.
The trend
for our commercial lines current accident year loss and loss expense ratio
before catastrophe losses over the past three years reflected normal loss cost
inflation as well as softer pricing that began in 2005 and continued through
2009, as discussed above.
Catastrophe
losses were volatile over the three-year period as discussed in Consolidated
Property Casualty Insurance Results of Operations, Page 46. Catastrophe losses
added 3.0, 4.6 and 1.1 percentage points to the commercial lines accident year
loss and loss expense ratios in the table above.
Commercial
lines reserve development for prior accident years continued to net to a
favorable amount in 2009, although it was less than in 2008, as discussed in
Commercial Lines Insurance Segment Reserves, Page 75. Accident years 2008
and 2007 for the commercial lines segment have developed favorably, as indicated
in the table above.
Trends
for commercial lines loss and loss expenses and the related ratios are further
analyzed in Commercial Lines of Business Analysis, Pages 52 and Page 57.
Commercial Lines Insurance Losses by Size
The 2009
decline of $16 million or 2.5 percent in the loss and loss expenses from new
losses and case reserve increases greater than $250,000, net of reinsurance, was
more than offset by a larger decline in commercial lines earned premiums,
causing an increase in the corresponding ratio. Our analysis indicated no
unexpected concentration of these losses and reserve increases by geographic
region, policy inception, agency or field marketing territory. We believe the
inherent volatility of loss experience for larger policies is greater than that
of smaller policies, and we continue to monitor that in addition to general
inflationary trends in loss costs. In 2007, our retention for our property
and casualty working treaties was $4 million.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 51 In 2008, we raised the casualty treaty retention to $5 million
and raised it to $6 million effective January 1, 2009, when we also
raised the property treaty retention to $5 million.
Commercial Lines Insurance Underwriting Expenses
Commercial
lines commission expenses as a percent of earned premium remained stable during
2009. The decrease in the commission expenses ratio in 2008 reflected a
lower level of our profit-sharing, or contingent commissions, which are
primarily based on the profitability of an agency’s aggregate property casualty
book of Cincinnati business.
In 2009,
non-commission underwriting expenses declined slightly, but to a lesser extent
than earned premiums, causing the non-commission underwriting expense ratio
component of the underwriting expense ratio to rise. In 2008, non-commission
underwriting expenses rose on declining earned premiums, which also led to
unfavorable deferred acquisition expense comparisons. Further, in 2008, the
salary cost contribution rose by approximately 0.8 percentage points and
the change in our pension plan contributed 0.5 percentage points to the ratio.
Refinements in the allocation of expenses between our commercial lines and
personal lines segments also contributed to minor variations in the
non-commission underwriting expenses.
Commercial
Lines Insurance Outlook
Industrywide
commercial lines written premiums are projected to decline approximately 5.6
percent in 2010 with the industry combined ratio estimated at 103.7
percent. As discussed in Item 1, Commercial Lines Property Casualty Insurance
Segment, Page 12, over the past several years, renewal and new business pricing
has come under steadily increasing pressure, reinforcing the need for more
flexibility and careful risk selection. Price competition remains intense and
shows no signs of abating in the near term.
We intend
to continue marketing our products to a broad range of business classes, pricing
our products appropriately and taking 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 about
rates, the use of three-year commercial policies and other policy conditions on
a case-by-case basis, even in lines and classes of business that are under
competitive pressure. Nonetheless, we expect commercial lines profitability to
remain under pressure in 2010, in part due to small average pricing declines on
policies renewed during 2009 for which premiums will be earned during
2010.
In Item
1, Strategic Initiatives, Page 8, we discuss the initiatives we are implementing
to achieve our corporate performance objectives. We discuss factors influencing
future results of our property casualty insurance operations in the Executive
Summary, Page 34.
Commercial Lines 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 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 events occur, regardless of when the
losses are actually reported, recorded or paid. For 2009, the only commercial
line of business that exhibited significant adverse profitability trends was
workers’ compensation. Most of the profit deterioration in worker’s compensation
was a result of prior accident year reserve development. As discussed
below, actions we are taking to improve pricing and reduce loss costs are
expected to benefit future profitability trends.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 52 Commercial Casualty
Accident year loss and loss expenses incurred and ratios to earned premiums:
Commercial
casualty is our largest business line. The decline in commercial casualty
premiums reflected the intensifying competition in the casualty market. In
addition, premiums for this business line reflect economic trends, including
changes in underlying exposures, particularly for general liability coverages
where the premium amount is heavily influenced by economically-driven measures
of risk exposure such as sales volume.
The
calendar year total loss and loss expense ratio increased during 2009 largely
because of a lower level, compared with 2008, of favorable development on prior
accident year reserves. Factors contributing to the 2008 higher level of
favorable prior accident year reserve development included refinements to our
IBNR reserve allocation, quarter-to-quarter reductions in actuarial reserve
estimates, the introduction of an additional umbrella liability reserving model,
sooner-than-expected moderation in the inflation trend of allocated loss
expenses and unusual deviations from predictions of reserving methods and
models.
The 2009
current accident year loss and loss expense ratio before catastrophe losses
deteriorated slightly, reflecting lower pricing per exposure and normal loss
cost inflation.
Commercial Property
Accident year loss and loss expenses incurred and ratios to earned premiums:
Commercial
property is our second largest business line. Net written premiums for 2009
increased slightly, largely due to more reinsurance ceded premium in 2008,
including $4 million to reinstate coverage for our catastrophe reinsurance
treaty. The overall declining trend in premium since 2007 also reflected
pricing declines.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 53 The
calendar year loss and loss expense ratio improved compared with 2008, primarily
due to lower catastrophe losses. The 2008 ratio was also adversely affected by
3.4 percentage points for new losses and case reserve increases greater than
$250,000. Development on prior period reserves was relatively stable for all
periods shown.
The 2009
current accident year loss and loss expense ratio before catastrophe losses also
improved compared with 2008. A portion of the higher 2008 ratio was due to a
higher loss expense allocation because of the level of non-catastrophe
weather-related losses. In addition, the refinement in the allocation of IBNR
reserves by accident year accounted for approximately 2 percentage points
of the difference between the 2007 and 2008 ratios.
Commercial Auto
Accident year loss and loss expenses incurred and ratios to earned premiums:
The
decline in commercial auto premiums over the three-year period 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 experiences pricing pressure because it often represents
the largest portion of insurance costs for many commercial
policyholders.
The
calendar year loss and loss expense ratio improved during 2009 due in part to a
higher amount of favorable development on prior accident year reserves. The 2009
accident year loss and loss expense ratio also improved, reflecting more
favorable loss experience due in part to the general slump in U.S. economic
activity and also reflecting volatility in the number of commercial auto losses
greater than $1 million.
Workers Compensation
Accident year loss and loss expenses incurred and ratios to earned premiums:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 54 Workers’
compensation premiums declined sharply in 2009, primarily due to lower exposures
from the weak economy and more selective underwriting and the non-renewal of a
number of policies in our worst pricing tier. In addition, premiums resulting
from audits of policyholder payroll levels declined $28 million, reflecting the
weak economy.
Since we
pay a lower commission rate on workers’ compensation business, this line has a
higher calendar year loss and loss expense breakeven point than our other
commercial business lines. Nonetheless, the ratio was at an unprofitable level
in each of the last three years, and management continues to work to improve
financial performance for this line. During 2009, we began using a predictive
modeling tool to improve risk selection and pricing capabilities. Predictive
modeling increases pricing precision so that our agents can better compete for
the most desirable workers’ compensation business. We also added to our staff of
loss control field representatives, premium audit field representatives and
field claims representatives specializing in workers’ compensation risks. In
early 2010, we implemented direct reporting of workers’ compensation claims,
allowing us to quickly obtain detailed information to promptly assign the
appropriate level of claims handling expertise for each case. Obtaining more
information sooner for specific claims allows for medical care appropriate to
the nature of each injury, benefiting injured workers, employers and agents
while ultimately lowering overall loss costs.
The
workers’ compensation business line includes our longest tail exposures, making
initial estimates of accident year loss and loss expenses incurred more
uncertain. 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. Our workers’ compensation reserve analyses completed during the
first half of 2009 indicated that loss cost inflation was higher than previously
estimated, leading us to make more conservative assumptions about future loss
cost inflation when estimating loss reserves, thereby significantly increasing
losses incurred. Prior analyses attributed a larger share of the rise in claim
payments for recent accident years to exposure growth rather than loss cost
inflation. However, declining claim frequencies reflected in reserving data as
of December 31, 2008, indicated that exposure growth was less of a source of the
rise in claim payments for recent accident years than was loss cost inflation.
The higher estimates of loss cost inflation derived from analyses during
2009 affected reserves estimated for many prior accident years. Accident
years 2006 through 2008 had net favorable development of $4 million, largely due
to favorable development on the loss expense component of the reserves. Accident
years 2000 through 2005 had net unfavorable development of $37 million, and
accident years prior to 2000 had net unfavorable development of $15 million.
Workers’ compensation prior accident year reserve development for full-year 2009
was unfavorable by $48 million for all prior accident years in total
compared with favorable development of $2 million for 2008. As discussed in
Property Casualty Insurance Loss and Loss Expense Reserves, including the table
on Page 42 showing ranges for estimated reserves, the significant strengthening
of reserves during 2009 moved the carried reserves for workers’ compensation
into the upper half of the range.
Specialty Packages
Accident year loss and loss expenses incurred and ratios to earned premiums:
Specialty
packages premiums were relatively flat over the three-year period. Our
commercial lines policy processing system for businessowners policies, which are
included in this business line, already had several of the technology features
we recently introduced to our agents with our new commercial lines policy
processing system, thereby meeting many of the ease of use requirements of our
agencies.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 55 The
calendar year and accident year loss and loss expense ratios reflected the
volatility in catastrophe losses over the three-year period. In addition,
pricing reductions and normal loss cost inflation continued to put upward
pressure on the ratios.
Surety and Executive Risk
Accident year loss and loss expenses incurred and ratios to earned premiums:
Surety
and executive risk premiums declined in 2009 as we non-renewed many policies in
an effort to improve the quality of the financial institution portion of this
book of business. Prior to the credit crisis in 2008, this line of business had
been growing in response to our marketing of these products.
Director
and officer liability coverage accounted for 60.3 percent of surety and
executive risk premiums in 2009 compared with 58.9 percent in 2008 and 62.3
percent in 2007. We have actively managed the potentially high risk of writing
director and officer liability by:
The
calendar year and current accident year loss and loss expense ratios rose
substantially in 2008 and remained high in 2009, driven by director and officer
new losses and case reserve increases greater than $250,000. During 2009, there
were 37 new director and officer losses and case reserve increases, compared
with 38 in 2008 and 20 in 2007. This added approximately $36 million to loss and
loss expenses compared with $43 million in 2008 and $9 million in 2007. The
higher level in both 2009 and 2008 was largely from claims related to prior
lending practices at financial institutions. To address the potential risk
inherent in the financial institutions book of our surety and executive risk
business line moving forward, we continue to work with our agents to limit the
number of new director and officer policies for financial institutions, in
addition to using credit rating and other metrics to carefully re-underwrite
in-force policies when they are considered for renewal.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 56 Machinery and Equipment
Accident year loss and loss expenses incurred and ratios to earned premiums:
Machinery
and equipment premiums continued to rise in 2009. Because of the relatively
small size of this business line, the calendar year and accident year loss and
loss expense ratios can fluctuate substantially.
Personal Lines Insurance Results Of Operations
Overview
— Three-Year Highlights
Performance
highlights for the personal lines segment include:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 57 year loss and loss expense ratio before catastrophe losses also rose substantially, in part due to approximately $20 million, or 2.9 percentage points, from refinements made to the allocation of IBNR reserves by accident year.
Our personal lines statutory combined ratio was 111.4 percent in 2009, 111.6 percent in 2008 and 94.7 percent in 2007. By comparison, the estimated industry personal lines combined ratio was 101.0 percent in 2009, 103.6 percent in 2008 and 96.1 percent in 2007. Our concentration of business in areas hard-hit by catastrophe events contributed to recent results that differed from the overall industry, an issue we are addressing in part through geographic expansion as noted below. The contribution of catastrophe losses to our personal lines statutory combined ratio was 16.1 percentage points in 2009, 14.5 percent points in 2008 and 1.3 percentage points in 2007, compared to an estimated 4.5, 7.5, and 2.1 percentage points, respectively, for the industry.
Personal Lines Insurance Premiums
Personal lines insurance is a strategic component of our overall relationship with many of our agencies and an important component of our agencies' 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 who are attracted by our superior claims service and the benefits of our package approach.
Our personal lines policy retention and new business levels have remained at higher levels following introduction in recent years of a limited program of policy credits for personal auto and homeowner pricing in most of the states in which we operate. The program provided credits for eligible new and renewal policyholders identified as above-average quality risks. Additional pricing and credit changes were implemented in early 2009, further improving pricing for the best accounts, which should help us retain and attract even more of our agents' preferred business.
Our personal lines new business written by our agencies rose significantly in 2009 as the number of agency locations writing our personal lines rose by 133, or 14.4 percent, following an increase of 136 agency locations in 2008. Since early 2008, we have worked to improve our geographic diversification by expanding our personal lines operation to several states less prone to catastrophes. There are seven states where we began writing business or significantly expanded our personal lines product offerings and automation capabilities beginning in 2008, and they accounted for $13 million of our 2009 increase in our personal lines new business written premiums. Those seven states are Arizona, Idaho, Maryland, Montana, North Carolina, South Carolina, and Utah.
For the three-year period, other written premiums, primarily premiums that are ceded to reinsurers and that lower our net written premiums, remained relatively stable. Additional premiums ceded to reinsurers to reinstate our catastrophe reinsurance treaty contributed $9 million to other written premiums in 2008.
Personal Lines Insurance Loss and Loss Expenses
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. Catastrophe losses were unusually high during 2009 and 2008, and also are inherently volatile, as discussed above and in Consolidated Property Casualty Insurance Results of Operations, Page 46. Development on loss and loss expense reserves for prior accident years continued to trend favorably in 2009 as discussed in Personal Lines Insurance Segment Reserves, Page 77.
The increase in the current accident year loss and loss expense ratio before catastrophe losses since 2007 reflects the pricing factors discussed above, normal loss cost inflation and higher non-catastrophe weather-related losses. During 2009, one unusually large fire loss for our homeowner line of business contributed $5 million to personal lines segment losses. In addition, refinements made to the allocation of IBNR reserves by accident year increased the 2008 ratio.
The effect on the loss and loss expense ratio from new losses and case reserve increases greater than $250,000, net of reinsurance, was higher in 2009 than it was in 2008. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 58 Personal Lines Insurance Losses by Size
Personal Lines Insurance Underwriting Expenses
Personal lines commission expense as a percent of earned premium for 2009 was essentially flat compared with 2008. The decrease in the commission expenses ratio in 2008 reflected a lower level of our profit-sharing, or contingent commissions, which are primarily based on the profitability of an agency's aggregate property casualty book of Cincinnati business.
Non-commission underwriting expenses declined in 2009 primarily due to lower depreciation expense on previously capitalized software expenditures. In 2008 there was an unusual expense of $3 million due to a pension charge. Refinements in the allocation of expenses between our commercial lines and personal lines segments also contributed to minor variations between year-to-year comparisons in the non-commission underwriting expenses.
Personal Lines Insurance Outlook
A.M. Best estimates industrywide personal lines written premiums may rise approximately 1.8 percent in 2010, with the combined ratio estimated at 100.3 percent. With improvement in our new business levels and by maintaining our strong policy retention rate along with rate increases in the homeowner line effected in late 2009, we expect our growth rate to be slightly higher than the industry target for 2010. In Item 1, Strategic Initiatives, Page 8, we discuss the initiatives we are implementing to address the unsatisfactory performance of our personal lines segment, in particular the homeowner line of business. We also describe steps that will enhance our response to the changing marketplace. We are aware that our personal lines pricing and loss activity are at levels that could put achievement of our corporate financial objectives at risk if those trends continue. We discuss our overall outlook for our property casualty insurance operations in the Executive Summary, Page 34.
Personal Lines of Business Analysis
We prefer to write personal lines coverages within accounts that include 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 line-of-business data to summarize growth and profitability trends separately for each line. The 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 events occur, regardless of when the losses are actually reported, recorded or paid. For 2009, the personal line of business that exhibited the most significant adverse profitability trend was homeowner. As discussed above, we continue to take action to improve pricing per risk and overall rates, which is expected to improve future profitability trends. In addition, we anticipate that the unusually high
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 59 catastrophe loss level of 2009 may return nearer to the historical average, with the long-term future catastrophe loss ratio improving due to our gradual geographic diversification into states less prone to catastrophe losses.
Personal Auto
Accident year loss and loss expenses incurred and ratios to earned premiums:
Net written premiums for personal auto increased slightly in 2009 as strong new business growth offset pricing decreases taken in early 2009 and business lost due to normal attrition. We continue to monitor and modify selected rates and credits to address our competitive position.
The calendar year loss and loss expense ratio rose slightly over the three-year period. In recent years, we have seen generally higher costs for liability claims, including severe injuries, and we have sought rate increases for liability coverages that partially offset price decreases for physical damage coverages.
Price reductions, in part reflecting our trend toward a higher quality book of business, combined with normal loss cost inflation as the primary drivers in the rise in the accident year loss and loss expense ratio before catastrophe losses since 2007. The 2008 accident year loss and loss expense ratio also reflected refinements made to our IBNR reserve allocation by accident year that contributed approximately 4 percentage points.
Homeowner
Accident year loss and loss expenses incurred and ratios to earned premiums:
Premiums for 2009 were relatively flat compared with 2008. Both years were lower than 2007 and reflected improved new business levels offset by higher reinsurance premiums in both years. Premiums ceded for reinsurance, which reduce premium revenue, were $22 million in 2009; $26 million in 2008,
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 60 including a reinstatement premium of $8 million; and $23 million in 2007. The pricing changes of the past several years 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 and to achieve long-term profitability. Implementation of predictive modeling has provided additional pricing points to target profitability. Various rate changes were implemented beginning in October 2009, including rate increases that respond in part to weather-related loss trends as well as other trends in loss costs. The increases for the homeowner line of business averaged approximately 6 percent in affected states, although some individual policies will see renewal increases in the double-digit range. These actions, in addition to geographic diversification, are important steps we are taking to improve homeowner results.
The calendar year loss and loss expense ratio over the past three years fluctuated with catastrophe losses, non-catastrophe weather-related losses and other large losses. Catastrophe losses have been above our expected range in recent years, averaging 34.5 percent of homeowner earned premium from 2008 to 2009, compared with the most recent 10-year average of 21.9 percent.
The current accident year loss and loss expense ratio before catastrophe losses remained high in 2009, in part due to the same non-catastrophe weather related losses and other large losses that affected the calendar year result. Non-catastrophe weather-related losses contributed about 14.0 percentage points to the 2009 ratio and about 5 percentage points to the 2008 ratio. In addition, the refinements made to our IBNR reserve allocation by accident year and a lower estimate of salvage and subrogation reserves raised the 2008 ratio by about 2 percentage points.
Other Personal
Accident year loss and loss expenses incurred and ratios to earned premiums:
Other personal premiums increased in 2009 reflecting the growth in our personal auto and homeowner lines before the effects of reinsurance. Most of our other personal coverages are endorsed to homeowner or auto policies.
The calendar year and accident year loss and loss expense ratio for other personal improved in 2009. Reserve development on prior accident years can fluctuate significantly for this business line because personal umbrella liability is a major component of other personal losses.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 61 Life Insurance Results Of Operations
Overview Three-year Highlights
Performance highlights for the life insurance segment include:
Life Insurance Results
Life Insurance 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.
Earned premiums increased in 2009 largely because of growth in our term and universal life insurance business. Earned premiums from term insurance grew $10 million, or 13.4 percent, and earned premiums from universal life insurance grew $4 million, or 17.8 percent.
Separate account investment management fee income contributed less than $1 million to total revenue in 2009, compared with a $2 million contribution in 2008 and $4 million in 2007. These fees declined primarily because of a net realized capital loss sharing agreement between the separate account and the general account.
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 32 life field marketing representatives work in partnership with our more than 100 property casualty field marketing representatives. Approximately 70 percent of our term and other life insurance product premiums were generated through our property casualty insurance agency relationships.
Life Insurance Profitability
Although we exclude most of our life insurance company investment income from investment segment results, 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. On a basis that includes investment income and realized gains or losses from life insurance-related invested assets, the life insurance company reported a net profit of $22 million in 2009, compared with a net loss of $19 million in 2008 and a net profit of $65 million in 2007. The life insurance company portfolio had after-tax realized investment losses of $13 million in 2009, including $15 million in other-than-temporary impairment charges, compared with after-tax realized investment losses of $58 million in 2008, which included $66 million in other-than-temporary impairment charges. Realized investment losses were minimal in 2007, when we reported after-tax realized investment gains of $26 million. Realized investment gains and losses are discussed under Investment Results of Operations, Page 64.
Life segment expenses consist principally of:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 62
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. These efficiencies have played a significant role in cost containment and in our ability to increase total premiums and policy count over the past 10 years with minimal headcount additions.
Life Insurance Outlook
Life insurer balance sheets strengthened nicely in 2009 after weathering a difficult 2008. Many companies increased prices or exited selected lines of business to preserve and enhance valuable capital. Our strong surplus position and straight-forward portfolio of products allowed us to maintain our pricing and continue to offer the products and services upon which our agents have come to rely. This strategy led to strong growth in our life and annuity lines in 2009; we expect this trend will continue with respect to life sales but expect some moderation with respect to annuity sales in 2010.
Our property casualty agencies remain the main distribution system for our life insurance segment, and we continue to emphasize securing an increasing share of the life insurance premium produced by these agencies. While other life insurers continue to expand nontraditional distribution channels such as direct sales, we intend to market through agencies affiliated with our property casualty insurance operations or independent life-only agencies. In 2009 our property casualty agencies produced 70 percent and our life-only agencies 30 percent of our life insurance premium. Term insurance continues to fit well with the sales goals of both our property casualty and life-only agencies and remains our largest product line. We continue to introduce new term products with features our agents tell us are important. We will complete a comprehensive review of our term portfolio as well as introduce a new second-to-die universal life product in 2010. We continue to emphasize the cross-serving opportunities of our worksite products for our property casualty agencies' commercial accounts.
As we seek to improve internal efficiencies, we are consolidating our legacy life insurance administrative systems into a single system. We anticipate this effort will be completed by mid-2011. We are also exploring online initiatives including intelligent electronic applications. We expect these projects to directly affect our ability to increase revenue and reduce expenses.
Current statutory laws and regulations require life insurers to hold redundant reserves, particularly for preferred risk underwriting classes. While these redundant reserves have no direct effect on GAAP results, they depress statutory earnings and require a large commitment of capital. Redundant reserves are a significant challenge, not just for our life insurance operations, but for all writers of term insurance and universal life insurance 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 one. 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 of its assumptions and methods to regulatory officials.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 63 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.
Investment Results
Investment Income
The primary drivers of investment income were:
We are investing available cash flow in both fixed income and equity securities in a manner that we believe balances current income needs with longer-term growth goals.
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.
Investment gains or losses are recognized upon the sales of investments or as otherwise required under GAAP. The timing of realized gains or losses from sales can have a material effect on results in any quarter.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 64 However, such gains or losses usually have little, if any, effect on total shareholders' equity because most equity and fixed maturity investments are carried at fair value, with the unrealized gain or loss included as a component of other comprehensive income.
Realized Investment Gains and Losses
As appropriate, we buy, hold or sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. Pretax realized investment gains in the past three years largely were due to the sale of equity holdings.
Net realized investment gains and losses totaling $440 million for the year ended December 31, 2009, reflected:
In 2008, most of the gain was due to sales of holdings of common and preferred stocks of financial services issuers, to reduce our historical weighting in financial sector securities. The majority of these holdings were sold following reductions or elimination of their cash dividends to shareholders. Because of our low cost basis, we were able to record gains on many of these sales despite the decline in overall stock market values during 2008. Realized gains were lower in 2007, although we chose to take gains from partial sales of selected holdings and to sell other holdings because of 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.
We generally purchase fixed income securities with the intention to hold until maturity. Securities that no longer meet our investment criteria, usually due to a change in credit fundamentals, are divested.
Change in the Valuation of Securities with Embedded Derivatives
We have a small portfolio of convertible preferred stocks and bonds, which have an embedded derivative component. In 2009 we recorded $27 million in fair value realized gains compared with $38 million and $11 million in fair value declines for 2008 and 2007. These changes in fair value were due to the application of ASC 815-15-25, which allows us to account for the entire hybrid financial instrument at fair value, with changes recognized in realized investment gains and losses. 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, , for details on the accounting for convertible security embedded options.
Other-than-temporary Impairment Charges
In 2009, we recorded $131 million in write-downs of 50 securities that we deemed had experienced an other-than-temporary decline in fair value versus $510 million for 126 securities in 2008 and $16 million in 2007. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 42. The other-than-temporary impairment charges in 2009 approximated 1.2 percent of our total invested assets at year-end compared with 5.7 percent for 2008. Other-than-temporary impairment charges also include unrealized losses of holdings that we intend to sell but have not yet completed a transaction.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 65 Other-than-temporary impairment charges from the investment portfolio by the asset class we
described in Item 1, Investments Segment, Page 18, are summarized below:
Other-than-temporary impairment charges from the investment portfolio by industry are
summarized as follows:
The decrease in other-than-temporary impairment charges in 2009 was largely due to the improvement in values as asset markets rebounded. The increase in other-than-temporary impairment charges in 2008 was largely due to write-downs of holdings of bonds and common and preferred stocks of financial services issuers, reflecting our historical weighting in this sector and the decline in overall stock market values during 2008.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 66 Investments Outlook
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2010, we expect to continue to allocate a portion of cash available for investment to equity securities, taking into consideration corporate liquidity and income requirements, as well as insurance department regulations and ratings agency comments. We discuss our portfolio strategies in Item 1, Investments Segment, Page 18.
We believe that a weak or prolonged recovery from current economic conditions could heighten the risk of renewed pressure on securities markets, which could lead to additional other-than-temporary impairment charges. Our asset impairment committee continues to monitor the investment portfolio. The current asset impairment policy is described in Critical Accounting Estimates, Asset Impairment, Page 42.
Other
Revenues for our Other businesses increased during 2009, primarily due to earned premiums from our excess and surplus lines business. Other also includes other income of our standard market insurance subsidiary, as well as non-investment operations of the parent company and its subsidiary, CFC Investment Company, and former subsidiary CinFin Capital Management Company. Upon commencing our excess and surplus lines operations in 2008, we also included results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources.
Losses before income taxes for Other were largely driven by interest expense from debt of the parent company plus losses and loss expenses and underwriting expenses from our excess and surplus lines operation.
Taxes
We had $150 million of income tax expense in 2009 compared with $111 million in 2008 and $337 million in 2007. The effective tax rate for 2009 was 25.7 percent compared with 20.7 percent in 2008 and 28.3 percent in 2007.
The change in our effective tax rate was driven by changes in pretax income from underwriting results, investment income from dividends and the amount of realized investment gains and losses. Higher tax-exempt interest and changes in our dividends received deduction in the current year compared with prior years also contributed with the change in the effective tax rates from 2007 to 2009.
Historically, we have pursued 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. See Tax-Exempt Fixed Maturities, Page 19 for further discussion on municipal bond purchases in our fixed-maturity investment portfolio. 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 an immaterial amount of 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. For our non-insurance subsidiaries, the dividend received deduction exempts 70 percent of dividends from qualified equities. Details about our effective tax rate are found on Note 11, Income Taxes, Page 108.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 67 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.
Parent Company Liquidity
The parent company's primary means of meeting liquidity requirements are dividends from our insurance subsidiary, investment income and sale proceeds from investments held at the parent company level. The parent company's primary contractual obligations are interest and principal payments on long- and short-term debt as described under Contractual Obligations, Page 71. Other uses of parent company cash include general operating expenses described under Other Commitments, Page 71, as well as dividends to shareholders and common stock repurchases. As of December 31, 2009, the parent company had $998 million in cash and marketable securities, providing strong liquidity to fund uses of cash.
This table below shows a summary, by the direct method, of the major sources and uses of liquidity by the parent company. Dividends received in 2009 and 2008 from our insurance subsidiary were much lower than in the several years prior to that, in order to maintain strong statutory surplus and financial strength ratings. We expect sources of liquidity to increase in 2010 and beyond, as we anticipate investment income growth and improved profitability for our property casualty operations. A dividend of $50 million was received from our insurance subsidiary in January 2010. The majority of expenditures for the parent company have been consistent during the last three years, and we expect future expenditures to remain fairly stable.
At the discretion of the board of directors, the company can return cash directly to
shareholders:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 68 Insurance Subsidiary Liquidity
Our insurance subsidiary's primary means of meeting liquidity requirements are investment income, sale proceeds from investments held at the subsidiary level and collection of insurance premiums. Property casualty insurance premiums generally are received before losses are paid under the policies purchased with those premiums. While first-year life insurance expenses normally exceed first-year premiums, subsequent premiums are used to generate investment income until the policy benefits are paid or the policy term expires.
Our insurance subsidiaries' primary contractual obligations are property casualty loss and loss expenses and life policyholder obligations as well as certain ongoing operating expenses as shown under Contractual Obligations, Page 71. Other uses of insurance subsidiary cash include payments of dividends to the parent company and other operating expenses as discussed under Other Commitments, Page 71.
This table shows a summary of operating cash flow of the insurance subsidiary (direct method):
Over the past three years, 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. We discuss the factors that affected insurance operations in Commercial Lines and Personal Lines Insurance Results of Operations, Page 48 and Page 57.
Additional Sources of Liquidity
Investing is a primary source of liquidity for both the parent company and our insurance subsidiary operations. For both, cash in excess of operating requirements is invested in fixed-maturity and equity securities. Equity securities provide the potential for future increases in dividend income and for appreciation. In Item 1, Investments Segment, Page 18, we discuss our investment strategy, portfolio allocation and quality.
Income from our investments is the most important investment contribution to cash flow. While we have never sold investments to make claims payments, the sale of investments could provide an additional source of liquidity at either the parent company or insurance subsidiary level, if required, although we follow a buy-and-hold investment philosophy seeking to compound cash flows over the long-term. In addition to possible sales of investments, proceeds of call or maturities of fixed maturities also can provide liquidity. During the next five years, $2.135 billion, or 28.4 percent, of our fixed-maturity portfolio will mature. At year-end 2009, total unrealized gains in the investment portfolio, before deferred income taxes, were $1.026 billion, up from $588 million at year-end 2008. Net unrealized gains in 2009 nearly doubled from year-end 2008, even after a significant amount of gains was realized during 2009. Further, financial resources of the parent company also could be made available to our insurance subsidiaries, if circumstances required. This flexibility would include our ability to access the capital markets and short-term bank borrowings.
One way we seek to maintain a solid financial position and provide capital flexibility is by keeping our ratio of debt to total capital moderate. We target a ratio below 20 percent. At year-end 2009, the ratio was 15.0 percent compared with 16.7 percent at year-end 2008. The decrease in the debt-to-total-capital ratio was due entirely to the increase in shareholders' equity at year-end 2009. Based on our present capital requirements, we do not believe we will need to increase debt levels during 2010. As a result, we believe that changes in our debt-to-capital ratio will again be a function of changes in shareholders' equity.
We had $790 million of long-term debt and $49 million in borrowings on our short-term lines of credit at year-end 2009. We generally have minimized our reliance on debt financing although we may use lines of credit to fund short-term cash needs.
Long-Term Debt
We provide details of our three long-term notes in Item 8, Note 8 of the Consolidated Financial Statements, Page 106. None of the notes are encumbered by rating triggers:
The company's senior debt is rated investment grade by independent ratings firms. On August 2, 2009, Fitch Ratings lowered our senior debt rating from A- to BBB+. Three other rating agencies made no changes
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 69 to our debt ratings in 2009. Our debt ratings from the other rating agencies are: a from A.M. Best, A3 from Moody's Investors Service and BBB+ from Standard & Poor's Ratings Services. The ratings are described in Item 1, Financial Strength, Page 3.
Short-Term Debt
At December 31, 2009, we had two lines of credit with commercial banks amounting to $225 million, with $49 million borrowed. Access to these lines of credit requires compliance with various covenants, including maintaining a minimum consolidated net worth and not exceeding a certain debt-to-capital ratio. As of December 31, 2009, we were well within compliance with all of the covenants under the credit agreements.
Our $75 million unsecured line of credit with PNC Bank, N.A. was established more than five years ago and was renewed effective August 31, 2009, for a one-year term to expire on August 29, 2010. CFC Investment Company, a subsidiary of Cincinnati Financial Corporation, also is a borrower under this line of credit. At year-end 2008, $49 million was outstanding on this line of credit, which was repaid in 2009. PNC Bank is a subsidiary of PNC Financial Services Group, Inc. (NYSE:PNC).
The second line of credit is an unsecured $150 million revolving line of credit administered by The Huntington National Bank. It was established in 2007 and will mature in 2012. CFC Investment Company, a subsidiary of Cincinnati Financial Corporation, also is a borrower under this line of credit. At year-end 2009, there was $49 million outstanding on this line of credit. The Huntington National Bank, a subsidiary of Huntington Bancshares Inc. (NASDAQ:HBAN), is the lead participant with a $75 million share. U.S. Bancorp (NYSE:USB), Bank of America (NYSE:BAC) and Northern Trust Corporation (NASDAQ:NTRS) also participate, each providing $25 million of capacity.
The line of credit includes a swing line sub-facility for same-day borrowing in the amount of $35 million. The credit agreement provides alternative interest charges based on the type of borrowing and our debt rating. The interest rate charged for an advancement is adjusted LIBOR plus the applicable margin. Based on our debt ratings at year-end 2009, interest for Eurodollar rate advances is adjusted LIBOR plus 33 basis points, and for floating rate advances is adjusted LIBOR. Utilization and commitment fees based on Cincinnati Financial Corporation's current debt rating are 5 basis points and 8 basis points, respectively. CFC Investment Company, a subsidiary of Cincinnati Financial Corporation, is a co-borrower under the agreement.
Liquidity and Capital Resources Outlook
A long-term perspective governs all of our major decisions, with the goal of benefiting our policyholders, agents, shareholders and associates over time. While our insurance results remained weak for 2009, even after a strong second half of the year, our improved capital position from year-end 2008 provided adequate cushion. We have taken the necessary steps to protect our capital and are confident in our strategies to return our insurance operations to growth and profitability.
Our consistent cash flows and prudent cash balances continue to create strong liquidity. As of December 31, 2009, we had $557 million in cash and cash equivalents. That strong liquidity and our consistent cash flows gives us the flexibility to meet current obligations while building value by prudently investing where we see potential for both current income and long-term return.
In any year, we consider the most likely source of pressure on liquidity would be an unusually high level of catastrophe losses within a short period of time. This could create additional obligations for our insurance operations by increasing the severity or frequency of claims. To address the risk of unusual insurance loss obligations including catastrophe events, we maintain property casualty reinsurance contracts with highly rated reinsurers, as discussed under 2010 Reinsurance Programs, Page 79. We also monitor the financial condition of our reinsurers because an insolvency could place in jeopardy a portion of our $675 million in outstanding reinsurance recoverables as of December 31, 2009.
Continued economic weakness also has the potential to affect our liquidity and capital resources in a number of different ways, including: delinquent payments from agencies, defaults on interest payments by fixed-maturity holdings in our portfolio, dividend reductions by holdings in our equity portfolio or declines in the market value of holdings in our portfolio.
Further, parent company liquidity could be constrained by State of Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay. During 2010, total dividends that our insurance subsidiary can pay to our parent company without regulatory approval are approximately $365 million.
Off-Balance-Sheet Arrangements
We do not use 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 2009 Annual Report on 10-K Page 70 Obligations
We pay obligations to customers, suppliers and associates in the normal course of our business operations. Some are contractual obligations that define the amount, circumstances and/or timing of payments. We have other commitments for business expenditures; however, the amount, circumstances and/or timing of our other commitments are not dictated by contractual arrangements.
Other Commitments
As of December 31, 2009, we believe our most significant other commitments are:
Contractual Obligations
As of December 31, 2009, we estimate our future contractual obligations as follows:
Our most significant contractual obligations are discussed in conjunction with related insurance reserves in Gross Property Casualty Loss and Loss Expense Payments and Gross Life Insurance Policyholder Obligations on Page 71 and Page 78, respectively. Other future contractual obligations include:
Property Casualty Loss and Loss Expense Obligations and Reserves
Gross Property Casualty Loss and Loss Expense Payments
Our estimate of future gross property casualty loss and loss expense payments of $4.096 billion is lower than loss and loss expense reserves of $4.142 billion as of year-end 2009. The $46 million difference is
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 71 due to life and health loss reserves, as discussed in Item 8, Note 5 of the Consolidated Financial Statements, Page 105.
While we believe that historical performance of property casualty and life loss payment patterns is a reasonable source for projecting future claim payments, there is inherent uncertainty in this estimate of contractual obligations. We believe that we could meet our obligations under a significant and unexpected change in the timing of these payments because of the liquidity of our invested assets, strong financial position and access to lines of credit.
Our estimates of gross property casualty loss and loss expense payments also do not include reinsurance receivables or ceded losses. As discussed in 2010 Reinsurance Programs, Page 79, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance unpaid receivables of $435 million at year-end 2009 are an offset to our gross property casualty loss and loss expense obligations. Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claim severity or frequency due to a catastrophic event. 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 losses under our reinsurance agreements depends on the financial viability of the reinsurers.
We direct our associates and agencies to settle claims and pay losses as quickly as is practical and we made $1.923 billion of net claim payments during 2009. At year-end 2009, net property casualty reserves reflected $2.026 billion in unpaid amounts on reported claims (case reserves), $792 million in loss expense reserves and $843 million in estimates of claims that were incurred but had not yet been reported (IBNR). The specific amounts and timing of obligations related to case reserves and associated loss expenses are not set contractually. The amounts and timing of obligations for IBNR claims and related loss expenses are unknown. We discuss our methods of establishing loss and loss expense reserves and our belief that reserves are adequate in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 38.
The historical pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The effective duration of our consolidated fixed-maturity portfolio was 5.3 years at year-end 2009. By contrast, the duration of our loss and loss expense reserves was approximately three years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow from operations is sufficient to meet these obligations. In addition, investment holdings could be liquidated, if necessary, to meet higher than anticipated loss and loss expenses.
Range of Reasonable Reserves
The company established a reasonably likely range for net loss and loss expense reserves of $3.459 billion to $3.774 billion at year-end 2009, with the company carrying net reserves of $3.661 billion. The likely range was $3.256 billion to $3.592 billion at year-end 2008, with the company carrying net reserves of $3.498 billion. Our loss and loss expense reserves are not discounted for the time-value of money, 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 5 of the Consolidated Financial Statements, Page 105.
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 Critical Accounting Estimates, Reserve Estimate Variability, Page 41.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2009 and 2008. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
Management's best estimate of total loss and loss expense reserves as of year-end 2009 was consistent with the corresponding actuarial best estimate. Management's best estimate of total loss and loss expense reserves as of year-end 2008 also was consistent with the corresponding actuarial best estimate.
Development of Reserves for Loss and Loss Expenses
We reconcile the beginning and ending balances of our reserves for loss and loss expenses at December 31, 2009, 2008 and 2007, in Item 8, Note 5 of the Consolidated Financial Statements, Page 105. The reconciliation of our year-end 2008 reserve balance to net incurred losses one year later recognizes approximately $188 million of favorable reserve development.
The table on the following page shows the development of estimated reserves for loss and loss expenses for the past 10 years.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 72
Section D, cumulative net reserve development, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 1999, had developed favorably by $164 million over 10 years, net of reinsurance, which was reflected in income over the 10 years. The table shows favorable reserve development as a negative number. Favorable reserve development on prior accident years, which represents a negative expense, is favorable to income. The reconciliation shows the effects on income before income taxes in 2009, 2008 and 2007 of changes in estimates of the reserves for loss and loss expenses for all accident years. The effect was favorable to pre-tax income for those three years by $188 million, $323 million, and $244 million, respectively. Our annual review has led us to add to income in each of the past 21 years due to favorable development of reserves on prior accident years.
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 2009 but incurred in 2002 are included in the cumulative deficiency or redundancy amount for 2002 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 reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future reserve development 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.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 73 Development of Estimated Reserves for Loss and Loss Expenses
Asbestos and Environmental Reserves
We carried $118 million of net loss and loss expense reserves for asbestos and environmental claims as of year-end 2009, compared with $114 million for such claims as of year-end 2008. These amounts constitute 3.2 percent and 3.3 percent of total loss and loss expense reserves as of these year-end dates.
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.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 74 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 developed in a reasonably stable fashion since 2004. Between 2006 and 2009, total asbestos and environmental reserves decreased 9.6 percent. Since our exposure to such claims is limited, we believe the paid survival ratio method is sufficient.
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 primarily due to workers' compensation IBNR reserve strengthening, as discussed in Commercial Lines Insurance Results of Operations, Page 49.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 75 The following table shows net reserve changes at year-end 2009, 2008 and 2007 by commercial
line of business and accident year:
Overall favorable development for commercial lines reserves of $147 million in 2009 illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty and workers' compensation. Favorable reserve development of $154 million for the commercial casualty line exceeded the segment total in 2009, while adverse reserve development for the workers' compensation line reduced segment favorable reserve development by $48 million. Drivers of commercial casualty and workers' compensation reserve development are discussed below.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 76
The above points cover drivers of commercial casualty and workers' compensation reserve development in 2009 attributable to unusual deviations from expectations and changes in methods, models, and procedures. An examination of factors contributing to the remaining $41 million of commercial lines favorable reserve development, not accounted for by the commercial casualty and workers' compensation lines, did not turn up any abnormal or unexpected variations. As noted in Critical Accounting Estimates, Key Assumptions - Loss Reserving, Page 40, our models predict that actual loss and loss expense emergence will differ from projections, and we do not attempt to monitor or identify such normal variations.
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 from year-end 2008 due to favorable reserve development and the decline in premiums and exposures for this segment, as we discussed in Personal Lines Insurance Results of Operations, Page 57.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 77 The following table shows net reserve changes at year-end 2009, 2008 and 2007 by personal
line of business and accident year:
Favorable development for personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. Several atypical factors discussed in Commercial Lines Insurance Segment Reserves, Page 75, that contributed to commercial lines segment reserve development in 2009 also contributed to personal lines favorable reserve development.
In consideration of the data's credibility, we analyze commercial and personal umbrella liability reserves together and then allocate the derived total reserve estimate to the commercial and personal coverages. Consequently, all of the umbrella factors that contributed to commercial lines reserve development also contributed to personal lines reserve development through the other personal line, of which personal umbrella coverages are a part. Specifically, refinements in the use of umbrella reserving models, revisions to umbrella trend selections, and refinements in the umbrella reserve allocation all contributed favorably to other personal reserve development in 2009. If our actuaries had reflected all of this information and these related changes in their year-end 2008 reserve estimates, other personal reserves carried at year-end 2008 would have been $19 million lower. Accordingly, favorable reserve development in 2009 for the other personal line and the personal lines segment would have been lower by a like amount.
Life Insurance Policyholder Obligations and Reserves
Gross Life Insurance Policyholder Obligations
Our estimates of life, annuity and disability policyholder obligations reflect future estimated cash payments to be made to policyholders for future policy benefits, policyholders' account balances and separate account liabilities. These estimates include death and disability claims, policy surrenders, policy maturities, annuity payments, minimum guarantees on separate account products, commissions and premium taxes offset by expected future deposits and premiums on in-force contracts.
Our estimates of gross life, annuity and disability obligations do not reflect net recoveries from reinsurance agreements. Ceded life reinsurance receivables were $213 million at year-end 2009. As discussed in
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 78 2010 Reinsurance Programs, Page 79, we purchase reinsurance to mitigate our life insurance risk exposure. At year-end 2009, ceded death benefits represented approximately 49.0 percent of our total policy face amounts in force.
These estimated cash outflows are undiscounted with respect to interest. As a result, the sum of the cash outflows for all years of $3.502 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy reserves and separate accounts for future policy benefits and claims of $2.399 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $2 million of separate accounts liabilities.
We have made significant assumptions to determine the estimated undiscounted cash flows of these policies and contracts that include mortality, morbidity, future lapse rates and interest crediting rates. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results.
Life Insurance Reserves
Gross life policy reserves were $1.783 billion at year-end 2009, compared with $1.551 billion at year-end 2008. 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.
2010 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 avoid 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 about 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 2010 property and casualty reinsurance program include:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 79
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 $65 million under an automatic facultative treaty. For risks with property values exceeding $65 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 most 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 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.
A form of reinsurance is also provided through The Terrorism Risk Insurance Act of 2002 (TRIA). TRIA was originally signed into law on November 26, 2002, and extended on December 22, 2005, in a revised form, and extended again on December 26, 2007. TRIA provides a temporary federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. TRIA now is scheduled to expire December 31, 2014. Under regulations promulgated under this statute, insurers are required to offer terrorism coverage for certain lines of property casualty insurance, including property, commercial multi-peril, fire, ocean marine, inland marine, liability, aircraft and workers' compensation. In the event of a terrorism event defined by TRIA, the federal government would reimburse terrorism claim payments subject to the insurer's deductible. The deductible is calculated as a percentage of subject written premiums for the preceding calendar year. Our deductible in 2009 was $383 million (20 percent of 2008 subject premiums), and we estimate it is $369 million (20 percent of 2009 subject premiums) in 2010.
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 Cincinnati Specialty Underwriters Insurance Company, which began issuing insurance policies in 2008, has separate property and casualty reinsurance treaties for 2010 through Swiss Reinsurance America Corporation. Primary components of the treaties include:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 80
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.
Cincinnati Life, our life insurance subsidiary, purchases reinsurance 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 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 for covered net losses in excess of $9 million. Our recovery is capped at $75 million for losses involving our associates. 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.
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 Item 1A, Risk Factors, Page 23. 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 2009 Annual Report on 10-K Page 81
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.
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:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 82
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 affects companies within that industry to varying degrees.
Risks associated with the five asset classes described in Item 1, Investments Segment, Page 18, 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. We address this risk by attempting to construct a generally laddered maturity schedule that allows us to reinvest cash flows at prevailing rates. Although the potential for a worsening financial condition, and ultimately default, does exist with investment-grade corporate bonds, we address this risk by performing credit analysis and monitoring as well as maintaining a diverse portfolio of holdings.
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 municipal services that 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.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 83 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 18.
Interest Rate Sensitivity Analysis
Because of our strong surplus, long-term investment horizon and ability to hold most fixed-maturity investments to 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.
Our dynamic financial planning model 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 was 5.3 years at year-end 2009, compared with 5.4 years at year-end 2008. A 100 basis point movement in interest rates would result in an approximately 5.3 percent change in the fair value of the fixed maturity portfolio. Generally speaking, the higher a bond is rated, the more directly correlated movements in its fair value are to changes in the general level of interest rates, exclusive of call features. The fair 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 to 200 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 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 2009, short-term investments included $5 million that was frozen in The Reserve's Primary Fund. This amount was received in early 2010.
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. As we saw in 2008, a downturn in the economy can have a negative effect on an equity portfolio. Industry- and company-specific risks also have the potential to substantially affect the value of our portfolio. We implemented new investment guidelines in 2008 to help address these risks by diversifying the portfolio and establishing parameters to help manage exposures.
Our equity holdings represented $2.701 billion in fair value and accounted for approximately 66.8 percent of the unrealized appreciation of the entire portfolio at year-end 2009. See Item 1, Investments Segment, Page 18, for additional details on our holdings.
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.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 84 Application of Asset Impairment Policy
As discussed in Item 7, Critical Accounting Estimates, Asset Impairment, Page 42, our fixed-maturity and equity investment portfolios are evaluated differently for other-than-temporary impairments. The company's asset impairment committee monitors a number of significant factors for indications that the value of investments trading below the carrying amount may not be recoverable. The application of our impairment policy resulted in other-than-temporary impairment charges that reduced our income before income taxes by $131 million in 2009, $510 million in 2008 and $16 million in 2007. Impairments are discussed in Item 7, Investment Results of Operations, Page 64.
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 2009, 355 of the 2,505 securities we owned were trading below 100 percent of book value compared with 944 of the 2,233 securities we owned at year-end 2008 and 373 of the 2,053 securities we owned at year-end 2007.
The 355 holdings trading below book value at year-end 2009 represented 16.8 percent of invested assets and $84 million in unrealized losses.
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 2009 Annual Report on 10-K Page 85 The following table summarizes the investment portfolio:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 86 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, 2009, 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 its 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, 2009. Its report is on Page 89. Deloitte's auditors met with our audit committee to discuss the results of their examination. They have the opportunity to discuss the adequacy of internal controls and the quality of financial reporting without management present.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 87 Managements 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, 2009, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management's assessment was 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, 2009. The assessment led management to conclude that, as of December 31, 2009, 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 audit report on our internal control over financial reporting as of December 31, 2009. This report appears on Page 89.
February 26, 2010
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 88 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, 2009 and 2008, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2009. 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, 2009, 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 statement 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. 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 the 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, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, 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, 2009, 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 to the consolidated financial statements, the company changed its method of accounting for the recognition and presentation of other-than-temporary impairments in 2009.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 89 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
Accompanying notes are an integral part of these statements.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 90 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Accompanying notes are an integral part of these statements.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 91 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
Accompanying notes are an integral part of these statements.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 92 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Accompanying notes are an integral part of these statements.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 93 Notes To Consolidated Financial Statements
1. Summary Of Significant Accounting Policies
Nature of Operations
Cincinnati Financial Corporation operates through our insurance group and two complementary subsidiary companies:
The Cincinnati Insurance Company leads our standard market property casualty insurance group that also includes two subsidiaries: The Cincinnati Casualty Company and The Cincinnati Indemnity Company. This group markets a broad range of standard market business, homeowner and auto policies. The group provides quality customer service to our select group of 1,180 independent insurance agencies with 1,463 reporting locations across 37 states. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life and disability income insurance and annuities, and The Cincinnati Specialty Underwriters Insurance Company, which began offering excess and surplus lines insurance products in 2008.
The two 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, and CFC Investment Company (CFC-I), which offers commercial leasing and financing services to our agents, their clients and other customers.
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 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-based awards. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2009.
Share-based Compensation
We grant qualified and non-qualified share-based compensation under authorized plans. The stock options vest ratably over three years following the date of grant and are exercisable over 10-year periods. In 2008, the committee approved a mix of stock options and restricted stock units for stock-based awards. Stock options granted had similar terms but generally were awarded for fewer shares compared with previous years to accommodate new awards of service-based and performance-based restricted stock units.
Employee Benefit Pension Plan
We sponsor a defined benefit pension plan that was modified during 2008. We froze entry into the pension plan, and only participants 40 years of age or older could elect to remain in the plan. 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. Refer to Note 13, Employee Retirement Benefits, Page 109 for more information regarding our defined benefit pension plan.
Property Casualty Insurance
Property casualty written premiums are deferred and recorded as earned premiums on a pro rata basis over the terms of the policies. We record as unearned premiums the portion of written premiums that applies 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 the policies. Our standard market insurance operations consist of two segments, commercial lines and personal lines. We assess recoverability of deferred acquisition costs at the segment level, consistent with the ways we acquire, service and manage insurance and measure profitability. We also have deferred acquisition costs in our surplus lines operation, which is reported in Other. We analyze our acquisition cost assumptions periodically to reflect actual experience; we evaluate our deferred acquisition cost for recoverability; and we regularly conduct reviews for potential premium deficiencies.
A premium deficiency is recorded when the sum of expected loss and loss adjustment expenses, expected policyholder dividends, unamortized acquisition costs and maintenance costs exceeds the total of unearned premiums and anticipated investment income. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 94 deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency. We did not record a premium deficiency for the three years ended 2009, 2008 and 2007.
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.
Effective in the second quarter 2009, we changed our presentation of underwriting expenses in our consolidated statements of income. We have summarized commissions, insurance operating expenses, increase in deferred acquisition costs and taxes, licenses and fees to a single caption, "Underwriting, acquisition and insurance expenses."
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 consolidated property casualty companies actively write property casualty insurance through independent agencies in 37 states. Our 10 largest states generated 68.1 percent and 68.7 percent of total earned premiums in 2009 and 2008. Ohio, our largest state, accounted for 21.0 percent and 20.9 percent of total earned premiums in 2009 and 2008. Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each accounted for between 4 percent and 9 percent of total earned premiums in 2009. Our largest single agency relationship accounted for approximately 1.2 percent of the company's total earned premiums in 2009. Our largest reinsurer, Swiss Reinsurance Company, accounted for 21.5 percent of total ceded earned premiums.
Policyholder Dividends
Certain workers' compensation policies include the possibility of a policyholder earning a return of a portion of its premium in the form of a policyholder dividend. The dividend generally is 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 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 that 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 2009 Annual Report on 10-K Page 95 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.
Effective in the second quarter 2009, we changed our presentation of underwriting expenses in our consolidated statements of income. We have summarized commissions, insurance operating expenses, increase in deferred acquisition costs and taxes, licenses and fees to a single caption, "Underwriting, acquisition and insurance expenses."
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 an amount equal to the contract holders' account value. At December 31, 2009, the current fair value of the BOLI invested assets and cash exceeded the current fair value of the contract holders' account value by approximately $7 million. If the BOLI projected fair value were to fall below the value we guaranteed, a liability would be 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 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 are highly liquid instruments that include liquid debt instruments with original maturities of less than three months. These are carried at cost and approximate fair value.
Investments
Our portfolio investments are primarily in publicly traded fixed-maturity, equity and short-term investments. Fixed-maturity investments (taxable bonds, tax-exempt bonds, redeemable preferred stocks and collateralized mortgage obligations) and equity investments (common and non-redeemable preferred stocks) are classified as available for sale and recorded at fair value in the consolidated financial
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 96 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 general intent is to hold fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values.
On April 1, 2009, we adopted Accounting Standards Codification (ASC) 320, Recognition and Presentation of Other-Than-Temporary Impairments (OTTI). Our invested asset impairment policy states that fixed maturities the company (1) intends to sell or (2) are more likely than not will be required to sell before recovery of their amortized cost basis are deemed to be other-than-temporarily impaired. The book value of any such securities is reduced to fair value as the new cost basis, and a realized loss is recorded in the period in which it is recognized. When these two criteria are not met, and the company believes that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount to the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the period in which it occurred. The difference between the fair value and the net present value of the cash flows of the security, the non-credit loss, is recognized in other comprehensive income as an unrealized loss. With the adoption of this ASC in the second quarter of 2009, we recognized a cumulative effect adjustment of $106 million, net of tax, to reclassify the non-credit component of previously recognized impairments by increasing retained earnings and reducing accumulated other comprehensive income.
ASC 320 does not allow retrospective application of the new other-than-temporary impairment model. Our Consolidated Statements of Income for the year ended December 31, 2009, are not measured on the same basis as prior period amounts and, accordingly, these amounts are not comparable.
When determining OTTI charges for our equity portfolio, our invested asset impairment policy considers qualitative and quantitative factors, including facts and circumstances specific to individual securities, asset classes, the financial condition of the issuer, changes in dividend payment, the length of time fair value had been less than book value, the severity of the decline in fair value below book value, the volatility of the security and our ability and intent to hold each position until its forecasted recovery.
Included within our other invested assets are life policy loans, venture capital fund investments and investment in real estate. Life policy loans are carried at the receivable value. We use the equity method of accounting for venture capital fund investments. The venture capital funds provide their financial statements to us and generally report investments on their balance sheets at fair value. Investment in real estate consists of one office building that is carried at cost less accumulated depreciation.
We include the non-credit portion of fixed maturities and all other 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 based on the trade date accounting method.
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.
Fair Value Disclosures
We account for our investment portfolio at fair value and apply fair value measurements as defined by ASC 820, Fair Value Measurements and Disclosures, to financial instruments. Fair value is applicable to ASC 320, Investments-Debt and Equity Securities, ASC 815, "Derivatives and Hedging," and ASC 825, Financial Instruments.
We adopted the provisions of Fair Value Measurements on January 1, 2008. Fair Value Measurements defines fair value as the exit price or the amount that would be (1) received to sell an asset or (2) paid to transfer a liability in an orderly transaction between marketplace participants at the measurement date. When determining an exit price we must, whenever possible, rely upon observable market data. 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 in the case of securities that are not publicly traded, we determine the fair value using various inputs including quotes from independent brokers. The fair value of investments not priced by FT Interactive Data is less than 1 percent of the fair value of our total investment portfolio.
For the purpose of ASC 825 disclosure, we estimate the fair value for liabilities of investment contracts and annuities. We also estimate the fair value for assets arising from policyholder loans on insurance contracts. These estimates are developed using discounted cash flow calculations across a wide range of economic interest rate scenarios with a provision for our own credit risk. We base fair value for long-term senior notes
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 97 on the quoted market prices for such notes. We base fair value for notes payable on our year-end outstanding balance.
Derivative Financial Instruments and Hedging Activities
We account for derivative financial instruments as defined by ASC 815, Derivatives and Hedging. The hedging definitions included in ASC 815 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.
Securities Lending Program
During the third quarter of 2008, we terminated our securities lending program.
Lease/Finance
Our leasing 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.
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 39-1/2 years) using straight-line and accelerated methods. Depreciation expense was $48 million in 2009, $35 million in 2008, and $38 million in 2007. We monitor land, building and equipment for potential impairments. Potential impairments may include a significant decrease in the fair 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. There were no recorded land, building and equipment impairments for 2009, 2008 or 2007.
We capitalize and amortize 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 and losses on investments and differences in the recognition of deferred acquisition costs and insurance reserves. We charge deferred income taxes associated with unrealized appreciation and depreciation (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.
There are no amounts in our ASC 740 liability 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 interest expense in the consolidated statements of income.
Subsequent Events
There were no subsequent events requiring adjustment to the financial statements or disclosure.
Pending Accounting Standards
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 98 Adopted Accounting Standards
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 99
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, 2009, 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, 2009, investments with book value of $85 million and fair value of $89 million were on deposit with various states in compliance with regulatory requirements.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 100 The following table analyzes cost or amortized cost, gross unrealized gains, gross unrealized losses, fair value and other-than-temporary impairments (OTTI) in accumulated other comprehensive income (AOCI) for our investments:
At year-end 2009, Procter & Gamble was our largest stock holding of the publicly traded common stock portfolio at 5.8 percent. At year-end 2008 and 2007 our largest stock holding made up 14.5 percent and 28.1 percent of the publicly traded common stock portfolio, respectively. We also diversified our investment portfolio as a result of the fourth-quarter 2009 Pfizer acquisition of Wyeth (NYSE:WYE). In addition to receiving approximately $146 million in cash for our Wyeth shares, we sold approximately 2.4 million shares of Pfizer subsequent to the merger. As a result of these transactions, our stock portfolio exposure to the healthcare sector reduced to 18.0 percent at December 31, 2009, from 24.6 percent at September 30, 2009.
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 2009 Annual Report on 10-K Page 101 Other-than-temporary Impairment Charges
The following table provides the amount of OTTI charges:
The following table provides the amount of credit losses on fixed-maturity securities for which a portion of OTTI has been recognized in other comprehensive income:
During 2009, we impaired 50 securities. At December 31, 2009, 121 fixed-maturity investments with a total unrealized loss of $25 million had been in an unrealized loss position for 12 months or more. Of that total, eight fixed maturity investments were trading below 70 percent of book value with a total unrealized loss of $2 million. Ten equity investments with a total unrealized loss of $26 million had been in an unrealized loss position for 12 months or more as of December 31, 2009. Of that total, no equity investments were trading below 70 percent of book value.
During 2008, we impaired 126 securities. At December 31, 2008, 142 fixed-maturity investments with a total unrealized loss of $78 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity investments were trading below 70 percent of book value. Six equity investments with a total unrealized loss of $41 million had been in an unrealized loss position for 12 months or more as of December 31, 2008, with two trading below 70 percent of book value. As a result of this evaluation, we did not record impairment on the six equity securities in an unrealized loss position in excess of 12 months at December 31, 2008.
During 2007, we impaired 20 securities. 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 of these securities were trading below 70 percent of book value with a total unrealized loss of $6 million. There were no equities trading below book value for 12 months or more.
When determining OTTI charges for our fixed-maturity portfolio, management places significant emphasis on whether issuers of debt are current on contractual payments and whether future contractual amounts are likely to be paid. As required by the new accounting standard for fixed-maturity securities, our invested asset impairment policy states that OTTI is considered to have occurred (1) if we intend to sell the impaired fixed maturity security; (2) if it is more likely than not we will be required to sell the fixed maturity security before recovery of its amortized cost basis; or (3) the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. If we intend to sell or it is more likely than not we will be required to sell, the book value of any such securities is reduced to fair value as the new cost basis, and a realized loss is recorded in the period in which it is recognized. When we believe that full collection of interest and/or principal is not likely, we determine the net present value of future cash flows by using the effective interest rate implicit in the security at the date of acquisition as the discount rate and compare that amount to the amortized cost and fair value of the security. The difference between the net present value of the expected future cash flows and amortized cost of the security is considered a credit loss and recognized as a realized loss in the period in which it occurred. The difference between the fair value and the net present value of the cash flows of the security, the non-credit loss, is recognized in other comprehensive income as an unrealized loss.
With the adoption of ASC 320 in the second quarter of 2009, we recognized a cumulative effect adjustment of $106 million, net of tax, to reclassify the non-credit component of previously recognized impairments by increasing retained earnings and reducing accumulated other comprehensive income. ASC 320 does not allow retrospective application of the new OTTI model. Our Consolidated Statements of Income for the year ended December 31, 2009, are not measured on the same basis as prior period amounts and, accordingly, these amounts are not comparable.
When determining OTTI charges for our equity portfolio, our invested asset impairment policy considers qualitative and quantitative factors, including facts and circumstances specific to individual securities, asset classes, the financial condition of the issuer, changes in dividend payment, the length of time fair
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 102 value had been less than book value, the severity of the decline in fair value below book value, the volatility of the security and our ability and intent to hold each position until its forecasted recovery.
For each of our equity securities in an unrealized loss position at December 31, 2009, we applied the objective quantitative and qualitative criteria of our invested asset impairment policy for OTTI. Our long-term equity investment philosophy, emphasizing companies with strong indications of paying and growing dividends, combined with our strong surplus, liquidity and cash flow, provides us the ability to hold these investments through what we believe to be slightly longer recovery periods occasioned by the recession and historic levels of market volatility. Each quarter we review the expected recovery period for each individual security. Based on the individual qualitative and quantitative factors, as discussed above, we evaluate and determine an expected recovery period for each security. A change in the condition of a security can warrant impairment before the expected recovery period. If the security has not recovered cost within the expected recovery period, the security is impaired.
3. Fair Value Measurements
Fair Value Hierarchy
In accordance with fair value measurements and disclosures, we categorized our financial instruments, based on the priority of the observable and market-based data for valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3). Our valuation techniques have not changed from December 31, 2008, and ultimately management determines fair value.
When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used.
Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:
We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. Reclassification of certain financial instruments may occur when input observability changes. As noted below in the Level 3 disclosure table, reclassifications are reported as transfers in/out of the Level 3 category as of the beginning of the quarter in which the reclassification occurred.
The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis for the periods ended December 31, 2009, and December 31, 2008. We do not have any material liabilities carried at fair value. There were also no significant transfers between Level 1 or Level 2.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 103
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is summarized in the tables below by security type with a summary of changes in fair value for the year ended December 31, 2009 and 2008. As of December 31, 2009, total Level 3 assets were less than 1 percent of financial assets measured at fair value compared with 1.6 percent at December 31, 2008.
For the year ended December 31, 2009, two preferred equity securities totaling $15 million were transferred from Level 3 to Level 2. There was also a $3 million OTTI of one preferred equity during the first quarter of 2009. As a result of the change in use of observable or unobservable inputs throughout 2009,
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 104 corporate fixed-maturity securities decreased $28 million as nine securities totaling $35 million transferred from Level 3 to Level 2 and two securities totaling $7 million transferred from Level 2 to Level 3. At December 31, 2009, total fair value of assets priced with broker quotes and other non-observable market inputs for the fair value measurements and disclosures was $36 million.
4. Deferred Acquisition Costs
This table summarizes components of our deferred policy acquisition costs asset:
5. Property Casualty Loss And Loss Expenses
This table summarizes our consolidated property casualty 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 affect 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 $188 million, $323 million and $244 million in calendar years 2009, 2008 and 2007. 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 $46 million for both 2009 and 2008, and $42 million at December 31, 2007, for certain life and health losses.
6. 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 2009 Annual Report on 10-K Page 105 Here is a summary of our life policy reserves:
Reserves for deferred annuities and other investment contracts were $736 million and $569 million for December 31, 2009, and December 31, 2008, respectively. Fair value for these deferred annuities and investment contracts was $737 million and $460 million for December 31, 2009, and December 31, 2008, respectively. Fair values of liabilities associated with certain investment contracts are calculated based upon internally developed models because active, observable markets do not exist for those items. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers as of December 31, 2009, to account for non-performance risk; (2) the rate of interest credited to policyholders is the portfolio net earned interest rate less a spread for expenses and profit; and (3) additional lapses occur when the credited interest rate is exceeded by an assumed competitor credited rate, which is a function of the risk-free rate of the economic scenario being modeled. The fair value of life policy loans outstanding principal and interest approximated $44 million, compared with book value of $40 million reported in the consolidated balance sheets as of December 31, 2009.
7. Notes Payable
At December 31, 2009 and 2008, we had two lines of credit with commercial banks with an aggregate borrowing capacity of $225 million. Our note payable balance, which approximates fair value, was $49 million at year-end 2009 and at year-end 2008. The $75 million line of credit expires August of 2010. The $150 million line of credit with a $49 million balance expires July of 2012. We had no compensating balance requirements on short-term debt for either 2009 or 2008. Interest rates charged on borrowings ranged from 2.58 percent to 6.86 percent during 2009.
8. Senior Debt
This table summarizes the principal amounts of our long-term debt excluding unamortized discounts:
The fair value of our senior debt approximated $740 million at year-end 2009 compared with $595 million at year-end 2008. Fair value for 2009 and 2008 was determined under ASC 820 based on market pricing of these or similar debt instruments that are actively trading. Fair value can vary with macro economic concerns. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt was reduced slightly from year-end 2008. None of the notes are encumbered by rating triggers.
9. Shareholders Equity And Dividend Restrictions
Our insurance subsidiary declared dividends to the parent company of $50 million in 2009, $160 million in 2008 and $420 million in 2007. 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 2010, the total dividends that our lead insurance subsidiary may pay to our parent company without regulatory approval is approximately $365 million.
As of December 31, 2009, 7.7 million shares of common stock were available for future equity award grants.
Declared cash dividends per share were $1.57, $1.56 and $1.42 for the years ended December 31, 2009, 2008 and 2007, respectively.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 106 Accumulated Other Comprehensive Income
The change in unrealized gains and losses on investments, pension obligations and
derivatives included:
10. Reinsurance
Our consolidated statements of income include earned consolidated property casualty insurance premiums on assumed and ceded business:
Our consolidated statements of income incurred consolidated property casualty insurance loss and loss expenses on assumed and ceded business:
Our consolidated statements of income include earned life insurance premiums on assumed and ceded business:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 107 Our consolidated statements of income include life insurance contract holders' benefits incurred on assumed and ceded business:
11. 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 consolidated balance sheets 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 its subsidiaries. As of December 31, 2009, 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:
ASC 740, Income Taxes
As a result of positions taken in our 2008 federal tax return filed with the IRS, we believe it is more likely than not that tax positions for which we previously carried a liability for unrecognized tax benefits will be sustained upon examination by the IRS.
Below is the unrecognized tax benefit for the years ended December 31:
In May 2008, the IRS concluded the examination phase of its audit of our 2005 and 2006 tax years and presented us with adjustments primarily related to the valuation of our loss reserves. In October 2008, we reached agreement with the IRS settling all issues related to the 2005 and 2006 tax years. As a result of the IRS agreement for tax years 2005 and 2006, management refined certain assumptions used to calculate the unrecognized tax benefits associated with loss reserves, resulting in a revised measurement of the unrecognized tax benefits as of December 31, 2008.
The IRS has begun the audit of tax years 2007 and 2008. It is reasonably possible that a change in our liability for unrecognized tax benefits may occur once the examination phase of this audit has concluded. At this time, we can neither estimate the settlement date of, nor quantify an estimated range for any potential change to our liability for unrecognized tax benefits relating to these years.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 108 In addition to our IRS filings, we file income tax returns in various state jurisdictions. Material amounts of income tax are paid to Ohio, Illinois and Florida. In December 2009, the State of Illinois began an income tax audit of amended returns for tax years 2002 through 2006 as well as an audit of the return filed for tax year 2007. Although we have not yet been presented with the final examination reports for any of these years, we do not expect any material changes as a result of the Illinois audits. With the exception of Illinois, no other state audits are currently under way nor are we aware of any audits pending. Excluding years under examination by Illinois, tax years 2006 and forward remain open for state examination.
12. 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, 2009.
Here are calculations for basic and diluted earnings per share:
The current sources of dilution of our common shares are certain equity-based awards as discussed in Note 17 Stock-Based Associate Compensation Plans, Page 113. The above table shows the number of anti-dilutive stock-based awards at year-end 2009, 2008 and 2007. We did not include these stock-based awards in the computation of net income per common share (diluted) because their exercise would have anti-dilutive effects.
13. Employee Retirement Benefits
We sponsor a defined benefit pension plan and a defined contribution plan (401(k) savings plan). During 2008, we changed the form of retirement benefit we offer some associates to a company match on contributions to the 401(k) plan from the defined benefit pension plan. We froze entry into the pension plan for new associates during 2008. Only participants 40 years of age or older could elect to continue to participate. For participants remaining in the pension plan, we continue to contribute to fund future benefit obligations. Benefits for the defined benefit pension plan are based on years of credited service and compensation level. Contributions are based on the prescribed method defined in the Pension Protection Act. 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.
We also maintain a supplemental executive retirement plan (SERP) with liabilities of approximately $5 million at year-end 2009 and $6 million at year-end 2008. The SERP is included in the obligation and expense amounts in the tables below. The company also makes available to a select group of associates the Cincinnati Financial Corporation Top Hat Savings Plan, a non-qualified deferred compensation plan.
For any participant who left the pension plan, benefit accruals were frozen during 2008. We transferred $60 million of the pension plan's accumulated benefit obligation during 2008 to an intermediary spin-off plan to facilitate the partial curtailment and settlement for these participants. For SERP participants who chose to leave the defined benefit pension plan, benefit accruals were frozen in the SERP as of December 31, 2008. During 2009, the frozen accrued benefit for those participants, collectively amounting to approximately $1 million, transferred to the Top Hat Savings Plan. Beginning in 2009, for these associates, the company has begun matching deferrals to the Top Hat Savings Plan up to the first 6 percent of an associate's compensation that exceeds the compensation limit specified by the Internal Revenue Code of 1986, as amended.
Pursuant to ASC 715-30 we recognized expense of $3 million during 2008 in the consolidated statement of income associated with the partial termination of the qualified pension plan. In addition, we recognized $27 million in the consolidated statement of income during 2008 for a settlement loss associated with the payout to the participants who left the pension plan of the obligation held in their behalf. Included in the charge is the contribution of $24 million to complete funding of benefits that were distributed in 2008 to participants leaving the pension plan.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 109 Matching contributions to our sponsored 401(k) plan, which we began making during 2008, totaled $7 million and $3 million during the years 2009 and 2008. Associates who are not accruing benefits under the pension plan are eligible to receive the company match of up to 6 percent of cash compensation. We also pay all operating expenses for the 401(k) plan. Participants vest in the company match for the 401(k) plan and Top Hat Savings Plan after three years of eligible service.
Defined Benefit Pension Plan Assumptions
Key assumptions used in developing the 2009 net pension obligation were a 6.10 percent discount rate and rates of compensation increases ranging from 4.00 percent to 6.00 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 0.10 percentage points due to market interest rate conditions at year-end 2009. We based the rates of compensation increase on the company's historical data.
Key assumptions used in developing the 2009 net pension expense were a 6.00 percent discount rate, an 8.00 percent expected return on plan assets and rates of compensation increases ranging from 4.00 percent to 6.00 percent. The 8.00 percent return on plan assets assumption is consistent with current expectations of inflation and based partially on the fact that our common stock holdings 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 decreased by 0.25 percentage points due to market interest rate conditions at the beginning of the year.
Here is a summary of the weighted-average assumptions we use to determine our net expense for the plan:
Benefit obligation activity using an actuarial measurement date for our qualified plan and SERP at December 31 follows:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 110 A reconciliation follows of the funded status for our qualified plan and SERP at the end of the measurement period to the amounts recognized in the consolidated balance sheets at December 31:
The weighted-average assumptions used to determine benefit obligations for our qualified plan and SERP 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 high grade corporate bond yields 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, as well as other changes in plan assets and benefit obligations recognized in other comprehensive income for our qualified plan and SERP at December 31:
The total recognized in net periodic benefit cost and other comprehensive income was $25 million, $62 million and $9 million for the periods ended December 31, 2009, 2008 and 2007, respectively. The estimated costs to be amortized from accumulated other comprehensive income into net periodic benefit cost over the next year for our plans are a $2 million actuarial loss and a $1 million prior service cost.
Defined Benefit Pension Plan Assets
The pension plan assets are managed to maximize total return over the long term while providing sufficient liquidity and current return to satisfy the cash flow requirements of the plan. The plan's day-to-day investment decisions are managed by our internal investment department; however, overall investment strategies are agreed upon by our employee benefits committee.
Reflecting the long-term time horizon of pension obligations, during 2009 we allocated 60 percent to 65 percent of the pension portfolio to domestic equity investments, which are priced from highly observable and actively traded markets. The remainder of the portfolio is allocated to domestic fixed-maturity investments and cash. Our corporate bond portfolio is investment grade. The plan does not engage in derivative transactions.
Investments in securities traded on a national securities exchange are valued at the last reported sales price on the last business day of the year. Investments in securities that are traded in active markets are based on quoted market prices at December 31, 2009 and 2008. Investments in securities that are not
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 111 actively traded are valued based on pricing models which the inputs have been corroborated by market data at December 31, 2009 and 2008.
The plan, which ultimately determines fair value, categorized its financial instruments, based on the priority of the observable and market-based data for valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3).
When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used.
Refer to Note 3, Fair Value Measurements, Page 103 for valuation techniques and categorization of financial instruments within the pension plan assets. The methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement.
The following table illustrates the fair value hierarchy for those assets measured at fair value on a recurring basis for period ended December 31, 2009. The pension plan does not have any assets categorized as Level 3. During 2008, plan assets held were 83 percent equity securities, 4 percent fixed maturities and 13 percent cash and cash equivalents.
Our pension plan assets included 642,113 shares of the company's common stock, which had a fair value of $17 million and $19 million at December 31, 2009 and 2008, respectively. The defined benefit pension plan did not purchase or sell any shares of our common stock during 2009 and 2008. The company paid $1 million in cash dividends on our common stock to the pension plan in both 2009 and 2008.
In 2010, we expect to contribute $25 million to our qualified plan. We expect to make the following benefit payments for our qualified plan and SERP, reflecting expected future service:
14. Statutory Accounting Information (Unaudited)
Insurance companies use statutory accounting practices (SAP) as prescribed by regulatory authorities. The primary differences between SAP and GAAP include:
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:
Cincinnati Financial Corporation 2008 Annual Report on 10-K Page 112 Statutory capital and surplus for our insurance subsidiary, The Cincinnati Insurance Company, includes capital and surplus of its four insurance subsidiaries.
15.
Transactions With Affiliated Parties
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $6 million, $6 million and $7 million on premium volume of approximately $36 million, $38 million and $37 million for 2009, 2008 and 2007, respectively.
16.
Commitments And Contingent Liabilities
In the ordinary course of conducting business, the company and its subsidiaries are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving the company's insurance subsidiaries in which the company is either defending or providing indemnity for third-party claims brought against insureds who are litigating first-party coverage claims. The company accounts for such activity through the establishment of unpaid loss and loss adjustment expense reserves. We believe that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, is immaterial to our consolidated financial condition, results of operations and cash flows.
The company and its subsidiaries also are occasionally involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, improper reimbursement of medical providers paid under workers' compensation insurance policies, erroneous coding of municipal tax locations and excessive premium charges for uninsured motorist coverage. The company's insurance subsidiaries also are occasionally parties to individual actions in which extra-contractual damages, punitive damages or penalties are sought, such as claims alleging bad faith in the handling of insurance claims.
On a quarterly basis, we review the outstanding lawsuits seeking such recourse. Based on our year-end review, we believe we have valid defenses to each. As a result, we believe the ultimate liability, if any, with respect to these lawsuits, after consideration of provisions made for estimated losses, is immaterial to our consolidated financial position.
Nonetheless, given the potential for large awards in certain of these actions and the inherent unpredictability of litigation, an adverse outcome could have a material adverse effect on the company's consolidated results of operations or cash flows.
17. Stock-Based Associate Compensation Plans
We currently have four equity compensation plans that together permit us to grant various types of equity awards. We currently grant incentive stock options, non-qualified stock options, service-based restricted stock units and performance-based restricted stock units under our shareholder-approved plans. We also have a Holiday Stock Bonus Plan that permits annual awards of one share of common stock to each full-time associate for each year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant stock to our outside directors as a component of their annual compensation.
We use the modified-prospective-transition method under which we recognize our pretax and after-tax share-based compensation costs, which are summarized below:
Options exercised during the year ended December 31, 2009, had no intrinsic value. The total intrinsic value of options exercised during the years ended December 31, 2008 and 2007 was $1 million and $8 million, respectively. (Intrinsic value is the market price less the exercise price.) Options vested during the years ended December 31, 2009, 2008 and 2007, had no intrinsic value.
As of December 31, 2009, we had $11 million of unrecognized total compensation cost related to non-vested stock options and restricted stock unit awards. That cost will be recognized over a weighted-average period of 1.5 years.
Stock options are granted to associates at an exercise price that is equal to the fair value as reported on the NASDAQ Global Select Market for the grant date and are exercisable over 10-year periods. The stock options generally vest ratably over a three-year period. In determining the share-based compensation amounts, we estimate the fair value of each option granted on the date of grant using the binomial option-pricing model. We make assumptions in four areas to develop the binomial option-pricing model:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 113
During 2009, we issued our common stock to eligible associates under our Holiday Stock Bonus Plan. No stock options, service-based or performance-based restricted stock units were granted to associates during 2009. The following weighted average assumptions were used for grants issued during 2008 and 2007 in determining fair value of share-based compensation:
Here is a summary of options information:
Cash received from the exercise of options was less than $1 million, $4 million and $19 million for the years ended December 31, 2009, 2008 and 2007, respectively. We did not realize a tax benefit on options exercised for the years ended December 31, 2009 and 2008. We realized a $2 million tax benefit on options exercised for the year ended December 31, 2007.
Options outstanding and exercisable consisted of the following at December 31, 2009:
The weighted-average remaining contractual life for exercisable awards as of December 31, 2009, was 3.7 years. A total of 16.9 million shares are authorized to be granted under the shareholder-approved plans. At December 31, 2009, 7.7 million shares were available for future issuance under the plans. During the second quarter of 2009, our shareholders approved the Directors' Stock Plan of 2009, which authorizes 300,000 shares to be granted to our directors. During 2009, we granted 23,944 shares of common stock under the expiring plan to our directors for 2008 board service fees. We currently issue new shares or use treasury shares for stock-based compensation award issues or exercises.
Restricted Stock Units
Service-based and performance-based restricted stock units are granted to associates at fair value of the shares on the date of grant less the present value of the dividends that holders of restricted stock units will not receive on the shares underlying the restricted stock units during the vesting period. Service-based restricted stock units cliff vest three years after the date of grant.
If certain performance targets are attained, performance-based restricted stock units vest on the first day of March after a three-calendar-year performance period. Quarterly, management reviews and determines the likelihood that the company will achieve the performance targets for the outstanding groups of performance-based restricted stock units.
As of December 31, 2009, management assumed that performance targets used for restricted stock unit awards granted during November 2008 would be met, and we recognized related compensation cost.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 114 Management concluded that the company would not meet performance targets for all other performance-based restricted stock unit awards and did not recognize related compensation costs.
Here is a summary of restricted stock unit information for 2009:
18. 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 and its non-insurer subsidiaries, CFC Investment Company and CSU Producers Resources Inc. We also report as Other the results of The Cincinnati Specialty Underwriters Insurance Company, as well as other income of our standard market property casualty insurance subsidiary. Also included in 2009, 2008 and 2007 results for this segment are the operations of a former subsidiary, CinFin Capital Management.
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 investment assets, regardless of ownership, in the investment operations segment.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 115 This table summarizes segment information:
19. Quarterly Supplementary Data (Unaudited)
This table includes unaudited quarterly financial information for the years ended December 31, 2009 and 2008:
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 116
We had no disagreements with the independent registered public accounting firm on accounting and financial disclosure during the last two fiscal years.
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, 2009. 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, 2009, 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 Report of the Independent Registered Public Accounting Firm are set forth in Item 8, Pages 88 and 89.
None
Part III
Our Proxy Statement will be filed with the SEC in preparation for the 2010 Annual Meeting of Shareholders no later than April 2, 2010. 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.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 117
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 118
The "Compensation of Named Executive Officers and Directors," section of our Proxy Statement for our Annual Meeting of Shareholders to be held May 1, 2010, which includes the "Report of the Compensation Committee," "Compensation Committee Interlocks and Insider Participation," and the "Discussion and Analysis," is incorporated herein by reference.
The following sections of our Proxy Statement for our Annual Meeting of Shareholders to be held May 1, 2010, are incorporated by reference: "Governance of Your Company - Director Independence" and "Governance of Your Company - Certain Relationships and Transactions."
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 119
The "Audit-Related Matters," section of our Proxy Statement for our Annual Meeting of Shareholders to be held May 1, 2010, which includes the Proposal 4-Ratification of Selection of Independent Registered Public Accounting Firm," "Report of the Audit Committee," "Fees Billed by the Independent Registered Public Accounting Firm," "Services Provided by the Independent Registered Public Accounting Firm," is incorporated herein by reference.
Part IV
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 120 SCHEDULE I
Cincinnati Financial Corporation and Subsidiaries
Summary of Investments Other than Investments in Related Parties
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 121 SCHEDULE I (CONTINUED)
Cincinnati Financial Corporation and Subsidiaries
Summary of Investments Other than Investments in Related Parties
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 122 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 90.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 123 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 90.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 124 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 90.
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 125 SCHEDULE III
Cincinnati Financial Corporation and Subsidiaries
Supplementary Insurance Information
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 126 SCHEDULE III (CONTINUED)
Cincinnati Financial Corporation and Subsidiaries
Supplementary Insurance Information
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 127 SCHEDULE IV
Cincinnati Financial Corporation and Subsidiaries
Reinsurance
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 128 SCHEDULE V
Cincinnati Financial Corporation and Subsidiaries
Valuation and Qualifying Accounts
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 129 SCHEDULE VI
Cincinnati Financial Corporation and Subsidiaries
Supplementary Information Concerning Property Casualty Insurance Operations
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 130 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.
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 2009 Annual Report on 10-K Page 131 INDEX OF EXHIBITS
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 132
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 133
Cincinnati Financial Corporation 2009 Annual Report on 10-K Page 134
United States Securities and Exchange Commission
Washington, D.C. 20549 Form 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the fiscal year ended December 31, 2009. TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from _____________________ to _____________________. Commission file number 0-4604
Cincinnati Financial Corporation
(Exact name of registrant as specified in its charter)
Ohio
(State of incorporation)
31-0746871
(I.R.S. Employer Identification No.)
6200 S. Gilmore Road
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Document Incorporated by Reference Portions of the definitive Proxy Statement for Cincinnati Financial Corporation's Annual Meeting of Shareholders to be held on May 1, 2010, are incorporated by reference into Part III of this Form 10-K.
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.
|
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Shareholder Information |
Financials & Analysis |
Business Information |
Ratings |
Electronic Delivery |
Investor Contacts |
Safe Harbor | Individuals & Families | Businesses & Organizations | Investors | Independent Agents | Career Seekers | Identity Protection, Phishing and Fraud Home Terms and Conditions Privacy Policies Copyright © 2010, Cincinnati Financial Corporation Investor Contacts |